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 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to ________ 0-22345 SHORE BANCSHARES, INC. (Exact name of registrant as specified in its charter) Maryland 52-1974638 - -------------------------------------- ------------------ (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 18 East Dover Street, Easton, Maryland 21601 - --------------------------------------- --------------------- (Address of Principal Executive Offices) (Zip Code) (410) 822-1400 Registrant's Telephone Number, Including Area Code Former name, former address and former fiscal year, if changed since last report. 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 by check mark whether the registrant is an accelerated filer (As defined in Rule 12b-2 of the Exchange Act). Yes X No __. APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: As of October 31, 2002, registrant had outstanding 5,372,061 shares of common stock. INDEX Part I. Item 1. Financial Statements Page Condensed Consolidated Balance Sheets - September 30, 2002 (unaudited) and December 31, 2001 3 Condensed Consolidated Statements of Income - For the three and nine months ended September 30, 2002 and 2001 (unaudited) 4 Condensed Consolidated Statements of Changes in Stockholders' Equity - For the nine months ended September 30, 2002 and 2001 (unaudited) 5 Condensed Consolidated Statements of Cash Flows - For the nine months ended September 30, 2002 and 2001 (unaudited) 6 Notes to Condensed Consolidated Financial Statements (unaudited) 7-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9-14 Item 3. Quantitative and Qualitative Disclosures about Market Risk 14 Item 4. Controls and Procedures 15 Part II. Item 6. Exhibits and Reports on Form 8-K 15 Signatures 16 Certifications 17-18 2 Part I Item 1. Financial Statements SHORE BANCSHARES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (Dollars in Thousands) September 30, December 31, ASSETS: 2002 2001 - ------- --------------- ---------------- (unaudited) Cash and due from banks $ 19,467 $ 17,424 Interest bearing deposits with other banks 6,962 14,179 Federal funds sold 33,254 20,035 Investment securities: Held-to-maturity, at amortized cost (fair value of $13,919, $11,042, respectively) 13,501 10,896 Available for sale, at fair value 107,361 114,932 Loans, less allowance for credit losses ($4,086, $4,189, respectively) 432,762 388,516 Premises and equipment, net 7,803 7,224 Accrued interest receivable on loans and investment securities 3,364 3,321 Investment in unconsolidated subsidiary 1,147 1,126 Goodwill 5,521 1,440 Other intangible assets 1,479 35 Deferred income taxes 215 681 Other real estate owned 9 56 Other assets 3,778 2,538 ----------- ----------- TOTAL ASSETS $636,623 $582,403 ======== ======== LIABILITIES: Deposits: Non-interest bearing demand $ 68,076 $ 65,305 NOW and Super NOW 92,667 91,288 Certificates of deposit $100,000 or more 92,600 75,096 Other time and savings 273,996 255,781 --------- --------- Total Deposits 527,339 487,470 Accrued interest payable 656 785 Short term borrowings 24,328 17,054 Long term debt 5,000 5,000 Other liabilities 2,800 1,124 ---------- --------- TOTAL LIABILITIES 560,123 511,433 ---------- --------- STOCKHOLDERS' EQUITY: Common Stock, Par Value $.01; authorized 35,000,000 shares; issued and outstanding: September 30, 2002 5,371,893 December 31, 2001 5,332,947 54 53 Additional paid in capital 23,833 23,039 Retained earnings 51,385 47,412 Accumulated other comprehensive income (loss) 1,228 466 --------- --------- TOTAL STOCKHOLDERS' EQUITY 76,500 70,970 --------- --------- TOTAL LIABILITIES & STOCKHOLDERS' EQUITY $636,623 $582,403 ======== ======== See accompanying notes to Condensed Consolidated Financial Statements. 3 SHORE BANCSHARES, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited) (Dollars in thousands, except per share amounts) For the three months ended September 30, For the nine months ended September 30, 2002 2001 2002 2001 ---- ---- ---- ---- INTEREST INCOME Loans, including fees $ 7,687 $ 7,801 $22,158 $23,746 Interest and dividends on investment securities: Taxable 1,374 1,280 4,378 4,256 Tax-exempt 124 191 344 418 Other interest income 150 415 434 1,189 ------- ------- -------- ------- Total interest income 9,335 9,687 27,314 29,609 ------ ------ ------ ------ INTEREST EXPENSE Certificates of deposit, $100,000 or more 756 958 2,287 3,122 Other deposits 2,143 3,059 6,909 9,506 Other interest 131 198 371 684 ----- ------ ------ ----- Total interest expense 3,030 4,215 9,567 13,312 ----- ------ ----- ------ NET INTEREST INCOME 6,305 5,472 17,747 16,297 PROVISION FOR CREDIT LOSSES 66 56 277 168 -------- ------- -------- -------- NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES 6,239 5,416 17,470 16,129 ----- ------ ------ ------ NONINTEREST INCOME Service charges on deposit accounts 477 454 1,421 1,370 Gain(loss) on sale of securities 18 - 23 (1) Insurance agency commissions 1,078 - 1,738 - Other noninterest income 241 216 713 566 ----- ------ ------ ----- Total noninterest income 1,814 670 3,895 1,935 ------ ---- ----- ----- NONINTEREST EXPENSE Salaries and employee benefits 2,596 1,740 6,761 5,273 Expenses of premises and fixed assets 454 340 1,306 1,096 Other noninterest expense 1,177 877 3,413 2,723 ------ ------ ------- ------- Total noninterest expense 4,227 2,957 11,480 9,092 ----- ------ ------- ------- INCOME BEFORE TAXES ON INCOME 3,826 3,129 9,885 8,972 Federal and State income taxes 1,338 1,111 3,500 3,142 -------- ------- ----- ----- NET INCOME $2,488 $2,018 $6,385 $5,830 ====== ====== ====== ====== Basic earnings per common share $ .46 $ .37 $ 1.19 $ 1.09 Diluted earnings per common share $ .46 $ .37 $ 1.18 $ 1.08 See accompanying notes to Condensed Consolidated Financial Statements. 4 SHORE BANCSHARES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (Unaudited) (Dollars in thousands) Accumulated Other Total Common Retained Comprehensive Stockholders' Stock Surplus Earnings Income(loss) Equity ----------- ----------- --------- --------------- ------------- Balances, January 1, 2002 $ 53 $ 23,039 $ 47,412 $ 466 $70,970 Comprehensive income: Net income - - 6,385 - 6,385 Other comprehensive income, net of tax: Unrealized gain on available for sale securities - - - 762 762 --------- Total comprehensive income 7,147 --------- Shares issued for employee benefit plans - 15 - - 15 Shares issued for acquisition of insurance agency 1 800 - - 801 Shares repurchased and retired - (21) - - (21) Cash dividends paid $0.45 per share - - (2,412) - (2,412) ------------ ------------ ------------ ------------ ------------- Balances, September 30, 2002 $ 54 $ 23,833 $ 51,385 $ 1,228 $ 76,500 ========== ======== ======== ========= ======== Balances, January 1, 2001 $ 53 $ 22,924 $ 42,601 $ (554) $ 65,024 Comprehensive income: Net income - - 5,830 - 5,830 Other comprehensive income, net of tax: Unrealized gain on available for sale securities - - - 1,632 1,632 --------- Total comprehensive income 7,462 --------- Shares issued for employee benefit plans - 89 - - 89 Cash dividends paid $0.45 per share - - (2,397) - (2,397) ------------ ----------- ------------ ------------ ------------- Balances, September 30, 2001 $ 53 $ 23,013 $ 46,034 $ 1,078 $ 70,178 ========== ======== ======== ======== ========= See accompanying Notes to Condensed Consolidated Financial Statements. 5 SHORE BANCSHARES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Dollars in thousands) For the Nine Months Ended September 30, 2002 2001 --------------- -------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net Income $ 6,385 $ 5,830 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 923 718 Discount accretion on debt securities (92) (115) Provision for credit losses, net (102) 47 Deferred income taxes (13) - (Gain) loss on sale of securities (23) 1 Loss on disposal of premises and equipment 2 - Loss on other real estate owned 4 - Equity in earnings of unconsolidated subsidiary (21) - Net changes in: Accrued interest receivable (43) (80) Other assets (1,240) (607) Accrued interest payable on deposits (129) (146) Accrued expenses 1,676 748 --------------- -------- Net cash provided by operating activities 7,327 6,396 --------------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from maturities and principal payments of securities available for sale 63,390 60,526 Proceeds from sale of investment securities available for sale 3,017 3,999 Purchase of securities available for sale (57,864) (77,711) Proceeds from maturities and principal payments of securities held to maturity 1,754 12,689 Purchase of securities held to maturity (4,367) (546) Net increase in loans (44,144) (10,950) Purchase of loans - (508) Proceeds from sale of loans - 34 Purchase of premises and equipment (753) (733) Proceeds from sale of premises and equipment 19 - Purchase other real estate owned - (47) Proceeds from sale of other real estate owned 43 - Acquisition, net of stock issued (5,103) - --------------- ------------- Net cash used in investing activities ( 44,008) (13,247) --------------- ------------- CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in demand, NOW, money market and savings deposits 24,262 6,542 Net increase in certificates of deposit 15,607 7,658 Net increase in securities sold under agreement to repurchase 7,274 4,385 Proceeds from issuance of common stock 16 89 Repurchase of common stock (21) - Dividends paid (2,412) (2,397) -------------- -------------- Net cash provided by financing activities 44,726 16,277 -------------- -------------- NET INCREASE IN CASH AND CASH EQUIVALENTS 8,045 9,426 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 51,638 39,715 ------------- -------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 59,683 $ 49,141 ============= ============== See accompanying Notes to Condensed Consolidated Financial Statements. 6 Shore Bancshares, Inc. Notes to Condensed Consolidated Financial Statements (Unaudited) 1) The consolidated financial statements include the accounts of Shore Bancshares, Inc. (the "Company") and its subsidiaries with all significant intercompany transactions eliminated. The consolidated financial statements conform to accounting principles generally accepted in the United States and to prevailing practices within the banking industry. The accompanying interim financial statements are unaudited; however, in the opinion of management all adjustments necessary to present fairly the financial position at September 30, 2002, the results of operations for the three- and nine-month periods ended September 30, 2002 and 2001, and cash flows for the nine-month periods ended September 30, 2002 and 2001, have been included. All such adjustments are of a normal recurring nature. There have been no significant changes to the Company's accounting policies as disclosed in the 2001 Annual Report. The results of operations for the nine months ended September 30, 2002 are not necessarily indicative of the results to be expected for the full year. This quarterly report on Form 10-Q should be read in conjunction with the Company's annual report on Form 10-K for the year ended December 31, 2001. 2) Year to date basic earnings per share is derived by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period of 5,354,573 shares for 2002 and 5,329,030 shares for 2001. The diluted earnings per share calculation is arrived at by dividing net income by the weighted average number of shares The diluted earnings per share calculation is derived by dividing net income by the weighted average number of shares outstanding, adjusted for the dilutive effect of outstanding options and warrants. Considering the effect of these common stock equivalents, the adjusted average shares for the nine months ended September 30, 2002 and 2001 were 5,415,176 and 5,381,339, respectively. 3) Under the provisions of Statements of Financial Accounting Standards (SFAS) Nos. 114 and 118, "Accounting by Creditors for Impairment of a Loan," a loan is considered impaired if it is probable that the Company will not collect all principal and interest payments according to the loan's contracted terms. The impairment of a loan is measured at the present value of expected future cash flows using the loan's effective interest rate, or at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loans principal balance. Interest income on other nonaccrual loans is recognized only to the extent of interest payments received. Information with respect to impaired loans and the related valuation allowance is shown below: September 30, December 31, (Dollars in thousands) 2002 2001 - ------------------------------------------------------------------------------------------------------------------------------------ Impaired loans with a specific allowance $ 20 $ 561 Impaired loans with a general allowance 734 382 -------- ------ Total impaired loans $ 754 $ 943 ======== ====== Allowance for credit losses applicable to impaired loans $ 70 $ 76 Allowance for credit losses applicable to other than impaired loans 4,016 4,113 ------- ------ Total allowance for credit losses $ 4,086 $4,189 ======== ====== Interest income on impaired loans recorded on the cash basis $ 27 $ 19 ========= ====== Impaired loans do not include groups of smaller balance homogeneous loans such as residential mortgage and consumer installment loans that are evaluated collectively for impairment. Reserves for probable credit losses related to these loans are based upon historical loss ratios and are included in the allowance for credit losses. 4) In the normal course of business, to meet the financial needs of its customers, the Banks are parties to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. At September 30, 2002, total commitments to extend credit were approximately $120,672,000. Outstanding letters of credit were approximately $ 6,301,000 at September 30, 2002. 7 5) In July 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 141(Statement 141), "Business Combinations," and Statement No. 142 (Statement 142), "Goodwill and Other Intangible Assets." Statement 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Statement 141 also specifies the criteria for intangible assets acquired in a purchase method business combination to be recognized and reported apart from goodwill. Statement 142 requires goodwill and intangible assets with indefinite lives to no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires intangible assets with definite useful lives to be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with the FASB's Statement No. 121 (Statement 121), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of." The Company adopted the provisions of Statement 141 effective July 1, 2001and Statement 142 effective January 1, 2002. As of January 1, 2002, the Company had $1,440,000 of goodwill recorded that was a result of the acquisition of a financial institution that occurred in 1997. The transaction qualified as a purchase business combination under APB 16, "Business Combinations". On May 1, 2002, $4,081,000 additional goodwill was recorded as a result of the acquisition of certain assets of The Avon-Dixon Agency, Inc. and its subsidiaries. The transaction was accounted for under SFAS No. 141, "Business Combinations". Each transferred set of assets and activities meets the definition of a business under EITF 98-3. Under the provisions of SFAS NO. 142, goodwill was subject to an initial assessment of impairment. The Company completed its initial assessment review and determined that there was no impairment of goodwill as of January 1, 2002. The Company will review goodwill on an annual basis for impairment and as events occur or circumstances change. The Company adopted SFAS NO. 142 effective January 1, 2002. The following presents the net income that would have been reported (pro-forma) had SFAS No. 142 been implemented January 1, 2001. (Dollars and amounts in thousands, except Three Months Ended Nine Months Ended per share data) September 30, September 30, - ------------------------------------------------------------------------------------------------------------------------------ 2002 2001 2002 2001 ---- ---- ---- ---- Reported net income $2,488 $2,018 $6,385 $5,830 Add back: goodwill amortization, net of tax effect - 35 - 105 --------- ---------- ------- ------ Pro-forma net income $ 2,488 $2,053 $6,385 $5,935 ===== ===== ===== ===== Basic net income per share: Reported net income $ .46 $ .37 $1.19 $1.09 Goodwill amortization - .02 - .02 --------- ---------- ------- ------- Pro-forma net income per share $ .46 $ .39 $1.19 $1.11 ==== ==== ==== ==== Diluted net income per share: Reported net income $ .46 $ .37 $1.18 $1.08 Goodwill amortization - .01 - .01 --------- ---------- ------- ------- Pro-forma net income per share $ .46 $ .38 $1.18 $1.09 ==== ==== ==== ==== The Company's other intangible assets at September 30, 2002 primarily represent unamortized intangibles related to the acquisition of The Avon-Dixon Agency, Inc. and its subsidiaries on May 1, 2002. At September 30, 2002, the carrying amount of these intangibles was $1,544,000, and they are being amortized on a straight-line basis over 5 or 15 years, depending on their estimated useful lives. Amortization expense related to other intangible assets was approximately $98,000 for the nine-month period ended September 30, 2002. In August 2001, the FASB issued SFAS No. 144, "Accounting for the Impairment of Long-Lived Assets" ("Statement 144") which supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" ("Statement 121") and the accounting and reporting provisions of APB No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for the disposal of a segment of a business. While Statement 144 retains many of the fundamental provisions of Statement 121, it establishes a single accounting model for long-lived assets to be disposed of by sale, and resolves certain implementation issues not previously addressed by Statement 121. Statement 144 is effective for fiscal 8 years beginning after December 15, 2002. This Statement did not have a material impact on the Company's financial statements. 6) On May 1, 2002, the Company completed its acquisition of certain assets of The Avon-Dixon Agency, Inc., a full service insurance agency, and its subsidiaries, all located in Easton, Maryland. The initial purchase price was $5,600,000 which was paid in the form of $4,800,000 cash and 39,037 shares of the Company's common stock, par value $.01 per share, valued at $800,000. An additional $1,400,000 may be payable if specific performance criteria set forth in the purchase agreement are realized. The Company recorded approximately $4,082,000 of goodwill and $1,542,000 of other intangible assets as a result of the acquisition. The Company is now offering a full range of insurance products and services to its customers. 7) On November 1, 2002 the Company's subsidiary, The Avon-Dixon Agency, LLC completed it's acquisition of certain assets of W. M. Freestate & Son, Inc. a full service insurance agency located in Centreville, Maryland. The initial purchase price was $768,750 which was paid in cash. An additional $512,200 may be payable if certain performance criteria set forth in the purchase agreement are realized. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Shore Bancshares, Inc. (the "Company") is the largest independent financial holding company located on the Eastern Shore of Maryland. It is the parent company of The Talbot Bank of Easton, Maryland located in Easton, Maryland and The Centreville National Bank of Maryland (collectively, the "Banks") located in Centreville, Maryland. The Banks operate 11 full service branches in Kent, Queen Anne's, Talbot, Caroline and Dorchester Counties. The Company is listed on the NASDAQ Small Cap Market, trading under the symbol "SHBI." On May 1, 2002 the Company completed its acquisition of certain assets and the assumption of certain liabilities of the Avon-Dixon Agency, Inc., a full service insurance agency, and its subsidiaries, all located in Easton, Maryland. The Company is now offering a full range of insurance products and services to its customers through three new wholly-owned subsidiaries, The Avon-Dixon Agency, LLC, Elliott Wilson Insurance, LLC, and Mubell Finance, LLC ( collectively, the "Insurance Agency"). The following discussion is designed to provide a better understanding of the financial position of the Company and should be read in conjunction with the December 31, 2001 audited Consolidated Financial Statements and Notes. Forward-Looking Information Portions of this Quarterly Report on Form 10-Q contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature, including statements that include the words "anticipate," "estimate," "should," expect," "believe," "intend," and similar expressions, are expressions about the Company's confidence, policies, and strategies, the adequacy of capital levels, and liquidity and are not guarantees of future performance. Such forward-looking statements involve certain risks and uncertainties, including economic conditions, competition in the geographic and business areas in which the Company and its affiliates operate, inflation, fluctuations in interest rates, legislation, and governmental regulation. These risks and uncertainties are described in more detail in the Company's Form 10-K, under the heading "Risk Factors." Actual results may differ materially from such forward looking statements, and the Company assumes no obligation to update forward-looking statements at any time. Critical Accounting Policies The Company's financial statements are prepared in accordance with accounting principals generally accepted in the United States of America (GAAP). The financial information contained within the financial statements is, to a significant extent, financial information contained that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. The Company believes its most critical accounting policy relates to the allowance for credit losses. The allowance for credit losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) SFAS 5, Accounting for Contingencies, which requires that losses be accrued when they are probable of occurring and estimable, and (ii) SFAS 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the loan balance and the value of collateral, present value of future cash flows or values that are observable in the secondary market. Management uses many factors, including economic conditions and trends, the value and adequacy of collateral, the volume and mix of the loan portfolio, and internal loan processes of the Company, in determining the inherent loss that may be present in the Company's loan portfolio. Actual losses could differ significantly from Management's estimates. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact the transactions could change. Management has significant discretion in making the adjustments inherent in the determination of the provision and allowance for credit losses, including in connection with the valuation of collateral, the 9 borrower's prospects of repayment, and in establishing allowance factors on the formula allowance and unallocated allowance components of the allowance. The establishment of allowance factors is a continuing exercise, based on Management's continuing assessment of the global factors such as delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of Management, national and local economic trends, concentrations of credit, quality of loan review system and the effect of external factors such as competition and regulatory requirements, and their impact on the portfolio. Allowance factors may change from period to period, resulting in an increase or decrease in the amount of the provision or allowance, based upon the same volume and classification of loans. Changes in allowance factors will have a direct impact on the amount of the provision, and a corresponding effect on net income. Errors in Management's perception and assessment of the global factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs. RESULTS OF OPERATIONS Overview Net income for the nine months ended September 30, 2002 was $6,385,000, an increase of 9.5% when compared to $5,830,000 for the same period in 2001. On a per share basis, diluted earnings were $1.18, compared to $1.08 for the same period last year. Return on average assets was 1.47% for the first nine months of 2002 compared to 1.40% for the first nine months of 2001. Return on average stockholders' equity increased from 11.53% at September 30, 2001 to 11.66% for the first nine months of 2002. Net income increased $470,000, totaling $2,488,000 for the third quarter of 2002, compared to $2,018,000 for the same period in 2001. On a per share basis, diluted earnings were $0.46 for the quarter, compared to $0.37 for the same period in 2001. Interest rates remained stable during the first nine months of 2002, however the overall yields on earning assets continues to decline as assets reprice and new assets are recorded at currently low interest rates. The average yield on earning assets was 6.36% for the nine-month period ending September 30, 2002 compared to7.56% for the same period last year. The overall rate paid for interest bearing deposits has also declined to 2.75% at September 30, 2002, compared to 4.14% one year ago. The interest rates paid for all deposits have declined as those deposits matured and repriced in the current rate environment. The average balance of loans increased $35,839,000 to $419,500,000 at September 30, 2002 when compared to September 30, 2001. The average balance of federal funds sold and interest bearing deposits with other banks increased $1,121,000 for the nine-month period ended September 30, 2002 when compared to the same period last year. The average balance of investment securities was $127,113,000 at September 30, 2002, an increase of $15,189,000 when compared to the same period last year. Average deposits increased $49,318,000 to $510,710,000 at September 30, 2002 compared to one year ago. Net Interest Income For the three months ended September 30, 2002 net interest income was $833,000 higher than the same period in 2001. The increase is the result of a $1,185,000 decrease in interest expense, primarily related to lower rates paid for deposits. Total interest income for the period declined $352,000 as a result of lower yields on earning assets. Net interest income totaled $17,747,000 for the nine months ended September 30, 2002, representing an increase of $1,450,000 or 8.9% over the same period last year. Total interest income declined $2,295,000 or 7.8%, totaling $27,314,000 for the nine months ended September 30, 2002 compared to the same period last year. Total interest expense for the nine months ended September 30, 2002 was $9,567,000, a reduction of $3,745,000 or 28.1% compared to last year. During November 2002, in response to continued weakness in the economy, the Federal Reserve cut short term interest rates by 50 basis points. During the first nine months of 2002 there had been no rate cuts, and the federal funds rate remained stable at 1.75%. The Federal Reserve cut short-term interest rates eight times during the nine-month period ended September 30, 2001, for a total of 350 basis points decline in short term rates. Yields on investment securities declined during the nine-month period as the major stock market indices continued to decline, and more investors looked to government quality investments. Loan demand remained strong, however the market for those loans is competitive. In an effort to offset the declining yields on loans, as well as the reinvestment rates available on investment securities, the Company continues to reduce the rates paid for deposits. For the nine-month period ended September 30, 2002, the Company's net interest margin declined only 4 basis points, compared to the same period last year. A further decline in the net interest margin is likely as earning assets are reinvested in the currently low interest rate environment and the Company's ability to further reduce the rates paid for interest bearing liabilities is limited. Interest and fees on loans declined $1,588,000 due to declining yields on loans for the nine-month period ended September 30, 2002 when compared to the same period in 2001. The average yield on loans declined from 8.29% to 7.09% for the nine-month period ended September 30, 2002 when compared to the same period last year. Interest on investment securities increased $48,000 due to increased volume of investments for the nine-month period ended September 30, 2002. Interest on federal funds sold and interest bearing deposits with other banks decreased $755,000 due to lower rates despite increased volume. The overall rate earned on federal funds sold was 1.76% for the nine months ended September 30, 2002, compared to 4.65% for the same period last year. The average rate earned on interest bearing deposits with other banks was 1.67% for the nine months ended September 30, 2002. 10 Interest expense declined as a result of reductions in the overall rates paid for deposits and other short term borrowings. The average rate paid for certificates of deposit decreased 141 basis points from 5.59% for the nine months ended September 30, 2001 to 4.18% for the nine months ended September 30, 2002. Average interest bearing deposits at September 30, 2002 were $446,808,000, an increase of $39,429,000 when compared to the same period in 2001. The average rate paid for NOW, savings and money market accounts was 1.23% for the nine-month period ended September 30, 2002 compared to 2.34% for the same period in 2001. On a tax equivalent basis, net interest income for the nine months ended September 30, 2002 was $1,484,000 higher than the same period last year due primarily to a decline in interest expense. The net interest margin was 4.15% when compared to 4.19% one year ago. The overall yield on earning assets declined 120 basis points to 6.36% and the overall rate paid for interest bearing liabilities declined 141 basis points to 2.71% for the nine-month period ended September 30, 2002 when compared to the same period last year. See the Analysis of Interest Rates and Interest Differentials below for further details. Loans comprised 72.3% and 72.7% of total average earning assets at September 30, 2002 and 2001, respectively. Analysis of Interest Rates and Interest Differentials. The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid through the first nine months of the year. September 30, 2002 September 30, 2001 ------------------ ------------------ Average Income Yield Average Income Yield (Dollars in thousands) Balance Expense Rate Balance Expense Rate - -------------------------------------------------------------------------------------------------------------------------------- Earning Assets Investment securities $127,113 $ 4,918 5.10% $111,924 $ 4,967 5.93% Loans 419,500 22,231 7.09% 383,661 23,792 8.29% Interest bearing deposits with other banks 7,736 96 1.67% 10,277 307 3.99% Federal funds sold 25,696 337 1.76% 22,034 777 4.65% ---------- --------- ----- ------------ -------- -------- Total earning assets $580,045 $27,582 6.36% $527,896 $29,843 7.56% Non-interest earning assets 32,132 $ 27,724 ------ -------- Total Assets $612,177 $555,620 ======== ======== Interest bearing liabilities Interest bearing deposits $446,808 $9,196 2.75% $407,379 $12,628 4.14% Short term borrowing 20,311 183 1.20% 19,147 477 3.32% Long term debt 5,000 188 5.04% 5,000 207 5.54% ---------- --------- ----- ------------ -------- ----- Total interest bearing liabilities $472,119 $9,567 2.71% $431,526 $13,312 4.12% Non-interest bearing liabilities 66,848 56,668 Stockholders' equity 73,210 67,426 ---------- ------------ Total liabilities and stockholders' equity $612,177 $555,620 ======== ======== Net interest spread $18,015 3.65% $16,531 3.43% ======= ======= Net interest margin 4.15% 4.19% (1) All amounts are reported on a tax equivalent basis computed using the statutory federal income tax rate exclusive of the alternative minimum tax rate of 34% and nondeductible interest expense. (2) Average loan balances include non-accrual loans. (3) Loan fee income is included in interest income for each loan category and yield calculations are based on the total. Non-interest Income Total non-interest income for the three- and nine-month periods ended September 30, 2002 increased $1,144,000 and $1,960,000, respectively, when compared to the same period in 2001. The increase is primarily attributable to insurance commission income resulting from the purchase of the assets of The Avon-Dixon Agency, Inc. and its subsidiaries on May 1, 2002. Insurance agency commissions for the three- and nine-month periods ended September 30, 2002 were $1,078,000 and $1,738,000, respectively. In addition, the Company had increased income from service charges, earnings of an unconsolidated subsidiary, and income from the sale of nondeposit investment products. 11 Non-interest Expense Total non-interest expense increased $1,270,000 and $2,388,000 for the three- and nine-month periods ended September 30, 2002 from the comparable period in 2001. Operation of the Company's insurance subsidiaries accounted for $978,000 and $1,610,000 of the increase during the three- and nine-months periods ended September 30, 2002, respectively, when compared to the same periods in 2001. Other increases relate to the start up costs associated with new products and services as well as general increases in overhead resulting form the growth of the Company. Income Taxes The effective tax rates for the three- and nine-month periods ended September 30,2002 were 35% and 35.4%, respectively, compared to 35.5% and 35%, respectively, for the same periods last year. There have been no significant changes in tax law or to the Company's tax structure which would materially impact the effective tax rate. Analysis of Financial Condition Loans Loans, net of allowance for credit losses and unearned income, totaled $432,762,000 at September 30, 2002, an increase of $44,246,000 or 11.4% from December 31, 2001. The increase is attributable to increased real estate lending during the year. Average loans, net of unearned income, for the nine-month period ended September 30, 2002 totaled $419,500,000, compared to $383,661,000 for the same period last year. Allowance for Credit Losses The Company has established an allowance for credit losses, which is increased by provisions charged against earnings and recoveries of previously charged-off debts. The allowance is decreased by current period charge-off of uncollectible debts. Management evaluates the adequacy of the allowance for credit losses on a quarterly basis and adjusts the provision for credit losses based upon this analysis. The evaluation of the adequacy of the allowance for credit losses is based on a risk rating system of individual loans as well as collective evaluation of smaller balance homogeneous loans based on factors such as past credit loss experience, local economic trends, non-performing and problem loans, and other factors which may impact collectibility. A loan is placed on nonaccrual when it is specifically determined to be impaired and principal and interest is delinquent for 90 days or more. The provision for credit losses was $56,000 and $277,000 for the three- and nine-month periods ended September 30, 2002, respectively, an increase of $10,000 and $109,000, respectively, when compared to the same periods last year. The increased provision is the result of continued growth in loans, identification of an increased number of watch list loans throughout the periods, as well as general economic conditions and other factors considered in the Company's methodology. A decline in nonaccrual loans and loan delinquencies during the three- and nine-month periods did not result in a decline in the provision because the loans were predominately real estate secured and posed little loss exposure to the Company. Net charge-offs for the three- and nine-month periods were $288,000 and $92,000, respectively, compared to net charge-offs of $46,000 and $121,000, respectively, for the same periods last year. The allowance for credit losses as a percentage of average loans was .97% and 1.11% as of September 30, 2002 and 2001, respectively. Based on Management's quarterly evaluation of the adequacy of the allowance for credit losses, it believes that the allowance credit losses is adequate at September 30, 2002. 12 The following table presents a summary of the activity in the allowance for credit losses. Nine Months Ended September 30, (Dollars in thousands) 2002 2001 - ------------------------------------------------------------------------------------------ Allowance balance - beginning of year $ 4,189 $ 4,199 Charge-offs: Commercial and other 273 110 Real estate 64 6 Consumer 128 85 -------- ---------- Totals 465 201 --------- ------- Recoveries: Commercial 14 33 Real estate 14 1 Consumer 57 46 ---------- ------- Totals 85 80 --------- ------- Net charge-offs: 380 121 Provision for credit losses 277 168 ---------- ---- Allowance balance-ending $ 4,086 $ 4,246 ========= ======== Average loans outstanding during period $419,500 $383,661 ======== ======== Net charge-offs (annualized) as a percentage of average loans outstanding during period .12% .04% ==== ========== Allowance for credit losses at period end as a percentage of average loans .97% 1.11% ==== ======== The general economic conditions in the Company's market area remain strong; however, because the Company's loans are predominately real estate secured, weaknesses in the local real estate market may have an adverse effect on collateral values. The Company does not have any concentrations of loans in any particular industry, nor does it engage in foreign lending activities. Nonperforming Assets The following table summarizes past due and non-performing assets of the Company. September 30, December 31, Non-performing Assets: 2002 2001 ------------ ------------ Non-accrual loans 754 943 Other real estate owned 9 56 ------ ------ 763 999 Past due loans 244 1,532 ------ ------ Total non-performing and past due loans $1,007 $2,531 ====== ====== Investment Securities Investment securities decreased $4,966,000 during the nine-month period ended September 30, 2002 when compared to December 31, 2001. The average balance of investment securities was $127,113,000 for the nine-month period ended September 30, 2002, compared to $111,924,000 for the same period in 2001. At September 30, 2002, the overall yield on investment securities was 5.10%, an 83 basis point decrease from 5.93% at September 30, 2001, on a tax equivalent basis. Deposits Total deposits at September 30, 2002 were $527,339,000, compared to $487,470,000 at December 31, 2001. Certificate of deposit rates declined significantly during 2002 as the result of lower overall interest rates. Many depositors began leaving money in shorter term certificates of deposit or money management accounts hoping that rates would increase. Certificates of deposit greater than $100,000 increased $17,504,000 during the nine-month period ended September 30, 2002 primarily as a result of an increase in municipal deposits. Other time and savings accounts increased $18,215,000 during the nine-month period ended September 30, 2002, and noninterest and interest bearing transaction accounts increased $2,771,000 during the same period. 13 Borrowed Funds Short term borrowings, which consist of securities sold under agreements to repurchase, increased $7,274,000, totaling $24,328,000 at September 30, 2002 when compared to December 31, 2001. The average rate paid for short term borrowings was 1.20% and 3.32% at September 30, 2002 and 2001, respectively. The Company also has an advance from the Federal Home Loan Bank of Atlanta in the amount $5,000,000 outstanding at September 30, 2002 and 2001. As of September 30, 2002, the interest rate on the advance was 4.97%. Liquidity and Capital Resources The Company derives liquidity through increased customer deposits, maturities in the investment portfolio, loan repayments and income from earning assets. To the extent that deposits are not adequate to fund customer loan demand, liquidity needs can be met in the short term funds markets through arrangements with its correspondent banks. The Banks are also members of the Federal Home Loan Bank of Atlanta, which provides another source of liquidity. There are no known trends or demands, commitments, events or uncertainties that Management is aware of which will materially affect the Company's ability to maintain liquidity at satisfactory levels. Total stockholders' equity was $76,500,000 at September 30, 2002, an increase of 7.8% when compared to December 31, 2001. Accumulated other comprehensive income, which consists solely of net unrealized gains and losses on investment securities available for sale, increased $762,000 since December 31, 2001, resulting in accumulated other comprehensive income at September 30, 2002 of $1,228,000. Bank regulatory agencies have adopted various capital standards for financial institutions, including risk-based capital standards. The primary objectives of the risk-based capital framework are to provide a more consistent system for comparing capital positions of financial institutions and to take into account the different risks among financial institutions' assets and off-balance sheet items. Risk-based capital standards have been supplemented with requirements for a minimum Tier 1 capital to assets ratio (leverage ratio). In addition, regulatory agencies consider the published capital levels as minimum levels and may require a financial institution to maintain capital at higher levels. A comparison of the capital as of September 30, 2002 with the minimum requirements is presented below. Minimum Actual Requirements ------ ------------ Tier 1 risk-based capital 15.42% 4.00% Total risk-based capital 16.37% 8.00% Leverage ratio 10.87% 4.00% Item 3. Quantitative and Qualitative Disclosures about Market Risk The Company's principal market risk exposure is to interest rates. The Company utilizes a simulation model to quantify the effect a hypothetical plus or minus 200 basis point change in rates would have on net interest income and the fair value of capital. The model takes into consideration the effect of call features of investments as well as repayments of loans in periods of declining rates. When actual changes in interest rates occur, the changes in interest earning assets and interest bearing liabilities may differ from the assumptions used in the model. As of December 31, 2001, the model produced the following sensitivity profile for net interest income and the fair value capital: Immediate Change in Rates Immediate Change in Rates ------------------------- +200 Basis Points -200 Basis Points Policy Limit - -------------------------------------------------------------------------------- %Change in net interest income (.43)% (2.8)% + 25% - %Change in fair value of capital (.16)% 4.4% + 15% - The Company continuously monitors exposure to interest rates and was within the policy guidelines established as of June 30, 2002, the most recent simulation analysis available. For more information regarding market risk and the Company's objectives and strategies in managing market risk, see "Management's Discussion and Analysis of Financial Condition and Results of Operations." 14 Item 4. Controls and Procedures (a) Evaluation of Disclosure Controls and Procedures The Company maintains disclosure controls and procedures (as those terms are defined in Exchange Act Rules 240.13a-14(c) and 15d-14(c)) that are designed to provide material information about the Company to the chief executive officer and the chief financial officer in a timely manner so that such information may be recorded, processed, summarized, and reported as required under the Securities Exchange Act of 1934. The chief executive officer and the chief financial officer have each reviewed and evaluated the effectiveness of the Company's current internal controls and procedures as of a date within 90 days prior to the filing date of this quarterly report and have each concluded that such disclosure controls and procedures are effective. (b) Changes in Internal Controls There have been no significant changes in the Company's internal controls or in other factors that could significantly affect such controls subsequent to the date of the evaluations by the chief executive officer and the chief financial officer. Neither the chief executive officer nor the chief financial officer is aware of any significant deficiencies or material weaknesses in the Company's internal controls, so no corrective actions have been taken with respect to such internal controls. Part II Item 6. Exhibits and Reports on Form 8-K. a) Exhibits 3.1 Shore Bancshares, Inc. Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 on Form 8-K filed by Shore Bancshares, Inc. on December 14, 2000). 3.2 Shore Bancshares, Inc. Amended and Restated By-Laws (incorporated by reference to Exhibit 3.2 on Form 8-K filed by Shore Bancshares, Inc. on December 14, 2000). 10.1 Form of Employment Agreement with W. Moorhead Vermilye (incorporated by reference to Appendix XIII of Exhibit 2.1 on Form 8-K filed by Shore Bancshares, Inc. on July 31, 2000). 10.2 Form of Employment Agreement with Daniel T. Cannon (incorporated by reference to Appendix XIII of Exhibit 2.1 on Form 8-K filed by Shore Bancshares, Inc. on July 31, 2000). 99.1 1998 Employee Stock Purchase Plan (incorporated by reference from the Shore Bancshares, Inc. Registration Statement on From S-8 filed on September 25, 1998 (Registration No. 333-64317)). 99.2 1998 Stock Option Plan (incorporated by reference from the Shore Bancshares, Inc. Registration Statement on Form S-8 filed on September 25, 1998(Registration No. 333-64319)). 99.3 Talbot Bancshares, Inc. Employee Stock Option Plan (incorporated by reference from the Shore Bancshares, Inc. Registration Statement on Form S-8 filed on May 4, 2001 (Registration No. 333-60214)). 15 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Shore Bancshares, Inc. Date: November 14, 2002 By: /s/ W. Moorhead Vermilye --------------------------------------------- W. Moorhead Vermilye President/CEO Date: November 14, 2002 By: /s/ Susan E. Leaverton ---------------------------------------------- Susan E. Leaverton, CPA Treasurer/Principal Accounting Officer 16 CERTIFICATIONS I, W. Moorhead Vermilye, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q (this "Report") of Shore Bancshares, Inc. (the "Company"); 2. Based on my knowledge, this 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 Report; 3. Based on my knowledge, the financial statements, and other financial information included in this Report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this Report; 4. The Company'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 Company and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the Company's disclosure controls and procedures as of the date within 90 days prior to the filing date of this report (the "Evaluation Date"); and c) presented in this Report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Company's other certifying officers and I have disclosed, based on our most recent evaluation, to the Company's auditors and the audit committee of Company's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls that could adversely affect the Company's ability to record, process, summarize and report financial data and have identified for the Company'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 Company's internal controls; and 6. The Company's other certifying officers and I have indicated in this 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 weakness. Date: November 14, 2002 /s/ W. Moorhead Vermilye ------------------------------- By: W. Moorhead Vermilye Title: President/CEO 17 I, Susan E. Leaverton, certify that: 1. I have reviewed this Quarterly Report on Form 10-Q (this "Report") of Shore Bancshares, Inc. (the "Company"); 2. Based on my knowledge, this 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 Report; 3. Based on my knowledge, the financial statements, and other financial information included in this Report, fairly present in all material respects the financial condition, results of operations and cash flows of the Company as of, and for, the periods presented in this Report; 4. The Company'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 Company and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) evaluated the effectiveness of the Company's disclosure controls and procedures as of the date within 90 days prior to the filing date of this report (the "Evaluation Date"); and c) presented in this Report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Company's other certifying officers and I have disclosed, based on our most recent evaluation, to the Company's auditors and the audit committee of Company's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls that could adversely affect the Company's ability to record, process, summarize and report financial data and have identified for the Company'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 Company's internal controls; and 6. The Company's other certifying officers and I have indicated in this 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 weakness. Date: November 14, 2002 /s/ Susan E. Leaverton --------------------------------- By: Susan E. Leaverton Title: Treasurer/Principal Accounting Officer 18 EXHIBIT INDEX ------------- 3.1 Shore Bancshares, Inc. Amended and Restated Articles of Incorporation (incorporated by reference to Exhibit 3.1 on Form 8-K filed by Shore Bancshares, Inc. on December 14, 2000). 3.2 Shore Bancshares, Inc. Amended and Restated By-Laws (incorporated by reference to Exhibit 3.2 on Form 8-K filed by Shore Bancshares, Inc. on December 14, 2000). 10.1 Form of Employment Agreement with W. Moorhead Vermilye (incorporated by reference to Appendix XIII of Exhibit 2.1 on Form 8-K filed by Shore Bancshares, Inc. on July 31, 2000). 10.2 Form of Employment Agreement with Daniel T. Cannon (incorporated by reference to Appendix XIII of Exhibit 2.1 on Form 8-K filed by Shore Bancshares, Inc. on July 31, 2000). 99.1 1998 Employee Stock Purchase Plan (incorporated by reference from the Shore Bancshares, Inc. Registration Statement on Form S-8 filed on September 25, 1998 (Registration No. 333-64317)). 99.2 1998 Stock Option Plan (incorporated by reference from the Shore Bancshares, Inc. Registration Statement on Form S-8 filed on September 25, 1998 (Registration No. 333-64319)). 99.3 Talbot Bancshares, Inc. Employee Stock Option Plan (incorporated by reference from the Shore Bancshares, Inc. Registration Statement on Form S-8 filed on May 4, 2001 (Registration No. 333-60214)).