US SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT Pursuant to Section 13 of the Securities Exchange Act of 1934 for the Quarterly Period Ended September 30, 1998 Commission File Number 0-22787 FOUR OAKS FINCORP, INC. (Exact name of registrant as specified in its charter) North Carolina 56-2028446 -------------- ---------- (State or other jurisdiction of (IRS Employer incorporation or organization) Identification Number) 6144 U. S. 301 South Four Oaks, N. C. 27524 ---------------------- (Address of principal executive offices) Registrant's Telephone Number, including area code 919-963-2177 ------------ Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months ( or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: [X] Yes [ ] No Indicate the number of shares outstanding of each of the issuer's classes of Common Stock as of the latest practicable date: Common Stock, 1,342,003 - -------------------------- ----------------------------- par value $1.00 per share (Number of shares outstanding (Title of Class) as of September 30, 1998) PART I - FINANCIAL INFORMATION ITEM 1 - FINANCIAL STATEMENTS CONSOLIDATED BALANCE SHEETS (All amounts in thousands) September 30, December 31, 1998 1997 ---- ---- (Unaudited) ASSETS Cash and due from banks ........................................ $ 6,175 6,454 Interest bearing bank balances ................................. 4,447 2,114 -------- -------- Total cash and cash equivalents ................................ 10,622 8,568 Investment securities .......................................... 35,582 35,082 Loans, net ..................................................... 155,623 138,099 Accrued interest receivable .................................... 3,008 2,007 Bank premises and equipment, net ............................... 5,054 5,092 Other real estate owned ........................................ 1,201 193 Intangible assets .............................................. 158 169 Prepaid expenses and other assets .............................. 874 861 -------- -------- Total assets ................................................... $212,122 190,071 ======== ======== LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Deposits: Demand - noninterest bearing ............................... $ 29,966 24,761 NOW accounts ............................................... 15,070 15,132 Savings .................................................... 18,825 17,252 Time $100,000 and over ..................................... 45,024 37,833 Other time ................................................. 78,775 73,010 -------- -------- Total deposits ............................................. 187,660 167,988 Accrued interest payable ....................................... 2,070 1,914 Other borrowed money ........................................... 3,000 3,000 Other liabilities .............................................. 473 302 -------- -------- Total liabilities .............................................. 193,203 173,204 -------- -------- Shareholders' equity: Capital stock: Common stock, $1.00 par value, 5,000,000 shares authorized, 1,342,003 and 1,313,472 issued and outstanding at September 30, 1998 and December 31, 1997 respectively 1,342 1,313 Surplus ........................................................ 5,640 5,165 Retained earnings .............................................. 11,731 10,249 Net unrealized gain (loss) on marketable equity securities ..... 206 140 -------- -------- Total shareholders' equity ..................................... 18,919 16,867 -------- -------- Total liabilities and shareholders' equity ..................... $212,122 190,071 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 2 CONSOLIDATED STATEMENTS OF INCOME - UNAUDITED (All amounts in thousands, except per share data) For the three For the nine months ended months ended September 30, September 30, 1998 1997 1998 1997 ---------------------------------- Interest income: Interest and fees on loans .......... $3,895 3,430 11,241 9,354 Interest on investment securities: US Government and agencies ........ 466 412 1,432 1,269 Municipalities .................... 51 71 164 219 Other investment securities ....... 10 24 40 71 Interest on overnight investments ... 23 6 101 23 ----- ----- ------ ------ Total interest income ..... 4,445 3,943 12,978 10,936 Interest expense: Interest on deposits ................ 2,083 1,743 5,985 4,888 Interest on borrowed money .......... 51 120 142 259 ----- ----- ------ ------ Total interest expense .... 2,134 1,863 6,127 5,147 ----- ----- ------ ------ Net interest income ................... 2,311 2,080 6,851 5,789 Provision for loan losses ............. 311 126 776 388 ----- ----- ------ ------ Net interest income after provision for loan losses .................. 2,000 1,954 6,075 5,401 ----- ----- ------ ------ Other income: Service charges ..................... 291 204 650 573 Credit life commissions ............. 21 21 81 64 Other operating income .............. 104 81 329 261 Securities gains (losses) ........... 0 6 5 16 ----- ----- ------ ------ Total noninterest income ...... 416 312 1,065 914 ----- ----- ------ ------ Other expenses: Salaries ............................ 683 598 1,995 1,706 Employee benefits ................... 84 109 347 300 Occupancy expenses .................. 62 63 184 175 Equipment expenses .................. 87 69 259 230 Other operating expenses ............ 538 524 1,545 1,462 ----- ----- ------ ------ Total noninterest expense . 1,454 1,363 4,330 3,873 ----- ----- ------ ------ Income before income taxes ............ 962 903 2,810 2,442 Income taxes .......................... 319 291 928 777 ----- ----- ------ ------ Net income ............................ $ 643 612 1,882 1,665 ====== ====== ====== ====== Net income per share .................. $ 0.48 0.48 1.42 1.31 ====== ====== ====== ====== Net income per common share, assuming dilution ................ $ 0.48 0.48 1.41 1.30 ====== ====== ====== ====== Cash dividend paid per share .......... $ 0.10 0.09 0.30 0.27 ====== ====== ====== ====== The accompanying notes are an integral part of the consolidated financial statements. 3 CONSOLIDATED STATEMENTS OF CASH FLOWS - UNAUDITED For the nine months ended September 30, September 30, (All amounts in thousands) 1998 1997 ---- ---- Operating activities Net income ............................................. $ 1,882 1,665 Adjustments to reconcile net income to cash provided by operations: Provision for loan losses ........................... 776 390 Provision for depreciation .......................... 246 212 (Gain) loss on sale of securities ................... (5) (16) (Gain) loss on sale of repossessed\foreclosed assets 11 28 Write off of loans, net of recoveries ............... -- (85) (Increase) Decrease in prepaid & other assets ....... (887) (376) (Increase) Decrease in interest receivable .......... (1001) (545) Increase (Decrease) in other liabilities ............ 184 43 Increase (Decrease) in interest payable ............. 156 174 Net amortization of bond premiums & discounts ....... 2 (5) -------- -------- Net cash provided from (used by) operating activities 1,364 1,485 -------- -------- Investing activities Proceeds from sales of investment securities ........ 14,298 13,534 Purchase of investment securities ................... (14,686) (8,660) Net increase in loans outstanding ................... (18,590) (27,411) Capital expenditures ................................ (208) (859) Proceeds from sale of assets acquired in settlement of loans ............................ 100 76 Acquisition of assets acquired in settlement of loans -- (66) -------- -------- Net cash used by investment activities .............. (19,086) (23,386) -------- -------- Financing activities Net increase (decrease) in short-term borrowings .... -- 5,000 Net increase in deposit accounts .................... 19,672 20,712 Proceeds from issuance of common stock .............. 504 297 Cash dividends ...................................... (400) (359) -------- -------- Net cash provided by financing activities ........... 19,776 25,650 -------- -------- Increase (Decrease) in cash and cash equivalents ....... 2,054 3,749 Cash and cash equivalents at beginning of period ....... 8,568 6,608 -------- -------- Cash and cash equivalents at end of period ............. $ 10,622 10,357 ======== ======== The accompanying notes are an integral part of the consolidated financial statements. 4 FOUR OAKS FINCORP, INC. Notes to Financial Statements 1. The accompanying unaudited consolidated financial statements include the accounts of the Company and its wholly owned subsidiary Four Oaks Bank & Trust Company (the "Bank"). All significant intercompany items have been eliminated. The significant accounting policies followed by the Company for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. These unaudited consolidated financial statements have been prepared in accordance with Rule 10-01 of Regulation S-X, and in management's opinion, all adjustments of a normal recurring nature necessary for a fair presentation have been included. The accompanying financial statements do not purport to contain all the necessary financial disclosures that might otherwise be necessary in the circumstances and should be read in conjunction with the consolidated financial statements and notes thereto in the Company's annual report for the year ended December 31, 1997. 2. Earnings Per Share. The following table provides a reconciliation of income available to common shareholders and the average number of common shares outstanding for the nine months ended September 30, 1998 and 1997, respectively: Nine Months Ended September 30, 1998 September 30, 1997 ------------------ ------------------ Net Income (numerator) $ 1,882,000 $ 1,665,000 ========== ========== Shares for Basic EPS (denominator) 1,330,000 842,000 Dilutive effect of stock options 4,059 14,514 ---------- ---------- Adjusted shares for diluted EPS 1,333,438 856,428 ========== ========== 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 available for sale securities. The Company's total comprehensive income for the nine months ended September 30, 1998 and 1997 was $1,948,000 and $1,693,000, respectively. Information concerning the Company's other comprehensive income for the nine months ended September 30, 1998 and 1997, respectively, is as follows (in thousands): 1998 1997 ---- ---- Unrealized gains (losses) on available for sale securities $ 109 $ 37 Reclassification of gains recognized in net income -- -- Income tax expense (benefit) relating to unrealized gains on available for sale securities (43) (9) ----- ---- Other comprehensive income (loss) $ 66 $ 28 ===== ==== 5 4. On June 15, 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (FAS 133). FAS 133 is effective for all fiscal quarters of all fiscal years beginning after June 15, 1999 (January 1, 2000 for the Company). FAS 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value are recorded each period in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Management of the Company anticipates that, due to its limited use of derivative instruments, the adoption of FAS 133 will not have a significant effect on the Company's results of operations or its financial position. 5. In October 1998, FASB issued Statement of Financial Accounting Standards No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise" (FAS 134). FAS 134 amends existing classification and accounting treatment of mortgage-backed securities, retained after mortgage loans held of sale as securitized for entities engaged in mortgage banking activities. These securities previously were classified and accounted for as trading and now may be classified as held-to-maturity or available-for-sale, also. FAS 134 is effective for the first fiscal quarter beginning after December 15, 1998. FAS 134 is not expected to have a material effect on the Company's financial statements. 6 ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion provides information about the major components of the financial condition and results of operations of the Company and should be read in conjunction with the Company's Consolidated Financial Statements and Notes thereto. Financial Condition. For the nine months ended September 30, 1998, interest bearing bank balances and investment securities combined increased 8%. These funds along with funds generated by the 12% increase in deposits were used to fund net loan increases of 13%. For the nine months ended September 30, 1998, borrowings decreased by $2,000,000. The Company's loan volumes are increasing due to seasonal funding of agricultural loans as well as growth in real estate, commercial, and consumer lending. Our local economy remains healthy with unemployment rates low and increased construction of residential and commercial properties. Accrued interest receivable has increased due to the increased volume of loans and the fact that the farm loans presently being funded are expected to pay both principal and interest in the fall after harvest. For the nine months ended September 30, 1998, other real estate owned increased to $1,201,000 due to the foreclosure of three properties since December 31, 1997. The Company presently has four properties recorded at the lower of adjusted loan value or expected selling price (i.e, September 30, 1998 fair market value). The properties anticipated values equal or exceed the recorded amount. Total shareholder's equity increased 12%, primarily attributable to the increase in retained earnings resulting from the Company's three for two split of its common stock effected as a stock dividend to shareholders of record at the close of business on July 6, 1998. Results of Operations. Net income increased 13% and 5% for the nine months and three months ended September 30, 1998, respectively, as compared to the same periods in 1997. The increases resulted from the effective management of the interest margin and increases in other income derived from new products and services. The 20% and 15% increase in loan income for the nine months and three months ended September 30, 1998, respectively, is due to loan growth. Interest earned on investments has increased due to portfolio growth and higher portfolio yields. Interest expense for the nine months and three months ended September 30, 1998, respectively, increased 19% and 15% over the same periods in 1997 due to total deposit growth of 15%, for both periods. Other expenses have increased 12% and 5% for the nine months and three months ended September 30, 1998, respectively, over the same periods of 1997. This increase is primarily due to higher salaries and operating costs resulting from additional accounts and transactions as the Company continues to grow. The Company's delinquency rate of 1.86% is favorable compared to historical trends. At September 30, 1998, the Company's nonperforming loans were $1,315,000 or 0.83% of total gross loans. The reserve for loan loss of $1,990,000 or 1.27% of total gross loans is considered adequate to cover future credit losses in the present portfolio. The provision for loan losses of $776,000 for the nine months ended September 30, 1998 increased 100% over the same period of 1997 due to additions to the reserve to offset chargeoffs on three problem loans. 7 Year 2000. As the year 2000 approaches, an important business issue has emerged regarding how existing application software programs and operating systems can accommodate this date value. Many existing application software products, including the Company's, were designed to accommodate a two-digit year. For example, "98" is stored on the system and represents 1998 and "00" represents 1900. The Bank utilizes a third-party vendor for processing its primary banking applications. In addition, the Bank also uses third-party vendor application software for all ancillary computer applications. The third-party vendor for the Company's banking applications is in the process of modifying, upgrading or replacing its computer applications to ensure Year 2000 compliance. In addition, the Company has instituted a Year 2000 compliance plan (the "Plan") whereby the Bank is reviewing the Year 2000 issues that may be faced by the Bank and its third-party vendors to ensure that the Bank's applications can properly process dates leading up to and after January 1, 2000. To assist in this effort, the Company has hired the services of a consultant to review the Plan and assist the Company in achieving Year 2000 compliance for mission critical items by December 31, 1998. "Mission critical" items include, among other things, data processing and item processing. The Plan consists of the following 5 phases: (i) Awareness, which includes customer and employee awareness of the Year 2000 problem and the establishment of a Year 2000 committee comprised of senior management (Phase one is substantially complete at this time); (ii) Assessment, which includes identifying all systems (hardware and software) that could be affected by the Year 2000 problem and testing them primarily by rolling dates forward to December 31, 1999 and allowing the system to process the data (Phase two is scheduled to be completed sometime during the fourth quarter of 1998); (iii) Renovation, which includes upgrading or replacing non-compliant systems with compliant hardware and software; (iv) Validation, which includes testing systems (hardware and software) to verify compliance (for mission critical items this Phase is scheduled to be completed by December 31, 1998); and (v) Implementation, which includes having all systems throughout the Bank Year 2000 compliant by June 30, 1999. The Company does not currently expect that the costs for ensuring that the Bank's applications properly process dates leading up to and after January 1, 2000 will be material to its financial condition and expects that the process will not result in a material disruption of its operations. In the event that the Bank's significant suppliers do not successfully and timely achieve Year 2000 compliance, the Bank's business, results of operations or financial condition could be adversely affected. As a lending institution, the Bank is also exposed to potential risk if borrowers suffer Year 2000-related difficulties and are unable to repay their loans. The Bank is discussing the Year 2000 issue with borrowers as part of the Assessment phase of the Plan and during the loan granting or renewal process. At this time, the Bank is unable to determine what impact, if any, the Year 2000 problem will have on the loan payment performance of the Bank's borrowers. Thus far, however, none of the Bank's borrowers have reported the expectation of a material adverse impact on their ability to repay loans as a result of the Year 2000 problem. The Bank is in the process of creating a contingency plan as part of the Assessment phase. The contingency plan will cover all mission critical and non-mission critical areas of the Bank's operations. The Bank estimates that the contingency plan will be complete sometime during the fourth quarter of 1998. 8 Forward Looking Information. Information set forth in this Quarterly Report on Form 10-Q, including under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations," contains various "forward looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, 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 and financial position to differ materially. Such forward looking statements can be identified by the use of the forward looking terminology, such as "may," "will," "expect," "anticipate," "estimate," or "continue" or the negative thereof or other variations thereof or comparable terminology. The Company cautions that any 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, including, without limitation, the effects of future economic conditions, governmental fiscal and monetary policies, legislative and regulatory changes, the risks of changes in interest rates on the level and composition of deposits, the effects of competition from other financial institutions, the failure of assumptions underlying the establishment of the allowance for possible loan losses, the low trading volume of the Common Stock, other considerations described in connection with specific forward looking statements and other cautionary elements specified in documents incorporated by reference in this Quarterly Report on Form 10-Q. 9 PART II - OTHER INFORMATION Item 1. Legal Proceedings There are no material pending legal proceedings involving the Company. Item 2. Changes in Securities and Use of Proceeds Not Applicable. Item 3. Defaults Upon Senior Securities Not Applicable. Item 4. Submission of Matters to a Vote of Security Holders Not Applicable. Item 5. Other Information Not Applicable. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 27 Financial Data Schedule (b) Reports on Form 8-K The Company filed a Current Report on Form 8-K, dated July 21, 1998, to amend certain effective registration statements of the Company to increase the number of shares registered thereunder to include the additional shares resulting from the application of the Company's three-for-two stock split to the registered shares remaining unsold under such registration statements as of July 21, 1998. 10 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. FOUR OAKS FINCORP, INC. Date: November 12, 1998 By: /s/ Ayden R. Lee, Jr. ----------------- ---------------------- Ayden R. Lee, Jr. President and Chief Executive Officer Date: November 12, 1998 By: /s/ Nancy S. Wise ----------------- ---------------------- Nancy S. Wise Senior Executive Vice President and Chief Financial Officer 11 INDEX TO EXHIBITS Exhibit Description 27 Financial Data Schedule 12