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 JUNE 30, 1998 OR ____TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO Commission File Number 0-26016 PALMETTO BANCSHARES, INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) South Carolina 74-2235055 --------------------------------- ----------------------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 301 Hillcrest Drive Laurens, South Carolina 29360 -------------------------------------------- (Address of principal executive offices) (Zip Code) (864) 984-4551 -------------------------------------------------- ( Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ---- ---- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at July 27, 1998 ----------------------------- ------------------------------- Common stock, $5.00 par value 3,089,852 PALMETTO BANCSHARES, INC. Quarterly Report on Form 10-Q For the Quarter and Six Months Ended June 30, 1998 INDEX Page No. ----- -------- PART I - FINANCIAL INFORMATION Consolidated Balance Sheets at June 30, 1998 and December 31, 1997 1 Consolidated Income Statements for the Three Months Ended June 30, 1998 and 1997 2 Consolidated Income Statements for the Six Months Ended June 30, 1998 and 1997 3 Consolidated Statements of Cash Flows for the Six Months Ended June 30, 1998 and 1997 4 Consolidated Statements of Changes in Shareholders' Equity for the Six Months Ended June 30, 1998 and 1997 5 Notes to Consolidated Interim Financial Statements 6 Management's Discussion and Analysis of Financial Condition and Results of Operations 7 - 15 PART II - OTHER INFORMATION 16 - 17 SIGNATURES 18 PALMETTO BANCSHARES, INC. AND SUBSIDIARY Consolidated Balance Sheets (Dollars in Thousands, except per share data) June 30 December 31 1998 1997 ----------------------------------- Assets (unaudited) Cash and due from banks $31,751 $25,539 Federal funds sold 570 388 Federal Home Loan Bank stock, at cost 1,541 1,452 Investment securities held to maturity (market values of $76,211 and $81,578 in 1998 and 1997, respectively) 74,653 80,006 Investment securities available for sale (amortized cost of $28,534 and $17,410, in 1998 and 1997, respectively) 28,864 17,725 Loans held for sale 1,660 -- Loans 387,371 367,963 Less allowance for loan losses (5,386) (5,152) ----------------------------------- Loans, net 381,985 362,811 Premises and equipment, net 14,444 13,386 Accrued interest 4,400 3,990 Other assets 8,340 7,910 ----------------------------------- Total assets $548,208 $513,207 =================================== Liabilities and Shareholders' Equity Liabilities: Deposits: Non-interest-bearing 77,449 70,595 Interest-bearing 395,899 378,795 ----------------------------------- Total deposits 473,348 449,390 Securities sold under agreements to repurchase 15,466 12,224 Commercial paper (Master note) 11,582 11,289 Federal funds purchased 6,200 1,500 Other liabilities 2,566 2,188 ----------------------------------- Total liabilities 509,162 476,591 ----------------------------------- Common stock subject to put/call option 4,810 3,784 Shareholders' Equity: Common stock-$5.00 par value. Authorized 10,000,000 shares; 3,089,852 issued and outstanding in 1998 and 3,089,552 issued and outstanding in 1997; 15,449 15,448 Additional paid-in capital 318 317 Retained earnings 23,076 20,658 Accumulated other comprehensive income 203 193 Common stock subject to put/call option, 274,841 common shares at $17.50 per share in 1998 and 275,180 common shares at $13.75 in 1997 (4,810) (3,784) ----------------------------------- Total shareholders' equity 34,236 32,832 ----------------------------------- Total liabilities and shareholders' equity $548,208 $513,207 =================================== See accompanying notes to consolidated interim financial statements. 1 PALMETTO BANCSHARES, INC. AND SUBSIDIARY Consolidated Income Statements (Unaudited) Three Months Ended June 30, 1998 and 1997 (Dollars in Thousands, except per share data) 1998 1997 ----------------------------------- Interest income: Interest and fees on loans $8,580 $7,410 Interest and dividends on investment securities available for sale: U.S. Treasury 198 288 State and municipal 117 100 Mortgage-backed securities 59 -- Interest and dividends on investment securities held to maturity: U.S. Treasury and U.S. Government agencies 253 372 State and municipal 486 367 Mortgage-backed securities 367 445 Interest on federal funds sold 71 111 Dividends on FHLB stock 29 -- ----------------------------------- Total interest income 10,160 9,093 ----------------------------------- Interest expense: Interest on deposits 3,757 3,674 Interest on securities sold under agreements to repurchase 179 144 Interest on federal funds purchased 13 12 Interest on commercial paper (Master note) 124 85 ----------------------------------- Total interest expense 4,073 3,915 ----------------------------------- Net interest income 6,087 5,178 Provision for loan losses 452 300 ----------------------------------- Net interest income after provision for loan losses 5,635 4,878 Non-interest income: Service charges on deposit accounts 855 807 Fees for trust services 335 237 Other income 430 360 ----------------------------------- Total non-interest income 1,620 1,404 Non-interest expenses: Salaries and other personnel 2,452 2,003 Net occupancy 421 332 Furniture and equipment 439 413 FDIC assessment 48 43 Postage and supplies 273 215 Marketing and advertising 187 196 Telephone 144 124 Other expense 834 777 ----------------------------------- Total non-interest expenses 4,798 4,103 ----------------------------------- Income before income taxes 2,457 2,179 ----------------------------------- Income tax provision 764 600 ----------------------------------- NET INCOME $1,693 $1,579 =================================== Increase in fair value of common stock (1,026) (470) ----------------------------------- Net income on common shares not subject to put/call $667 $1,109 =================================== Net income per share-basic, not subject to put/call $0.24 $0.40 Net income per share-dilutive, not subject to put/call $0.23 $0.39 Cash dividends declared per share $0.12 $0.09 See accompanying notes to consolidated interim financial statements. 2 PALMETTO BANCSHARES, INC. AND SUBSIDIARY Consolidated Income Statements (Unaudited) Six Months Ended June 30, 1997 and 1996 (Dollars in Thousands, except per share data) 1998 1997 ----------------------------------- Interest income: Interest and fees on loans $16,934 $14,926 Interest and dividends on investment securities available for sale: U.S. Treasury and U.S. Government agencies 392 448 State and municipal 189 206 Mortgage-backed securities 65 -- Interest and dividends on investment securities held to maturity: U.S. Treasury and U.S. Government agencies 516 663 State and municipal 971 712 Mortgage-backed securities 762 831 Interest on federal funds sold 134 165 Dividends on FHLB stock 56 -- ----------------------------------- Total interest income 20,019 17,951 ----------------------------------- Interest expense: Interest on deposits 7,530 7,192 Interest on securities sold under agreements to repurchase 349 278 Interest on federal funds purchased 38 55 Interest on commercial paper 252 147 ----------------------------------- Total interest expense 8,169 7,672 ----------------------------------- Net interest income 11,850 10,279 Provision for loan losses 842 600 ----------------------------------- Net interest income after provision for loan losses 11,008 9,679 Non-interest income: Service charges on deposit accounts 1,678 1,567 Fees for trust services 670 473 Other income 764 730 ----------------------------------- Total non-interest income 3,112 2,770 Non-interest expenses: Salaries and other personnel 4,861 4,247 Net occupancy 836 674 Furniture and equipment 870 812 FDIC assessment 94 85 Postage and supplies 527 439 Marketing and advertising 424 370 Telephone 287 258 Other expenses 1,668 1,525 ----------------------------------- Total non-interest expenses 9,567 8,410 ----------------------------------- Income before income taxes 4,553 4,039 ----------------------------------- Income tax provision 1,393 1,108 ----------------------------------- NET INCOME $3,160 $2,931 Increase in fair value of ESOP stock (1,026) (470) ----------------------------------- Net income on common shares not subject to put/call $2,134 $2,461 =================================== Net income per share-basic, not subject to put/call $0.76 $0.89 Net income per share-dilutive, not subject to put/call $0.74 $0.87 Cash dividends declared per share $0.24 $0.17 See accompanying notes to consolidated interim financial statements. 3 PALMETTO BANCSHARES, INC. AND SUBSIDIARY Consolidated Statements of Cash Flows (Unaudited) For Six Months Ended June 30, 1998 and 1997 (Dollars in Thousands) 1998 1997 ----------------------------------- Cash flows from operating activities: Net income $3,160 $2,931 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 1,335 1,042 Provision for loan losses 842 600 Origination or acquisition of loans held for sale (20,580) (25,077) Sale of loans held for sale 18,743 29,152 Gain on sale of loans 177 -- Change in accrued interest receivable (410) (470) Change in other assets (816) (1,681) Change in other liabilities, net 372 755 ----------------------------------- Net cash (used) provided by operating activities 2,823 7,252 Cash flows from investing activities: Purchase of investment securities held to maturity (1,559) (17,710) Purchase of investment securities available for sale (13,038) (9,945) Proceeds from maturities of investment securities held to maturity 3,000 3,200 Proceeds from maturities of investment securities available for sale 770 800 Proceeds from sale of investment securities available for sale 983 552 Principal paydowns on mortgage-backed securities held to maturity 3,857 1,044 Purchase of Federal Home Loan Bank stock (89) -1452 Net increase in loans (20,016) (13,516) Purchases of premises and equipment (1,745) (786) ----------------------------------- Net cash used in investing activities (27,837) (37,813) Cash flows from financing activities: Net increase in deposit accounts 21,884 26,931 Acquisition of deposits, net 2,029 -- Net increase in securities sold under agreements to repurchase 3,242 2,689 Net increase in commercial paper 293 2,859 Net increase (decrease) in federal funds purchased 4,700 (3,000) Proceeds from issuance of common stock 2 122 Proceeds from sale of treasury stock -- 126 Dividends paid (742) (520) ----------------------------------- Net cash provided by financing activities 31,408 29,207 ----------------------------------- Net increase (decrease) in cash and cash equivalents 6,394 (1,354) ----------------------------------- Cash and cash equivalents at beginning of the period 25,927 30,324 ----------------------------------- Cash and cash equivalents at end of the period $32,321 $28,970 =================================== Supplemental Information: Cash paid during the period for: Interest expense 8,234 7,563 =================================== Income taxes 1,157 305 =================================== Supplemental schedule of non-cash investing and financing transactions: Change in unrealized gain on investment securities available for sale 10 (37) =================================== See accompanying notes to consolidated interim financial statements. 4 PALMETTO BANCSHARES, INC. AND SUBSIDIARY Consolidated Statements of Changes in Shareholders' Equity (Unaudited) For the Six Months Ended June 30, 1998 and 1997 (Dollars in Thousands) Accumulated Additional Other Common Paid-in Retained Treasury Comprehensive Stock Capital Earnings Stock Income, net ----- ------- -------- ----- ----------- Balance at December 31, 1996 15,165 334 15,894 (121) 166 Net income 2,931 Other comprehensive income, net of tax: Unrealized holding losses arising during period, net of tax effect of $28 Less: reclassification adjustment for gains included in net income, net of tax effect of $4 Net unrealized gains on securities (37) Comprehensive Income Cash dividend declared (519) Issuance of 27,000 shares in connection with stock option 135 (14) Sale of 9,111 shares treasury stock 4 121 Common stock subject to put/call option -------------------------------------------------------------- Balance at June 30, 1997 15,300 320 18,310 0 129 ============================================================== Balance at December 31, 1997 15,448 317 20,658 0 193 Net income 3,160 Other comprehensive income, net of tax: Unrealized holding gains arising during period, net of tax effect of $6 Less: reclassification adjustment for gains included in net income, net of tax effect of $0 Net unrealized gains on securities 10 Comprehensive Income Cash dividend declared (742) Issuance of 300 shares in connection with stock option 1 1 Common stock subject to put/call option -------------------------------------------------------------- Balance at June 30, 1998 15,449 318 23,076 0 203 ============================================================== Common Stock Subject to Put/Call Option Total ------ ----- Balance at December 31, 1996 (3,314) 28,124 Net income 2,931 Other comprehensive income, net of tax: Unrealized holding losses arising during period, net of tax effect of $28 (44) Less: reclassification adjustment for gains included in net income, net of tax effect of $4 7 Net unrealized gains on securities ------------- Comprehensive Income 2,894 ------------- Cash dividend declared (519) Issuance of 27,000 shares in 0 connection with stock option 121 Sale of 9,111 shares treasury stock 125 Common stock subject to put/call option (470) (470) ------------------------ Balance at June 30, 1997 (3,784) 30,275 ======================== Balance at December 31, 1997 (3,784) 32,832 Net income 3,160 Other comprehensive income, net of tax: Unrealized holding gains arising during period, net of tax effect of $6 10 Less: reclassification adjustment for gains included in net income, net of tax effect of $0 0 Net unrealized gains on securities ------------- Comprehensive Income 3,170 ------------- Cash dividend declared (742) Issuance of 300 shares in connection with stock option 2 Common stock subject to put/call option (1,026) (1,026) ------------------------ Balance at June 30, 1998 (4,810) 34,236 ======================== See accompanying notes to consolidated interim financial statements. 5 PALMETTO BANCSHARES, INC. AND SUBSIDIARY Notes To Consolidated Interim Financial Statements 1. Basis of Presentation The accompanying unaudited consolidated interim financial statements have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and footnotes required by generally accepted accounting principles for complete financial statements are not included herein. The interim statements should be read in conjunction with the financial statements and notes thereto included in Palmetto Bancshares, Inc.'s (the Company's) Annual Report on Form 10-K for the year ended December 31, 1997. In the Company's opinion, all adjustments necessary for a fair presentation of these interim statements have been included and are of a normal and recurring nature. The results of operations for the six-month period ended June 30, 1998 are not necessarily indicative of the results which may be expected for the entire year. 2. Principles of Consolidation The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, The Palmetto Bank (the Bank), and Palmetto Capital, Inc., a wholly-owned subsidiary of The Palmetto Bank. The Bank provides a full-range of banking services, including the taking of deposits and the making of loans. Palmetto Capital, Inc. offers the brokerage of stocks, bonds, mutual funds and unit investment trusts. Palmetto Capital, Inc. also offers advisory services and variable rate annuities. In consolidation, all significant intercompany accounts and transactions have been eliminated. 3. Summary of Significant Accounting Changes In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (SFAS) No. 130 Reporting Comprehensive Income. The statement is effective for annual and quarterly financial statements for fiscal years beginning after December 15, 1997, with earlier application permitted. For the Company, the statement became effective in the first quarter of 1998 and required reclassification of earlier financial statements for comparative purposes. SFAS No. 130 requires that changes in the amounts of comprehensive income items be shown in a primary financial statement. Comprehensive income is defined by the statement as "the changes in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners." On January 1, 1998, the Company adopted the provisions of SFAS No. 130. The Company adopted the Statement of Changes in Equity approach to disclosing changes in comprehensive income. 6 PALMETTO BANCSHARES, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS DISCUSSION OF FINANCIAL CONDITION CHANGES FROM DECEMBER 31, 1997 TO JUNE 30, 1998 General On April 13, 1998, the Bank opened a new office on Butler Road in Mauldin, South Carolina, which is located in Greenville County. On April 17, 1998, the Bank assumed the deposits of Greenwood Bank & Trust's Ninety-Six office located in Greenwood County, South Carolina. This assumption of approximately $2 million increases the Bank's presence in this market. On April 20, 1998, the Bank opened a new office on Woodruff Road in Greenville, South Carolina. These openings bring the Bank's total number of branches to 26. Assets Liquid assets which include cash, federal funds sold, and investments available for sale increased by $17.5 million, or 40%, for the six-month period. This increase was largely due to the increase in cash and due from banks of $6.2 million and a $11.1 million increase in available for sale securities. During 1997, the Bank joined the Federal Home Loan Bank ("FHLB") of Atlanta to increase the Bank's available liquidity. As a FHLB member, the Bank is required to acquire and retain shares of capital stock in the FHLB of Atlanta based on certain ratios as of the beginning of the year. Based on these calculations, the Bank was required to make an additional investment of $89,000 in FHLB stock in 1998. No ready market exists for this stock and it has no quoted market value. However, redemption of this stock has historically been at par value. Investment securities held to maturity decreased during the six-month period by $5.4 million, or 7%. This decrease was due to maturities of $3.0 million and principal pay downs on mortgage-backed securities of $3.9 million. These decreases were slightly offset by purchases of $1.6 million. Loans, net, increased by $19.2 million, or 5%, during the six-month period as a result of normal growth. The allowance for loan losses was decreased to 1.39% from 1.42% at June 30, 1998 and 1997, respectively. At June 30, 1998, the Company had $1.7 million in loans held for sale with commitments to sell these loans in July 1998. The mortgage servicing rights related to the mortgage servicing department's activities are approximately $1.5 million at June 30, 1998, which represents their fair value. Loans serviced for the benefit of others amounted to approximately $147.4 million at June 30, 1998. Other assets increased by $430,000, or 5%, due to normal growth. This increase was slightly offset with amortization of various prepaids and intangibles. 7 Liabilities and Shareholders' Equity Deposit balances increased by 5% during the period, from $449.4 million to $473.3 million. The increase was due to normal growth. Securities sold under agreements to repurchase have increased by $3.2 million or 27%, and commercial paper associated with the alternative commercial sweep accounts (master note program) increased by $293,000 or 3%. These changes are the result of normal fluctuations in the accounts. Federal funds purchased increased by $4.7 million due to normal fluctuations. Total shareholders equity increased by $1.4 million, for the six-month period as a result of net income of $3,160,000; less dividends paid of $742,000; and reduced by the increase in the reclassification of the Employee Stock Ownership Plan (ESOP) shares subject to put/call of $1,026,000. The stock in the ESOP has a put and a call feature if the stock is not "readily tradable on an established market." A 1995 private letter ruling by the IRS clarified that such term means listed on a national securities exchange. Since the Company's stock is not listed on a national securities exchange, the shares in the ESOP Plan and shares distributed in 1998 are subject to the put/call feature. Accordingly, 274,841 shares are recorded outside of shareholders' equity at their fair value, which is determined annually by an independent valuation. The most recent valuation dated April 2, 1998, values the stock at $17.50 per share. The Company's Board of Directors voted to terminate the ESOP effective February 28, 1997. The shares distributed in 1998 due to the termination of the ESOP will be subject to the put/call until June 29, 1999. Liquidity The liquidity ratio is an indication of a company's ability to meet its short-term funding obligations. The Company's policy is to maintain a liquidity ratio between 15% - 25%. At June 30, 1998, the Company's liquidity ratio was 18.55%. The Company has certain cash needs, including general operating expenses and the payment of dividends and interest on borrowings. The Company currently has no debt outstanding and has declared $0.24 per share in dividends so far in 1998. There can be no guarantee, however, that any additional dividends will be paid. Liquidity is provided from the Company's subsidiary, the Bank. The only restrictions on the amount of dividends available for payment to Bancshares are guidelines established by regulatory authorities for capital to asset ratios. The South Carolina Board of Financial Institutions' guideline suggests a primary capital to asset ratio of at least 7%. The Bank's current primary capital ratio is 7.87%; therefore, at June 30, 1998, the Bank had $4.8 million of excess retained earnings available for the payment of dividends. The Bank plans to continue its quarterly dividend payout. 8 Capital Resources As of June 30, 1998, the Company and the Bank were in compliance with each of the applicable regulatory capital requirements and met or exceeded the "adequately capitalized" regulatory guidelines. The table below sets forth various capital ratios for the Company and the Bank: Adequately As of Capitalized Well Capitalized 6/30/98 Requirement Requirement - --------------------------- ----------- ------------------- --------------- Company: Total Risk-based Capital 9.94% 8.00% 10.00% Tier 1 Risk-based Capital 8.69 4.00 6.00 Tier 1 Leverage Ratio 6.59 4.00 5.00 Bank: Total Risk-based Capital 9.94 8.00 10.00 Tier 1 Risk-based Capital 8.69 4.00 6.00 Tier 1 Leverage Ratio 6.59 4.00 5.00 Primary Capital to Assets 7.87 7.00 7.00 - --------------------------- ----------- ------------------- --------------- Because the Company's total risk-based capital ratio is 9.94%, the Company is defined to be "adequately-capitalized" under currently applicable regulatory guidelines. The Company's strategic plan for controlled growth and profit improvement reflects sufficient internally generated capital to return the risk-weighted ratios to the "well-capitalized" guidelines, presently anticipated to occur before year-end. 9 Accounting and Reporting Matters In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings per Share, which is effective for both interim and annual periods ending after December 15, 1997. This statement supersedes Accounting Principles Board Opinion No. 15, Earnings per Share. The purpose of this statement is to simplify current reporting and make U.S. reporting comparable to international standards. The statement requires dual presentation of basic and diluted EPS by entities with complex capital structures (as defined by the statement). Although the adoption of this standard changed the appearance of the Company's income statement, there is not a material difference between basic and diluted earnings per share for the Company. In June 1997, the FASB issued SFAS No. 130 Reporting Comprehensive Income. The statement is effective for annual and quarterly financial statements for fiscal years beginning after December 15, 1997, with earlier application permitted. For the Company, the statement became effective in the first quarter of 1998 and required reclassification of earlier financial statements for comparative purposes. SFAS No. 130 requires that changes in the amounts of comprehensive income items be shown in a primary financial statement. Comprehensive income is defined by the statement as "the changes in equity (net assets) of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners." The Company adopted the Statement of Changes in Equity approach to disclosing changes in comprehensive income. Also, in June 1997, the FASB issued SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. The statement is effective for financial statements for fiscal years beginning after December 15, 1997, with earlier application permitted. SFAS No. 131 changes the way public companies report information about segments of their business in their annual financial statements and requires them to report selected segment information in their quarterly reports issued to shareholders. A company is required to report on operating segments based on the management approach. An operating segment is defined as any component of an enterprise that engages in business activities from which it may earn revenues and incur expenses. The management approach is based on the way that management organizes the segments within the enterprise for making operating decisions and assessing performance. The Company anticipates that adoption of this standard will not have a material effect on the Company. In February 1998, the FASB issued SFAS No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits. The statement is effective for fiscal years beginning after December 15, 1997. SFAS No. 132 provides additional information to facilitate financial analysis and eliminates certain disclosures which are no longer useful. To the extent practical, the statement also standardizes disclosures for retiree benefits. The Company anticipates that adoption of this standard will not have a material effect on the Company. In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The statement is effective for all fiscal quarters of all fiscal years beginning after June 15, 1999. SFAS No. 133 establishes accounting and reporting standards for derivative instruments and for hedging activities. The statement requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The Company anticipates that adoption of this standard will not have a material effect on the Company. 10 COMPARISON OF THE RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 1998 AND 1997 Net income for the three months ended June 30, 1998 was $1.7 million, an increase of 7% from the $1.6 million reported for the same period in 1997. Net income per common share-basic, not subject to put/call, was $0.24 for the 1998 period as compared with $0.40 for the comparable period in 1997. Net income per common share-dilutive, not subject to put/call, was $0.23 for the 1998 period as compared with $0.39 for the comparable period in 1997. The reason that net income per share declined in 1998 versus 1997 even though net income increased is because the adjustment to net income for the ESOP valuation increased dramatically compared to prior year. Net Interest Income The largest component of the Company's net income is the Bank's net interest income, defined as the difference between gross interest and fees on earnings assets, primarily loans and investment securities, and interest paid on deposits and borrowed funds. Net interest income is affected by the interest rates earned or paid and by volume changes in loans, securities, deposits and borrowed funds. For the three-month period ended June 30, 1998, net interest income was $6.1 million, which represented an 18% increase from the same period in 1997. This increase was the result of increases in the volume of earning assets. Earning assets averaged $494.8 million and $452.2 million during the second quarters of 1998 and 1997, respectively. The increases in volume were due to the growth of loans and investments compared to year-end 1997. The average tax-equivalent net interest margin for the 1998 period was 5.11%, compared to 4.77% for the same period in 1997. Interest income on loans increased 16% due to increased volume and increased average rate. Interest income on investment securities decreased 6% to $1.5 million during the 1998 period compared to the corresponding period in 1997 due to decreased rate. Interest income on federal funds sold increased due to increased volume of federal funds sold compared to the same period last year. The yield on average earning assets, which includes loans and investment securities, increased from 8.10% for the three months ended June 30, 1997 to 8.24% for the three months ended June 30, 1998. The prime interest rate remained constant at 8.5% for the quarters ended June 30, 1998 and 1997. Total interest expense increased by 4% during the 1998 period mostly due to an increased volume of deposits at June 30, 1998, compared to June 30, 1997. Market Risk Market risk is the risk of loss from adverse changes in market prices and rates. The Company's market risk arises principally from interest rate risk inherent in its lending, deposit and borrowing activities. Management actively monitors and manages its inherent rate risk exposure. Although the Company manages other risks, as in credit quality and liquidity risk, in the normal course of business, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Company's financial condition and results of operations. Other types of market risks, such as foreign 11 currency exchange rate risk ad commodity price risk, do not arise in the normal course of the Company's business activities. The Company's profitability is affected by fluctuations in interest rates. Management's goal is to maintain a reasonable balance between exposure to interest rate fluctuations and earnings. A sudden and substantial increase in interest rates may adversely impact the Company's earnings to the extent that the interest rates on interest-earning assets and interest-bearing liabilities do not change at the same speed, to the same extent or on the same basis. The Company monitors the impact of changes in interest rates on its net interest income using several tools. The Bank's goal is to minimize interest rate risk between interest bearing assets and liabilities at various maturities through its Asset-Liability Management (ALM). ALM involves managing the mix and pricing of assets and liabilities in the face of uncertain interest rates and an uncertain economic outlook. It seeks to achieve steady growth of net interest income with an acceptable amount of interest rate risk and sufficient liquidity. The process provides a framework for determining, in conjunction with the profit planning process, which elements of the Company's profitability factors can be controlled by management. Understanding the current position and implications of past decisions is necessary in providing direction for the future financial management of the Company. The Company uses an asset-liability model to determine the appropriate strategy for current conditions. Interest sensitivity management is part of the asset-liability management process. Interest sensitivity gap (GAP) is the difference between total rate sensitive assets and rate sensitive liabilities in a given time period. The Company's current GAP analysis reflects that in periods of increasing interest rates, rate sensitive assets will reprice slower than rate sensitive liabilities. The Company's GAP analysis also shows that at the interest repricing of one year, the Company's net interest margin would be adversely impacted. This analysis, however, does not take into account the dynamics of the marketplace. GAP is a static measurement that assumes if the prime rate increases by 100 basis points, all assets and liabilities that are due to reprice will increase by 100 basis points at the next opportunity. However, the Company is actually able to experience a benefit from rising rates in the short term because deposit rates do not follow the national money market. They are controlled by the local market. Loans do follow the money market; so when rates increase they reprice immediately, but the Company is able to manage the deposit side. The Company generally does not raise deposit rates as fast or as much. The Company also has the ability to manage its funding costs by choosing alternative sources of funds. The Company's current GAP position would also be interpreted to mean that in periods of declining interest rates, the Company's net interest margin would benefit. However, competitive pressures in the local market may not allow the Company to lower rates on deposits, but force the Company to lower rates on loans. Because the Company's management feels that GAP analysis is a static measurement, it manages its interest income through its asset/liability strategies which focus on a net interest income model based on management's projections. The Company has a targeted net interest income range of plus or minus twenty percent based on a 300 basis point shock over twelve months. The asset/liability committee meets weekly to address interest pricing issues, and this model is reviewed monthly. Management will continue to monitor its liability sensitive position in times of higher interest rates which might adversely affect its net interest margin. The Company does not feel that the market risk to the Company has changed significantly since December 31, 1997. 12 Provision for Loan Losses The provision for loan losses was $452,000 for the three months ended June 30, 1998 and 1997, respectively. The provision is adjusted each month to reflect loan volume growth and allow for loan charge-offs and recoveries. Management's objective is to maintain the allowance for loan losses at an adequate level to cover potential future losses in the portfolio. Additions to the allowance for loan losses are based on management's evaluation of the loan portfolio under current economic conditions, past loan loss experience, and such other factors which, in management's judgment, deserve recognition in estimating loan losses. Loans are charged off when, in the opinion of management, they are deemed to be uncollectible. Recognized losses are charged against the allowance, and subsequent recoveries are added to the allowance. Loans over 90 days delinquent, and on non-accrual amounted to approximately $1,664,000 and $1,617,000 at June 30, 1998 and 1997, respectively. The net charge-off ratio has increased from prior year to 0.32%. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. The allowance for loan losses is subject to periodic evaluation by various regulatory authorities and may be subject to adjustment, based upon information that is available to them at the time of their examination. Other Operating Income Total non-interest income increased by $216,000, or 15%, for the three months ended June 30, 1998, as compared to the same period in 1997. The largest contributor to the increase in non-interest income is fees for trust services, which increased $98,000, or 41%, due to new business and increased assets under management. Assets under management increased $1.8 million, or 1%, during the three months ended June 30, 1998. The second largest portion of this increase can be attributed to service charges on deposit accounts, which increased by $48,000, or 6%, during the 1998 period compared to the same period in 1997 due primarily to increased deposit accounts and increased transactions. Other Operating Expenses Total non-interest expenses increased by $695,000, or 17%, during the 1998 three-month period over the same period in 1997. The largest contributor to non-interest expense was salaries and other personnel expense which increased $449,000, or 22%, due to normal salary increases and increased personnel at the new branches. The second largest contributor was net occupancy expense, which increased $89,000, or 27%, due to increased depreciation, utilities and lease expense related to the new branches. Postage and supplies expense increased $58,000, or 27%, due to increased customer mailings related to the opening of the new branches. Income Taxes The Company incurred income tax expense of $764,000 for the 1998 three-month period compared to $600,000 for the same period in 1997 due to the increase in taxable income. This expense is based on an expected annual effective tax rate of approximately 30%. 13 COMPARISON OF THE RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1996 Net income for the six months ended June 30, 1998 was $3.2 million, an increase of 8% from the $2.9 million reported for the same period in 1997. Net income per common share-basic, not subject to put/call, was $0.76 for the 1998 period as compared with $0.89 for the comparable period in 1997. Net income per common share-dilutive, not subject to put/call, was $0.74 for the 1998 period as compared with $0.87 for the comparable period in 1997. The reason that net income per share declined in 1998 versus 1997 even though net income increased is because the adjustment to net income for the ESOP valuation increased dramatically compared to prior year. Net Interest Income The largest component of the Company's net income is the Bank's net interest income, defined as the difference between gross interest and fees on earnings assets, primarily loans and investment securities, and interest paid on deposits and borrowed funds. Net interest income is affected by the interest rates earned or paid and by volume changes in loans, securities, deposits, and borrowed funds. For the six-month period ended June 30, 1998, net interest income was $11.9 million, which represented a 15% increase from the same period in 1997. This increase was the result of increases in the volume of earning assets. Earning assets averaged $486.5 million and $442.7 million during the first six months of 1998 and 1997, respectively. The increases in volume were due to the growth of loans and investments compared to year-end 1997. The average tax equivalent net interest margin for the 1998 period was 5.08%, compared to 4.83% for the same period in 1997. Interest income on loans increased 13% due to increased volume. Despite growth in the investment security portfolio, interest income on investment securities remained fairly constant at $2.9 million during the 1998 period compared to the corresponding period in 1997 due to a lower weighted average rate (WAR) earned on the portfolio. The WAR (tax equivalent) on the portfolio was 6.96% and 7.01%, at June 30, 1998 and 1997, respectively. The reduction in the WAR appears reasonable based on the decrease in the Treasury Yield curve in the last 12 months. At June 30, 1998, the Treasury Yield curve for a 5 year term was 5.47%, compared to 6.32% one year ago. Interest income on federal funds sold decreased due to decreased average volume of federal funds sold compared to the first six months of last year. The yield on average earning assets, which includes federal funds sold, loans and investment securities, increased from 8.18% for the six months ended June 30, 1997 to 8.30% for the six months ended June 30, 1998. The prime interest rate remained constant at 8.50% for the first and second quarters. Total interest expense increased by 6% during the 1998 period mostly due to an increased volume of deposits at June 30, 1998, compared to June 30, 1997. Average total interest-bearing liabilities, increased by 9% from June 30, 1997 to June 30, 1998. The average rate paid on interest bearing liabilities decreased from 4.03% during the six-month period in 1997, to 3.93% during the 1998 period. The profitability of the Bank is influenced significantly by management's ability to control the relationship between rate sensitive assets and liabilities, and the current interest rate environment. See further discussion under "Comparison of the Results of Operations for the Three Months Ended June 30, 1998 and 1997" above. 14 Provision for Loan Losses The provision for loan losses was $842,000 for the six months ended June 30, 1998 compared to $600,000 for the six months ended June 30, 1997. See further discussion under "Comparison of the Results of Operations for the Three Months Ended June 30, 1998 and 1997" above. Other Operating Income Total non-interest income increased by $342,000, or 12%, for the six months ended June 30, 1998, as compared to the same period in 1997. The largest contributor to this increase is fees for trust services, which increased $197,000, or 42%, due to new business and increased assets under management. Assets under management were $183.0 million and $136.9 million at June 30, 1998 and 1997, respectively, representing a 34% increase. The second largest portion of this increase can be attributed to service charges on deposit accounts, which increased by $111,000, or 7%, during the 1998 period compared to the same period in 1997 due primarily to increased deposit accounts and increased transactions. Other Operating Expenses Total non-interest expenses increased by $1.2 million, or 14%, during the 1998 six-month period over the same period in 1997. The largest contributor to non-interest expense was salaries and other personnel expense which increased $614,000, or 15%, due to normal salary increases and increased personnel at the new branches. The number of full-time equivalent employees at June 30, 1998 was 312, compared to 264 at June 30, 1997. The second largest increase was in net occupancy expense which increased $162,000 or 24%. This increase was due to increased depreciation, rent and utilities related to the new branches. Income Taxes The Company incurred income tax expense of $1.4 million for the 1998 six-month period compared to $1.1 million for the same period in 1997 due to the increase in taxable income. This expense is based on an expected effective tax rate of approximately 30%. INDUSTRY DEVELOPMENTS Certain proposed industry-related legislation could have an effect on both the costs of doing business and the competitive factors facing the financial institution industry. Because of the uncertainty of the final terms and likelihood of passage of the proposed legislation, the Company is unable to assess the impact of any proposed legislation on its financial condition or operations at this time. 15 PALMETTO BANCSHARES, INC. AND SUBSIDIARY Part II - Other Information Item 1. Legal Proceedings Palmetto Bancshares, Inc. (the Company) is not engaged in any legal proceedings. From time to time The Palmetto Bank (the Bank) is involved in legal proceedings incidental to its normal course of business as a bank. Management believes none of these proceedings is likely to have a materially adverse effect on the business of the Company or the Bank. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits: Exhibit No. Description ----------- ----------- 3.1.1 Articles of Incorporation filed on May 13, 1982 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 3 to the Company's Registration Statement on Form S-4, No. 33-19367, filed with the Securities and Exchange Commission on December 30, 1987 3.1.2 Articles of Amendment filed on May 5, 1988 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.2 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on August 20, 1992 3.1.3 Articles of Amendment filed on January 26, 1989 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.3 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on August 20, 1992 3.1.4 Articles of Amendment filed on April 23, 1990 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.4 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on August 20, 1992 3.1.5 Articles of Amendment filed on October 16, 1996 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 3.1.5 of the Company's quarterly report on Form 10-Q for the 16 fiscal quarter ended September 30, 1996. 3.2.1 By-Laws adopted April 10, 1990: Incorporated by reference to Exhibit 3.2.1 to the Company's 10-K, filed with the Securities and Exchange Commission on March 31, 1997. 3.2.2 Amendment to By-Laws dated April 12, 1994: Incorporated by reference to Exhibit 3.2.2 to the Company's 10-K, filed with the Securities and Exchange Commission on March 31, 1997. 4.1.1 Articles of Incorporation of the Registrant: Included in Exhibits 3.1.1 -- .5 4.2 Bylaws of the Registrant: Included in Exhibits 3.2.1 -- .2. 4.3 Specimen Certificate for Common Stock: Incorporated by reference to Exhibit 4.3 to the Company's Registration Statement on Form S-8, Commission File No. 33-51212, filed with the Securities and Exchange Commission on August 20, 1992 10.1 Palmetto Bancshares, Inc. 1997 Stock Compensation Plan filed with the Securities and Exchange Commission on March 23, 1998, as exhibit 10.1 to the Company's form 10-K. 27.1* Financial Data Schedule * Filed herewith. (b) Reports on Form 8-K The Company did not file any reports on Form 8-K during the three months ended June 30, 1998. 17 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. PALMETTO BANCSHARES, INC. By: /s/ L. Leon Patterson - --------------------------------------- L. Leon Patterson Chairman and Chief Executive Officer /s/ Paul W. Stringer - --------------------------------------- Paul W. Stringer President and Chief Operating Officer (Chief Accounting Officer) Date: July 22, 1998 18 EXHIBIT INDEX Exhibit No. Description - ----------- ----------- 3.1.1 Articles of Incorporation filed on May 13, 1982 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 3 to the Company's Registration Statement on Form S-4, No. 33-19367, filed with the Securities and Exchange Commission on December 30, 1987 3.1.2 Articles of Amendment filed on May 5, 1988 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.2 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on August 20, 1992 3.1.3 Articles of Amendment filed on January 26, 1989 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.3 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on August 20, 1992 3.1.4 Articles of Amendment filed on April 23, 1990 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 4.1.4 to the Company's Registration Statement on Form S-8, filed with the Securities and Exchange Commission on August 20, 1992 3.1.5 Articles of Amendment filed on October 16, 1996 in the office of the Secretary of State of South Carolina: Incorporated by reference to Exhibit 3.1.5 of the Company's quarterly report on Form 10-Q for the fiscal quarter ended September 30, 1996. 3.2.1 By-Laws adopted Arpil 10, 1990: Incorporated by reference to Exhibit 3.2.1 to the Company's 10-K, filed with the Securities and Exchange Commission on March 31, 1997. 3.2.2 Amendment to By-Laws dated April 12, 1994: Incorporated by reference to Exhibit 3.2.2 to the Company's 10-K, filed with the Securities and Exchange Commission on March 31, 1997. 4.1.1 Articles of Incorporation of the Registrant: Included in Exhibits 3.1.1 -- .5 4.2 Bylaws of the Registrant: Included in Exhibits 3.2.1 -- .2. 4.3 Specimen Certificate for Common Stock: Incorporated by reference to 19 Exhibit 4.3 to the Company's Registration Statement on Form S-8, Commission File No. 33-51212, filed with the Securities and Exchange Commission on August 20, 1992 27.1* Financial Data Schedule * Filed herewith. 20