UNITED STATES 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, 2002 [ ] 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. (check mark) Yes ____No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). ____Yes (check mark) No As of November 14, 2002, there were 5,711,136 shares issued and 5,304,452 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, 2002 (Unaudited) and December 31, 2001 1 Condensed consolidated statements of income for the three months ended September 30, 2002 and 2001 (Unaudited) 2 Condensed consolidated statements of income for the nine months ended September 30, 2002 and 2001 (Unaudited) 3 Condensed consolidated statements of comprehensive income for the three and nine months ended September 30, 2002 and 2001 (Unaudited) 4 Condensed consolidated statements of cash flows for the nine months ended September 30, 2002 and 2001 (Unaudited) 5 - 6 Notes to consolidated financial statements 7 - 9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 - 17 Item 3. Quantitative and Qualitative Disclosures About Market Risk 17 Item 4. Controls and Procedures 17 PART II - OTHER INFORMATION Item 1. Legal Proceedings 17 Item 2. Changes in Securities and Use of Proceeds 17 Item 3. Defaults Upon Senior Securities 17 Item 4. Submission of Matters to a Vote of Security Holders 18 Item 5. Other Information 18 Item 6. Exhibits and Reports on Form 8-K 18 Signatures 19 Certifications 19 - 21 Exhibits 22 - 26 CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION September 30, 2002 and December 31, 2001 September 30, December 31, 2002 2001 - --------------------------------------------------------------------------------------------------------------------- (Dollars in thousands) (Unaudited) ASSETS Cash and due from banks: Interest earning $ 7,508 $ 2,793 Noninterest earning 21,304 12,380 Federal funds sold 5,582 944 Investment securities - available for sale, at fair value 123,533 73,702 Loans-net of unearned income and deferred fees 475,865 306,891 Allowance for loan losses (7,203) (4,286) ------------------- ------------------- Net loans 468,662 302,605 ------------------- ------------------- Premises and equipment, net 10,345 5,009 Accrued interest receivable 2,983 1,853 Deposit premium and goodwill, net 8,268 4,105 Deferred tax assets 3,450 2,033 Other assets 7,519 1,317 ------------------- ------------------- Total assets $ 659,154 $ 406,741 =================== =================== LIABILITIES Deposits: Demand, noninterest bearing $ 38,011 $ 28,470 Savings and interest bearing demand deposits 188,520 101,553 Time deposits 295,399 174,420 ------------------- ------------------- Total deposits 521,930 304,443 ------------------- ------------------- Accrued interest payable 1,023 792 Repurchase agreements 13,348 11,167 Borrowings 59,395 50,000 Other liabilities 6,875 3,356 ------------------- ------------------- Total liabilities 602,571 369,758 SHAREHOLDERS' EQUITY Common stock; 20,000,000 shares authorized; shares issued 2002 - 5,676,776 and 2001 - 3,658,689 56,424 34,805 Retained earnings, substantially restricted 3,949 2,306 Accumulated other comprehensive income 1,455 568 Treasury stock; 2002 - 396,684 shares and 2001 - 61,350 shares (5,245) (696) ------------------- ------------------- Total shareholders' equity 56,583 36,983 ------------------- ------------------- Total liabilities and shareholders' equity $ 659,154 $ 406,741 =================== =================== See Notes to Condensed Consolidated Financial Statements - 1 - CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF INCOME Three Months Ended September 30, 2002 and 2001 2002 2001 - --------------------------------------------------------------------------------------------------------------------- (In thousands except per share data) (Unaudited) Interest income: Loans and loan fees $ 7,407 $ 5,171 Investment securities 1,542 1,236 Federal funds and other interest income 98 134 ------------------- ------------------- Total interest income 9,047 6,541 ------------------- ------------------- Interest expense: Deposits 3,274 3,246 Borrowings and repurchase agreements 804 489 ------------------- ------------------- Total interest expense 4,078 3,735 ------------------- ------------------- Net interest income 4,969 2,806 Provision for loan losses 2,560 300 ------------------- ------------------- Net interest income after provision for loan losses 2,409 2,506 Noninterest income: Service charges and other fees 594 517 Net gain on sale of securities available for sale 518 - Other noninterest income 1,252 666 ------------------- ------------------- Total noninterest income 2,364 1,183 ------------------- ------------------- Noninterest expenses: Salaries and employee benefits 2,313 1,634 Occupancy 399 284 Data processing 224 158 Directors fees 63 55 Advertising 67 86 Furniture and equipment 260 164 Amortization of intangibles 170 153 Other expenses 747 393 ------------------- ------------------- Total noninterest expenses 4,243 2,927 ------------------- ------------------- Net income before income tax expense 530 762 Income tax expense 171 272 ------------------- ------------------- Net income $ 359 $ 490 =================== =================== Earnings per share - basic $ 0.07 $ 0.13 =================== =================== Earnings per share - diluted $ 0.06 $ 0.13 =================== =================== See Notes to Condensed Consolidated Financial Statements - 2 - CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF INCOME Nine Months Ended September 30, 2002 and 2001 2002 2001 - --------------------------------------------------------------------------------------------------------------------- (In thousands except per share data) (Unaudited) Interest income: Loans and loan fees $ 21,663 $ 16,111 Investment securities 4,591 3,560 Federal funds and other interest income 305 461 ------------------- ------------------- Total interest income 26,559 20,132 ------------------- ------------------- Interest expense: Deposits 9,332 10,296 Borrowings and repurchase agreements 2,350 1,331 ------------------- ------------------- Total interest expense 11,682 11,627 ------------------- ------------------- Net interest income 14,877 8,505 Provision for loan losses 3,790 900 ------------------- ------------------- Net interest income after provision for loan losses 11,087 7,605 Noninterest income: Service charges and other fees 1,701 1,220 Net gain on sale of securities available for sale 761 77 Other noninterest income 3,035 1,816 ------------------- ------------------- Total noninterest income 5,497 3,113 ------------------- ------------------- Noninterest expenses: Salaries and employee benefits 6,755 4,728 Occupancy 1,145 847 Data processing 686 470 Directors fees 199 160 Advertising 389 289 Furniture and equipment 825 536 Amortization of intangibles 493 444 Other expenses 2,247 1,324 ------------------- ------------------- Total noninterest expenses 12,739 8,798 ------------------- ------------------- Net income before income tax expense 3,845 1,920 Income tax expense 1,403 131 ------------------- ------------------- Net income $ 2,442 $ 1,789 =================== =================== Earnings per share - basic $ 0.46 $ 0.48 =================== =================== Earnings per share - diluted $ 0.44 $ 0.48 =================== =================== See Notes to Condensed Consolidated Financial Statements - 3 - CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Three and Nine Months Ended September 30, 2002 and 2001 2002 2001 - --------------------------------------------------------------------------------------------------------------------- (In thousands) (Unaudited) Three month periods ended September 30, 2002 and 2001: Net income $ 359 $ 490 Reclassification of gains recognized in net income (518) - Unrealized gains on securities available for sale, net of deferred tax effect 869 777 ------------------- ------------------- Comprehensive income $ 710 $ 1,267 =================== =================== Nine month periods ended September 30, 2002 and 2001: Net income $ 2,442 $ 1,789 Reclassification of gains recognized in net income (761) (77) Unrealized gains on securities available for sale, net of deferred tax effect 1,648 920 ------------------- ------------------- Comprehensive income $ 3,329 $ 2,632 =================== =================== See Notes to Condensed Consolidated Financial Statements - 4 - CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Nine Months Ended September 30, 2002 and 2001 2002 2001 - --------------------------------------------------------------------------------------------------------------- (In thousands) (Unaudited) Cash Flows From Operating Activities Net income $ 2,442 $ 1,789 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of deposit premium 493 444 Depreciation 996 612 Gain on sale of equipment - (2) Gains on sale of securities available for sale (761) (77) Amortization/(accretion) of premiums/(discounts) on on securities, net 609 (144) Deferred income tax expense (benefit) (56) (888) Provision for loan losses 3,790 900 Changes in assets and liabilities: Accrued interest receivable 34 33 Other assets (2,855) (190) Accrued interest payable and other liabilities 144 (645) ------------------- -------------- Net cash provided by operating activities 4,836 1,832 ------------------- -------------- Cash Flows From Investing Activities Loan originations, net of principal repayments (37,117) (34,026) Additions to premises and equipment (909) (637) Proceeds from sale of equipment 1 38 Net (purchase) sale of Federal Home Loan Bank stock 308 (1,495) Purchase of securities available for sale (59,376) (56,535) Proceeds from maturities of securities available for sale 19,630 34,670 Proceeds from sale of securities available for sale 30,205 9,014 Capitalized purchase costs (39) (69) Net cash acquired from purchase of subsidairy 8,649 - ------------------- -------------- Net cash used in investing activities (38,648) (49,040) ------------------- -------------- Cash Flows From Financing Activities Net increase in deposits 61,246 30,682 Net increase in repurchase agreements 2,181 350 Net increase (decrease) in borrowings (7,019) 15,000 Cash dividends paid (535) - Issuance of common stock for options 765 - Purchase of common stock (4,549) (427) ------------------- -------------- Net cash provided by financing activities $ 52,089 $ 45,605 ------------------- -------------- (continued on next page) See Notes to Condensed Consolidated Financial Statements - 5 - CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Nine Months Ended September 30, 2002 and 2001 2002 2001 - ------------------------------------------------------------------------------------------------------- (In thousands) (Unaudited) Net change in cash and cash equivalents $ 18,277 $ (1,603) Cash and cash equivalents: Beginning 16,117 28,426 ------------------- ------------------- Ending $ 34,394 $ 26,823 =================== =================== Supplemental Disclosure of Cash Flow Information Transfer from loans to real estate acquired through foreclosure $ 1,419 $ - =================== =================== Dividends payable $ 264 $ - =================== =================== Cash paid for: Income taxes $ 1,775 $ 929 =================== =================== Interest $ 11,451 $ 11,686 =================== =================== Purchase of First Community Financial Corp: Loans, net of reserves $ (134,149) $ - Investments (39,001) - Other assets acquired (10,435) - Goodwill and deposit premium (4,617) - Deposits 156,241 - Borrowings 16,414 - Other liabilities assumed 3,342 - Issuance of stock 20,854 - ------------------- ------------------- Net cash and cash equivalents acquired $ 8,649 $ - =================== =================== - 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") and Capital Bank Investment Services ("CBIS"). The interim financial statements have been prepared in accordance with generally accepted accounting principles. Accordingly, 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 2001 Annual Report on Form 10-K. 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, 2002 are not necessarily indicative of the results of operations that may be expected for the year ended December 31, 2002. The accounting policies followed are as set forth in Note 1 of the Notes to Financial Statements in the Company's 2001 Annual Report on Form 10-K. 2. Acquisition of First Community Financial Corporation On January 18th, 2002, the Company acquired First Community Financial Corporation ("First Community") in Burlington, North Carolina., the holding company for Community Savings Bank, Inc. ("Community Savings Bank"). Community Savings Bank was originally chartered in 1934, and its market area consists of the communities in Alamance County, North Carolina. Community Savings Bank primarily engaged in soliciting deposit accounts from businesses and the general public and making commercial loans, construction loans, residential real estate loans, home equity line of credit loans, consumer loans and various investments. Each First Community share of common stock was exchanged for 1.30275 shares of Capital Bank Corporation common stock plus $16.20 cash or alternatively for all cash or all stock. As a result of the acquisition, the Company issued an additional 1.9 million shares of stock. The transaction was accounted for under the purchase method and was intended to qualify as a tax-free reorganization under Section 368(a) of the Internal Revenue Code. The following table reflects the unaudited pro forma combined results of operations, assuming the acquisition had occurred at the beginning of fiscal 2001: 2002 2001 ------------------- ------------------- (In thousands except per share amounts) Net interest income $ 15,174 $ 13,503 Net income 2,546 2,510 Net earnings per diluted share 0.46 0.44 In management's opinion, these unaudited pro forma amounts are not necessarily indicative of what actual combined results of operations might have been if the acquisition had been effective at the beginning of fiscal 2001. A summary of estimated fair values of assets acquired and liabilities assumed were as follows: - 7 - (In thousands) Loans receivable $ 134,149 Investments 39,001 Premises and equipment 5,424 Goodwill 3,835 Deposit premium 782 Other assets 11,261 Deposits (156,241) Borrowings (16,414) Other liabilities (3,342) --------------- Investment in subsidiary, net of dividends to shareholders and capitalized acquisition costs $ 18,455 =============== 3. Comprehensive Income Comprehensive income includes net income 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 relate to unrealized gains and losses on securities available for sale, net of the applicable income tax effect. The Company's comprehensive net income and information concerning the Company's other comprehensive income items for the three and nine month periods ended September 30, 2002 and 2001 are as shown above in the Company's Condensed Consolidated Statements of Comprehensive Income. 4. Earnings 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 Capital Bank Corporation, 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, 2002 and 2001. 2002 2001 ------------------- ------------------- (Dollars in thousands) (Unaudited) Three month periods ended September 30, 2002 and 2001: Income available to stockholders - basic and diluted $ 359 $ 490 =================== =================== Shares used in the computation of earnings per share: Weighted average number of shares outstanding - basic 5,375,899 3,711,284 Incremental shares from assumed exercise of stock options 219,068 54,716 ------------------- ------------------- Weighted average number of shares outstanding - diluted 5,594,967 3,766,000 =================== =================== - 8 - 2002 2001 ------------------- ------------------- (Dollars in thousands) (Unaudited) Nine month periods ended September 30, 2002 and 2001: Income available to stockholders - basic and diluted $ 2,442 $ 1,789 =================== =================== Shares used in the computation of earnings per share: Weighted average number of shares outstanding - basic 5,345,572 3,722,557 Incremental shares from assumed exercise of stock options 205,172 35,692 ------------------- ------------------- Weighted average number of shares outstanding - diluted 5,550,744 3,758,249 =================== =================== Options to purchase 689,000 shares of common stock were used in the diluted calculation. All options currently issued under existing plans were included in the diluted calculation because the average fair market value of a common share of stock was greater than each option exercise price. 5. Income Taxes Prior to the three month period ended March 31, 2001, the Corporation recorded minimal net income tax expenses. This was due primarily to the generation of consolidated net operating losses during the start up phase and the establishment of a valuation allowance against deferred tax assets until such time as the Company demonstrated the ability to utilize those deferred tax assets in the future. Management determined during the three month period ended March 31, 2001 that the Company would more likely than not be able to utilize those assets in the future. Accordingly, during the period ended March 31, 2001, the remaining valuation allowances were reversed and all reserved deferred tax assets were recorded on the consolidated financial statements of the Company, resulting in a one time net tax benefit of $356,000. 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, 2002 and 2001 for Capital Bank Corporation and its wholly owned subsidiaries, Capital Bank and Capital Bank Investment Services, Inc. This discussion and analysis is intended to provide pertinent information concerning financial position, results of operations, liquidity, and capital resources. 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 and Section 21E of the Securities Exchange Act of 1934, 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 - 9 - 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 Exhibit 99.3 to this report, the Company's periodic reports and other filings with the SEC. Overview Capital Bank Corporation (the "Company") is a financial holding company incorporated under the laws of North Carolina on August 10, 1998. The Company's election to become a financial holding company was effective April 23, 2001. The Company's primary function is to serve as the holding company for its wholly-owned subsidiaries, Capital Bank (the "Bank") and Capital Bank Investment Services, Inc. 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. At a special meeting of shareholders held on March 26, 1999, the shareholders of the Bank approved the reorganization of the Bank into Capital Bank Corporation. In the holding company reorganization, the shareholders of the Bank each received a right to one share of Company stock for each share of Bank stock that they owned. Prior to April 14, 2000, the Bank operated primarily throughout the central part of North Carolina with branch facilities located in Raleigh (1), Cary (2), Sanford (3), and Siler City (1). In April, 2000, the Bank acquired 5 branches from another area financial institution which was accounted for as a purchase transaction. The transaction included branches in the eastern part of North Carolina including Oxford (2), Warrenton (1), Seaboard (1), and Woodland (1). In June, 2000, the Bank opened a new branch and moved its corporate headquarters to an office on Glenwood Avenue in Raleigh, North Carolina. In January 2001, the Bank opened a third branch in Raleigh. On March 1, 2001, Capital Bank Corporation announced that it had formed Capital Bank Investment Services, Inc. ("CBIS"), an investment services subsidiary and agreed to acquire an independent branch brokerage office located in Raleigh, North Carolina. CBIS makes available a full range of non-deposit investment services to individuals and corporations, including customers of the Bank. These investment services include full-service securities brokerage, asset management, financial planning and retirement services, such as 401(k) plans, all provided exclusively through a strategic alliance with Raymond James Financial Services, Inc. ("Raymond James"). These services will be available in the offices of the Bank through registered investment representatives. On October 5, 2001, the Company entered into a definitive agreement to acquire First Community Financial Corporation ("First Community") in Burlington, North Carolina, the holding company for Community Savings Bank, Inc. ("Community Savings Bank"). Community Savings Bank operates in the communities in and around Burlington and Graham (Alamance County), and was primarily engaged in soliciting deposit accounts from businesses and the general public and making commercial loans, construction loans, residential real estate loans, home equity line of credit loans, consumer loans and various investments. The acquisition was approved at a special shareholder meeting on January 17, 2002 and the transaction took place effective the close of business on January 18, 2002. Each First Community share of common stock was exchanged for 1.30275 shares of Capital Bank Corporation common stock - 10 - plus $16.20 cash or, alternatively, for all cash or all stock. The transaction was accounted for under the purchase method and was intended to qualify as a tax-free reorganization under Section 368(a) of the Internal Revenue Code. On May 1, 2002, the Company entered into a definitive agreement to acquire High Street Corporation ("High Street") in Asheville, North Carolina. High Street was incorporated on October 30, 2001 to serve as the holding company for High Street Banking Company ("High Street Bank"). High Street has had no significant assets other than the outstanding capital stock of High Street Bank. High Street Bank was originally incorporated on April 25, 1997, and its market area consists of the communities of Asheville and Hickory, North Carolina. High Street Bank is primarily engaged in soliciting deposit accounts from businesses and the general public and making commercial loans, construction loans, residential real estate loans, home equity line of credit loans, consumer loans and various investments. The Company has received all required approvals and management anticipates that the merger will be completed on or about December 1, 2002. As of September 30, 2002, High Street Corporation had consolidated assets of $161.1 million, consolidated loans of $127.7 million, consolidated deposits of $134.5 million and consolidated shareholders' equity of $15.2 million. The Company has no operations other than those of its subsidiaries, Capital Bank and Capital Bank Investment Services, Inc. The Bank is a full-service community bank and the CBIS is a full service brokerage firm. The Company's profitability depends principally upon the net interest income, provision for loan losses, noninterest income and noninterest expenses of the Bank and the net commissions generated by CBIS. Critical Accounting Policies The accounting policies followed are as set forth in Note 1 of the Notes to Financial Statements in the Company's 2001 Annual Report on Form 10-K . The Company has not experienced any material change in its critical accounting policies since December 31, 2001. Financial Condition Total consolidated assets of the Company at September 30, 2002 were $659.2 million compared to $406.7 million at December 31, 2001, an increase of $252.5 million, or 62%. On September 30, 2002, loans, including loans held for sale of $7.6 million, were $475.9 million, up $169.0 million, or 55%, compared to December 31, 2001. Investment securities were $123.5 million and federal funds sold were $5.6 million at September 30, 2002, up $49.8 million and $4.6 million, respectively, from December 31, 2001. During the nine month period ended September 30, 2002, cash and cash equivalents, including federal funds sold, increased by $18.3 million. All increases were primarily the result of the acquisition of First Community and its subsidiary bank, Community Savings Bank, as of January 18, 2002 as described above and through internal growth of existing branches. Loans and investments acquired were $173.1 million. Earning assets represented 93% of total assets as of September 30, 2002. The allowance for loan losses as of September 30, 2002 was $7.2 million and represented approximately 1.51% of total loans. Management believes that the amount of the allowance is adequate at this time. - 11 - Deposits as of September 30, 2002 were $521.9 million, an increase of $217.5 million or 71% from December 31, 2001, primarily the result of deposits acquired from First Community of $156.2 million and through internal growth. As a result, the acquired deposits caused the Company's deposit mix to change with higher rate Certificates of Deposit ("CDs") representing a larger portion of total deposits for part of the year. The increase in CDs partially offset a trend towards lower rate funds that the Company had moved towards over the previous year. However, due to the current low CD rate environment, many depositors have shifted funds into money markets and interest bearing checking products causing the portfolio mix as of September 30, 2002 to approximate the December 31, 2001 mix with CDs representing 57% of total deposits. During the nine month period ended September 30, 2002, certificates of deposit increased by $121.0 million, or 69% from $174.4 million to $295.4 million. At the same time, noninterest bearing demand deposit accounts increased $9.5 million, or 34%, from $28.5 million to $38.0 million and savings and interest bearing demand deposit accounts increased $87.0 million, or 86%, from $101.6 million to $188.5 million. During 2001, the Company's dependency on CDs declined as the result of a conscious effort on management's part to attract lower cost core deposits such as money market and interest bearing checking accounts along with an effort to reduce the overall rates paid on CDs while still remaining price competitive. Management intends to continue with this strategy throughout the remainder of 2002. Borrowings increased from $50.0 million as of December 31, 2001 to $59.4 million as of September 30, 2002, as the Company assumed the outstanding borrowings of First Community, amounting to approximately $16.4 million, along with its other assets and liabilities. Both Capital Bank Corporation and First Community took advantage of the low rates offered by the Federal Home Loan Bank during the latter part of 2001 and leveraged those additional borrowings into higher yielding investments. Total consolidated shareholders' equity was $56.6 million as of September 30, 2002, an increase of $19.6 million from December 31, 2001, due primarily to the issuance of additional common stock as a part of the acquisition of First Community. Results of Operations For the three month period ended September 30, 2002, the Company reported net income of $359,000 or $.06 per diluted share compared to $490,000 or $.13 per diluted share for the same period in 2001. The decline in net income resulted because significant improvements in other areas of operating performance were offset by a $2.6 million provision for loan losses during the three month period ended September 30, 2002, compared to a $300,000 provision for the same three month period in 2001. This provision boosted the allowance for loan losses to 1.51% of total loans and covered charge-offs, net of recoveries, of approximately $2.2 million in loans, most of which related to two large commercial borrowers. While the higher provision negatively impacted profitability, earnings benefited from strength in other key areas such as net interest income, which increased 77% to $5.0 million from $2.8 million in the same period of 2001, and noninterest income, which doubled from the same period last year. Noninterest expense increased only 45% by comparison. For the nine month period ended September 30, 2002, the Company reported net income of $2.4 million or $.44 per diluted share compared to $1.8 million or $.48 per diluted share for the same - 12 - period in 2001. Earnings for the year were also negatively impacted by the increased loan loss provisions as a result of several isolated loan charge-offs. Net interest income in the first nine months of 2002 was $14.9 million, up 75% compared to $8.5 million in the same period of 2001 due primarily to increased balances in loans and deposits. Pretax income for the nine month period ended September 30, 2002 was $3.8 million, an increase of $1.9 million or 100% over the $1.9 million recorded during the same period in 2001. During the period ended March 31, 2001, the Company recorded a one time reversal of valuation allowances on deferred income tax assets done as a result of continued trends of profitability. See Note 4 in Part I, Item 1 of this report for additional information. This reversal, net of current tax expense for the period, resulted in a net tax benefit of $356,000 recorded in the first quarter of 2001. For the nine month period ended September 30, 2002, income tax expense was $1.4 million compared to $131,000 recorded for the same period in 2001. During 2001, the rapid decline in short term interest rates had a negative impact on interest margins as the yield on the Company's earning assets adjusted downward at a faster rate than the interest rates paid on deposits. As rates have stabilized during the first nine months of 2002, the average rate paid on deposits has adjusted downward while the yields on assets have remained relatively stable resulting in an increase in the overall net interest spread. The Company's net interest margin (net interest income as a percentage of average earning assets) for the three and nine month periods ended September 30, 2002 were 3.28% and 3.39%, compared to 3.08% and 3.27% respectively, in the corresponding periods of 2001. The provisions for loan losses were $2.6 and $3.8 million, respectively, for the three and nine month periods ended September 30, 2002. These provisions were used to maintain the allowance for loan losses at a prudent level considering the charge-offs, net of recoveries, of approximately $2.2 million and $3.5 million in loans, respectively, for the three and nine month periods ended September 31, 2002. At September 30, 2002, the allowance for loan losses was 1.51% of total loans. Loans 90 days or more past due or in nonaccrual status totaled $3.6 million and represented .78% of total loans as of September 30, 2002. Noninterest income for the three and nine month periods ended September 30, 2002, was $2.4 million and $5.5 million, respectively, compared to $1.2 million and $3.1 million for the same periods in 2001. The $1.2 million increase in noninterest income for the three month period ended September 30, 2002 over the prior year was primarily attributable to securities gains taken in the third quarter of 2002 of $518,000 compared to zero for the same period in 2001 and a substantial rise in fees on sold loans recorded by the Bank's mortgage origination department as a result of the lower interest rate environment and increased mortgage refinance business. Mortgage loan origination fees increased from $480,000 during the third quarter of 2001 to $784,000 for the same period in 2002 primarily due to high refinancing activity. The $2.4 million increase in noninterest income for the nine month period ended September 30, 2002 over the same period in the prior year was primarily attributable to securities gains taken throughout the 2002 year of $761,000 compared to $77,000 for the previous year and increases in mortgage loan origination fees. Mortgage loan origination fees for the nine month period ended September 30, 2002 were $1.9 million compared to $1.4 million for the same period in 2001. In addition, the Company started a new overdraft checking privilege program called Bounce Free checking during the second quarter of 2001 which has resulted in a substantial increase in fee income. Fees for non-sufficient funds, which include the new Bounce Free checking program income, have increased from $774,000 during the nine months ended September 30, 2001 to $1.1 - 13 - million during the same period in 2002. Other increases in noninterest income from the nine month period ended September 30, 2001 to the same period in 2002 include revenues generated by the government lending department which was formed in early 2001, which recorded fees of $218,000 in 2002 compared to $71,000 in 2001 and increases in cash surrender values of bank owned life insurance policies, which increased from $22,000 in 2001 to $164,000 in 2002 as a result of additional policies acquired with the acquisition of First Community. Finally, the deposit base on which fees are earned increased substantially during the first quarter of 2002 as a result of the First Community acquisition. Noninterest expense for the three and nine month periods ended September 30, 2002 was $4.2 million and $12.7 million, respectively, compared to $2.9 million and $8.8 million, respectively, for the corresponding periods in 2001. Salaries and employee benefits, representing the largest expense category, increased from $1.6 million and $4.7 million, respectively, for the three and nine month periods ended September 30, 2001 to $2.3 million and $6.8 million, respectively, for the same periods in 2002. This increase reflects an increase in the number of personnel employed by the Company due to the First Community acquisition and management's intention to maintain adequate staffing levels to meet customer needs and keep pace with expected growth. As of September 30, 2002, the Company had 179 full-time equivalent employees compared to 127 for the same period in 2001. Occupancy costs, the second highest component of noninterest expenses, increased from $284,000 and $847,000, respectively, for the three and nine month periods ended September 30, 2001 to $399,000 and $1.1 million, respectively, for the same periods in 2002. This increase is primarily associated with the acquisition of the 4 additional branches in connection with the First Community transaction. 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. Income tax expense was $171,000 and $1.4 million, respectively, during the three and nine month periods ended September 30, 2002 compared to $272,000 and $131,000, respectively, during the same periods in 2001. At September 30, 2002, the Company had net deferred tax assets of $3.5 million resulting from timing differences associated primarily with the deductibility of certain expenses reflected on the financial statements. Prior to 2001, the Company was unable to use deferred tax benefits and recorded deferred tax assets only to the extent those amounts offset current taxes. During March 2001, previously recorded valuation allowances were reversed and deferred tax assets were recorded on the consolidated financial statements of the Company, resulting in a one-time net tax benefit of $356,000. 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 credit quality is maintained after a loan is booked, the Bank has a loan review department and a loan review process which includes an internal senior level Loan Review Committee which meets each month. Account officers obtain updated financial information on all large commercial loan relationships and review each relationship with the Committee on an annual basis. In addition, an outside consulting firm performs a review of the Bank's largest commercial relationships as well as a sample of loans from the consumer, mortgage and smaller commercial loan portfolios each year. The consulting firm also reviews - 14 - underwriting, documentation and risk grading analysis to determine if the Company's risk assessments are accurate and that its loan review process is appropriate. The Bank 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. 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. Based on this allowance calculation, management charged operations in the amount of $3.8 million for the nine months ended September 30, 2002 to provide for probable losses related to uncollectible loans. In addition, an allowance of $2.6 million was acquired by the Bank from Community Savings Bank. Loan loss reserves were 1.51% and 1.54% of gross loans, respectively, as of September 30, 2002 and 2001. The following table presents an analysis of changes in the allowance for loan losses for the three and nine month periods ended September 30, 2002 and 2001: Three Months Nine Months Ended September 30, Ended September 30, 2002 2001 2002 2001 ------------ --------------- --------------- ------------ (In thousands) Allowance for loan losses, beginning of period $ 6,873 $ 4,038 $ 4,286 $ 3,463 Net charge-offs: Loans charged off: Commercial 2,111 104 3,355 117 Consumer 218 59 449 78 ------------ ---------------- -------------- ------------ Total charge-offs 2,329 163 3,804 195 ------------ ---------------- -------------- ------------ Recoveries of loans previously charged off: Commercial 88 1 244 1 Consumer 11 1 47 8 ------------ ---------------- -------------- ------------ Total recoveries 99 2 291 9 ------------ ---------------- -------------- ------------ Total net charge-offs 2,230 161 3,513 186 ------------ ---------------- -------------- ------------ Loss provisions charged to operations 2,560 300 3,790 900 Allowances transferred during acquisition - - 2,640 - ------------ ---------------- -------------- ------------ Allowance for loan losses, end of period $ 7,203 $ 4,177 $ 7,203 $ 4,177 ============ ================ ============== ============ Net chargeoffs to average loans during the period 0.47% 0.06% 0.77% 0.07% Allowance as a percent of gross loans 1.54% 1.51% 1.54% 1.51% The Company experienced higher loan charge offs in the three and nine month periods ended September 30, 2002 when compared to the corresponding periods of the prior year. Management believes that this is due in part to a weakened economy. In the third quarter of 2002, the Bank charged-off $2.3 million compared to $163,000 for the same period of 2001. For the nine month period ended September 30, 2002, the Company charged off $3.8 million. Of that amount, $2.9 million related to four business customer relationships. - 15 - The Bank has also experienced an increase in nonperforming assets, which includes nonperforming loans and foreclosed property. Nonperforming assets as a percent of total assets increased from .55% as of September 30, 2001 to .84% for the corresponding period in 2002, primarily the result of increases in foreclosed property. In the third quarter of 2002, nonperforming loans as a percentage of total loans increased to .78% from .77% as of the same period in 2001. Foreclosed property increased from zero at December 31, 2001 to $1.9 million. Of that amount, $1.4 million related to one residential property recently acquired by the Company through foreclosure. The Company is actively marketing all of its foreclosed property. However, due to the softness of the upscale housing market, it is uncertain as to how long the larger of the foreclosed properties will remain as an asset of the Company. 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, 2002 and 2001: Period Ended September 30, 2002 2001 ------------ ------------ (In thousands) Nonperforming assets: Nonaccrual loans: Commercial real estate $ 1,389 $ 1,738 Commercial 451 - Consumer 362 209 Mortgage 1,446 187 ------------ ------------ Total nonperforming loans 3,648 2,134 Foreclosed property held 1,866 - ------------ ------------ Total nonperforming assets $ 5,514 $ 2,134 ============ ============ Nonperforming loans to total loans 0.78% 0.77% Nonperforming assets to total assets 0.84% 0.55% Allowance coverage of nonperforming loans 197% 196% 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 Board of Directors. The Company had $34.4 million in its most liquid assets, cash and cash equivalents, at quarter end. The Company's principal sources of funds are 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 75% of total assets at September 30, 2002. In addition, the Company has the ability to take advantage of various other funding programs available from the Federal Home Loan Bank of Atlanta. Shareholders' equity was $56.6 million or $10.72 per share at September 30, 2002. 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 - 16 - 30, 2002, Capital Bank Corporation had a Tier 1 capital ratio of 9.09%, a total risk-based capital ratio of 10.35% and a leverage ratio of 7.25%. These ratios exceed the federal regulatory minimum requirements for a "well-capitalized" bank. 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. 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, 2001 to September 30, 2002. Item 4 Controls and Procedures - ------ ----------------------- Based on the Company's most recent evaluation, which was completed within 90 days of the filing of this Form 10-Q, the Company's Chief Executive Officer and Chief Financial Officer believe the Company's disclosure controls and procedures (as defined in Rules 13a-14 and 15d-14 of the Securities Exchange Act of 1934, as amended) are effective. There have been no significant changes in internal controls or in other factors that could significantly affect these controls subsequent to the date of the most recent evaluation of the Company's internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses. 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 - 17 - Item 4 Submission of Matters to a Vote of Security Holders - ------ --------------------------------------------------- On September 24, 2002, a special meeting of shareholders of the Company was held to consider and vote upon two issues: (i) to approve the merger agreement and related plan of merger between Capital Bank Corporation and High Street Corporation and (ii) to approve the issuance of up to 1,700,000 shares of Capital Bank Corporation common stock in connection with the merger. Both items were approved by the Company's shareholders. Of the 5,341,247 shares eligible to vote, 3,083,394 were voted as shown on the following tables: (i) To approve the merger agreement and related plan of merger, dated as of May 1, 2002 between Capital Bank Corporation and High Street Corporation and transactions contemplated thereby, by which Capital Bank Corporation will acquire High Street Corporation through the merger of High Street Corporation into Capital Bank Corporation, with Capital Bank Corporation being the surviving corporation of such merger: For Against Abstain Total -------------------------------------------------------------------- 3,046,558 30,054 6,782 3,083,394 (ii) To approve the issuance of up to 1,700,000 shares of Capital Bank Corporation common stock to shareholders of High Street Corporation in connection with Capital Bank Corporation's acquisition of High Street Corporation in a merger transaction. The issuance of these shares is subject to adjustment as described in detail in the Joint Proxy Statement/Prospectus: For Against Abstain Total -------------------------------------------------------------------- 3,028,269 44,953 10,172 3,083,394 In each case, the vote required to approve the action was obtained. Item 5 Other Information - ------ ------------------ None Item 6 Exhibits and Reports on Form 8-K - ------ -------------------------------- (a) Exhibits -------- Exhibit 99.1 Certification of Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Exhibit 99.2 Certification of Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Exhibit 99.3 Risk Factors. (b) Reports on Form 8-K ------------------- None - 18 - 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, 2002 By: /s/ Allen T. Nelson, Jr. ________________________ Allen T. Nelson, Jr., Executive Vice President and CFO I, James A. Beck, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Capital Bank Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): - 19 - a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 _____________________ /s/ James A. Beck ---------------------------------- James A. Beck Chief Executive Officer I, Allen T. Nelson, Jr., certify that: 1. I have reviewed this quarterly report on Form 10-Q of Capital Bank Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and - 20 - c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 _____________________ /s/ Allen T. Nelson --------------------------------- Allen T. Nelson, Jr. Chief Financial Officer - 21 -