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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the Fiscal Year Ended December 31, 2005
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 NO. 000-23971
CITIZENS SOUTH BANKING CORPORATION
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(Exact name of registrant as specified in its charter)
Delaware 54-2069979
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
519 South New Hope Road, Gastonia, NC 28054-4040
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(Address of Principal Executive Offices) Zip Code
(704)868-5200
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(Registrant's telephone number)
Securities Registered Pursuant to
Section 12(b) of the Act: None
Securities Registered Pursuant to
Section 12(g) of the Act: Common Stock, par value $0.01 per share
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(Title of Class)
Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. YES [X] NO [ ]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. YES [ ] NO [X]
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 twelve months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
requirements for the past 90 days. YES [X] NO [ ].
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X].
Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large Accelerated Filer [ ] Accelerated Filer [X] Non-Accelerated Filer [ ]
Indicate by check mark whether the Registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). YES [ ] NO [X]
As of March 13, 2006, there were issued and outstanding 8,279,320 shares of
the Registrant's Common Stock.
The aggregate market value of the voting and non-voting common equity held
by non-affiliates of the Registrant, computed by reference to the last sale
price on March 13, 2006, as reported by the Nasdaq National Market, was
approximately $83.4 million.
DOCUMENTS INCORPORATED BY REFERENCE
(1) Proxy Statement for the 2006 Annual Meeting of Stockholders of the
Registrant (Part III).
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CITIZENS SOUTH BANKING CORPORATION
AND SUBSIDIARIES
FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005
TABLE OF CONTENTS
PAGE
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PART I
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Item 1. Business..................................................................... 1
Item 1A. Risk Factors ................................................................ 7
Item 1B. Unresolved Staff Comments.................................................... 9
Item 2. Properties................................................................... 10
Item 3. Legal Proceedings............................................................ 11
Item 4. Submission of Matters to a Vote of Security Holders.......................... 11
PART II
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Item 5. Market for Registrant's Common Stock, Related Shareholder Matters
and Purchases of Equity Securities.......................................... 11
Item 6. Selected Financial Data...................................................... 13
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations..................... 14
Item 7A. Quantitative and Qualitative Disclosures About Market Risk................... 38
Item 8. Financial Statements and Supplementary Data.................................. 39
Report of Independent Registered Public Accounting Firm...................... 39
Consolidated Statements of Financial Condition............................... 40
Consolidated Statements of Operations........................................ 41
Consolidated Statements of Comprehensive Income.............................. 42
Consolidated Statements of Changes in Stockholders Equity.................... 43
Consolidated Statements of Cash Flows........................................ 44
Notes to Consolidated Financial Statements................................... 45
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure........................................................ 68
Item 9A. Controls and Procedures...................................................... 68
Management's Annual Report on Internal Control over Financial Reporting...... 68
Report of Independent Registered Public Accounting Firm...................... 70
Item 9B. Other Information............................................................ 72
PART III
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Item 10. Directors and Executive Officers of the Registrant........................... 72
Item 11. Executive Compensation....................................................... 72
Item 12. Security Ownership of Certain Beneficial Owners and Management............... 72
Item 13. Certain Relationships and Related Transactions............................... 72
Item 14. Principal Accountant Fees and Services....................................... 72
Item 15. Exhibits, Financial Statement Schedules, and Reports on Forms 8-K............ 73
SIGNATURES
PART I
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ITEM 1. BUSINESS
CITIZENS SOUTH BANKING CORPORATION
Citizens South Banking Corporation (also referred to as the "Company", the
"Registrant", "We", "Us", or "Our") is a Delaware corporation that owns all of
the outstanding shares of common stock of Citizens South Bank (the "Bank"). The
shares of common stock of the Company trade on the Nasdaq National Market under
the ticker symbol "CSBC." The Company's principal business activities are
overseeing and directing the business of the Bank. The Company's assets consist
primarily of the outstanding capital stock of the Bank, deposits held at the
Bank, and investment securities. The Company became the holding company for the
Bank on September 30, 2002, in connection with the mutual-to-stock conversion of
Citizens South Holdings, MHC, the mutual holding company of Citizens South
Banking Corporation, a federal corporation, formerly named Gaston Federal
Bancorp, Inc., which was originally formed on March 18, 1998, for the purpose of
acting as the holding company for the Bank.
The Company's executive office is located at 519 South New Hope Road, P.O.
Box 2249, North Carolina 28053-2249. Its telephone number at this address is
(704) 868-5200. The Company also maintains a website at www.citizenssouth.com
that includes important information on our Company, including a list of our
products and services, branch locations, current financial information, and
links to the Company's 1934 Securities Exchange Act filings with the SEC.
CITIZENS SOUTH BANK
Citizens South Bank, which was chartered in 1904, is a federally chartered
savings bank headquartered in Gastonia, North Carolina. The Bank's principal
business activity is offering FDIC-insured deposits to local customers through
its 15 branch offices and investing those deposits, together with funds
generated from operations and borrowings, in residential and nonresidential real
estate loans, construction loans, commercial business loans, consumer loans,
investment securities, and mortgage-backed securities. The Bank also acts as a
broker in both the origination of loans secured by one-to-four family dwellings
and in the sale of uninsured financial products. The Bank's results of
operations are heavily dependent on net interest income, which is the difference
between the interest earned on loans and securities and the interest paid on
deposits and borrowings. Results of operations are also materially affected by
the Bank's provision for loan losses, gains or losses from the sales of assets,
fee income generated from deposit and loan accounts, commissions earned from the
sale of uninsured investment products, and noninterest expenses. The Bank's
noninterest expense primarily consists of compensation and employee benefits,
occupancy expense, professional services, advertising, and other noninterest
expenses. Results of operations are also significantly affected by general
economic and competitive conditions, changes in interest rates, and actions of
regulatory and governmental authorities.
Citizens South Bank has 15 full-service branch offices in the North
Carolina Counties of Gaston, Union, Rowan, and Iredell and one loan production
office located in Mecklenburg County, North Carolina. The Bank's executive
office is located at 519 South New Hope Road, P.O. Box 2249, Gastonia, North
Carolina 28053-2249. Its telephone number at this address is (704) 868-5200.
ACQUISITION OF TRINITY BANK
On October 31, 2005, the Company consummated the merger of Trinity Bank
("Trinity") into Citizens South Bank. At the time of the acquisition, Trinity
had total assets of approximately $165 million, total loans of $114 million,
total deposits of $136 million and total equity of $13 million. Trinity was
headquartered in Monroe, North Carolina, which is approximately 50 miles east of
the Company's headquarters. Trinity had three offices located in Union County,
North Carolina, which has the fastest population growth of any county in North
Carolina. The combined bank has 15 full-service locations and one loan
production office, and ranks 8th in the Charlotte Metropolitan Statistical Area
in deposit market share.
1
Under the terms of the merger agreement, the Company issued a combination
of shares of common stock and cash for the outstanding shares of common stock of
Trinity Bank. Trinity shareholders were given the option of receiving 1.3931
shares of Citizens South common stock for each share of Trinity common stock,
$18.25 in cash for each share of Trinity common stock, or a mixture of stock and
cash for each Trinity share, such that 50% of the shares of Trinity common stock
would be exchanged for Citizens South common stock. On October 31, 2005, Trinity
shareholders received merger consideration of approximately 1,280,052 shares of
common stock of the Company (subject to payment of cash in lieu of fractional
shares) and approximately $16.8 million in cash (including cash paid in lieu of
fractional shares), resulting in a total transaction value of approximately
$37.8 million. The transaction price represented approximately 255% of Trinity's
book value as of September 30, 2005. Additional information regarding this
transaction may be obtained by reviewing the Registration Statement that the
Company filed with the Securities and Exchange Commission on August 1, 2005, and
amended September 14, 2005.
In order to provide financing for the cash portion of the Trinity
acquisition, on October 28, 2005, the Company completed a private placement of
an aggregate amount of $15.0 million in trust preferred securities, liquidation
amount of $1,000 per security (the "Preferred Securities"), through a newly
formed Delaware statutory trust subsidiary, CSBC Statutory Trust I (the
"Trust"). In connection with the issuance of the Preferred Securities, on
October 28, 2005, the Company entered into an Indenture by and between the
Company and Wilmington Trust Company, as trustee. The Preferred Securities
mature on December 15, 2035, but may be redeemed beginning December 15, 2010, if
the Company exercises its rights to redeem the Debentures. The Preferred
Securities require quarterly interest payments to the holders of the Preferred
Securities, initially at a fixed rate of 6.095% through December 2010, and
thereafter at a variable rate of three-month LIBOR plus 1.57%, reset quarterly.
Additional information regarding the Preferred Securities may be obtained by
reviewing the Current Report on Form 8-K filed with the Securities and Exchange
Commission on November 4, 2005.
MARKET AREA AND COMPETITION
We consider our primary market area to be the North Carolina Counties of
Gaston, Rowan, Iredell, Union, Mecklenburg, Cabarrus, Lincoln, and Cleveland,
and the South Carolina County of York. Our market area predominately centers in
the suburbs surrounding the metropolitan area of Charlotte, North Carolina. The
metropolitan area of Charlotte has a diverse economic base that includes
business sectors in banking and finance, insurance, manufacturing, textiles,
apparel, fabricated metals, construction, health care, transportation, retail
trade, telecommunications, government services, and education. The Bank's
corporate headquarters is located in Gastonia, North Carolina, which is located
in the I-85 corridor, approximately 20 miles west of Charlotte.
The Bank's corporate headquarters and eight of its branch offices are
located in Gaston County, North Carolina. These offices are located in the
cities of Gastonia (four offices), Dallas, Mount Holly, Belmont, and Stanley.
According to data provided by the FDIC as of June 30, 2005, there were 13 banks
and thrifts operating in Gaston County with $1.9 billion in deposits. As of June
30, 2005, the Bank had $188.6 million in deposits in Gaston County, or 9.9% of
the total County deposits. This represents the third highest market share in
Gaston County.
We also have three branch offices in Union County, North Carolina, in the
cities of Monroe, Stallings, and Weddington. According to data provided by the
FDIC as of June 30, 2005, there were nine banks and thrifts operating in Union
County with $1.3 billion in deposits. As of June 30, 2005, the Bank had $129.3
million in deposits in Union County, or 9.6% of the total County deposits. This
represents the fifth highest market share in the County.
The Bank also has two branch offices in Rowan County, North Carolina, in
the cities of Salisbury and Rockwell. According to data provided by the FDIC as
of June 30, 2005, there were 12 banks and thrifts operating in Rowan County with
$1.3 billion in deposits. As of June 30, 2005, the Bank had $110.7 million in
deposits in Rowan County, or 8.8% of the total County deposits. This represents
the fourth highest market share in the County.
We also have two branch offices in Iredell County, North Carolina, in the
cities of Statesville and Mooresville. According to data provided by the FDIC as
of June 30, 2005, there were 16 banks and thrifts operating in Iredell County
with $1.7 billion in deposits. As of June 30, 2005, the Bank had $75.7 million
in deposits in Iredell County, or 4.3% of the total County deposits. This
represents the eighth highest market share in the County.
2
EMPLOYEES
As of December 31, 2005, the Company had 146 full-time and 14 part-time
employees, none of whom is represented by a collective bargaining unit. The
Company provides employee benefit programs, including an Employee Stock
Ownership Plan, matching contributions to a 401(k) retirement/savings plan,
group life, heath, and dental insurance, and paid vacation and sick leave.
Management believes its relationship with its employees is good.
SUPERVISION AND REGULATION
Citizens South Banking Corporation is a unitary savings and loan holding
company, subject to regulation and supervision by the Office of Thrift
Supervision ("OTS"). The OTS has enforcement authority over Citizens South
Banking Corporation and its non-savings institution subsidiaries. This authority
permits the OTS to restrict or prohibit activities that are determined to be a
risk to Citizens South Bank. Federal law prohibits a savings and loan holding
company from acquiring control of another savings institution or holding company
thereof, without prior written approval of the OTS. It also prohibits the
acquisition or retention of, with specified exceptions, more than 5% of the
equity securities of a company engaged in activities that are not closely
related to banking or financial in nature or acquiring or retaining control of
an institution that is not federally insured. In evaluating applications by
holding companies to acquire savings institutions, the OTS must consider the
financial and managerial resources, future prospects of the savings institution
involved, the effect of the acquisition on the risk to the insurance fund, the
convenience and needs of the community and competitive factors.
Citizens South Bank is a federal savings bank and derives its lending and
investment powers from the Home Owners' Loan Act, as amended, and the
regulations of the OTS. Under these laws and regulations, Citizens South Bank
may invest in mortgage loans secured by residential and commercial real estate,
commercial business and consumer loans, certain types of debt securities and
certain other assets. Citizens South Bank also may establish subsidiaries that
may engage in activities not otherwise permissible for Citizens South Bank,
including real estate investment and securities and insurance brokerage.
Citizens South Bank is a federally chartered SAIF-insured stock savings bank,
subject to examination, supervision, and regulation by the OTS, as its primary
federal regulator, and the Federal Deposit Insurance Corporation ("FDIC"), as
the deposit insurer. Citizens South Bank is also a member of and owns stock in
the Federal Home Loan Bank of Atlanta, which is a part of the Federal Home Loan
Bank System. The Bank must file reports with the OTS and the FDIC concerning its
activities and financial condition in addition to obtaining regulatory approvals
prior to entering into certain transactions such as mergers or acquisitions.
This regulation and supervision establishes a comprehensive framework of
activities in which an institution may engage and is intended primarily for the
protection of the insurance fund and depositors. Under this system of federal
regulation, financial institutions are periodically examined to ensure that they
satisfy applicable standards with respect to their capital adequacy, assets,
management, earnings, liquidity and sensitivity to market interest rates.
Citizens South Bank is also regulated to a lesser extent by the Board of
Governors of the Federal Reserve System, governing reserves to be maintained
against deposits and other matters. Citizens South Bank's relationship with its
depositors and borrowers also is regulated to a great extent by both federal and
state laws, especially in matters concerning the ownership of deposit accounts
and the form and content of Citizens South Bank's loan documents.
The following discussion summarizes certain material elements of the
regulatory framework applicable to Citizens South Banking Corporation and its
subsidiaries. These summaries of statutes and regulations are not intended to be
complete and such summaries are qualified in their entirety by reference to such
statutes and regulations. A change in the statutes, regulations, or regulatory
policies applicable to the Company, or its subsidiaries, could have a material
effect on the business of the Company.
Standards for Safety and Soundness. Federal law requires each federal
banking agency to prescribe certain standards for all insured depository
institutions. These standards relate to, among other things, internal controls,
information systems and audit systems, loan documentation, credit underwriting,
interest rate risk exposure, asset growth, compensation, and other operational
and managerial standards as the agency deems appropriate. If the appropriate
federal banking agency determines that an institution fails to meet any standard
prescribed by the guidelines, the agency may require the institution to submit
to the agency an acceptable plan to achieve compliance with the standard. If an
institution fails to meet these standards, the appropriate federal banking
agency may require the institution to submit a compliance plan. The OTS has
primary enforcement responsibility over federal savings institutions and has the
authority to bring enforcement action against all "institution-affiliated
parties," including stockholders, and attorneys, appraisers and accountants who
knowingly or recklessly participate in wrongful action likely to have an adverse
effect on an insured institution. Formal enforcement action may range from the
issuance of a capital directive, a cease and desist order, removal of officers
and/or directors of the institution, receivership, conservatorship, civil
penalties, or the termination of deposit insurance. The FDIC also has the
authority to recommend to the Director of the OTS that enforcement action be
taken with respect to a particular savings institution. If action is not taken
by the Director, the FDIC has authority to take action under specified
circumstances.
3
OTS regulations require savings banks to meet three minimum capital
standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8%
risk-based capital ratio. At December 31, 2005, Citizens South Bank's capital
exceeded all applicable requirements. Under prompt corrective action
regulations, the OTS is required and authorized to take supervisory actions
against undercapitalized savings banks. For this purpose, a savings bank is
placed in one of the following five categories based on the bank's capital: 1)
well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and
10% total risk-based capital); 2) adequately capitalized (at least 4% leverage
capital, 4% tier 1 risk-based capital and 8% total risk-based capital); 3)
undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based
capital or 3% leverage capital); 4) significantly undercapitalized (less than 6%
total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital);
and 5) critically undercapitalized (less than 2% tangible capital). At December
31, 2005, Citizens South Bank met the criteria for being considered
"well-capitalized."
OTS regulations govern capital distributions by a federal savings bank,
which include cash dividends, stock repurchases and other transactions charged
to the capital account. A savings bank must file an application for approval of
a capital distribution if; (1) the total capital distributions for the
applicable calendar year exceed the sum of the savings bank's net income for
that year to date plus the savings bank's retained net income for the preceding
two years; (2) the bank would not be at least adequately capitalized following
the distribution; (3) the distribution would violate any applicable statute,
regulation, agreement or OTS-imposed condition; or (4) the savings bank is not
eligible for expedited treatment of its filings. Even if an application is not
otherwise required, every savings bank that is a subsidiary of a holding company
must still file a notice with the OTS at least 30 days before the board of
directors declares a dividend or approves a capital distribution. The OTS may
disapprove a notice or application if; (1) the savings bank would be
undercapitalized following the distribution; (2) the proposed capital
distribution raises safety and soundness concerns; or (3) the capital
distribution would violate a prohibition contained in any statute, regulation or
agreement.
Community Reinvestment Act and Fair Lending Laws. All savings banks have a
responsibility under the Community Reinvestment Act and related regulations of
the OTS to help meet the credit needs of their communities, including low- and
moderate-income neighborhoods. In connection with its examination of a federal
savings bank, the OTS is required to assess the savings bank's record of
compliance with the Community Reinvestment Act. In addition, the Equal Credit
Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in
their lending practices on the basis of characteristics specified in those
statutes. A bank's failure to comply with the provisions of the Community
Reinvestment Act could, at a minimum, result in regulatory restrictions on its
activities. The failure to comply with the Equal Credit Opportunity Act and the
Fair Housing Act could result in enforcement actions by the OTS, as well as
other federal regulatory agencies and the Department of Justice. Citizens South
Bank received a "Satisfactory" Community Reinvestment Act rating in its most
recent federal examination.
Transactions with Affiliates. A federal savings bank's authority to engage
in transactions with its "affiliates" is limited by OTS regulations and by
Sections 23A and 23B of the Federal Reserve Act (the "FRA"). The term
"affiliates" for these purposes generally means any company that controls or is
under common control with an institution. Citizens South Banking Corporation and
its non-savings institution subsidiaries are affiliates of Citizens South Bank.
In general, transactions with affiliates must be on terms that are as favorable
to the savings bank as comparable transactions with non-affiliates. In addition,
certain types of these transactions are restricted to an aggregate percentage of
the savings bank's capital. Collateral in specified amounts must usually be
provided by affiliates in order to receive loans from the savings bank. In
addition, OTS regulations prohibit a savings bank from lending to any of its
affiliates that are engaged in activities that are not permissible for bank
holding companies and from purchasing the securities of any affiliate, other
than a subsidiary.
4
Citizens South Bank's authority to extend credit to its directors,
executive officers and 10% shareholders, as well as to entities controlled by
such persons, is currently governed by the requirements of Sections 22(g) and
22(h) of the FRA and Regulation O of the Federal Reserve Board. Among other
things, these provisions require that extensions of credit to insiders (i) be
made on terms that are substantially the same as, and follow credit underwriting
procedures that are not less stringent than, those prevailing for comparable
transactions with unaffiliated persons and that do not involve more than the
normal risk of repayment or present other unfavorable features, and (ii) not
exceed certain limitations on the amount of credit extended to such persons,
individually and in the aggregate, which limits are based, in part, on the
amount of Citizens South Bank's capital. In addition, extensions of credit in
excess of certain limits must be approved by Citizens South Bank's Board of
Directors.
Qualified Thrift Lender Test. As a federal savings bank, Citizens South
Bank is subject to a qualified thrift lender, or "QTL," test. Under the QTL
test, Citizens South Bank must maintain at least 65% of its portfolio assets in
qualified thrift investments in at least nine months of the most recent 12-month
period. Portfolio assets generally means total assets of a savings institution,
less the sum of specified liquid assets up to 20% of total assets, goodwill and
other intangible assets, and the value of property used in the conduct of the
savings bank's business. Qualified thrift investments includes various types of
loans made for residential and housing purposes, investments related to such
purposes, including certain mortgage-backed and related securities, and loans
for personal, family, household and certain other purposes up to a limit of 20%
of portfolio assets. Qualified thrift investments also include 100% of an
institution's credit card loans, education loans and small business loans.
Citizens South Bank also may satisfy the QTL test by qualifying as a "domestic
building and loan association" as defined in the Internal Revenue Code of 1986.
A savings bank that fails the qualified thrift lender test must either convert
to a bank charter or operate under specified restrictions. At December 31, 2005,
Citizens South Bank maintained approximately 76% of its portfolio assets in
qualified thrift investments and satisfied the QTL test as of that date.
Insurance of Deposit Accounts. Deposit accounts in Citizens South Bank are
insured by the Savings Association Insurance Fund of the Federal Deposit
Insurance Corporation, generally up to a maximum of $100,000 per separately
insured depositor. Citizens South Bank's deposits therefore are subject to FDIC
deposit insurance assessments. The FDIC has adopted a risk-based system for
determining deposit insurance assessments. The FDIC is authorized to raise the
assessment rates as necessary to maintain the required ratio of reserves to
insured deposits of 1.25%. In addition, all FDIC-insured institutions must pay
assessments to the FDIC at an annual rate of approximately 0.015% of insured
deposits to fund interest payments on bonds maturing in 2017 issued by a federal
agency to recapitalize the predecessor to the Savings Association Insurance
Fund.
On February 15, 2006, federal legislation to reform federal deposit
insurance was signed into law. This law requires, among other things, the merger
of the Savings Association Insurance Fund and the Bank Insurance Fund into a
unified insurance deposit fund, an increase in the amount of federal deposit
insurance coverage from $100,000 to $130,000 (with a cost of living adjustment
to become effective in five years), and the reserve ratio to be modified to
provide for a range between 1.15% and 1.50% of estimated insured deposits. The
law requires the FDIC to issue implementing regulations and the changes required
by the law will not become effective until final regulations have been issued,
which must be no later than 270 days from February 15, 2006.
Federal Home Loan Bank System. Citizens South Bank is a member of the
Federal Home Loan Bank System ("FHLB"), which provides a central credit facility
primarily for member institutions. As a member of the FHLB of Atlanta, Citizens
South Bank is required to acquire and hold shares of capital stock in the FHLB
in an amount at least equal to 1% of the aggregate principal amount of its
unpaid residential mortgage loans and similar obligations at the beginning of
each year, or 1/20 of its borrowings from the FHLB, whichever is greater. As of
December 31, 2005, Citizens South Bank was in compliance with this requirement.
Federal Reserve System. The Federal Reserve Board regulations require
savings banks to maintain non-interest-earning reserves against their
transaction accounts, such as negotiable order of withdrawal and regular
checking accounts. At December 31, 2005, Citizens South Bank was in compliance
with these reserve requirements. The balances maintained to meet the reserve
requirements imposed by the Federal Reserve Board may be used to satisfy
liquidity requirements imposed by the Office of Thrift Supervision.
The Gramm-Leach-Bliley Financial Modernization Act of 1999. The
Gramm-Leach-Bliley Act ("G-L-B Act") was enacted in November 1999. The G-L-B Act
restricted unitary savings and loan holding companies to those activities
permissible for financial holding companies or for multiple savings and loan
holding companies. A financial holding company may engage in activities that are
financial in nature, including underwriting equity securities and insurance,
incidental to financial activities or complementary to a financial activity. A
multiple savings and loan holding company is generally limited to activities
permissible for bank holding companies under Section 4(c)(8) of the Bank Holding
Company Act, subject to the prior approval of the OTS, and certain additional
activities authorized by OTS regulations.
5
The USA PATRIOT Act. The USA Patriot Act of 2001 gives the federal
government new powers to address terrorist threats through enhanced domestic
security measures, expanded surveillance powers, increased information sharing
and broadened anti-money laundering requirements. The USA Patriot Act also
requires the federal banking agencies to take into consideration the
effectiveness of controls designed to combat money laundering activities in
determining whether to approve a merger or other acquisition application of a
member institution. Accordingly, if we engage in a merger or other acquisition,
our controls designed to combat money laundering would be considered as part of
the application process. We have established policies, procedures and systems
designed to comply with these regulations.
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act of 2002 was enacted in
response to public concerns regarding corporate accountability in connection
with certain accounting scandals. The stated goals of the Sarbanes-Oxley Act are
to increase corporate responsibility, to provide for enhanced penalties for
accounting and auditing improprieties at publicly traded companies, and to
protect investors by improving the accuracy and reliability of corporate
disclosures pursuant to the securities laws. The Sarbanes-Oxley Act generally
applies to all companies that file or are required to file periodic reports with
the Securities and Exchange Commission, under the Securities Exchange Act of
1934.
The Sarbanes-Oxley Act includes specific additional disclosure
requirements, requires the Securities and Exchange Commission and national
securities exchanges to adopt extensive additional disclosure, corporate
governance and other related rules, and mandates further studies of certain
issues by the Securities and Exchange Commission. The Sarbanes-Oxley Act
represents significant federal involvement in matters traditionally left to
state regulatory systems, such as the regulation of the accounting profession,
and to state corporate law, such as the relationship between a board of
directors and management and between a board of directors and its committees.
Federal Securities Laws. Citizens South Banking Corporation common stock is
registered with the Securities and Exchange Commission under the Securities
Exchange Act of 1934. Citizens South Banking Corporation is subject to the
information, proxy solicitation, insider trading restrictions and other
requirements under the Securities Exchange Act of 1934. Shares of common stock
purchased by persons who are not affiliates of Citizens South Banking
Corporation may be resold without registration. Shares purchased by an affiliate
of Citizens South Banking Corporation will be subject to the resale restrictions
of Rule 144 under the Securities Act of 1933. If Citizens South Banking
Corporation meets the current public information requirements of Rule 144 under
the Securities Act of 1933, each affiliate of Citizens South Banking Corporation
that complies with the other conditions of Rule 144, including those that
require the affiliate's sale to be aggregated with those of other persons, would
be able to sell in the public market, without registration, a number of shares
not to exceed, in any three-month period, the greater of 1% of the outstanding
shares of Citizens South Banking Corporation, or the average weekly volume of
trading in the shares during the preceding four calendar weeks. In the future,
Citizens South Banking Corporation may permit affiliates to have their shares
registered for sale under the Securities Act of 1933.
TAXATION
Federal. The Company and the Bank are subject to the provisions of the
Internal Revenue Code of 1986, as amended (the "Code") in the same general
manner as other corporations. For federal income tax purposes, the Bank reports
its income and expenses on the accrual method of accounting and uses a tax year
ending December 31 for filing its federal income tax returns.
The Small Business Protection Act of 1996 (the "1996 Act") eliminated the
use of the reserve method of accounting for bad debt reserves by savings
institutions, effective for taxable years beginning after 1995. Prior to the
1996 Act, the Bank was permitted to establish a reserve for bad debts and to
make annual additions to the reserve. As a result of the 1996 Act, the Bank was
required to use the specific charge off method in computing its bad debt
deduction beginning with its 1996 federal tax return. In addition, the 1996 Act
required the recapture of the excess of tax bad debt reserves at September 30,
1996 over those established as of September 30, 1988. The reserve was recaptured
over a six-year period and was completely amortized as of December 31, 2005.
6
State of North Carolina. Under North Carolina law, the corporate income tax
is 7.0% of federal taxable income as computed under the Code, subject to certain
prescribed adjustments. In addition, an annual state franchise tax is imposed at
a rate of 0.15% applied to the greatest of the company's capital stock, surplus
and undivided profits, investment in tangible property in North Carolina or 55%
of the appraised valuation of property in North Carolina.
State of Delaware. Delaware franchise taxes are imposed on the Company. Two
methods are provided for calculating the tax and the lesser tax is payable. The
first method is based on the authorized number of shares. The tax under this
method is $90.00 for the first 10,000 authorized number of shares plus $50.00
for each additional 10,000 shares or part thereof. The second method is based on
an assumed par value capital. The tax rate under this method is $200 per
$1,000,000 or portion thereof of assumed par value capital. Assumed par is
computed by dividing total assets by total issued shares (including treasury
shares). Assumed par value capital is calculated by multiplying the lesser of
assumed par or stated par value by total authorized shares.
ITEM 1A. RISK FACTORS
You should consider carefully the following risk factors in evaluating an
investment in the shares of Citizens South Banking Corporation common stock.
Citizens South Banking Corporation's Commercial Real Estate, Multi-Family
Construction, and Commercial Business Loans Expose It to Increased Lending
Risks.
At December 31, 2005, Citizens South Banking Corporation's portfolio of
commercial real estate, multifamily, and construction loans totaled $272.6
million, or 57.56% of total gross loans, and its portfolio of commercial
business loans totaled $30.1 million, or 6.36% of total gross loans. These types
of loans generally expose a lender to greater risk of non-payment and loss than
one- to four-family residential mortgage loans because repayment of the loans
often depends on the successful operations and the income stream of the
borrowers. Such loans typically involve larger loan balances to single borrowers
or groups of related borrowers compared to one- to four-family residential
mortgage loans. Also, many of Citizens South Banking Corporation's borrowers
have more than one commercial real estate or multi-family loan outstanding with
it. Consequently, an adverse development with respect to one loan or one credit
relationship can expose it to a significantly greater risk of loss compared to
an adverse development with respect to a one- to four-family residential
mortgage loan.
Citizens South Banking Corporation May Fail to Realize the Anticipated
Benefits of its Recent Merger.
On October 31, 2005, Citizens South Bank completed its acquisition of
Trinity Bank. The success of the merger will depend on, among other things, the
Company's ability to realize anticipated cost savings and to combine the
businesses of Citizens South Bank and Trinity Bank in a manner that does not
materially disrupt the existing customer relationships of Citizens South Bank or
Trinity Bank or result in decreased revenues from any loss of customers. If the
Company is not able to successfully achieve these objectives, the anticipated
benefits of the merger may not be realized fully or at all or may take longer to
realize than expected.
Citizens South Banking Corporation's Financial Success Depends, in Part, on
the Successful Integration of Trinity Bank Following the Merger.
Citizens South Banking Corporation's future growth and profitability
depends, in part, on its ability to manage the combined operations of Citizens
South Bank and Trinity Bank. For the acquisition to be successful, the Company
will have to succeed in combining the personnel and operations of Citizens South
Bank and Trinity Bank and in achieving expense savings by eliminating redundant
operations. Citizens South Banking Corporation cannot assure you that its plan
to integrate and operate the combined operations will be timely or efficient, or
that it will successfully retain existing customer relationships of Trinity
Bank.
Changes in Market Interest Rates Could Adversely Affect Citizens South
Banking Corporation's Financial Condition and Results of Operations.
7
Citizens South Banking Corporation's results of operations and financial
condition are significantly affected by changes in interest rates. Its results
of operations depend substantially on net interest income, which is the
difference between the interest income earned on interest-earning assets and the
interest expense paid on interest-bearing liabilities. Because interest-earning
assets generally reprice or mature more quickly than interest-bearing
liabilities, a decrease in interest rates generally would result in a decrease
in the Company's net interest income. Based on results generated by its interest
rate risk model, an immediate and sustained decrease of 200 basis points
throughout the yield curve would decrease its annual net interest income by
17.0% for the period ended December 31, 2005. The assumptions used in the model
do not provide for actions that may be taken by management during the period to
offset the effects of changes in interest rates on net interest income.
Changes in interest rates also affect the value of Citizens South Banking
Corporation's interest-earning assets, and in particular its securities
portfolio. Generally, the value of securities fluctuates inversely with changes
in interest rates. At December 31, 2005, Citizens South Banking Corporation's
investment and mortgage-backed securities available for sale totaled $123.7
million. Unrealized losses on securities available for sale, net of tax,
amounted to $1.6 million and are reported as a separate component of
stockholders' equity. Decreases in the fair value of securities available for
sale, therefore, could have an adverse effect on stockholders' equity.
Citizens South Banking Corporation also is subject to reinvestment risk
associated with changes in interest rates. Changes in interest rates may affect
the average life of loans and mortgage-related securities. Decreases in interest
rates can result in increased prepayments of loans and mortgage-related
securities, as borrowers refinance to reduce borrowing costs. Under these
circumstances, the Company is subject to reinvestment risk to the extent that it
is unable to reinvest the cash received from such prepayments at rates that are
comparable to the rates on existing loans and securities. Additionally,
increases in interest rates may decrease loan demand and make it more difficult
for borrowers to repay adjustable rate loans.
Citizens South Banking Corporation's Stock-Based Benefit Plans May Dilute
Your Ownership Interest.
Citizens South Banking Corporation has adopted stock option plans and
recognition and retention plans. These stock-based benefit plans can be funded
from the issuance of authorized but unissued shares of common stock or through
open market purchases by Citizens South Banking Corporation. The Company
currently is purchasing shares of its common stock in a Board-authorized share
repurchase program. Stockholders will experience a reduction or dilution in
ownership interest in the event newly issued shares, instead of repurchased
shares, are used to fund stock option exercises and stock awards.
Citizens South Banking Corporation's Recognition and Retention Plans Will
Continue to be a Significant Cost, Which Will Reduce Profitability and
Stockholders' Equity.
Citizens South Banking Corporation has adopted recognition and retention
plans. Under the plans, its officers and directors have been awarded, at no cost
to them other than customary taxes for which they are responsible, shares of
common stock. The shares of common stock awarded under the recognition plans are
expensed by Citizens South Banking Corporation over their vesting period at the
fair market value of the shares on the date they are awarded.
Various Factors May Make Takeover Attempts More Difficult to Achieve.
Citizens South Banking Corporation's board of directors has no current
intention to sell control of Citizens South Banking Corporation. Provisions of
the Company's certificate of incorporation and bylaws, federal regulations,
Delaware law and various other factors may make it more difficult for companies
or persons to acquire control of Citizens South Banking Corporation without the
consent of its board of directors. As a Citizens South Banking Corporation
stockholder, you may want a takeover attempt to succeed because, for example, a
potential acquirer could offer a premium over the then-prevailing price of
Citizens South Banking Corporation's common stock. The factors that may
discourage takeover attempts or make them more difficult include:
8
Office of Thrift Supervision regulations. The charter of Citizens South
Bank includes a provision that, for a period of five years after the
mutual-to-stock conversion, prohibits any person from acquiring or offering to
acquire, directly or indirectly, more than 10% of any class of equity security
of Citizens South Bank. The Company completed the mutual-to-stock conversion of
its mutual holding company on September 30, 2002.
Certificate of incorporation and statutory provisions. Provisions of the
certificate of incorporation and bylaws of Citizens South Banking Corporation
and Delaware law may make it more difficult and expensive to pursue a takeover
attempt that management opposes. These provisions also would make it more
difficult to remove Citizens South Banking Corporation's current board of
directors or management, or to elect new directors. These provisions include
limitations on voting rights of beneficial owners of more than 10% of its common
stock, supermajority voting requirements for certain business combinations and
the election of directors to staggered terms of three years. Citizens South
Banking Corporation's bylaws also contain provisions regarding the timing and
content of stockholder proposals and nominations and qualification for service
on the board of directors.
Required change in control payments and issuance of stock options and
recognition plan shares. Citizens South Banking Corporation has entered into
employment agreements and change of control agreements with certain executive
officers, which will require payments to be made to them in the event their
employment is terminated following a change in control of Citizens South Banking
Corporation or Citizens South Bank. Citizens South Banking Corporation also has
adopted plans to permit additional issuances of stock options and recognition
plan shares to key employees and directors that will require payments to them in
connection with a change in control of Citizens South Banking Corporation. These
payments will have the effect of increasing the costs of acquiring Citizens
South Banking Corporation, thereby discouraging future takeover attempts.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
9
ITEM 2. PROPERTIES
The following table sets forth certain information regarding offices
currently in operation at December 31, 2005. Management considers the facilities
to be well maintained and sufficiently suitable for present operations. The net
book value of the properties, including land, building, and improvements, net of
accumulated depreciation was $19.2 million at December 31, 2005.
Approximate Owned
Location Principal Use Facility Size or Leased
-------------------------------------- ---------------------- ------------- ---------
(square feet)
519 South New Hope Road Headquarters and 22,400 Owned
Gastonia, North Carolina 28054-4040 Banking Office
245 West Main Avenue Banking Office and 12,400 Owned
Gastonia, North Carolina 28052-4140 Back Office Processing
2609 South New Hope Road, Suite 2 Hispanic Banking 1,233 Leased
Gastonia, North Carolina 28056-1666 Office
192 East Woodrow Avenue Banking Office 3,400 Owned
Belmont, North Carolina 28012-3163
233 South Main Street Banking Office 2,370 Owned
Mount Holly, North Carolina 28120-1620
1670 Neal Hawkins Road Banking Office and 5,320 Owned
Gastonia, North Carolina 28056-6429 Mortgage Center
3135 Dallas High Shoals Highway Banking Office 3,225 Owned
Dallas, North Carolina 28034-1307
412 South Highway 27 Banking Office 3,225 Owned
Stanley, North Carolina 28164-2055
401 West Innes Street Banking Office 5,560 Owned
Salisbury, North Carolina 28144-4232
106 West Main Street Banking Office 1,500 Owned
Rockwell, North Carolina 28138-8859
307 North Center Street Banking Office and 8,260 Owned
Statesville, North Carolina 28677-4063 Leased Space
19410 Jetton Road, Suite 110 Loan Production Office 1,490 Leased
Cornelius, North Carolina 28031-4403
310 West Franklin Street Banking Office 4,692 Leased
Monroe, North Carolina 28112-4704
13731 Providence Road Banking Office 2,520 Owned
Weddington, North Carolina 28104-8615
101 Stallings Road Banking Office 3,560 Leased
Stallings, North Carolina 28104-5065
649 Brawley School Road Banking Office 3,800 Owned
Mooresville, North Carolina 28177-9121
10
ITEM 3. LEGAL PROCEEDINGS
Periodically, there have been various claims and lawsuits involving the
Company or the Bank, such as claims to enforce liens, condemnation proceedings
on properties in which we hold security interests, claims involving the making
and servicing of real property loans and other issues incident to our business.
We are not a party to any pending legal proceedings that we believe would have a
material adverse effect on the financial condition, operations, or cash flows of
the Company or the Bank.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the security holders during the
fourth quarter of 2005.
PART II
- -------
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK, RELATED STOCKHOLDER MATTERS, AND
PURCHASES OF EQUITY SECURITIES
a. The Company's common stock, $0.01 par value per share, trades on the
Nasdaq National Market under the symbol CSBC. Price and volume information is
contained in The Wall Street Journal and other daily newspapers in the Nasdaq
section under the National Market System listings. As of February 1, 2006, the
Company had 1,669 stockholders of record (excluding the number of persons or
entities holding stock in street name through various brokerage firms), and
8,285,817 shares outstanding. The following brokers made a market in the
Company's stock during 2005:
Citigroup Global Markets, Inc. 1-800-223-7743
Fig Partners, LLC 1-404-601-7200
Friedman, Billings, Ramsey & Co. 1-800-688-3272
FTN Midwest Securities Corp. 1-800-880-7264
Hill, Thompson, Magid and Co. 1-800-631-3083
Howe Barnes Investments, Inc. 1-800-621-2364
Keefe, Bruyette & Woods, Inc. 1-800-342-5529
Knight Equity Markets, L.P. 1-800-222-4910
Merrill Lynch, Pierce, Fenner 1-800-937-0501
Moors & Cabot, Inc. 1-800-723-9866
Morgan Stanley & Co., Inc. 1-800-223-6559
Ryan Beck & Co., Inc. 1-800-325-7926
Sandler O'Neill & Partners 1-212-466-8020
Sterne, Agee & Leach 1-800-239-2408
UBS Capital Markets L.P. 1-203-719-7400
11
The following table sets forth quarterly market sales price ranges,
dividend information, and repurchase activity for the Company's common stock
over the past two years.
2005 QUARTER 1 QUARTER 2 QUARTER 3 QUARTER 4
- ------------------------------ ------------ ------------ ------------ ------------
Price Range
High $ 14.25 $ 13.90 $ 12.80 $ 12.75
Low 12.91 11.76 11.41 11.70
Dividend 0.07 0.07 0.07 0.07
Shares Repurchased 184,600 0 48,300 211,023
Avg. Price Paid Per Share $ 13.56 NA $ 12.44 $ 12.09
2004 QUARTER 1 QUARTER 2 QUARTER 3 QUARTER 4
- ------------------------------ ------------ ------------ ------------ ------------
Price Range
High $ 14.40 $ 13.74 $ 13.27 $ 14.27
Low 13.37 12.60 12.41 12.41
Dividend 0.065 0.065 0.065 0.065
Shares Repurchased 240,000 909,438 70,000 20,000
Avg. Price Paid Per Share $ 13.64 $ 13.03 $ 12.98 $ 12.69
b. Not applicable.
c. During the three-month period ended December 31, 2005, the Company
repurchased the following shares of stock.
UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
TOTAL
NUMBER OF MAXIMUM
SHARES NUMBER OF
PURCHASED SHARES THAT MAY
TOTAL NUMBER AS PART BE PURCHASED
OF SHARES AVERAGE PRICE OF THE CURRENT UNDER CURRENT
2005 PURCHASED PAID PER SHARE REPURCHASE PLAN REPURCHASE PLAN
- ---------- --------------- --------------- --------------- ---------------
October 0 NA 0 226,100
November 32,500 $ 12.18 176,400 193,600
December 178,523 $ 12.08 354,923 15,077
Total 211,023 $ 12.09 354,923 15,077
On February 28, 2005, the Board of Directors of the Company authorized the
repurchase of up to 370,000 shares, or approximately 5%, of the Company's
outstanding shares of common stock. These repurchases may be carried out through
open market purchases, block trades, and negotiated private transactions. The
stock may be repurchased on an ongoing basis and will be subject to the
availability of stock, general market conditions, the trading price of the
stock, alternative uses for capital, and the Company's financial performance. As
of December 31, 2005, management had repurchased a total of 354,923 shares at an
average price of $12.50 per share and had 15,077 shares remaining to be
repurchased under this plan. Management will consider repurchasing additional
shares of common stock of the Company at prices management considers to be
attractive and in the best interests of both the Company and its stockholders.
Any repurchased shares will be held as treasury stock and will be available for
general corporate purposes.
12
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth certain information concerning the financial
position of Citizens South Banking Corporation and its subsidiaries as of and
for the dates indicated. The consolidated data is derived from, and should be
read in conjunction with the Consolidated Financial Statements of the Company
and its subsidiaries and related notes presented in Item 8.
AT AND FOR THE YEARS ENDED DECEMBER 31,
----------------------------------------------------------------
(Dollars in thousands, except per share data) 2005 2004 2003 2002 2001
- ---------------------------------------------------------------- ---------- ---------- ---------- ---------- ----------
INCOME STATEMENT DATA:
Interest income ................................................ $ 26,948 $ 21,110 $ 21,969 $ 24,716 $ 16,382
Interest expense ............................................... 11,469 7,943 8,732 10,195 9,770
---------- ---------- ---------- ---------- ----------
Net interest income ............................................ 15,479 13,167 13,237 14,521 6,612
Provision for loan losses ...................................... 985 330 60 225 120
---------- ---------- ---------- ---------- ----------
Net interest income after provision for loan losses ............ 14,494 12,837 13,177 14,296 6,492
Noninterest income ............................................. 4,441 4,824 5,561 4,121 3,006
Noninterest expense ............................................ 14,339 13,629 13,891 11,381 7,092
---------- ---------- ---------- ---------- ----------
Income before income taxes ..................................... 4,596 4,032 4,847 7,036 2,406
Income tax expense ............................................. 1,323 1,077 1,456 2,528 702
---------- ---------- ---------- ---------- ----------
Net income ..................................................... $ 3,273 $ 2,955 $ 3,391 $ 4,508 $ 1,704
========== ========== ========== ========== ==========
PER SHARE DATA (1):
Basic net income ............................................... $ 0.45 $ 0.39 $ 0.39 $ 0.51 $ 0.20
Diluted net income ............................................. 0.45 0.38 0.39 0.51 0.20
Cash dividends declared ........................................ 0.28 0.26 0.24 0.16 0.14
Year-end book value ............................................ 10.16 9.74 10.11 10.64 4.62
BALANCE SHEET DATA:
Total assets ................................................... $ 701,094 $ 508,961 $ 495,751 $ 492,873 $ 447,581
Loans receivable, net .......................................... 468,232 314,127 295,026 299,906 334,321
Mortgage-backed and related securities ......................... 70,236 81,169 89,168 70,409 25,405
Investment securities .......................................... 53,429 52,407 56,233 39,594 25,946
Deposits ....................................................... 517,544 374,744 342,446 340,862 353,692
Borrowings ..................................................... 91,342 55,772 58,981 47,575 42,057
Stockholders' equity ........................................... 84,258 72,394 87,699 96,383 41,630
PERFORMANCE RATIOS:
Return on average assets ....................................... 0.60% 0.59% 0.68% 0.98% 0.65%
Return on average equity ....................................... 4.40 3.78 3.61 7.61 4.16
Avg. interest-earning assets to
avg. interest-bearing liabilities ............................. 109.40 110.96 118.65 109.19 116.08
Noninterest expense to average total assets .................... 2.64 2.73 2.81 2.48 2.70
Interest rate spread ........................................... 3.00 2.78 2.57 3.26 2.05
Net interest margin (2) ........................................ 3.23 2.98 2.94 3.48 2.69
ASSET QUALITY RATIOS:
Allowance for loan losses to total loans at the end of year .... 1.08% 0.95% 1.00% 0.99% 0.93%
Nonperforming loans to total loans ............................. 0.54 0.30 0.18 0.17 0.35
Nonperforming assets to total assets ........................... 0.53 0.34 0.14 0.37 0.59
CAPITAL RATIOS:
Average equity to average total assets ......................... 13.69% 15.64% 18.96% 12.93% 15.55%
Equity to assets at year end ................................... 12.02 14.22 17.68 19.56 9.30
Dividend payout ratio (1) (3) .................................. 62.22 66.67 61.54 31.37 70.00
(1) All per share data for periods prior to September 30, 2002, has been
adjusted to reflect the exchange ratio of 2.1408-to-1 in conjunction with
the Company's stock offering.
(2) Net interest margin is calculated by dividing net interest income by
average interest-earning assets for the period.
(3) Dividend payout ratio is calculated by dividing cash dividends per share
declared for the period by net income per share for the period. Citizens
South Holdings, MHC, the former mutual holding company for Citizens South
Banking Corporation, began waiving dividends in August 2000 and as of
September 30, 2002, had waived dividends totaling approximately $1.8
million. The MHC owned between 53% and 58% of the outstanding common stock
of the Company during the period in which the dividends were waived.
13
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
Citizens South Banking Corporation (the "Company") is a Delaware
corporation that owns all of the outstanding shares of common stock of Citizens
South Bank (the "Bank"), a federally chartered savings bank headquartered in
Gastonia, North Carolina. The Company's principal business activities are
overseeing and directing the business of the Bank and investing the net stock
offering proceeds retained by the Company. The Company's assets consist
primarily of the outstanding capital stock of the Bank, deposits held at the
Bank, and investment securities. The Bank's principal business activity is
offering FDIC-insured deposit accounts to local customers through its 15 branch
offices and investing those deposits, together with funds generated from
operations and borrowings, in residential and nonresidential real estate loans,
construction loans, commercial business loans, consumer loans, investment
securities, and mortgage-backed securities. The Bank also acts as a broker in
both the origination of loans secured by one-to-four family dwellings and in the
sale of uninsured financial products (see Item 1. "Business" of this report).
Our primary business strategy since our initial public stock offering in
1998 has been to transform the Bank from a traditional retail savings bank to a
full-service community bank, offering a complete array of both commercial and
retail loan and deposits, wealth management services, mortgage banking
activities, brokerage services, and other related financial services. In
executing this strategy, the Company has 1) concentrated much of its lending
efforts on nonresidential real estate and construction loans, 2) originated
substantially all fixed rate one-to-four family residential loans as a broker
for a third party, and 3) focused its deposit gathering efforts on core deposits
(demand deposit accounts, money market accounts, and savings accounts). As a
result, nonresidential real estate and construction loans comprised
approximately 58% of the Company's loan portfolio at December 31, 2005, compared
to approximately 22% at December 31, 2001. Also, during the same period, the
Company's portfolio of one-to-four family residential loans decreased from 57%
of the Company's loan portfolio at December 31, 2001, to 21% of the Company's
loan portfolio at December 31, 2005. Core deposits have increased as a
percentage of total deposits from approximately 38% at December 31, 2003 to
approximately 41% at December 31, 2005. Management expects to continue to
execute this business strategy in 2006.
On October 31, 2005, the Company consummated the merger of Trinity Bank
("Trinity") into Citizens South Bank. At the time of the acquisition, Trinity
had total assets of $165.5 million, net loans of $112.8 million, deposits of
$135.6 million, borrowed money of $14.0 million and equity of $13.3 million.
Trinity was headquartered in Monroe, North Carolina, which is approximately 50
miles east of the Company's headquarters. Trinity had three offices located in
Union County, North Carolina, which has the fastest population growth of any
county in North Carolina. The combined bank has 15 full-service locations and
one loan production office, and ranks 8th in the Charlotte Metropolitan
Statistical Area in deposit market share.
Under the terms of the merger agreement, the Company issued a combination
of common stock and cash for the outstanding common shares of Trinity Bank.
Trinity shareholders were given the option of receiving 1.3931 shares of
Citizens South common stock for each share of Trinity common stock, $18.25 in
cash for each share of Trinity common stock, or a mixture of stock and cash for
each Trinity share, such that 50% of the shares of Trinity common stock will be
exchanged for Citizens South common stock. On October 31, 2005, Trinity
shareholders received merger consideration of approximately 1,280,052 shares of
common stock of the Company (subject to payment of cash in lieu of fractional
shares) and approximately $16.8 million in cash (including cash paid in lieu of
fractional shares), resulting in a total transaction value of approximately
$37.8 million. The transaction price represented approximately 255% of Trinity's
book value. Additional information regarding this transaction may be obtained by
reviewing the Registration Statement that the Company filed with the Securities
and Exchange Commission on August 1, 2005, and amended September 14, 2005.
14
In order to provide financing for the cash portion of the Trinity
acquisition, on October 28, 2005, the Company completed a private placement of
an aggregate amount of $15.0 million in trust preferred securities, liquidation
amount of $1,000 per security (the "Preferred Securities"), through a newly
formed Delaware statutory trust subsidiary, CSBC Statutory Trust I (the
"Trust"). In connection with the issuance of the Preferred Securities, on
October 28, 2005, the Company entered into an Indenture by and between the
Company and Wilmington Trust Company, as trustee. The Preferred Securities
mature on December 15, 2035, but may be redeemed beginning December 15, 2010, if
the Company exercises its rights to redeem the Debentures. The Preferred
Securities require quarterly interest payments to the holders of the Preferred
Securities, initially at a fixed rate of 6.095% through December 2010, and
thereafter at a variable rate of three-month LIBOR plus 1.57%, reset quarterly.
Additional information regarding the Preferred Securities may be obtained by
reviewing the Form 8-K filed with the Securities and Exchange Commission on
November 4, 2005.
On September 30, 2002, the Company completed its mutual-to-stock conversion
and related stock offering, resulting in an equity to assets ratio of 19.56% at
December 31, 2002. In order to properly leverage the Company's capital position,
the Company has executed a number of strategies including 1) repurchasing
Company stock at prices that are considered attractive, 2) paying dividends on
outstanding stock, 3) building new banking offices in areas that the Company
believes improve the value of the franchise, and 4) patiently pursuing
acquisitions of other financial institutions or related companies. As of
December 31, 2005, the Company had repurchased a total of 2,389,358 shares, or
26.4% of the outstanding shares of common stock, at an average price of $13.35.
As a result of the execution of these capital management strategies, the
Company's equity to assets ratio was 12.02% at December 31, 2005. Management
plans to continue to execute these strategies until the Company's capital is
appropriately leveraged.
The Bank's results of operations are heavily dependent on net interest
income, which is the difference between the interest earned on loans and
securities and the interest paid on deposits and borrowings. Results of
operations are also materially affected by the Bank's provision for loan losses,
gains or losses from the sales of assets, fee income generated from deposit and
loan accounts, commissions earned from the sale of uninsured investment
products, and noninterest expenses. The Bank's noninterest expense primarily
consists of compensation and employee benefits, occupancy expense, professional
services, advertising, and other noninterest expenses. Results of operations are
also significantly affected by general economic and competitive conditions,
changes in interest rates, and actions of regulatory and governmental
authorities.
Net income was $3.3 million, or $0.45 per diluted share, for the year ended
December 31, 2005, compared to $3.0 million, or $0.38 per diluted share, for the
year ended December 31, 2004. The earnings provided a return on average equity
of 4.40% in 2005, compared to 3.78% in 2004, and a return on average assets of
0.60% in 2005, compared to 0.59% in 2004.
Certain actions have been taken that have adversely impacted our results of
operations for the years ended December 31, 2005 and 2004. Specifically, during
2005 we acquired Trinity Bank in a transaction valued at $37.8 million. As a
result of the acquisition of Trinity, the Company recognized merger and computer
conversion related expenses of $384,000 during the year. Also, in 2004 we
determined that unrealized losses on $2.0 million in perpetual preferred stock
issued by Fannie Mae and $2.0 million in perpetual preferred stock issued by
Freddie Mac were "other-than-temporary" impairments. As a result, management
recorded a noncash, pretax loss of $983,000. All of these securities were sold
during 2005 and the Company did not have any other perpetual preferred stock on
its books at December 31, 2005.
Management's Discussion and Analysis is provided to assist in understanding
and evaluating the results of operations and financial condition of the Company
and its subsidiaries. The following discussion should be read in conjunction
with the consolidated financial statements and related notes included in Item 8.
of this report.
FORWARD-LOOKING STATEMENTS
This report contains certain forward-looking statements that represent the
Company's expectations or beliefs concerning future events. Such forward-looking
statements are based on our current beliefs and expectations and are inherently
subject to significant business, economic, and competitive uncertainties and
contingencies, many of which are beyond our control. These forward-looking
statements are based on assumptions with respect to future business strategies
and decisions that are subject to change based on changes in the economic and
competitive environment in which we operate. Forward-looking statements speak
only as of the date they are made and the Company is under no duty to update
these forward-looking statements or to reflect the occurrence of unanticipated
events. A number of factors could cause actual conditions, events, or results to
differ significantly from those described in the forward-looking statements.
15
Factors that could cause such a difference include, but are not limited to, the
timing and amount of revenues that may be recognized by the Company, changes in
local or national economic trends, increased competition among depository and
financial institutions, continuation of current revenue and expense trends
(including trends affecting chargeoffs and provisions for loan losses), our
ability to successfully integrate the Trinity Bank acquisition, and adverse
legal, regulatory or accounting changes. Because of the risks and uncertainties
inherent in forward-looking statements, readers are cautioned not to place undue
reliance on these statements. Readers should carefully review the risk factors
described in other documents the Company files from time to time with the SEC,
including annual reports on Form 10-K, quarterly reports on Form 10-Q, and
Current Reports on Form 8-K.
CRITICAL ACCOUNTING POLICIES
The accounting and financial policies of the Company and its subsidiaries
are prepared in accordance with accounting principles generally accepted in the
United States and conform to general practices in the banking industry. We
consider accounting policies that require significant judgment and assumptions
by management that have, or could have, a material impact on the carrying value
of certain assets or on income to be critical accounting policies. Changes in
underlying factors, assumptions or estimates could have a material impact on our
future financial condition and results of operations. Based on the size of the
item or significance of the estimate, the following accounting policies are
considered critical to our financial results.
Allowance for Loan Losses. The allowance for loan losses is calculated with
the objective of maintaining an allowance sufficient to absorb estimated
probable loan losses. Management's determination of the adequacy of the adequacy
of the allowance is based on quarterly evaluations of the loan portfolio and
other relevant factors. However, this evaluation is inherently subjective, as it
requires an estimate of the loss for each type of loan and for each impaired
loan, an estimate of the amounts and timing of expected future cash flows, and
an estimate of the value of the collateral.
Management has established a systematic method for periodically evaluating
the credit quality of the loan portfolio in order to establish an allowance for
loan losses. The methodology is set forth in a formal policy and includes a
review of all loans in the portfolio on which full collectibility may or may not
be reasonably assured. The loan review considers among other matters, the
estimated fair value of the collateral, economic conditions, historical loan
loss experience, our knowledge of inherent losses in the portfolio that are
probable and reasonable estimable and other factors that warrant recognition in
providing an appropriate loan loss allowance. Specific allowances are
established for certain individual loans that management considers impaired
under Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting
by Creditors for Impairment of a Loan." The remainder of the portfolio is
segmented into groups of loans with similar risk characteristics for evaluation
and analysis. In originating loans, we recognize that losses will be experienced
and that the risk of loss will vary with, among other things, the type of loan
being made, the creditworthiness of the borrower, the term of the loan, general
economic conditions, and in the case of a secured loan, the quality of the
collateral. We increase our allowance for loan losses by charging provisions for
loan losses against our current period income. Management's periodic evaluation
of the adequacy of the allowance is consistently applied and is based on our
past loan loss experience, particular risks inherent in the different kinds of
lending that we engage in, adverse situations that may affect the borrower's
ability to repay, the estimated value of any underlying collateral, current
economic conditions, and other relevant internal and external factors that
affect loan collectibility. Management believes this is a critical accounting
policy because this evaluation involves a high degree of complexity and requires
us to make subjective judgments that often require assumptions or estimates
about various matters.
Other-Than-Temporary Impairment of Securities. We have historically
reviewed investment securities with significant declines in fair value for
potential other-than-temporary impairment pursuant to the guidance provided by
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.
Effective December 31, 2005, management evaluated the Company's investment
portfolio and determined that all unrealized losses were the direct result of
temporary changes in interest rates and that such losses may be recovered in the
foreseeable future. As a result, management did not consider any unrealized
losses as "other-than-temporary" as of December 31, 2005.
Effective December 31, 2004, management determined that unrealized losses
on $2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0
million in perpetual preferred stock issued by Freddie Mac were
"other-than-temporary" impairments. As a result, management recorded a noncash,
pretax loss of $983,000.
16
The unrealized losses on these securities were considered to be
"other-than-temporary" by management for the following reasons: 1) both Fannie
Mae and Freddie Mac had experienced accounting irregularities that have resulted
in restated financial results from prior periods; 2) the yield on perpetual
preferred stock recently issued by Fannie Mae is much higher than the yield of
the preferred stock held by the Company, which decreased the value of the
Company's security; 3) the preferred stock for Fannie Mae was downgraded and the
preferred stock for both Companies were on a negative watch list; 4) the Freddie
Mac preferred stock repriced in December 2004, yet it continued to have
significant unrealized losses at year end; 5) neither of the preferred stock
issues had stated maturity dates, so the recovery of the unrealized losses was
not expected to occur in the foreseeable future. The credit issues facing Fannie
Mae and Freddie Mac only affected the performance of the Company's perpetual
preferred stock. Management sold the subject securities in 2005 and the Company
did not own any other perpetual preferred stock at December 31, 2005.
COMPARISON OF FINANCIAL CONDITION FOR THE YEARS ENDED DECEMBER 31, 2005 AND
2004
Total assets increased by $192.1 million, or 37.8%, from $509.0 million at
December 31, 2004, to $701.1 million at December 31, 2005. Approximately $177.4
million, or 92.4%, of this asset growth was due to the acquisition of Trinity,
including the $25.2 million in goodwill and core deposit intangible created as a
result of this transaction.
Cash and cash equivalents increased by $15.1 million, or 130.0%, from $11.6
million at December 31, 2004, to $26.7 million at December 31, 2005. This
increase was primarily funded by a $6.5 million increase in deposits, a $20.2
million increase in borrowed money, $45.6 million in net sales, amortization,
and maturies of investment and mortgage-backed securities. The effects of these
increases in cash and cash equivalents were partly offset by a $43.0 million
increase in net outstanding loans, purchases of premises and equipment of $1.4
million, stock repurchases totaling $5.7 million and cash dividend payments of
$2.1 million. The total deal value of the Trinity acquisition of $37.8 million
was funded by the issuance of 1,280,052 shares of common stock valued at $16.7
million with the remaining $18.8 million in consideration provided by an
increase in borrowed money. Management expects that the level of cash and cash
equivalents will decrease in 2006 as these assets are used to fund additional
loan growth.
Investment securities increased by $1.0 million, or 1.9%, from $52.4
million at December 31, 2004, to $53.4 million at December 31, 2005. This
increase was primarily the result of $5.3 million in investment securities
acquired from Trinity. During 2005, the Company sold $9.4 million in investment
securities, experienced maturities and calls of $5.1 million in investments, and
purchased $10.6 million in investment securities. Management expects that
outstanding investment securities will decrease during 2006 as the proceeds from
maturities will be used to repay borrowed money and fund future loan growth.
Mortgage-backed securities decreased by $11.0 million, or 13.5%, from $81.2
million at the end of 2004, to $70.2 million at the end of 2005. This decrease
was primarily due to the maturity and principal amortization of $20.2 million of
mortgage-backed securities, the sale of $30.3 million of mortgage-backed
securities, and the purchase of $8.8 million of mortgage-backed securities
during the year. In addition, the Company acquired $32.2 million in
mortgage-backed securities in the Trinity acquisition. Management expects that
the principal amortization of its mortgage-backed securities portfolio will
decrease in 2006 as mortgage loan interest rates increase during the year.
Management plans to reinvest the proceeds received from mortgage-backed
securities into higher-yielding commercial and consumer loans as cash flows are
generated from these investments through maturities and principal and interest
payments.
Net loans outstanding increased by $154.1 million, or 49.0%, from $314.1
million at December 31, 2004, to $468.2 million at December 31, 2005.
Approximately $112.8 million, or 73.2%, of net loan growth was due to the
acquisition of Trinity. The remaining loan growth of $41.3 million, or 26.8%,
was generated organically. Management continues to emphasize the origination of
shorter-term commercial real estate and consumer loans. During 2005, these
loans, which include construction loans, multifamily residential loans,
nonresidential real estate loans, consumer loans, and commercial business loans,
increased by $149.5 million, or 66.3%, to $375.0 million at December 31, 2005.
Also during 2005, the Company's portfolio of one-to-four family residential
loans increased from $91.7 million to $98.6 million. The Company originates and
closes substantially all new fixed-rate one-to-four family residential loans as
a broker for an independent third party on a servicing-released basis. This
generates additional fee income and reduces the potential adverse effects of
rising interest rates on the Company's future earnings that normally result from
holding long-term fixed-rate loans. Management expects that in 2006 the
Company's portfolio of one-to-four family dwelling loans will decrease while the
remaining loan portfolio continues to experience strong growth due to the
Company's expansion into the York County, South Carolina market with a loan
production office during the first quarter of 2006 and the continued strong
local economy of the Charlotte metropolitan area.
17
Also during 2005, the Company opened a full-service office in Belmont,
North Carolina, and acquired three full-service offices from the Trinity Bank
acquisition. As a result, premises and equipment increased by $2.4 million, or
14.2%, to $19.8 million at December 31, 2005. The Company plans to enter into
the York County, South Carolina market with a loan production office in the
first quarter of 2006.
Total liabilities increased by $180.2 million, or 41.3%, from $436.6
million at December 31, 2004, to $616.8 million at December 31, 2005. This
increase was primarily due the $152.2 million of liabilities acquired in the
Trinity acquisition. The remaining $28.0 million increase was primarily due to a
$6.5 million increase in deposits and a $20.2 million increase in borrowed
money. Total deposits increased by $142.8 million, or 38.1%, from $374.7 million
at December 31, 2004, to $517.5 million at December 31, 2005. The Trinity
acquisition accounted for a $135.6 million increase in deposits. A large portion
of the organic increase of $6.5 million in deposits came from core deposits,
which management considers to be checking accounts, money market accounts, and
savings accounts. This continued increase in core deposits reflects management's
commitment to building new and enhancing existing customer relationships through
improving technology and an expanding branch network. Borrowed money increased
by $35.6 million, or 63.8%, from 2004 to 2005. This increase was partly due
$15.6 million in borrowed money acquired from Trinity. The remaining increase in
borrowed money was primarily used for the purpose of providing funds to acquire
Trinity. Management expects that the level of borrowed money will decrease in
2006 as maturing advances are repaid using funds from maturing investment
securities.
Total stockholders' equity increased by $11.9 million, or 16.4%, from $72.4
million at December 31, 2004 to $84.3 million at December 31, 2005. This
increase was primarily due to the issuance of 1,280,052 shares of common stock
totaling $16.8 million in conjunction with the acquisition of Trinity. In
addition, the Company recognized $3.3 million in net income for the year.
These increases were partly offset by the repurchase of 443,923 shares of
common stock for $5.7 million at an average price of $12.74 per share. These
shares were repurchased as a part of stock repurchase plans announced in May
2004 and February 2005. The May 2004 repurchase plan provided for the repurchase
of up to 815,000 shares of stock, or approximately 10% of the outstanding
shares. All of the shares authorized under this plan were repurchased by
February 2005. The February 2005 repurchase plan provided for the repurchase of
370,000 shares, or 5.0% of the outstanding shares. As of December 31, 2005, the
Company had repurchased 354,923 shares under the plan and had 15,077 shares
remaining to be repurchased. Management plans to continue to repurchase shares
of common stock in the Company at prices that are considered to be attractive
and in the best interests of both the Company and its stockholders. Total
stockholders' equity also decreased in 2005 as a result of the payment of $2.1
million in cash dividends, or $0.28 per share, and a $1.1 million increase in
accumulated net unrealized losses on investments available for sale.
RESULTS OF OPERATIONS
The following discussion relates to operations for the year ended December
31, 2005, compared to the year ended December 31, 2004, as well as the year
ended December 31, 2004, compared to the year ended December 31, 2003. The net
income of the Company is heavily dependent upon net interest income. Net
interest income is the difference between the interest earned on loans,
investment and mortgage-backed securities, and interest-bearing deposits in
other banks, offset by the interest paid on deposits and borrowings.
COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2005
AND 2004
Net income was $3.3 million, or $0.45 per diluted share, for the year ended
December 31, 2005, compared to $3.0 million, or $0.38 per diluted share, for the
year ended December 31, 2004. The earnings provided a return on average equity
of 4.40% in 2005, compared to 3.78% in 2004, and a return on average assets of
0.60% in 2005, compared to 0.59% in 2004.
18
Net interest income, the Company's largest source of income, increased by
$2.3 million, or 17.6%, to $15.5 million during the year ended December 31,
2005, compared to $13.2 million for the year ended December 31, 2004. This
increase was due in part to a 22 basis point increase in the average net
interest rate spread from 2.78% for 2004 to 3.00% for 2005. This increase was
largely due to a series of 25 basis point increases in the federal funds rate by
the Federal Reserve Board that resulted in a 2.00% increase in the prime-lending
rate during the year to 7.25% at December 31, 2005. Approximately 57% of the
Company's loan portfolio reprices each month, the majority of which are tied to
the prime lending rate. This also contributed to a 25 basis point increase in
the Company's net interest margin from 2.98% in 2004 to 3.23% in 2005. As
interest rates stabilize, the Company's net interest margin will come under some
pressure as its portfolio of time deposits reprices at higher market rates
without any offsetting increases in the yield on its prime-based loan portfolio.
During 2005, the Company's ratio of average interest-bearing assets to average
interest-bearing liabilities decreased from 111.0% in 2004 to 109.4% in 2005.
This declining ratio of average interest-earning assets to average
interest-bearing liabilities, which partly offset the positive effect of the
increased net interest rate spread, was due primarily from the repurchase of
443,923 shares of common stock for $5.7 million.
Interest income for the year ended December 31, 2005, increased by $5.8
million, or 27.7%, to $26.9 million. This increase was primarily due to a $37.0
million, or 8.4%, increase in average interest-earning assets from $442.5
million in 2004 to $479.5 million in 2005, coupled with an 85 basis point, or
17.8%, increase in the average yield on interest-earning assets to 5.62% for
2005. During the year, average outstanding loans increased by $53.1 million, or
18.0%, from $294.6 million to $347.7 million, while the average yield on loans
increased from 5.47% to 6.36% from 2004 to 2005. These changes were primarily
the result acquiring $112.8 million in loans from the Trinity acquisition in
October 2005, organic loan growth of $43.0 million during the year, and a 2.0%
increase in the prime-lending rate during the year. As a result, interest income
on loans increased by $6.0 million, or 37.3%, to $22.1 million in 2005.
Interest earned on interest-bearing bank balances increased by $321,000, or
226.1%, to $463,000 in 2005. The average balance of interest-bearing bank
balances increased by $1.8 million, or 15.5%, to $13.4 million and the average
yield on these deposits increased by 224 basis points to 3.46%. Interest earned
on investment securities decreased by $303,000, or 15.9%, to $1.6 million in
2005. This increase in interest income was primarily due to a $9.1 million, or
16.8%, decrease in the average outstanding balance of investment securities to
$45.1 million in 2005. The average yield on investment securities increased by
four basis points to 3.55% for 2005 due to the increased level of short-term
interest rates during 2005. Interest income from mortgage-backed securities
decreased by $192,000, or 6.5%, to $2.8 million in 2005. This decrease was
largely due to an $8.7 million, or 10.7%, decrease in the average balance of
mortgage-backed securities to $73.3 million during 2005. Also, during 2005, the
average yield on mortgage-backed securities increased from 3.59% to 3.76%, due
in part to slower prepayment levels resulting from higher mortgage interest
rates during the year. Management expects the levels of investment and
mortgage-backed securities will decline during 2006, with the proceeds of any
sales, maturities, and normal amortization, to be used to fund additional loan
originations, stock repurchases, and repayments on maturing borrowed money.
Interest expense increased $3.5 million, or 44.4%, to $11.5 million for the
year ended December 31, 2005. This increase was due to a $39.5 million, or 9.9%,
increase in average interest-bearing liabilities from $398.8 million in 2004 to
$438.3 million in 2005. In addition, the average cost of funds increased by 63
basis points, or 31.7%, to 2.62% in 2005. Interest expense on deposits increased
$2.8 million, or 46.5%, to $9.0 million in 2005. This increase was primarily due
to a $26.3 million, or 7.6%, increase in average deposits in 2005 and a 64 basis
point, or 36.1% increase in the cost of deposits to 2.41% in 2005. Average
deposits increased due to $135.6 million in deposits acquired from Trinity in
October 2005 and $6.5 million in organic growth. The cost of funds increased due
to the 2.0% increase in short-term rates during 2005. Interest paid on borrowed
money increased by $676,000, or 37.2%, to $2.5 million in 2005. Average
borrowings increased by $13.1 million, or 24.8%, to $66.2 million at December
31, 2005, while the average rate paid on borrowings increased from 3.42% in 2004
to 3.76% in 2005 due to higher market interest rates in 2005. Management expects
that the cost of funds for deposits and borrowings will increase in 2006 if
short-term interest rates continue to increase.
The Company provided $985,000 and $330,000 in loan loss provisions for the
years ended December 31, 2005 and 2004, respectively. The allowance for loan
losses as a percentage of loans was 1.08% at December 31, 2005, and 0.95% at
December 31, 2004. The provision for loan losses increased due to strong organic
growth in the Company's loan portfolio of $43.0 million, coupled with net
charge-offs of $400,000 during the year. The level of nonperforming loans
increased by $1.6 million to $2.6 million at December 31, 2005. As a result, the
ratio of nonperforming loans to net loans increased from 0.30% at December 31,
2004, to 0.54% at December 31, 2005. Also, real estate owned increased by
$351,000 to $1.2 million at December 31, 2005. All of the properties acquired
through foreclosure are one-to-four family residential properties and
residential lots that are in various stages of disposition. As a result, the
ratio of nonperforming assets to total assets increased from 0.34% at December
31, 2004, to 0.53% at December 31, 2005. Refer to "Allowance for Loan Losses"
for further discussion.
19
For the year ended December 31, 2005, noninterest income decreased by
$383,000, or 7.9%, from $4.8 million to $4.4 million. Excluding the net gain on
sale of securities and other assets of $674,000 for the year ended December 31,
2004, and $62,000 for the year ended December 31, 2005, noninterest income
increased by $229,000, or 5.5%. The Company experienced increases of $60,000 in
fee income on deposit accounts, $27,000 from mortgage banking and lending
activities, $39,000 in commissions on sale of financial products, $59,000 in
dividends on FHLB stock, $23,000 from the cash value of bank-owned life
insurance, and $116,000 in other noninterest income. Part of the reason for
these increases was the additional noninterest income generated during the last
two months of the year from the Trinity acquisition. The increase in
mortgage-banking and loan fee income was primarily due to an increased amount of
fee income from commercial and consumer loans. This increase was partly offset
by decreased mortgage banking fees of $35,000 in 2005 as compared to 2004. This
was largely due to an increase in longer-term mortgage interest rates during
2005 which resulted in fewer mortgage loan originations. Management expects that
mortgage lending activity will continue to slow down in 2006 if long-term
mortgage interest rates continue to rise during the year. Fee income on deposit
accounts was higher largely due to the increased number of accounts which
resulted in an increase in fees generated from overdrawn checking accounts.
Management believes that a continued focus on growing retail and commercial
checking accounts will result in a moderate improvement in fee income on deposit
accounts in 2006. The increase on dividends on FHLB stock is directly related to
the rate paid by the FHLB and the number of outstanding shares (based on
outstanding advances). Management expects that the dividend rate paid by the
FHLB will increase in 2006 due to recent increases in short-term interest rates.
Commissions earned from the sale of uninsured products is expected to continue
to increase as the Company added an additional sales representative from the
Trinity acquisition. These increases in noninterest income were partly offset by
a $95,000 reduction in the fair value adjustment on deferred compensation assets
which is offset by a corresponding decrease in compensation expense, resulting
in no net impact on net income. During 2006, the Company will realize the
benefits of the Trinity acquisition for the entire year, resulting in an
expected continued increase in noninterest income.
Gain on sale of securities decreased by $612,000, or 90.8%, from 2004 to
2005. During the year ended December 31, 2004, the Company sold $1.8 million in
investment securities and $6.4 million in mortgage-backed securities at a net
gain of $454,000. The proceeds from these sales were used to generate funds to
repurchase shares of stock and originate loans. During the year ended December
31, 2005, the Company sold $9.4 million in investment securities and $30.3
million in mortgage-backed securities at a net gain of $17,000. Most of these
sales were from securities acquired from Trinity. These proceeds were primarily
used to repurchase additional investments that were more reflective of the
Company's investment philosophy of investing in shorter-term investment
securities and mortgage-backed securities that provide a stable level of cash
flow to fund future loan growth. The Company also recognized a $45,000 net gain
on sale of both $517,000 of other real estate owned and $191,000 of premises and
equipment.
Noninterest expense increased by $710,000, or 5.2%, from $13.6 million in
2004 to $14.3 million in 2005. This increase was largely due to the acquisition
of Trinity, which added approximately 35 employees and three additional
full-service offices, and the opening of a new full-service office in Belmont,
North Carolina. As a result, compensation expense increased $692,000, or 10.5%
from $6.6 million in 2004 to $7.3 million in 2005. The Company integrated the
back-office functions of Trinity during the first quarter of 2006, which will
result in a decrease of approximately eight employees. In addition, the Company
opened a loan production office in Rock Hill, South Carolina, during the first
quarter of 2006, which will be staffed by two additional employees. Occupancy
expense increased by $322,000, or 18.1%, primarily due to the increase in the
number of full-service offices from 11 at the end of 2004 to 15 at the end of
2005. No additional full-service offices are planned for 2006. The Company also
experienced merger and conversion expenses in 2005 in the amount of $384,000. No
additional material merger-related expenses are anticipated for 2006. Data
processing increased by $131,000, or 59%, due to the operation of two computer
systems resulting from the Trinity acquisition. The Company plans to consolidate
these two systems during the first quarter of 2006. Other noninterest expense,
which includes expenses related to employee travel and training, deposit
operations, loan administration, financial reporting, franchise and other taxes,
and other miscellaneous items, increased by $300,000, or 16.1%, primarily due
expenses related to operating a much larger organization. In addition, modest
increases were experienced in the areas of NOW account expense ($42,000) and
professional services ($5,000). The Company expects to realize annualized pretax
cost savings of approximately $800,000 after the completion of the computer and
back-office integration of Trinity after the first quarter of 2006. Most of
these savings are expected to come from consolidating the back office functions
of Trinity into the existing operations of the Company and the consolidation of
the two computer systems.
20
The Company experienced modest decreases in expense related to office
supplies ($80,000), advertising ($54,000), telephone ($34,000), and amortization
of intangible assets ($16,000). Advertising costs are expected to increase in
2006 as part of the Company's efforts to retain Trinity customers and build
brand recognition in a new market. The Company has focused much of its marketing
efforts on increasing its core deposits. The Company will continue to focus on
building new retail and commercial loan and deposit relationships in 2006. In
addition, the amortization of intangible assets is expected to increase to
$734,000 in 2006, from $409,000 in 2005, due to the amortization of the core
deposit intangible created as a result of the Trinity acquisition. The core
deposit intangible resulting from the Trinity acquisition has a balance of $2.3
million, which is being amortized over an eight-year period on an accelerated
basis. Management expects that noninterest expense will increase in 2006 as the
Company operates a larger organization that includes four additional offices.
Effective December 31, 2004, management determined that unrealized losses
on $2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0
million in perpetual preferred stock issued by Freddie Mac were
"other-than-temporary" impairments. As a result, management recorded a noncash,
pretax loss of $983,000. The unrealized losses on these securities were
considered to be "other-than-temporary" by management for the following reasons:
1) both Fannie Mae and Freddie Mac had experienced recent accounting
irregularities that have resulted in restated financial results from prior
periods; 2) the yield on perpetual preferred stock recently issued by Fannie Mae
is much higher than the yield of the preferred stock held by the Company, which
decreased the value of the Company's security; 3) the preferred stock for Fannie
Mae was downgraded and the preferred stock for both Companies are on a negative
watch list; 4) the Freddie Mac preferred stock repriced in December 2004, yet it
continued to have significant unrealized losses at year end; 5) neither of the
preferred stock issues had stated maturity dates, so the recovery of the
unrealized losses is not expected to occur in the foreseeable future. The credit
issues facing Fannie Mae and Freddie Mac only affected the performance of the
Company's perpetual preferred stock. The Company did not own any other perpetual
preferred stock at December 31, 2004. Management did not consider any unrealized
losses on its investment securities to be "other-than-temporary" as of December
31, 2005, since all unrealized losses were considered to be due to temporary
changes in interest rates.
The Company's provision for income taxes was $1.3 million and $1.1 million
for the years ended December 31, 2005 and 2004, respectively. The change was
primarily due to a $563,000 increase in pretax income. The effective tax rate
increased from 26.7% to 28.8% due to a smaller percentage of income being
derived from tax-advantaged assets such as municipal securities, U.S. Government
Agency securities, and bank-owned life insurance that generate tax-exempt
income. Management expects that the effective tax rate for 2006 will increase as
a smaller percentage of pretax income is expected to be derived from
tax-advantaged assets.
COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2004
AND 2003
Net income was $3.0 million, or $0.38 per diluted share, for the year ended
December 31, 2004, compared to $3.4 million, or $0.39 per diluted share, for the
year ended December 31, 2003. The earnings provided a return on average equity
of 3.78% in 2004, compared to 3.61% in 2003, and a return on average assets of
0.59% in 2004, compared to 0.68% in 2003.
Net interest income, the Company's largest source of income, decreased
slightly in 2004 by $70,000, or 0.5%. This decrease was due in part to the
declining ratio of average interest-earning assets to average interest-bearing
liabilities during 2004. The Company's ratio of average interest-earning assets
to average interest-bearing liabilities decreased from 118.65% in 2003 to
110.96% in 2004 due primarily from the repurchase of 1,250,000 shares of common
stock for $16.4 million. The Company's net interest margin increased slightly
from 2.94% in 2003 to 2.98% in 2004. However, the spread between the yield on
interest-earning assets and the cost of interest-bearing liabilities has
improved by 21 basis points from 2.57% in 2003 to 2.78% in 2004. This increase
was largely due to a series of 25 basis point increases in the federal funds
rate by the Federal Reserve Board that resulted in a 1.25% increase in the
prime-lending rate during the year to 5.25% at December 31, 2004. Approximately
57% of the Company's loan portfolio reprices each month, the majority of which
are tied to the prime lending rate. As such, management believes that the
Company's net interest margin and resulting net interest income will improve in
2005, if short-term interest rates continue to increase, prepayments on loans
and mortgage-backed securities slow to more normalized levels, and loan demand
improves. However, if short-term interest rates decline, loan prepayments
accelerate, or loan demand slows, management's expectations for 2005 may not be
realized.
21
Interest income for the year ended December 31, 2004, decreased by
$859,000, or 3.9%, to $21.1 million. This decrease was primarily due to a
$682,000, or 4.1%, reduction in interest income on loans. During the year,
average outstanding loans decreased by $2.9 million, or 1.0%, from $297.5
million to $294.6 million, while the average yield on loans decreased from 5.7%
to 5.5%. These changes were primarily the result of a continued high level of
loan prepayments and refinancings that reduced both yields and outstanding
balances. The reduction in average outstanding loans was primarily concentrated
in the Company's portfolio of one-to-four family residential loans due to the
fact that the Company originates and closes substantially all new fixed-rate
residential loans as a broker for an independent third party. This reduces the
Company's vulnerability to increases in interest rates and provides current
period fee income. During 2004 loans secured by one-to-four family residences
decreased by $11.1 million, or 10.8%, to $91.7 million at December 31, 2004,
while the remaining loan portfolio, which consists of construction loans,
multifamily residential loans, commercial real estate loans, commercial business
loans and consumer loans, increased by $30.3 million, or 15.5%, to $225.5
million at December 31, 2004. The Company has expanded into the high growth
market of Cornelius, North Carolina with a loan production office and has
recently hired three additional commercial lenders and one additional mortgage
loan originator. Management believes that these actions, coupled with the recent
increases in the prime lending rate, will improve the level of outstanding loans
and the yield on the loan portfolio in 2005.
Interest earned on interest-bearing bank balances decreased by $107,000, or
43.0%, to $142,000 in 2004. The average balance of interest-bearing bank
balances decreased by $11.2 million, or 49.3%, to $11.6 million. These funds
were primarily used to repurchase stock and purchase higher yielding investment
securities. The average yield on these interest-earning bank balances increased
slightly from 1.09% in 2003 to 1.22% in 2004. Interest earned on investment
securities increased by $410,000, or 27.4%, to $1.9 million in 2004. This
increase in interest income was primarily due to a $15.7 million, or 40.8%,
increase in the average outstanding balance of investment securities. These
additional securities were funded primarily by deposit growth and existing
interest-bearing bank balances. The average yield on investment securities
decreased by 37 basis points to 3.51% for 2004 due to the historically low
levels of short-term interest rates during 2004. Interest income from
mortgage-backed securities decreased by $480,000, or 14.0%, to $2.9 million in
2004. This decrease was largely due to a $9.9 million, or 10.8%, decrease in the
average balance of mortgage-backed securities during 2004, resulting in part
from the sale of $6.4 million of mortgage-backed securities during the year.
These proceeds were used, in part, to repurchase shares of the Company's common
stock in the Company. Also, during 2004, the average yield on mortgage-backed
securities decreased from 3.73% to 3.59%, due in part to higher prepayment
levels resulting from attractive mortgage interest rates during the year.
Management expects the levels of investment and mortgage-backed securities will
decline during 2005, with the proceeds of any sales, maturities, and normal
amortization, to be used to fund additional loan originations and stock
repurchases.
Interest expense for the year ended December 31, 2004 decreased $789,000,
or 9.0%, to $7.9 million. This decrease was due to a $374,000, or 5.8%, decrease
in interest expense on deposits and a $415,000, or 18.6%, decrease in interest
expense on borrowed funds. Average interest-bearing deposits increased $17.0
million, or 5.2%, to $345.7 million at December 31, 2004. Most of this increase
was attributable to a $13.6 million increase in average core deposits, which
includes checking accounts, money market demand accounts, and savings accounts.
The remaining increase of $3.4 million was attributable to certificates of
deposits. This change in the deposit mix reflects management's commitment to
building new and enhancing existing customer relationships by focusing on a
customer's primary financial needs such as checking accounts, savings accounts,
and money market demand accounts. The average interest rate paid on deposits
decreased from 1.97% in 2003 to 1.73% in 2004 due to lower market rates and an
emphasis on lower-costing core deposits. Average borrowings increased by $1.8
million, or 3.5%, to $53.1 million at December 31, 2004, while the average rate
paid on borrowings decreased from 4.35% in 2003 to 3.42% in 2004 due to lower
market interest rates in 2004 and the restructuring of $15.0 million in Federal
Home Loan Bank advances in 2003. This restructuring reduced the average interest
rate on these $15.0 million in advances from 5.8% to 1.8%. Management expects
that the cost of funds for deposits and borrowings will increase in 2005 if
short-term interest rates continue to increase.
22
The Company provided $330,000 and $60,000 in loan loss provisions for the
years ended December 31, 2004 and 2003, respectively. The allowance for loan
losses as a percentage of loans was 0.95% at December 31, 2004, and 1.00% at
December 31, 2003. The provision for loan losses increased due to strong growth
in the Company's loan portfolio of $19.1 million, coupled with net charge-offs
of $270,000 during the year. The level of nonperforming loans increased by
$417,000 to $946,000 at December 31, 2004. Most of this increase was
attributable to a $434,000 increase in nonperforming one-to-four family
residential loans, which are secured by real estate. As a result, the ratio of
nonperforming loans to net loans increased from 0.18% at December 31, 2003, to
0.30% at December 31, 2004. Also, real estate owned increased by $661,000 to
$806,000 at December 31, 2004. All of the properties acquired through
foreclosure are one-to-four family residential properties that are in various
stages of disposition. As a result, the ratio of nonperforming assets to total
assets increased from 0.14% at December 31, 2003, to 0.34% at December 31, 2004.
Refer to the "Allowance for Loan Losses" section of Item 7. of this report for
further discussion.
For the year ended December 31, 2004, noninterest income decreased by
$737,000, or 13.3%, from $5.6 million to $4.8 million. Excluding the net gain on
sale of securities and other assets of $674,000 for the year ended December 31,
2004, and $1.0 million for the year ended December 31, 2003, noninterest income
decreased by $390,000, or 8.6%. The primary reasons for the decrease were a
$286,000 reduction in mortgage banking and loan fee income and a $134,000
reduction in the fair value adjustment on rabbi trust accounts. The decrease in
mortgage-banking and loan fee income was primarily due to a reduced number of
residential loan originations in 2004 as compared to 2003. This was largely due
to a moderate increase in longer-term mortgage interest rates during 2004.
Management expects that mortgage lending activity will continue to slow down in
2005 if long-term mortgage interest rates continue to rise during the year. The
reduction in the fair value adjustment on rabbi trust accounts is offset by a
corresponding decrease in compensation expense, resulting in no net impact on
net income. The Company also realized moderate decreases in fee income on
deposit accounts, commissions on sale of uninsured products, dividends on FHLB
stock, and other income. Fee income on deposit accounts decreased by $23,000, or
1.0%, due to a slight reduction of fees generated from overdrawn checking
accounts. Management believes that a continued focus on growing retail and
commercial checking accounts will result in a moderate improvement in fee income
on deposit accounts in 2005. Commissions earned from the sale of uninsured
products decreased by $41,000, or 25.6%, to $120,000 for the year ending
December 31, 2004. During 2004, the Company changed brokerage vendors from UVEST
to Raymond James and hired an additional sales representative. Management
believes that these actions will result in increased commissions during 2005.
The $6,000 decrease on dividends on FHLB stock is directly related to the rate
paid by the FHLB and the number of outstanding shares (based on outstanding
advances). Management expects that the dividend rate paid by the FHLB will
increase in 2005 due to recent increases in short-term interest rates. Other
income decreased by only $1,000, and is expected to be at a comparable level in
2005.
Gain on sale of securities decreased by $567,000, or 55.6%, from 2003 to
2004. During the year ended December 31, 2004, the Company sold $1.8 million in
investment securities and $6.4 million in mortgage-backed securities at a net
gain of $454,000. The proceeds from these sales were used to generate funds to
repurchase shares of stock and originate loans. During the year ended December
31, 2003, the Company sold $8.1 million in investment securities and $12.2
million in mortgage-backed securities at a net gain of $1.0 million. These gains
were used to offset the impact of vesting a portion of the shares of common
stock granted in the Citizens South Banking Corporation 2003 Recognition and
Retention Plan, which is described in "Note - 14 Employee Benefit Plans" under
Item 8. of this report. The Company also recognized a $219,000 increase in net
gain on sale of other assets from 2003 to 2004. This increase was primarily due
to the sale of a branch office in 2004 that resulted in a gain of $218,000. The
operations of this office were consolidated into the new corporate office in May
2004 and the office was subsequently vacated. The office was sold for $374,000
in December 2004.
Noninterest expense decreased by $262,000, or 1.9%, from $13.9 million in
2003 to $13.6 million in 2004. The primary reasons for this decrease were a
$702,000 decrease in compensation, a $1.3 million prepayment penalty on FHLB
advances in 2003, and a $249,000 reduction in the amortization of intangible
assets. The $702,000, or 9.6%, decrease in compensation was largely due to a
$694,000 reduction in the vesting expense of the common stock granted in the
Citizens South Banking Corporation 2003 Recognition and Retention Plan. The
vesting schedule for this stock is 30% in 2003 and 10% in 2004 and each year
thereafter until completely vested. Management expects that compensation expense
will increase in 2005 as additional loan officers are hired to increase loan
production, personnel are hired to staff a new office in Belmont, North Carolina
and a loan production office in Cornelius, North Carolina, and unvested options
are expensed in accordance with SFAS No. 123 (revised), Share Based Payment. The
$1.3 million prepayment penalty in 2003 was associated with the restructuring of
$15.0 million in borrowed funds. This action was taken by the Company in an
effort to capitalize on historically low interest rates, lower the Company's
cost of funds, and improve the Company's net interest margin. This restructuring
is expected to reduce interest expense by approximately $1.7 million over a
five-year period. The amortization of intangible assets decreased by $249,000,
or 37.0%, during 2004. The Company's core deposit intangible is being amortized
over a eight-year period on an accelerated basis. The unamortized balance of the
core deposit intangible as of December 31, 2004, was $783,000. Management
expects the expense from the amortization of intangible assets to continue to
decrease in 2005. The Company also realized moderate decreases in NOW account
expenses, professional expenses, and deposit insurance. Management expects that
these expenses will increase moderately in 2005, as the number of checking
accounts is expected to increase and additional professional services are
expected to be needed due to changing laws and regulations.
23
The decreases in noninterest expenses listed above were partly offset by
increases in occupancy expense, data processing, advertising, and other
noninterest expenses. Occupancy expense increased by $434,000, or 32.3%, to $1.8
million in 2004. This increase was primarily due to the opening of the corporate
office in 2004 and a new banking office in the third quarter of 2003. The
Company sold a banking office in December 2004 that was vacant as a result of
the opening of the new corporate office in May 2004. Management expects that
office occupancy will increase in 2005 as the Company opens a full-service
banking office in Belmont, North Carolina during the third quarter 2005 and
obtains leased space for its loan production office in Cornelius, North
Carolina. Data processing increased by $106,000, to $222,000 for the year ending
December 31, 2004. During 2004 the Company upgraded its technology capabilities
in the areas of online banking, cash management services, document imaging and
core processing. These new capabilities allow the Company to offer a higher
level of service to its existing customers, and to better compete for new
customers. Management expects that data processing costs will moderately
increase in 2005. Advertising expense increased by $60,000, or 21.4% during 2004
to $341,000. The Company has focused much of its marketing efforts on increasing
its core deposits. The Company will continue to focus on building new retail and
commercial loan and deposit relationships in 2005. Advertising costs are
expected to decrease slightly in 2005. Other noninterest expenses, which
includes expenses related to employee travel and training, deposit operations,
loan administration, financial reporting, franchise and other taxes, and other
miscellaneous items, increased by $471,000, or 33.9%. A large portion of the
increase was due to training on the new computer system and enhanced products,
relocating to the corporate office, and costs associated with supporting a
larger number of deposit and loan accounts. Management expects that other
noninterest expenses will decrease slightly in 2005. There were also moderate
increases in expenses related to office supplies and telephone and
communications. These expenses are expected to remain flat in 2005 due to
reduced per item costs prescribed in new vendor contracts for office supplies
and telecommunications.
Effective December 31, 2004, management determined that unrealized losses
on $2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0
million in perpetual preferred stock issued by Freddie Mac were
"other-than-temporary" impairments. As a result, management recorded a noncash,
pretax loss of $983,000. The unrealized losses on these securities were
considered to be "other-than-temporary" by management for the following reasons:
1) both Fannie Mae and Freddie Mac have experienced recent accounting
irregularities that have resulted in restated financial results from prior
periods; 2) the yield on perpetual preferred stock recently issued by Fannie Mae
is much higher than the yield of the preferred stock held by the Company, which
decreases the value of the Company's security; 3) the preferred stock for Fannie
Mae was recently downgraded and the preferred stock for both Companies are on a
negative watch list; 4) the Freddie Mac preferred stock repriced in December
2004, yet it continued to have significant unrealized losses at year end; 5)
neither of the preferred stock issues have stated maturity dates, so the
recovery of the unrealized losses is not expected to occur in the foreseeable
future. The credit issues facing Fannie Mae and Freddie Mac only impact the
performance of the Company's perpetual preferred stock. The Company did not own
any other perpetual preferred stock at December 31, 2004.
The Company's provision for income taxes was $1.1 million and $1.5 million
for the years ended December 31, 2004 and 2003, respectively. The change was
primarily due to an $815,000 decrease in pretax income. The effective tax rate
decreased from 30.2% to 26.7% due to a larger percentage of income being derived
from tax-advantaged assets such as municipal securities, U.S. Government Agency
securities, and bank-owned life insurance that generate tax-exempt income.
Management expects that the effective tax rate for 2005 will increase as a
smaller percentage of pretax income is expected to be derived from
tax-advantaged assets.
24
NET INTEREST INCOME
The net income of the Company is heavily dependent upon net interest
income. Net interest income represents the difference between income on
interest-earning assets and expense on interest-bearing liabilities. Net
interest income also depends on the relative amounts of interest-earning assets
and interest-bearing liabilities and the interest rate earned or paid on them,
respectively. The following table sets forth certain information relating to the
Company for the years ended December 31, 2005, 2004 and 2003. For the years
indicated, the total dollar amount of interest income from average
interest-earning assets and the resultant yields, as well as the interest
expense on average interest-bearing liabilities, is expressed both in dollars
and rates. No tax equivalent adjustments were made.
TABLE 1
AVERAGE BALANCES AND NET INTEREST INCOME ANALYSIS
December 31, 2005 December 31, 2004
------------------------------------ ----------------------------------
Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/
(Dollars in Thousands) Balance Expense Cost Balance Expense Cost
- -------------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
ASSETS:
Interest-earning assets:
Loans receivable (1) ............... $ 347,720 $ 22,128 6.36% $ 294,647 $ 16,116 5.47%
Interest-bearing bank deposits ..... 13,394 463 3.46 11,598 142 1.22
Investment securities .............. 45,113 1,603 3.55 54,234 1,906 3.51
Mortgage-backed securities ......... 73,283 2,754 3.76 82,025 2,946 3.59
---------- ---------- ---------- ---------- ---------- ----------
Total interest-earning assets ........ 479,510 26,948 5.62 442,504 21,110 4.77
Noninterest-earning assets ........... 63,801 57,433
---------- ----------
Total assets ......................... $ 543,311 $ 499,937
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest-bearing liabilities:
Demand deposit accounts ............ $ 36,798 $ 211 0.57% $ 32,964 $ 103 0.31%
Money market deposit accounts ...... 78,092 1,791 2.29 59,121 842 1.42
Savings accounts ................... 26,219 159 0.61 32,802 165 0.50
Certificates of deposit ............ 231,000 6,816 2.95 220,838 5,017 2.27
Borrowed funds ..................... 66,199 2,492 3.76 53,053 1,816 3.42
---------- ---------- ---------- ---------- ---------- ----------
Total interest-bearing liabilities ... 438,308 11,469 2.62 398,779 7,943 1.99
---------- ----------
Noninterest-bearing liabilities ...... 30,641 22,966
---------- ----------
Total liabilities .................... 468,949 421,745
Stockholders' equity ................. 74,362 78,192
---------- ----------
Total liabilities and equity ......... $ 543,311 $ 499,937
========== ==========
Net interest income .................. $ 15,479 $ 13,167
========== ==========
Interest rate spread (2) ............. 3.00% 2.78%
========== ==========
Net interest margin (3) .............. 3.23% 2.98%
========== ==========
Ratio of average interest-earning
assets to avg. interest-bearing
liabilities ......................... 109.40% 110.96%
========== ==========
December 31, 2003
----------------------------------
Interest Average
Average Income/ Yield/
(Dollars in Thousands) Balance Expense Cost
- -------------------------------------- ---------- ---------- ----------
ASSETS:
Interest-earning assets:
Loans receivable (1) ............... $ 297,517 $ 16,798 5.65%
Interest-bearing bank deposits ..... 22,847 249 1.09
Investment securities .............. 38,523 1,496 3.88
Mortgage-backed securities ......... 91,939 3,426 3.73
---------- ---------- ----------
Total interest-earning assets ........ 450,826 21,969 4.87
Noninterest-earning assets ........... 44,372
----------
Total assets ......................... $ 495,198
==========
LIABILITIES AND STOCKHOLDERS' EQUITY:
Interest-bearing liabilities:
Demand deposit accounts ............ 28,525 91 0.32%
Money market deposit accounts ...... 43,097 550 1.28
Savings accounts ................... 39,705 305 0.77
Certificates of deposit ............ 217,395 5,555 2.56
Borrowed funds ..................... 51,238 2,231 4.35
---------- ---------- ----------
Total interest-bearing liabilities ... 379,960 8,732 2.30
----------
Noninterest-bearing liabilities ...... 21,365
----------
Total liabilities .................... 401,325
Stockholders' equity ................. 93,873
----------
Total liabilities and equity ......... $ 495,198
==========
Net interest income .................. $ 13,237
==========
Interest rate spread (2) ............. 2.57%
==========
Net interest margin (3) .............. 2.94%
==========
Ratio of average interest-earning
assets to avg. interest-bearing
liabilities ......................... 118.65%
==========
- ----------
(1) Average loan balances include nonaccrual loans.
(2) Interest rate spread represents the difference between the average yield on
interest-earning assets and the average cost of interest-earning
liabilities.
(3) Net interest margin is calculated by dividing net interest income by
average interest-earning assets.
Changes in interest income and expense can result from changes in both
volume and rates. The following table sets forth information regarding changes
in our interest income and interest expense for the periods indicated. For each
category of our interest-earning assets and interest-bearing liabilities,
information is provided on changes attributable to (i) changes in volume
(changes in volume multiplied by old rate); (ii) changes in rate (changes in
rate multiplied by old volume); (iii) the net change. The changes attributable
to the combined impact of volume and rate have been allocated proportionately to
the changes due to volume and the changes due to rate.
25
TABLE 2
VOLUME AND RATE VARIANCE ANALYSIS
For The Year Ended For the Year Ended
December 31, 2005 vs December 31, 2004 December 31, 2004 vs December 31, 2003
Increase (Decrease) Increase (Decrease)
Due to Due to
-------------------------------------- --------------------------------------
(In Thousands) Volume Rate Net Volume Rate Net
- --------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
Interest income:
Loans receivable .............. $ 3,151 $ 2,861 $ 6,012 $ (161) $ (521) $ (682)
Interest-bearing bank deposits 25 296 321 (143) 36 (107)
Investment securities ......... (324) 21 (303) 534 (124) 410
Mortgage-backed securities .... (340) 148 (192) (359) (121) (480)
---------- ---------- ---------- ---------- ---------- ----------
Total interest income ........... 2,512 3,326 5,838 (129) (730) (859)
---------- ---------- ---------- ---------- ---------- ----------
Interest expense:
Deposits ...................... 524 2,326 2,850 234 (608) (374)
Borrowed funds ................ 482 194 676 82 (497) (415)
---------- ---------- ---------- ---------- ---------- ----------
Total interest expense .......... 1,006 2,520 3,526 316 (1,105) (789)
--------- ---------- ---------- ---------- ---------- ----------
Net interest income ............. $ 1,506 $ 806 $ 2,312 $ (445) $ 375 $ (70)
========== ========== ========== ========== ========== ==========
LOANS
The Company generally makes consumer loans, commercial loans and
residential mortgage loans within its market area. In the past, we concentrated
our lending activities on conventional first mortgage loans secured by
one-to-four family properties. However, since converting to a stock-owned
company in 1998, the Company has focused more of its lending activities on
construction loans, nonresidential real estate loans, commercial business loans
and consumer loans. A substantial portion of our loan portfolio is secured by
real estate, either as primary or secondary collateral, located in our primary
market area. The Company has a diversified loan portfolio with no material
concentrations to any one borrower or industry.
Our lending activities are subject to the written, non-discriminatory,
underwriting standards and loan origination procedures established by management
and approved by our Board of Directors. Loan originations come from a number of
sources including real estate agents, home builders, walk-in customers,
referrals and existing customers. Loan officers also call on local businesses
soliciting commercial products. We advertise our loan products in various print
media including the local newspaper. In our marketing, we emphasize our
community ties, personalized customer service, and an efficient underwriting and
approval process. All real estate collateral is appraised or evaluated in
accordance with regulatory requirements. On new loan originations, we require
hazard, title and, to the extent applicable, flood insurance on all security
property. The amounts and types of loans outstanding over the past five years
are shown on the following table.
26
TABLE 3
LOAN PORTFOLIO
December 31, 2005 December 31, 2004 December 31, 2003
------------------------ ------------------------ ------------------------
Amount Percent Amount Percent Amount Percent
---------- ---------- ---------- ---------- ---------- ----------
(Dollars in Thousands)
Real estate loans:
One-to-four family residential $ 98,635 20.83% $ 91,714 28.92% $ 102,751 34.48%
Multifamily residential 24,594 5.19 10,632 3.35 11,987 4.02
Construction 62,687 13.24 25,033 7.89 8,913 2.99
Nonresidential 185,319 39.13 114,551 36.12 94,357 31.66
---------- ---------- ---------- ---------- ---------- ----------
Total real estate loans 371,235 78.39 241,930 76.28 218,008 73.15
Commercial business loans 30,128 6.36 14,002 4.41 14,001 4.70
Consumer loans 72,237 15.25 61,245 19.31 66,020 22.15
---------- ---------- ---------- ---------- ---------- ----------
Total gross loans 473,600 100.00% 317,177 100.00% 298,029 100.00%
========== ========== ==========
Less:
Deferred loan fees, net 264 21 34
Allowance for loan losses 5,104 3,029 2,969
---------- ---------- ----------
Total loans, net $ 468,232 $ 314,127 $ 295,026
========== ========== ==========
December 31, 2002 December 31, 2001
----------------------- -----------------------
Amount Percent Amount Percent
---------- ---------- ---------- ----------
(Dollars in Thousands)
Real estate loans:
One-to-four family residential $ 140,360 46.32% $ 191,522 56.74%
Multifamily residential 8,962 2.96 8,696 2.58
Construction 9,903 3.27 11,219 3.32
Nonresidential 69,313 22.88 53,110 15.74
---------- ---------- ---------- ----------
Total real estate loans 228,538 75.43 264,547 78.38
Commercial business loans 12,084 3.99 6,930 2.05
Consumer loans 62,368 20.58 66,058 19.57
---------- ---------- ---------- ----------
Total gross loans 302,990 100.00% 337,535 100.00%
========== ==========
Less:
Deferred loan fees, net 89 78
Allowance for loan losses 2,995 3,136
---------- ----------
Total loans, net $ 299,906 $ 334,321
========== ==========
Our Board of Directors must approve all loans in excess of $3.0 million or
more, or in any amount to borrowers with existing exposure to us in excess of
$3.0 million, or in any amount that when added to the borrower's existing
exposure to us causes such total exposure to be in excess of $3.0 million. In
addition, all unsecured loans in excess of $500,000, or in any amount when added
to a borrower's existing unsecured exposure to us causes such unsecured exposure
to be in excess of $500,000, must be approved by our Board of Directors. Loans
of $3.0 million or less, or customers with exposure (including the proposed
loan) of $3.0 million or less, or unsecured loans of $500,000 or less, or
customers with unsecured exposure (including the proposed loan) of $500,000 or
less, as applicable, may be approved individually or jointly by our lending
officers within loan approval limits delegated by our Board of Directors. In
addition, the Board of Directors has delegated "incremental" loan approval
limits to certain lending officers which allows them to approve a new loan to an
existing customer in an amount equal to, or less than, their incremental loan
limit that would otherwise require approval by the Board of Directors or the
additional approval of another lending officer. Any loan approved by a lending
officer using their incremental loan limit must be ratified by the Board of
Directors or approved by another lending officer, as applicable, after the loan
has been made.
27
The following table represents the maturity distribution of the Company's
loans by type, including fixed rate loans, as of December 31, 2005. Demand
loans, loans having no stated schedule of repayments and no stated maturity, and
overdrafts are reported as becoming due within one year. Loan balances do not
include undisbursed loan proceeds, unearned discounts, unearned income and
allowance for loan losses.
TABLE 4
MATURITY DISTRIBUTION OF LOAN PORTFOLIO
One year One to Over Five
or Less Five Years Years Total
---------- ---------- ---------- ----------
(In thousands)
Real Estate:
One-to-four family residential $ 3,570 $ 11,784 $ 83,281 $ 98,635
Multifamily residential ....... 259 15,395 8,940 24,594
Construction .................. 37,409 22,061 3,217 62,687
Nonresidential ................ 31,683 128,791 24,845 185,319
Commercial business ............. 15,864 14,240 24 30,128
Consumer ........................ 3,762 7,657 60,818 72,237
---------- ---------- ---------- ----------
Total loans ..................... $ 92,547 $ 199,928 $ 181,125 $ 473,600
========== ========== ========== ==========
The following table sets forth the dollar amount of all loans as of
December 31, 2005, for which final payment is not due until after December 31,
2006. The table also shows the amount of each type of loan that has a fixed rate
of interest and those that have an adjustable rate of interest.
TABLE 5
INTEREST RATE DISTRIBUTION OF LOAN PORTFOLIO
Fixed Adjustable
Rates Rates Total
---------- ---------- ----------
(In thousands)
Real Estate Loans:
One-to-four family residential $ 35,846 $ 59,219 $ 95,065
Multifamily residential ...... 9,708 14,627 24,335
Construction ................. 6,668 18,610 25,278
Nonresidential ............... 54,805 98,831 153,636
---------- ---------- ----------
Total real estate loans ......... 107,027 191,287 298,314
Commercial business ............. 5,966 8,298 14,264
Consumer loans .................. 5,998 62,477 68,475
---------- ---------- ----------
Total loans .................. $ 118,991 $ 262,062 $ 381,053
========== ========== ==========
Scheduled contractual principal repayments of loans do not reflect the
actual life of such assets. The average life of a loan is substantially less
than its contractual terms because of prepayments. In addition, due-on-sale
clauses on loans generally give us the right to declare loans immediately due
and payable in the event, among other things, that the borrower sells the real
property subject to the mortgage and the loan is not repaid. The average life of
mortgage loans tends to increase, however, when current mortgage loan market
rates are substantially higher than rates on existing mortgage loans and,
conversely, decrease when rates on existing mortgage loans are substantially
higher than current mortgage loan market rates.
Nonperforming Assets and Delinquencies. When a borrower fails to make a
required payment on a loan, we attempt to cure the deficiency by contacting the
borrower and collecting the payment. Computer generated late notices are mailed
15 days after a payment is due. In most cases, deficiencies are cured promptly.
If a delinquency continues, additional contact is made either through a notice
or other means and we will attempt to work out a payment schedule and actively
encourage delinquent residential mortgage borrowers to seek home ownership
counseling. While we generally prefer to work with borrowers to resolve such
problems, we will institute foreclosure or other proceedings, as necessary, to
minimize any potential loss. Loans are placed on nonaccrual status generally if,
in the opinion of management, principal or interest payments are not likely in
accordance with the terms of the loan agreement, or when principal or interest
is past due 90 days or more. Interest accrued but not collected at the date the
loan is placed on nonaccrual status is reversed against income in the current
period. Loans may be reinstated to accrual status when payments are under 90
days past due and, in the opinion of management, collection of the remaining
past due balances can be reasonably expected. Our Board of Directors is informed
monthly of the total amount of loans which are more than 30 days delinquent.
Loans that are more than 90 days delinquent or in foreclosure are reviewed by
the Board on an individual basis each month.
28
The following table sets forth information with respect to our
nonperforming assets at the dates indicated. As of such dates, we had no
restructured loans within the meaning of SFAS No. 15.
TABLE 6
SCHEDULE OF NONPERFORMING ASSETS
December 31,
------------------------------------------------------------------
2005 2004 2003 2002 2001
---------- ---------- ---------- ---------- ----------
(Dollars in thousands)
Loans accounted for on a nonaccrual basis:
Real estate loans:
One-to-four family residential ....... $ 681 $ 627 $ 193 $ 329 $ 756
Multifamily residential .............. 0 0 0 0 70
Construction ......................... 956 0 0 90 0
Nonresidential real estate ........... 397 209 20 0 0
Commercial business ...................... 274 30 203 21 150
Consumer ................................. 243 80 113 76 196
---------- ---------- ---------- ---------- ----------
Total nonaccrual loans ................... 2,551 946 529 516 1,172
Accruing loans which were contractually
past due 90 days or more ............. 0 0 0 0 0
---------- ---------- ---------- ---------- ----------
Total nonperforming loans ................ 2,551 946 529 516 1,172
Real estate owned ........................ 1,157 806 145 1,307 1,470
---------- ---------- ---------- ---------- ----------
Total nonperforming assets ............... $ 3,708 $ 1,752 $ 674 $ 1,823 $ 2,642
========== ========== ========== ========== ==========
Nonperforming loans to total loans ....... 0.54% 0.30% 0.18% 0.17% 0.35%
Nonperforming assets to total assets ..... 0.53% 0.34% 0.14% 0.37% 0.59%
Real Estate Acquired in Settlement of Loans. Real estate acquired by us as
a result of foreclosure or by deed-in-lieu of foreclosure is classified as real
estate acquired in settlement of loans until sold. Generally, foreclosed assets
are held for sale and such assets are carried at the lower of cost or market
value minus estimated cost to sell the property. After the date of acquisition,
all costs incurred in maintaining the property are expensed and costs incurred
for the improvement or development of such property are capitalized up to the
extent of their net realizable value. At December 31, 2005, we had $1.2 million
in real estate acquired in settlement of loans. This balance is comprised of
seven single-family residences and twelve residential lots located in the Bank's
normal lending area. These properties are in various stages of disposition.
Restructured Loans. Under accounting principles generally accepted in the
United States of America ("GAAP"), we are required to account for certain loan
modifications or restructuring as a "troubled debt restructuring." In general,
the modification or restructuring of a debt constitutes a troubled debt
restructuring if we, for economic or legal reasons related to the borrower's
financial difficulties, grant a concession to the borrowers that we would not
otherwise consider. Debt restructurings or loan modifications for a borrower do
not necessarily always constitute troubled debt restructurings, however, and
troubled debt restructurings do not necessarily result in nonaccrual loans. We
had three restructured loans as of December 31, 2005, totaling $1.1 million.
29
Asset Classification. The OTS has adopted various regulations regarding
problem assets of financial institutions. The regulations require that each
insured institution review and classify its assets on a regular basis. In
addition, in connection with examinations of insured institutions, OTS examiners
have the authority to identify problem assets and, if appropriate, require them
to be classified. There are three classifications for problem assets:
substandard, doubtful and loss. Substandard assets have one or more defined
weaknesses and are characterized by the distinct possibility that the insured
institution will sustain some loss if the deficiencies are not corrected.
Doubtful assets have the weaknesses of substandard assets with the additional
characteristic that the weaknesses make collection or liquidation in full on the
basis of currently existing facts, conditions and values questionable, and there
is a high possibility of loss. An asset classified as loss is considered
uncollectible and of such little value that continuance as an asset of the
institution is not warranted. If an asset or portion thereof is classified as
loss, we establish specific allowances for loan losses for the full amount of
the portion of the asset classified as loss. All or a portion of general loan
loss allowances established to cover possible losses related to assets
classified substandard or doubtful can be included in determining an
institution's regulatory capital, while specific valuation allowances for loan
losses generally do not qualify as regulatory capital. Assets that do not
currently expose the insured institution to sufficient risk to warrant
classification in one of the aforementioned categories but possess weaknesses
are designated "special mention" and monitored by us.
As of December 31, 2005, we had $4.8 million in assets classified
substandard, $508,000 classified doubtful, and no assets classified as loss. The
aggregate amount designated special mention as of December 31, 2005, was $3.5
million. Pursuant to SFAS No. 114, "Accounting by Creditors for Impairment of a
Loan," management determined that impaired loans were not material as of
December 31, 2005.
As of December 31, 2004, we had $3.5 million classified as substandard,
$202,000 classified as doubtful and no assets classified as loss. The aggregate
amount designated special mention was $5.0 million. Pursuant to SFAS 114,
management determined that impaired loans were not material as of December 31,
2004.
ALLOWANCE FOR LOAN LOSSES
Management has established a systematic methodology for evaluating the
adequacy of the Company's allowance for loan losses. The methodology is set
forth in a formal policy and considers all loans in the portfolio. Specific
allowances are established for certain individual loans that management
considers impaired under SFAS 114. The remainder of the portfolio is segmented
into groups of loans with similar risk characteristics for evaluation and
analysis. In originating loans, we recognize that losses will be experienced and
that the risk of loss will vary with, among other things, the type of loan being
made, the creditworthiness of the borrower, the term of the loan, general
economic conditions, and in the case of a secured loan, the quality of the
collateral. We increase our allowance for loan losses by charging provisions for
loan losses against our current period income. Management's periodic evaluation
of the adequacy of the allowance is consistently applied and is based on our
past loan loss experience, particular risks inherent in the different kinds of
lending that we engage in, adverse situations that may affect the borrower's
ability to repay, the estimated value of any underlying collateral, current
economic conditions, and other relevant internal and external factors that
affect loan collectibility.
At December 31, 2005, we had an allowance for loan losses of $5.1 million.
Management believes that this amount meets the requirement for losses on loans
that management considers to be impaired, for known losses, and for risks
inherent in the remaining loan portfolios. Although management believes that it
uses the best information available to make such determinations, future
adjustments to the allowance for loan losses may be necessary and results of
operations could be significantly adversely affected if circumstances differ
substantially from the assumptions used in making the determinations. The
allowance for loan losses is subject to periodic evaluation by various
regulatory authorities and may be subject to adjustment upon their examination.
The following table sets forth an analysis of our allowance for loan losses.
30
TABLE 7
ALLOWANCE OF LOAN LOSSES
At and For the Twelve Months Ended
December 31,
------------------------------------------------------------------
2005 2004 2003 2002 2001
---------- ---------- ---------- ---------- ----------
(Dollars in Thousands)
Allowance at beginning of period ............. $ 3,029 $ 2,969 $ 2,995 $ 3,136 $ 1,566
Charge-offs:
One-to-four family residential ............ 5 14 0 16 0
Nonresidential mortgage loans ............. 182 174 0 175 0
Commercial business loans ................. 158 76 0 150 0
Consumer loans ............................ 76 14 94 42 104
---------- ---------- ---------- ---------- ----------
Total charge-offs ............................ $ 421 $ 278 $ 94 $ 383 $ 104
Recoveries:
One-to-four family residential ............ 0 0 0 0 0
Nonresidential mortgage loans ............. 5 1 0 0 0
Commercial business loans ................. 14 4 0 0 0
Consumer loans ............................ 2 3 8 17 1
---------- ---------- ---------- ---------- ----------
Total recoveries ............................. $ 21 $ 8 $ 8 $ 17 $ 1
---------- ---------- ---------- ---------- ----------
Net charge-offs .............................. $ 400 $ 270 $ 86 $ 366 $ 103
Provision for loan losses .................... 985 330 60 225 120
Allowance acquired in acquisition ............ 1,490 0 0 0 1,553
---------- ---------- ---------- ---------- ----------
Allowance at end of period ................ $ 5,104 $ 3,029 $ 2,969 $ 2,995 $ 3,136
========== ========== ========== ========== ==========
Allowance for loan losses to total gross loans 1.08% 0.95% 1.00% 0.99% 0.93%
Net charge-offs to average loans ............. 0.12% 0.09% 0.03% 0.11% 0.06%
31
The following table sets forth the breakdown of the allowance for loan
losses by loan category at the dates indicated. Management believes that the
allowance can be allocated by category only on an approximate basis. The
allocation of the allowance to each category is not necessarily indicative of
future losses and does not restrict the use of the allowance to absorb losses in
any other category.
TABLE 8
ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
December 31, 2005 December 31, 2004 December 31, 2003
------------------------- ------------------------- -------------------------
% of % of % of
Amount Total Loans Amount Total Loans Amount Total Loans
---------- ------------ ---------- ------------ ---------- ------------
(Dollars in Thousands)
Real estate loans:
One-to-four family residential $ 300 20.83% $ 250 28.92% $ 399 33.48%
Multifamily residential ...... 250 5.19 100 3.35 100 4.02
Construction ................. 500 13.24 300 7.89 150 2.99
Nonresidential ............... 1,854 39.13 609 36.12 550 31.66
---------- ------------ ---------- ------------ ---------- ------------
Total real estate loans ......... 2,904 78.39 1,259 76.28 1,199 73.15
Commercial business ............. 1,000 6.36 600 4.41 600 4.70
Consumer loans .................. 1,200 15.25 1,171 19.31 1,170 22.15
---------- ------------ ---------- ------------ ---------- ------------
Total allowance for loan losses . $ 5,104 100.00% $ 3,029 100.00% $ 2,969 100.00%
========== ============ ========== ============ ========== ============
December 31, 2002 December 31, 2001
------------------------- -------------------------
% of % of
Amount Total Loans Amount Total Loans
---------- ------------ ---------- ------------
(Dollars in Thousands)
Real estate loans:
One-to-four family residential $ 475 46.32% $ 800 56.74%
Multifamily residential ...... 100 2.96 100 2.58
Construction ................. 150 3.27 150 3.32
Nonresidential ............... 500 22.88 225 15.74
---------- ------------ ---------- ------------
Total real estate loans ......... 1,225 75.43 1,275 78.38
Commercial business ............. 600 3.99 744 2.05
Consumer loans .................. 1,170 20.58 1,117 19.57
---------- ------------ ---------- ------------
Total allowance for loan losses . $ 2,995 100.00% $ 3,136 100.00%
========== ============ ========== ============
DEPOSITS
Our deposit products include a broad selection of deposit instruments,
including checking accounts, money market deposit accounts, savings accounts,
individual retirement accounts, and term certificate accounts. We offer these
products to both retail and commercial customers. Deposit account terms vary
with the principal difference being the minimum balance deposit, early
withdrawal penalties and the interest rate. We review our deposit mix and
pricing weekly. We believe that we are competitive in the type of accounts and
interest rates we offer on our deposit products. We do not seek to pay the
highest deposit rates, but a competitive rate. Management determines the rates
paid based on a number of conditions, including rates paid by competitors, rates
on U.S. Treasury securities, rates offered on alternative lending programs, and
the deposit growth rate we are seeking to achieve. The following table sets
forth information concerning our deposit accounts.
32
TABLE 9
DEPOSIT PORTFOLIO COMPOSITION
December 31, 2005 December 31, 2004 December 31, 2003
----------------------- ----------------------- -----------------------
Average Average Average
Actual Interest Actual Interest Actual Interest
Category Balance Rate Balance Rate Balance Rate
- --------------------------------- ---------- ---------- ---------- ---------- ---------- ----------
(Dollars in Thousands)
Noninterest bearing demand ...... $ 35,226 0.0% $ 19,734 0.0% $ 12,906 0.0%
Interest bearing demand ......... 50,263 0.6 32,949 0.3 30,780 0.3
Money market deposit ............ 104,421 2.3 77,924 1.4 48,189 1.3
Savings accounts ................ 23,654 0.6 29,174 0.5 36,754 0.8
Certificates of deposit ......... 303,980 3.0 214,962 2.3 213,817 2.6
---------- ---------- ---------- ---------- ---------- ----------
Total Deposits .............. $ 517,544 2.3% $ 374,744 1.7% $ 342,446 1.9%
========== ========== ========== ========== ========== ==========
The following table indicates the amount of our time deposits (also
referred to as certificates of deposits) with a principal balance greater than
$100,000 by time remaining until maturity as of December 31, 2005.
TABLE 10
MATURITIES OF TIME DEPOSITS OVER $100,000
Maturity Period Time Deposits
-------------------------------------------- ---------------
(In Thousands)
Within three months......................... $ 20,599
Three to six months......................... 21,518
Six through twelve months................... 29,015
Over twelve months.......................... 35,857
---------------
Total time deposits over $100,000........ $ 106,989
===============
The following table sets forth the amount of time deposits in the Bank
categorized by rates as of December 31st at the dates indicated.
TABLE 11
TIME DEPOSIT INTEREST RATE COMPOSITION
At December 31,
------------------------------------
Interest Rate 2005 2004 2003
------------------------- ---------- ---------- ----------
(In Thousands)
Less than 2.00% ......... $ 4,712 $ 74,951 $ 85,060
2.01-4.00% .............. 222,880 118,275 108,170
4.01-6.00% .............. 76,388 21,616 20,470
6.01-8.00% .............. 0 120 117
---------- ---------- ----------
$ 303,980 $ 214,962 $ 213,817
========== ========== ==========
33
The following table sets forth the amount of time deposits in the Bank
categorized by rates and maturities at December 31, 2005.
TABLE 12
TIME DEPOSIT MATURITY SCHEDULE
During the Years Ended December 31,
--------------------------------------------------------------
2009
Interest Rate 2006 2007 2008 or Later Total
------------------------- ---------- ---------- ---------- ---------- ----------
(In Thousands)
Less than 2.0% .......... $ 4,678 $ 0 $ 34 $ 0 $ 4,712
2.01-4.0% ............... 186,075 27,130 5,039 4,636 222,880
4.01-6.0% ............... 33,643 23,881 4,458 14,406 76,388
6.01-8.0% ............... 0 0 0 0 0
---------- ---------- ---------- ---------- ----------
Total ................... $ 224,396 $ 51,011 $ 9,531 $ 19,042 $ 303,980
========== ========== ========== ========== ==========
CAPITAL ADEQUACY AND RESOURCES
OTS regulations require savings banks to meet three minimum capital
standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8%
risk-based capital ratio. At December 31, 2005, Citizens South Bank's capital
exceeded all applicable requirements. Under prompt corrective action
regulations, the OTS is required and authorized to take supervisory actions
against undercapitalized savings banks. For this purpose, a savings bank is
placed in one of the following five categories based on the bank's capital: 1)
well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and
10% total risk-based capital); 2) adequately capitalized (at least 4% leverage
capital, 4% tier 1 risk-based capital and 8% total risk-based capital); 3)
undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based
capital or 3% leverage capital); 4) significantly undercapitalized (less than 6%
total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital);
and 5) critically undercapitalized (less than 2% tangible capital). At December
31, 2005, Citizens South Bank met the criteria for being considered
"well-capitalized."
Funding for future growth is dependent upon the earnings of the Company and
its subsidiaries. At December 31, 2005, the Company had a capital to assets
ratio of 12.02%. As such, the Company fully expects to be able to meet future
capital needs caused by growth and expansion as well as regulatory requirements.
The Company plans to continue to repurchase its shares of common stock in the
open market from time to time as market conditions warrant. During 2005, the
Company repurchased 443,923 shares of common stock for a total purchase price of
$5.7 million.
LIQUIDITY
The objectives of the Company's liquidity management policy include
providing adequate funds to meet the cash needs of both borrowers and
depositors, to provide for the on-going operations of the Company, and to
capitalize on opportunities for expansion. Liquidity management addresses the
Company's ability to meet deposit withdrawals on demand or at contractual
maturity, to repay borrowings as they mature, and to fund new loans and
investments as opportunities arise. The primary sources of internally generated
funds are principal and interest payments on loans receivable, increases in
local deposits, cash flows generated from operations, and cash flows generated
by investments. If the Company requires funds beyond its internal funding
capabilities, it may rely upon external sources of funds such in brokered
deposits and Federal Home Loan Bank ("FHLB") advances. The Company has $113.3
million in additional advances available from its line of credit from the FHLB.
The FHLB functions as a central reserve bank providing credit for member
financial institutions. As a member of the FHLB, we are required to own capital
stock in the FHLB and we are authorized to apply for advances on the security of
such stock and certain of our mortgage loans and other assets (principally
securities that are obligations of, or guaranteed by, the U.S. Government)
provided certain creditworthiness standards have been met. Advances are made
pursuant to several different credit programs. Each credit program has its own
interest rate and range of maturities. Depending on the program, limitations on
the amount of advances are based on the financial condition of the member
institution and the adequacy of collateral pledged to secure the credit. The
Company may also solicit brokered deposits for providing funds for asset growth;
however, to date, the Company has not used such deposits to supplement its
liquidity position.
34
In the normal course of business, various commitments are outstanding that
are not reflected in the consolidated financial statements. Commitments to
extend credit and undisbursed advances on customer lines of credit are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract. The funding of these commitments and
previously approved undisbursed lines of credit could effect the Company's
liquidity position. At December 31, 2005, the Company had loan commitments of
$31.7 million, including $5.4 million in undisbursed construction loan proceeds,
and unused lines of credit of $82.7 million. The Company believes that it has
adequate resources to fund loan commitments and lines of credit as they arise.
The Company does not have any special purpose entities of other similar forms of
off-balance sheet financing.
Under existing contractual obligations, the Company will be required to
make payments in future periods. The following table presents aggregated
information about payments due under such contractual obligations at December
31, 2005. The Company expects that a portion of the deposits will not be renewed
upon maturity. If there is a higher than normal level of time deposits that are
not renewed at maturity, then the Company may experience a decrease in
liquidity. This may result in the Company offering higher than market interest
rates to maintain deposits, which would increase interest expense. Transaction
deposit accounts with indeterminate maturities have been classified as having
payments due in one year or less.
TABLE 13
CONTRACTUAL MATURITIES
Payments Due by Period at December 31, 2005
---------------------------------------------------------------
One Year One to Three to Over Five
Or Less Three Years Five Years Years Total
---------- ----------- ---------- ---------- ----------
(in thousands)
Borrowed Funds .......... $ 26,378 $ 19,000 $ 16,000 $ 29,964 $ 91,342
Deposits ................ 437,960 60,542 19,042 0 517,544
Lease Obligations ....... 319 507 265 0 1,091
---------- ---------- ---------- ---------- ----------
Total ................... $ 464,657 $ 80,049 $ 35,307 $ 29,964 $ 609,977
========== ========== ========== ========== ==========
MARKET RISKS
Market risk reflects the risk of economic loss resulting from adverse
changes in market price and interest risks. The risk of loss can be reflected in
diminished market values and/or reduced net interest income in future periods.
The Company's most significant form of market risk is interest rate risk,
as the majority of the Company's assets and liabilities are sensitive to changes
in interest rates. The structure of the Company's loan and deposit portfolios is
such that significant declines in interest rates could adversely impact net
market values and net interest income. The Company does not maintain a trading
account, nor is it subject to currency exchange risk or commodity price risk.
The Company's Asset/Liability Committee ("ALCO") is responsible for monitoring
and managing exposure to interest rate risk, as discussed below in "Interest
Rate Sensitivity".
INTEREST RATE SENSITIVITY
The Company's ALCO monitors the Company's level of interest rate
sensitivity and ensures that the level of sensitivity of the Company's net
portfolio value is maintained within limits established by the Board of
Directors. Through such management, the ALCO seeks to reduce the vulnerability
of the Company's operations to changes in interest rates. During the past year,
the ALCO utilized the following strategies to manage interest rate risk: (1)
emphasizing the origination and retention of short-term commercial business
loans and nonresidential mortgage loans; (2) emphasizing the origination of
adjustable-rate home equity lines of credit; (3) emphasizing the origination and
retention of adjustable-rate one-to-four family residential mortgage loans; (4)
originating all new fixed-rate mortgage loans as a broker for a third party; and
(5) investing in shorter-term investment securities.
35
The Office of Thrift Supervision requires the computation of amounts by
which the net present value of the Bank's cash flow from assets, liabilities,
and off balance sheet items (the Bank's net portfolio value or "NPV") and the
net interest income ("NII") of the Bank would change in the event of a range of
assumed changes in market interest rates. These computations estimate the effect
on a bank's NPV and NII from instantaneous and permanent one hundred- to three
hundred-basis point increases and decreases in market interest rates. The
following table presents the Bank's projected change in NPV and NII at December
31, 2005, as calculated by an independent third party, based upon information
provided by the Bank. The Bank's level of sensitivity, given a hypothetical,
immediate, and sustained change in interest rates from + 300 basis points to -
300 basis points, is within the range of acceptable sensitivity established by
the Board of Directors.
TABLE 14
INTEREST RATE SENSITIVITY
Estimated Theoretical Estimated Theoretical
Hypothetical, Immediate, Net Interest Income Net Portfolio Value
and Sustained ----------------------- -----------------------
Changes in Interest Rates Amount % Change Amount % Change
------------------------------ ---------- ---------- ---------- ----------
(dollars in thousands)
300 basis point rise $ 21,988 10.5% $ 112,321 -0.4%
200 basis point rise 21,324 7.2% 112,809 0.0%
100 basis point rise 20,607 3.6% 113,009 0.2%
No change 19,893 0.0% 112,801 0.0%
100 basis point decline 18,627 -6.4% 110,195 -2.3%
200 basis point decline 16,513 -17.0% 104,553 -7.3%
300 basis point decline 14,119 -29.0% 97,608 -13.5%
Certain shortcomings are inherent in the methodology used in the above
interest rate risk measurement. Modeling changes in NPV require the making of
certain assumptions, which may or may not reflect the manner in which actual
yields and costs respond to changes in market interest rates. In this regard,
the NPV table presented assumes that the composition of the interest sensitive
assets and liabilities existing at the beginning of a period remains constant
over the period being measured and also assumes that a particular change in
interest rates is reflected uniformly across the yield curve regardless of the
duration to maturity or repricing of specific assets and liabilities.
Accordingly, although the NPV table provides an indication of the Bank's
interest rate risk exposure at a particular point in time, such measurements are
not intended to and do not provide a precise forecast of the effect of changes
in market interest rates on the Bank's net interest income and will differ from
actual results.
IMPACT OF INFLATION AND CHANGING PRICES
The consolidated financial statements and related notes have been prepared
in accordance with GAAP, which require the measurement of financial position and
operating results in terms of historical dollars, without considering the change
in the relative purchasing power of money over time due to inflation. Unlike
most industrial companies, nearly all the assets and liabilities of the Company
are financial in nature. As a result, interest rates have a more significant
impact on the Company's performance than the effect of inflation. Interest rates
do not necessarily change in the same magnitude as the price of goods and
services.
36
TABLE 15
QUARTERLY FINANCIAL DATA (UNAUDITED)
First Quarter Second Quarter Third Quarter Fourth Quarter
-------------- -------------- -------------- --------------
(in thousands, except per share data)
2005
Interest income .................................. $ 5,801 $ 6,128 $ 6,482 $ 8,537
Interest expense ................................. 2,172 2,463 2,774 4,060
-------------- -------------- -------------- --------------
Net interest income .............................. 3,629 3,665 3,708 4,477
Provision for loan losses ........................ 150 120 140 575
-------------- -------------- -------------- --------------
Net int. income after provision for loan losses .. 3,479 3,545 3,568 3,902
Noninterest income ............................... 985 1,115 1,095 1,246
Noninterest expense .............................. 3,185 3,370 3,281 4,503
-------------- -------------- -------------- --------------
Income before income taxes ....................... 1,279 1,290 1,382 645
Income taxes ..................................... 377 389 418 139
-------------- -------------- -------------- --------------
Net income ....................................... $ 902 $ 901 $ 964 $ 506
============== ============== ============== ==============
Per share data:
Net income:
Basic ................................... $ 0.13 $ 0.13 $ 0.14 $ 0.06
Diluted ................................. 0.13 0.13 0.14 0.06
Cash dividends declared ..................... 0.07 0.07 0.07 0.07
Common stock price:
High .................................... 14.25 13.90 12.80 12.75
Low ..................................... 12.91 11.76 11.41 11.70
2004
Interest income .................................. $ 5,155 $ 4,995 $ 5,318 $ 5,642
Interest expense ................................. 1,871 1,911 2,058 2,103
-------------- -------------- -------------- --------------
Net interest income .............................. 3,284 3,084 3,260 3,539
Provision for loan losses ........................ 30 30 60 210
-------------- -------------- -------------- --------------
Net int. income after provision for loan losses .. 3,254 3,054 3,200 3,329
Noninterest income ............................... 1,326 1,165 1,076 1,257
Noninterest expense .............................. 3,197 2,862 3,265 4,305
-------------- -------------- -------------- --------------
Income before income taxes ....................... 1,383 1,357 1,011 281
Income taxes ..................................... 422 409 241 5
-------------- -------------- -------------- --------------
Net income ....................................... $ 961 $ 948 $ 770 $ 276
============== ============== ============== ==============
Per share data:
Net income:
Basic ................................... $ 0.12 $ 0.12 $ 0.11 $ 0.04
Diluted ................................. 0.12 0.12 0.11 0.03
Cash dividends declared ..................... 0.065 0.065 0.065 0.065
Common stock price:
High .................................... 14.40 13.74 13.27 14.27
Low ..................................... 13.37 12.60 12.41 12.41
37
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Information responsive to this item in contained in Item 7. above under the
captions "Management of Market Risk" and "Liquidity and Capital Resources".
38
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
[LOGO OF CHERRY BEKAERT & HOLLAND]
REPORT OF INDEPENDENT REGISTERD PUBLIC ACCOUNTING FIRM
The Board of Directors
Citizens South Banking Corporation
Gastonia, North Carolina
We have audited the accompanying consolidated statements of condition of
Citizens South Banking Corporation and subsidiaries as of December 31, 2005 and
2004 and the related consolidated statements of operations, comprehensive
income, changes in stockholders' equity and cash flows for each of the years in
the three-year period ended December 31, 2005. These financial statements are
the responsibility of management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Citizens South
Banking Corporation and subsidiaries as of December 31, 2005 and 2004 and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2005, in conformity with accounting
principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of Citizens South
Banking Corporation's internal control over financial reporting as of December
31, 2005, based on criteria established in Internal Control-Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO) and our report dated March 3, 2006 expressed an unqualified opinion
thereon.
/s/ Cherry, Bekaert & Holland, L.L.P.
Gastonia, North Carolina
March 3, 2006
39
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Condition
DECEMBER 31,
----------------------------------
2005 2004
--------------- ---------------
ASSETS
Cash and due from banks $ 8,863,423 $ 5,799,611
Interest-earning bank balances 17,790,015 5,790,650
--------------- ---------------
Cash and cash equivalents 26,653,438 11,590,261
Investment securities available-for-sale 53,428,704 52,407,378
Mortgage-backed and related securities available-for-sale 70,236,442 81,169,479
Loans, net of deferred fees 473,335,554 317,156,086
Allowance for loan losses (5,103,528) (3,029,108)
--------------- ---------------
Loans, net 468,232,026 314,126,978
Other real estate owned 1,156,867 805,556
Premises and equipment, net 19,818,978 17,362,825
Accrued interest receivable 2,538,696 1,662,085
Federal Home Loan Bank stock 4,083,700 3,460,700
Intangible assets 32,424,118 7,559,512
Bank owned life insurance 14,827,784 12,885,164
Other assets 7,693,218 5,931,406
--------------- ---------------
Total assets $ 701,093,971 $ 508,961,344
=============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits $ 517,543,801 $ 374,744,428
Borrowed money 72,308,000 55,000,000
Subordinated debt 15,464,000 -
Retail repurchase agreements 3,570,267 771,538
Deferred compensation 5,848,862 5,850,061
Other liabilities 2,101,393 201,060
--------------- ---------------
Total liabilities 616,836,323 436,567,087
Commitments and contingencies
Stockholders' Equity
Preferred stock, 10,000,000 shares authorized, none issued - -
Common stock, $0.01 par value, 20,000,000 shares authorized
in 2005 and 2004, 9,062,727 shares issued in 2005 and 2004, and
8,291,544 shares outstanding in 2005 and 7,432,144 shares
outstanding in 2004 90,628 90,628
Additional paid-in-capital 68,467,766 68,380,746
Unallocated common stock held by Employee Stock Ownership Plan (1,613,033) (1,795,877)
Unearned compensation related to Recognition and Retention Plan (1,418,608) (1,698,424)
Retained earnings, substantially restricted 30,310,653 29,765,725
Accumulated unrealized loss on securities available-for-sale,
net of tax (1,567,034) (418,552)
Treasury stock of 771,183 shares at December 31, 2005, and
1,630,583 shares at December 31, 2004, at cost (10,012,724) (21,929,989)
--------------- ---------------
Total stockholders' equity 84,257,648 72,394,257
--------------- ---------------
Total liabilities and stockholders' equity $ 701,093,971 $ 508,961,344
=============== ===============
See notes to consolidated financial statements.
40
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Operations
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2005 2004 2003
------------ ------------ ------------
INTEREST INCOME
Loans $ 22,128,174 $ 16,115,649 $ 16,797,651
Investment securities 2,065,833 2,048,161 1,745,240
Mortgage-backed and related securities 2,754,091 2,946,442 3,426,438
------------ ------------ ------------
Total interest income 26,948,098 21,110,252 21,969,329
INTEREST EXPENSE
Deposits 8,976,879 6,127,372 6,501,361
Borrowed funds 2,492,434 1,815,867 2,230,995
------------ ------------ ------------
Total interest expense 11,469,313 7,943,239 8,732,356
------------ ------------ ------------
Net interest income 15,478,785 13,167,013 13,236,973
Provision for loan losses 985,000 330,000 60,000
------------ ------------ ------------
Net interest income after provision for loan losses 14,493,785 12,837,013 13,176,973
NONINTEREST INCOME
Fee income on deposit accounts 2,486,197 2,426,137 2,448,921
Fee income on mortgage banking and lending activities 573,358 545,948 831,806
Gain on sale of securities 16,688 453,725 1,020,673
Gain on sale of other assets 45,131 220,543 1,213
Commissions on sales of financial products 159,180 120,035 161,296
Dividends on FHLB stock 155,310 96,289 102,057
Fair market adjustment on deferred compensation assets 83,251 177,983 312,230
Increase in value of bank owned life insurance 614,452 591,862 490,082
Other income 307,718 191,755 192,833
------------ ------------ ------------
Total noninterest income 4,441,285 4,824,277 5,561,111
NONINTEREST EXPENSE
Compensation and benefits 7,271,073 6,579,309 7,281,487
Occupancy 2,100,862 1,779,070 1,345,107
Office supplies expense 241,827 321,375 303,640
NOW account expense 255,182 212,926 261,490
Advertising 287,288 340,773 280,597
Professional services 540,281 534,723 581,321
Telephone 284,116 317,665 310,356
Data processing 352,709 221,678 115,192
Deposit insurance 53,932 53,916 59,666
Amortization of intangible assets 408,907 424,808 674,184
Prepayment penalty on FHLB advances - - 1,289,000
Impairment on investment securities - 982,893 -
Merger and conversion expense 383,809 - -
Other expense 2,159,563 1,859,693 1,389,071
------------ ------------ ------------
Total noninterest expense 14,339,549 13,628,829 13,891,111
------------ ------------ ------------
Income before income taxes 4,595,521 4,032,461 4,846,973
Provision for income taxes 1,322,812 1,077,040 1,456,407
------------ ------------ ------------
Net income $ 3,272,709 $ 2,955,421 $ 3,390,566
============ ============ ============
EARNINGS PER SHARE
Basic earnings per share $ 0.45 $ 0.39 $ 0.39
Diluted earnings per share $ 0.45 $ 0.38 $ 0.39
See notes to consolidated financial statements.
41
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Comprehensive Income
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2005 2004 2003
------------ ------------ ------------
Net income $ 3,272,709 $ 2,955,421 $ 3,390,566
Other comprehensive income, net of tax:
Unrealized losses on securities
Unrealized holding losses arising
during period, net of tax effect of
$640,014, $49,616, and $520,397, respectively (1,137,802) (88,205) (925,151)
Reclassification adjustment for loss
included in net income, net of tax effect of
$6,008, $163,341, and $367,442, respectively (10,680) (290,384) (653,231)
------------ ------------ ------------
Other comprehensive loss (1,148,482) (378,589) (1,578,382)
------------ ------------ ------------
Comprehensive income $ 2,124,227 $ 2,576,832 $ 1,812,184
============ ============ ============
See notes to consolidated financial statements.
42
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Changes in Stockholders' Equity
Unearned
Additional Unallocated Compensation
Preferred Common Paid-In Common Stock Related to
Stock Stock Capital Held by ESOP RRP
------------ ------------ ------------ ---------------- ----------------
Balance, December 31, 2002 - 90,628 68,175,723 (2,161,566) -
Comprehensive results:
Net income - - - - -
Other comprehensive results, net of tax - - - - -
Allocation from shares purchased
with loan to ESOP - - 104,873 182,844 -
Repurchase of common stock - - - - -
Issuance of Recognition and Retention
Plan stock - - - - (2,954,297)
Vesting of Recognition and Retention Plan - - - - 974,848
Exercise of options - - - - -
Cash dividends declared on common stock - - - - -
------------ ------------ ------------ ---------------- ----------------
Balance, December 31, 2003 - 90,628 68,280,596 (1,978,722) (1,979,449)
Comprehensive results:
Net income - - - - -
Other comprehensive results,
net of tax - - - - -
Allocation from shares purchased with
loan to ESOP - - 100,150 182,845 -
Repurchase of common stock - - - - -
Issuance of Recognition and Retention
Plan stock - - - - -
Vesting of Recognition and Retention Plan - - - - 281,025
Exercise of options - - - - -
Issuance of treasury stock (100 shares) - - - - -
Cash dividends declared on common stock - - - - -
------------ ------------ ------------ ---------------- ----------------
Balance, December 31, 2004 - 90,628 68,380,746 (1,795,877) (1,698,424)
Comprehensive results:
Net income - - - - -
Other comprehensive results, net of tax - - - - -
Allocation from shares purchased with
loan to ESOP - - 87,020 182,844 -
Repurchase of common stock - - - - -
Issuance of Recognition and Retention
Plan stock - - - - -
Vesting of Recognition and Retention Plan - - - - 279,816
Exercise of options - - - - -
Issuance of treasury stock
(1,280,052 shares) - - - - -
Cash dividends declared on common stock - - - - -
------------ ------------ ------------ ---------------- ----------------
Balance, December 31, 2005 $ - $ 90,628 $ 68,467,766 $ (1,613,033) $ (1,418,608)
============ ============ ============ ================ ================
Retained Accumulated
Earnings Unrealized Total
Substantially Gains(Losses), Treasury Stockholders'
Restricted net of tax Stock Equity
---------------- ---------------- ------------- -------------
Balance, December 31, 2002 28,739,476 1,538,419 - 96,382,680
Comprehensive results:
Net income 3,390,566 - - 3,390,566
Other comprehensive results, net of tax - (1,578,382) - (1,578,382)
Allocation from shares purchased
with loan to ESOP - - - 287,717
Repurchase of common stock - - (9,801,707) (9,801,707)
Issuance of Recognition and Retention
Plan stock - - 2,954,297 -
Vesting of Recognition and Retention Plan - - - 974,848
Exercise of options (1,169,571) - 1,319,364 149,793
Cash dividends declared on common stock (2,136,607) - - (2,136,607)
---------------- ---------------- ------------- -------------
Balance, December 31, 2003 28,823,864 (39,963) (5,528,046) 87,668,908
Comprehensive results: -
Net income 2,955,421 - - 2,955,421
Other comprehensive results,
net of tax - (378,589) - (378,589)
Allocation from shares purchased with
loan to ESOP - - - 282,995
Repurchase of common stock - - (16,403,258) (16,403,258)
Issuance of Recognition and Retention
Plan stock - - - -
Vesting of Recognition and Retention Plan - - - 281,025
Exercise of options - - - -
Issuance of treasury stock (100 shares) - - 1,315 1,315
Cash dividends declared on common stock (2,013,560) - - (2,013,560)
---------------- ---------------- ------------- -------------
Balance, December 31, 2004 29,765,725 (418,552) (21,929,989) 72,394,257
Comprehensive results:
Net income 3,272,709 - - 3,272,709
Other comprehensive results, net of tax - (1,148,482) - (1,148,482)
Allocation from shares purchased with
loan to ESOP - - - 269,864
Repurchase of common stock - - (5,654,999) (5,654,999)
Issuance of Recognition and Retention
Plan stock - - - -
Vesting of Recognition and Retention Plan - - - 279,816
Exercise of options (189,295) - 329,964 140,669
Issuance of treasury stock
(1,280,052 shares) (470,678) - 17,242,300 16,771,622
Cash dividends declared on common stock (2,067,808) - - (2,067,808)
---------------- ---------------- ------------- -------------
Balance, December 31, 2005 $ 30,310,653 $ (1,567,034) $ (10,012,724) $ 84,257,648
================ ================ ============= =============
See notes to consolidated financial statements.
43
CITIZENS SOUTH BANKING CORPORATION
Consolidated Statements of Cash Flows
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2005 2004 2003
-------------- -------------- --------------
OPERATING ACTIVITIES
Net Income $ 3,272,709 $ 2,955,421 $ 3,390,566
Adjustments to reconcile net income to net cash
provided by operating activities
Provision for loan losses 985,000 330,000 60,000
Depreciation 1,221,098 1,036,209 697,578
Impairment on investment securities - 982,893 -
Deferred income tax (benefit) 224,212 (40,661) (238,800)
(Gain) loss on sale of investments
available-for-sale (16,688) (453,725) (1,020,673)
(Gain) loss on sale of other assets (45,131) (220,543) (1,213)
Deferred loan origination fees 243,035 (74,330) 176,411
Amortization of intangible assets 408,907 424,808 674,184
Allocation of shares to the ESOP 269,864 282,995 287,717
Vesting of shares issued for the RRP Plan 279,816 281,025 974,848
(Increase) decrease in interest receivable (249,399) 280,814 (30,289)
Purchase of bank-owned life insurance - - (5,000,000)
Net (increase) decrease in other operating assets 3,971,815 (1,819,969) (1,359,526)
-------------- -------------- --------------
Net cash (used in) provided by operating
activities 10,565,238 3,964,937 (1,389,197)
INVESTING ACTIVITIES
Acquisition of Trinity Bank, net of cash acquired (16,771,138) - -
Net decrease(increase) in loans made to customers (43,043,715) (19,256,152) 4,642,964
Proceeds from the sale of premises and equipment 191,064 428,835 25,000
Proceeds from the sale of investment securities 9,391,794 1,810,745 8,051,817
Proceeds from the sale of mortgage-backed
and related securities 30,325,830 6,381,533 12,153,771
Proceeds from sale of REO 517,393 64,909 1,014,791
Maturities and prepayments of investment securities 5,066,025 22,363,848 16,109,679
Maturities and prepayments of mortgage-backed
and related securities 20,232,254 22,733,334 33,630,059
Purchases of investment securities (10,623,066) (20,302,959) (41,263,571)
Purchases of mortgage-backed and related securities (8,788,599) (21,330,211) (65,652,143)
Purchases (sales) of FHLB stock 331,500 (545,700) (275,500)
Purchases of premises and equipment (1,375,950) (3,668,508) (6,852,372)
-------------- -------------- --------------
Net cash used in investing activities (14,546,608) (11,320,326) (38,415,505)
FINANCING ACTIVITIES
Net increase in deposits 6,534,989 32,298,752 1,583,744
Dividends to stockholders (2,067,808) (2,013,560) (2,136,607)
Exercise of options 140,669 - 149,793
Repurchase of common stock (5,654,999) (16,403,258) (9,801,707)
Increase (decrease) in borrowed money 18,981,000 (3,300,000) 11,800,000
Increase (decrease) in repurchase agreements 1,171,053 90,144 (393,788)
Decrease in advances from
borrowers for insurance and taxes (60,357) 59,387 (181,336)
-------------- -------------- --------------
Net cash provided by financing activities 19,044,547 10,731,465 1,020,099
Net increase (decrease) in cash and cash equivalents 15,063,177 3,376,076 (38,784,603)
Cash and cash equivalents at the beginning of the year 11,590,261 8,214,185 46,998,788
-------------- -------------- --------------
Cash and cash equivalents at the end of the year $ 26,653,438 $ 11,590,261 $ 8,214,185
============== ============== ==============
See notes to consolidated financial statements.
44
CITIZENS SOUTH BANKING CORPORATION
Notes to Consolidated Financial Statements
NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Citizens South Banking Corporation (also referred to as the "Company", the
"Registrant", "We", "Us", or "Our") is a Delaware corporation that owns all of
the outstanding shares of common stock of Citizens South Bank (the "Bank"). The
shares of common stock of the Company trade on the Nasdaq National Market under
the ticker symbol "CSBC." The Company's principal business activities are
overseeing and directing the business of the Bank. The Company's assets consist
primarily of the outstanding capital stock of the Bank, deposits held at the
Bank, and investment securities. The Company became the holding company for the
Bank on September 30, 2002, in connection with the mutual-to-stock conversion of
Citizens South Holdings, MHC, the mutual holding company of Citizens South
Banking Corporation, a federal corporation, formerly named Gaston Federal
Bancorp, Inc., which was originally formed on March 18, 1998, for the purpose of
acting as the holding company for the Bank.
CITIZENS SOUTH BANK
Citizens South Bank, which was chartered in 1904, is a federally chartered
savings bank headquartered in Gastonia, North Carolina. The Bank's principal
business activity is offering FDIC-insured deposits to local customers through
its 15 branch offices and investing those deposits, together with funds
generated from operations and borrowings, in residential and nonresidential real
estate loans, construction loans, commercial business loans, consumer loans,
investment securities, and mortgage-backed securities. The Bank also acts as a
broker in both the origination of loans secured by one-to-four family dwellings
and in the sale of uninsured financial products. The Bank's results of
operations are heavily dependent on net interest income, which is the difference
between the interest earned on loans and securities and the interest paid on
deposits and borrowings. Results of operations are also materially affected by
the Bank's provision for loan losses, gains or losses from the sales of assets,
fee income generated from deposit and loan accounts, commissions earned from the
sale of uninsured investment products, and noninterest expenses. The Bank's
noninterest expense primarily consists of compensation and employee benefits,
occupancy expense, professional services, advertising, and other noninterest
expenses. Results of operations are also significantly affected by general
economic and competitive conditions, changes in interest rates, and actions of
regulatory and governmental authorities. The Bank's wholly-owned subsidiary,
Citizens South Financial Services, Inc. (doing business as Citizens South
Investment Services) acts as an independent agent selling various uninsured
financial products.
Citizens South Bank has 15 full-service branch offices in the North
Carolina Counties of Gaston, Union, Rowan, and Iredell and one loan production
office located in Mecklenburg County, North Carolina.
Principles of Consolidation - The consolidated financial statements include
the accounts of Citizens South Banking Corporation, its wholly-owned subsidiary,
Citizens South Bank, and the Bank's wholly-owned subsidiary, Citizens South
Financial Services, Inc. All significant intercompany accounts and transactions
have been eliminated.
Use of Estimates - The financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America which
require management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results
could differ from those estimates.
Cash and Cash Equivalents - The Company considers cash on hand, cash due
from banks, which are maintained in financial institutions, and interest-earning
deposits, which are maintained with the Federal Home Loan Bank ("FHLB") and
other correspondent banks, as cash and cash equivalents. Also, from time to
time, the Company may be required by Federal Reserve Board regulations to
maintain non-interest-earning reserves against the Company's transaction
accounts, such as negotiable order of withdrawal and regular checking accounts.
These balances maintained to meet the reserve requirements imposed by the
Federal Reserve Board are also considered to be cash and cash equivalents. At
December 31, 2005, Citizens South Bank was in compliance with these reserve
requirements.
Securities - Management determines the appropriate classification of
securities at the time of purchase.
45
Securities classified as available-for-sale are carried at fair value. Such
securities are used to execute asset/liability management strategies and to
manage liquidity. Purchases and sales of securities are recorded on a trade-date
basis. Gains and losses are determined using the specific identification method.
Adjustments for unrealized gains or losses, net of related income tax effect,
are recorded as an addition or deduction from equity in the form of other
comprehensive results.
The Company has no securities classified as held-to-maturity.
Amortization of premiums and accretion of discounts are included in
interest income over the life of the related security, or in the case of
mortgage-backed and related securities, the estimated life of the security.
Gains or losses on the sale of securities are recognized on a specific
identification, trade-date basis.
Citizens South Bank is a member of the FHLB System, which provides a
central credit facility primarily for member institutions. As a member of the
FHLB of Atlanta, the Bank is required to acquire and hold shares of capital
stock in the FHLB in an amount at least equal to 1% of the aggregate principal
amount of its unpaid residential mortgage loans and similar obligations at the
beginning of each year, or 1/20 of its borrowings from the FHLB, whichever is
greater. The Bank holds shares of capital stock in the FHLB at cost.
Loans and Allowance for Loan Losses - Loans are carried at their principal
amount outstanding. Income on loans is accrued based upon the outstanding
principal balance. Generally, loans are classified as nonaccrual, and the
accrual of interest is discontinued, when the contractual payment of principal
and interest has become 90 days past due or when, in management's judgment,
principal or interest is not collectible in accordance with the terms of the
obligation. Cash receipts on nonaccrual loans are applied to principal. The
accrual of interest resumes when the loan returns to performing status.
The Company evaluates impairment of its residential mortgage and consumer
loans on a collective basis. Commercial loans are considered to be impaired
when, based on current information, it is probable that the Company will not
collect all amounts due in accordance with contractual terms. Management
monitors internally generated reports, including past due reports, payment
histories, criticized asset reports, which include loans with historical payment
problems or borrowers in troubled industries as well as other sources of
information such as borrower financial statements, the value collateral, etc. to
identify impaired loans. Discounted cash flow analyses or the estimated fair
value of collateral are used in determining the fair value of impaired loans.
When the ultimate collectibility of the principal balance of an impaired loan is
in doubt, cash receipts are applied to principal.
The allowance for loan losses is determined by management and maintained at
a level based on losses inherent in the portfolio that are probable and
reasonably estimated at the balance sheet date. Management's determination of
the adequacy of the allowance is based on an evaluation of the portfolio,
historical loan loss experience, availability and quality of collateral, changes
in economic conditions, and the quality of the loan portfolio. Loans are charged
to the allowance at the time they are determined to be losses. Subsequent
recoveries are credited to the allowance.
Concentrations of Credit Risk - The Company makes loans to individuals and
small businesses primarily in the Company's normal lending area which includes
the North Carolina Counties of Gaston, Rowan, Union, and Iredell Counties, and
the surrounding counties. The Company has a diversified loan portfolio, and the
borrowers' ability to repay their loans is not dependent upon any specific
economic segment.
The Company maintains cash balances at various correspondent banks that
have balances in excess of the FDIC insurance limits.
Premises and Equipment - Premises and equipment are stated at cost less
accumulated depreciation and amortization. Depreciation and amortization are
computed over the estimated useful lives of the assets (from three to 30 years)
primarily by the straight-line method. Leasehold improvements are amortized on a
straight-line basis over the shorter of the estimated useful life of the
improvement or the lease term.
Other Real Estate Owned - Other real estate owned is comprised of real
estate properties acquired in partial or total satisfaction of problem loans.
The properties are recorded at the lower of cost or fair value less estimated
costs to sell at the date acquired. Losses arising at the time of acquisition of
such properties are charged against the allowance for loan losses. Subsequent
write-downs that may be required to the carrying value of these properties are
charged to noninterest expenses. Gains and losses realized from the sale of
other real estate owned are included in noninterest income.
46
Loan Origination Fees - Origination fees received and direct costs incurred
are deferred and amortized to interest income over the contractual lives of the
loans, using the level yield method.
Income Taxes - Deferred income taxes reflect the net tax effects of
temporary differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for income tax purposes.
Amounts provided for deferred income taxes relate primarily to differences
between tax and financial reporting for unrealized gains and losses on
securities available-for-sale, allowances for loan losses, depreciation, and
deferred compensation.
Advertising - Advertising costs are expensed as incurred.
Reclassifications - Certain of the prior year amounts have been
reclassified to conform to current year presentation. Such reclassifications are
immaterial to the financial statements.
Goodwill and Other Intangible Assets - Statement of Financial Accounting
Standards ("SFAS") No. 142, Goodwill and Other Intangible Assets, requires that
goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead tested for impairment at least annually in accordance
with its provisions. In connection with adoption of SFAS No. 142, the Company is
required to perform an initial assessment of whether there is an indication that
goodwill is impaired. During the second quarter of 2002, the Company completed
its initial analysis of potential impairment under the provisions of SFAS No.
142, and determined based on that analysis that goodwill was not impaired. The
Company also completed its annual impairment tests at December 31, 2005 and 2004
and determined based on that analysis that goodwill was not impaired. Goodwill
will be tested for impairment annually, or between annual tests if an event
occurs or circumstances change that would more likely than not reduce the fair
value of a reporting unit below its carrying amount. The Company had no goodwill
related to acquisitions initiated prior to July 1, 2001, or other intangible
assets recorded prior to the adoption of the provisions of SFAS No. 142 whose
carrying amounts or amortization were changed by the adoptions of the provisions
of SFAS No. 142. SFAS No. 142 also requires that intangible assets with definite
useful lives be amortized over their respective estimated useful lives to their
estimated residual values. In accordance with SFAS No. 142 the Company's core
deposit intangibles, are amortized over their estimated useful life of eight
years on an accelerated basis.
Comprehensive Income - SFAS No. 130, Reporting Comprehensive Income,
establishes standards for the reporting and display of comprehensive income and
its components in financial statements. SFAS No. 130 defines comprehensive
income as net income, as currently reported, as well as unrealized gains and
losses on assets available for sale and certain other items not currently
included in the income statement. The disclosure requirements of SFAS No. 130
have been included in the Consolidated Statements of Comprehensive Income.
Operating Segments - SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, establishes standards for the way public
business enterprises report information about operating segments. This statement
also establishes standards for related disclosures about products, services,
geographic areas and major customers. In adopting SFAS No. 131, the Company has
determined that, using the definitions contained in the statement, all of its
activities constitute only one reportable operating segment.
Stock-Based Compensation - In December 2004, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 123R, Share-Based Payment. SFAS No.
123R establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods or services. It also addresses
transactions in which an entity incurs liabilities in exchange for goods or
services that are based on the fair value of the entity's equity instruments or
that may be settled by the issuance of those equity instruments. The primary
focus of this statement is on accounting for transactions in which an entity
obtains employee services in exchange for share-based payment transactions. This
Statement is effective for the beginning of the first interim or annual
reporting period that begins after December 15, 2005. SFAS No. 123R will be
adopted by the Company January 1, 2006. Based on the unvested options
outstanding at December 31, 2005, the Company expects that the adoption of SFAS
123R will not result in any material additional compensation expense during 2006
and 2007.
47
The Company applies the provisions of Accounting Principles Board Opinion
No. 25 in accounting for the plans and accordingly, no compensation expense has
been recognized in connection with the granting of the stock options. In
accordance with SFAS No. 123, Accounting for Stock-Based Compensation, the
Company adopted the disclosure-only option and elected to apply the provisions
of APB No. 25 for financial statement purposes. The Company recognizes
compensation expense for fixed awards with pro rata vesting on a straight-line
basis.
Had the compensation cost for the Company's stock option plan been
determined in accordance with the fair-value accounting provisions of SFAS No.
123, net income, basic earnings per share and diluted earnings per share would
have been as follows:
Year Ended Year Ended Year Ended
December 31 December 31 December 31
2005 2004 2003
-------------- -------------- --------------
Net income:
As reported $ 3,272,709 $ 2,955,421 $ 3,390,566
Pro forma $ 3,065,718 $ 2,860,909 $ 1,847,027
Basic earnings per share:
As reported $ 0.45 $ 0.39 $ 0.39
Pro forma $ 0.43 $ 0.38 $ 0.21
Diluted earnings per share:
As reported $ 0.45 $ 0.38 $ 0.39
Pro forma $ 0.42 $ 0.37 $ 0.21
The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option-pricing model with the following weighted average
assumptions used for the years ended December 31, 2005: dividend yield of 2.0%,
expected volatility of 30%, a risk-free interest rate of 4.0%, and expected
lives of seven years for the options. The following weighted average assumptions
used for the years ended December 31, 2004: dividend yield of 2.0%, expected
volatility of 31%, a risk-free interest rate of 3.3%, and expected lives of six
years for the options. The following weighted average assumptions used for the
years ended December 31, 2003: dividend yield of 3.3%, expected volatility of
34%, a risk-free interest rate of 5.0%, and expected lives of seven years for
the options.
In October 2005, the Board of Directors vested all outstanding options that
were issued prior to December 31, 2003, to minimize the expense recognized on
stock options upon adoption of SFAS No. 123 (revised). The purpose of this
action was to reduce the additional compensation expense resulting from adopting
this accounting pronouncement. As a result, the expected additional compensation
that would have been recognized during the year ended December 31, 2006, was
reduced from $124,000 to $17,000.
SFAS No. 153, Exchanges of Nonmonetary Assets, was issued by the FASB in
December 2004. This Statement amends APB Opinion No. 29, Accounting for
Nonmonetary Transactions, and is based on the principle that exchanges on
nonmonetary assets should be measured based on the fair value of the assets
exchanged. The provisions of this statement are effective for nonmonetary asset
exchanges occurring in fiscal periods beginning after June 15, 2005. The
adoption of FAS No. 153 is not expected to have a material impact on the
consolidated financial statements of the Company.
SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, was
issued in February 2006 by the FASB, as an amendment of FASB Statements No. 133
and 140. This Statement amends SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, and SFAS No. 140, Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities and
resolves issues in Statement No. 133 Implementation Issue No. D1, Application of
Statement 133 to Beneficial Interests in Securitized Financial Assets. The
provisions of this statement are effective for all financial instruments
acquired or issued after the beginning of an entity's first fiscal year that
begins after September 15, 2006. The adoption of FAS No. 155 is not expected to
have a material impact on the consolidated financial statements of the Company.
48
Staff Accounting Bulletin ("SAB") No. 105, Application of Accounting
Principles to Loan Commitments, was issued in March 2004 by the SEC. This SAB
summarizes the application of accounting principles generally accepted in the
United States to loan commitments accounted for as derivative instruments. The
provisions of this SAB were effective after March 31, 2004. The adoption of this
Staff Accounting Bulletin did not have a material impact on the consolidated
financial statements of the Company.
NOTE 2 - BUSINESS COMBINATION
On October 31, 2005, the Company consummated the merger of Trinity Bank
("Trinity") into Citizens South Bank. Trinity was headquartered in Monroe, North
Carolina, which is approximately 50 miles east of the Company's headquarters.
Accordingly, the results of operations of Trinity are included in the
consolidated financial statements for the two-month period ended December 31,
2005. Trinity had three offices located in Union County, North Carolina, which
has the fastest population growth of any county in North Carolina. The Company
pursued the acquisition of Trinity in order to gain access to this high-growth
market which complements the Company's existing locations and to improve the
Company's efficiency ratio by adding an increased number of customer accounts to
the Company's existing operating structure. The combined bank has 15
full-service locations and one loan production office, and ranks 8th in the
Charlotte Metropolitan Statistical Area in deposit market share.
Under the terms of the merger agreement, the Company issued a combination
of common stock and cash for the outstanding common shares of Trinity Bank.
Trinity shareholders were given the option of receiving 1.3931 shares of
Citizens South common stock for each share of Trinity common stock, $18.25 in
cash for each share of Trinity common stock, or a mixture of stock and cash for
each Trinity share, such that 50% of the shares of Trinity common stock will be
exchanged for Citizens South common stock. On October 31, 2005, Trinity
shareholders received merger consideration of approximately 1,280,249 shares of
common stock of the Company (subject to payment of cash in lieu of fractional
shares) and approximately $16.8 million in cash (including cash paid in lieu of
fractional shares), resulting in a total transaction value of approximately
$37.8 million. The transaction price represented approximately 255% of Trinity's
book value, and resulted in goodwill of $23.0 million and a core deposit
intangible of $2.3 million. Additional information regarding this transaction
may be obtained by reviewing the Registration Statement that the Company filed
with the Securities and Exchange Commission on August 1, 2005, and amended
September 14, 2005, which is incorporated herein by reference.
In order to provide financing for the cash portion of the Trinity
acquisition, on October 28, 2005, the Company completed a private placement of
an aggregate amount of $15.0 million in trust preferred securities, liquidation
amount of $1,000 per security (the "Preferred Securities"), through a newly
formed Delaware statutory trust subsidiary, CSBC Statutory Trust I (the
"Trust"). In connection with the issuance of the Preferred Securities, on
October 28, 2005, the Company entered into an Indenture by and between the
Company and Wilmington Trust Company, as trustee. The Preferred Securities
mature on December 15, 2035, but may be redeemed beginning December 15, 2010, if
the Company exercises its rights to redeem the Debentures. The Preferred
Securities require quarterly interest payments to the holders of the Preferred
Securities, initially at a fixed rate of 6.095% through December 2010, and
thereafter at a variable rate of three-month LIBOR plus 1.57%, reset quarterly.
Additional information regarding the Preferred Securities may be obtained by
reviewing the Current Report on Form 8-K filed with the Securities and Exchange
Commission on November 4, 2005, which is incorporated herein by reference.
The following table summarizes the estimated fair values of the assets
acquired and liabilities assumed at October 31, 2005, the date of the
acquisition.
Cash and cash equivalents ...................................... $ 4,227,031
Investment securities .......................................... 37,562,308
Loans, net ..................................................... 112,289,368
Premises and equipment ......................................... 2,404,414
Intangible assets .............................................. 2,320,000
Goodwill ....................................................... 22,954,606
Other assets ................................................... 8,666,551
---------------
Total assets acquired ..................................... 190,424,278
Deposits ....................................................... 136,264,384
Other liabilities .............................................. 16,389,010
---------------
Total liabilities assumed ................................. 152,653,394
---------------
Net assets acquired ............................................ $ 37,770,884
===============
49
The $2.3 million of intangible assets was assigned to the core deposit
intangible, which is being amortized over an eight-year life on an accelerated
basis. Goodwill of $23.0 million represents the excess of the purchase price
over the fair value of assets acquired and liabilities assumed, none of which is
deductible for income tax purposes.
The following summarizes the results of operations as though the
acquisition of Trinity Bank has occurred at December 31st.
2005 2004
----------------- -----------------
Interest income ................................................ $ 33,805,000 $ 28,065,000
Interest expense ............................................... (14,480,000) (11,539,000)
----------------- -----------------
Net interest income ............................................ 19,325,000 16,526,000
Provision for loan losses ...................................... (1,000,000) (602,000)
----------------- -----------------
Net interest income after provision ....................... 18,325,000 15,924,000
Noninterest income ............................................. 5,175,000 5,784,000
Noninterest expense ............................................ (17,830,000) (17,964,000)
----------------- -----------------
Income before income taxes ..................................... 5,670,000 3,744,000
Provision for income taxes ..................................... (1,718,000) 344,000
----------------- -----------------
Net income ..................................................... $ 3,952,000 $ 4,088,000
================= =================
Basic earnings per share ....................................... $ 0.55 $ 0.54
Diluted earnings per share ..................................... $ 0.54 $ 0.53
NOTE 3 - INVESTMENT SECURITIES
The aggregate book and fair values, as well as gross unrealized gains and
losses, of investment securities as of December 31, 2005 and 2004 were as
follows:
December 31, 2005
----------------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
--------------- --------------- --------------- ---------------
Investment securities Available for Sale
U.S. government agencies $ 38,307,463 $ - $ (657,823) $ 37,649,640
Municipals 12,900,010 151,716 (102,316) 12,949,410
Corporate bonds 1,500,000 - (28,500) 1,471,500
Other equity securities 1,224,349 133,805 - 1,358,154
--------------- --------------- --------------- ---------------
Total available-for-sale $ 53,931,822 $ 285,521 $ (788,639) $ 53,428,704
=============== =============== =============== ===============
50
December 31, 2005
----------------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
--------------- --------------- --------------- ---------------
Mortgage-backed and related securities
- --------------------------------------
Available-for-Sale
------------------
Fannie Mae $ 47,979,201 $ - $ (1,238,688) $ 46,740,513
Freddie Mac 21,246,072 3,326 (784,665) 20,464,733
Ginnie Mae 1,512,239 - (13,432) 1,498,807
CMO 1,569,785 - (37,396) 1,532,389
--------------- --------------- --------------- ---------------
Total mortgage-backed and
related securities $ 72,307,297 $ 3,326 $ (2,074,181) $ 70,236,442
=============== =============== =============== ===============
December 31, 2004
----------------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
--------------- --------------- --------------- ---------------
Investment securities Available for Sale
- ----------------------------------------
U.S. government agencies $ 34,293,006 $ 13,764 $ (257,255) $ 34,049,515
Municipals 10,319,824 263,472 (7,466) 10,575,830
Corporate bonds 2,000,000 - (60,000) 1,940,000
Trust preferred securities 2,000,000 34,000 - 2,034,000
Fannie Mae preferred stock 1,439,428 - - 1,439,428
Freddie Mac preferred stock 1,577,678 - - 1,577,678
Other equity securities 759,690 31,237 - 790,927
--------------- --------------- --------------- ---------------
Total available-for-sale $ 52,389,626 $ 342,473 $ (324,721) $ 52,407,378
=============== =============== =============== ===============
December 31, 2004
----------------------------------------------------------------------
Book Unrealized Unrealized Fair
Value Gains Losses Value
--------------- --------------- --------------- ---------------
Mortgage-backed and related securities
- --------------------------------------
Available-for-Sale
------------------
Fannie Mae $ 47,660,078 $ 85,638 $ (536,615) $ 47,209,101
Freddie Mac 27,879,867 64,831 (319,674) 27,625,024
Ginnie Mae 3,140,070 4,117 (18,041) 3,126,146
CMO 1,913,759 - (3,886) 1,909,873
SBAs 1,280,960 18,375 - 1,299,335
--------------- --------------- --------------- ---------------
Total mortgage-backed and
related securities $ 81,874,734 $ 172,961 $ (878,216) $ 81,169,479
=============== =============== =============== ===============
51
The book value and estimated fair value of debt securities at December 31,
2005, by contractual maturity, are shown below. Expected maturities will differ
from contractual maturities because borrowers may have the right to call or
prepay obligations with or without call or prepayment penalties.
December 31, 2005
-------------------------------------
Book Fair
Value Value
----------------- -----------------
Available-for-Sale
------------------
Due in one year or less $ 8,500,010 $ 8,393,153
Due after one year through five years 31,871,097 31,365,146
Due after five years through ten years 7,732,336 7,669,175
Due after ten years 3,104,030 3,171,576
Equities 2,724,349 2,829,654
----------------- -----------------
$ 53,931,822 $ 53,428,704
================= =================
Mortgage-backed and related securities $ 72,307,297 $ 70,236,442
================= =================
Gross realized gains on the sale of securities available for sale were
$48,589, $453,725, and $1,105,627 for the years ended December 31, 2005,
December 31, 2004, and December 31, 2003, respectively. Gross realized losses on
the sale of securities available for sale were $31,901, $0, and $84,954 for the
years ended December 31, 2005, December 31, 2004, and December 31, 2003,
respectively. After-tax net gains on the sale of securities were $10,680,
$290,384, and $653,231 for the years ended December 31, 2005, December 31, 2004,
and December 31, 2003, respectively.
Investment securities having a carrying amount of approximately $41,293,942
have been pledged as collateral to secure public deposits at December 31, 2005.
Investment securities having a carrying amount of $6,048,257 have been pledged
as collateral for repurchase agreements at December 31, 2005. Investment
securities having a carrying value of $12,657,717 have been pledged as
collateral for wholesale repurchase agreements at December 31, 2005. Investment
securities having a carrying value of $8,331,500 have been pledged as collateral
for Federal Home Loan Bank advances at December 31, 2005.
Interest earned from municipal securities, which is exempt from income
taxes, for the past three years were $441,102, $405,335, and $329,101for the
years ending December 31, 2005, December 31, 2004, and December 31, 2003,
respectively.
52
The unrealized losses and fair value of the investments by investment type
segregated between those that have been in a continuous unrealized loss position
for less than twelve months and more than twelve months at December 31, 2005 and
December 31, 2004 are as follows:
December 31, 2005
-----------------------------------------------------------------------------------------------
Less than 12 months 12 months or more Total
----------------------------- ----------------------------- -----------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Description of Securities Value Loss Value Loss Value Loss
- --------------------------- ------------- ------------- ------------- ------------- ------------- -------------
US government agencies $ 7,332,954 $ (162,634) $ 22,813,660 $ (495,189) $ 30,146,614 $ (657,823)
Municipals 4,749,820 (93,376) 1,263,015 (8,940) 6,012,835 (102,316)
Federal agency mortgage
backed securities 26,801,760 (501,032) 40,226,036 (1,573,149) 67,027,796 (2,074,181)
Corporate bonds - - 1,471,500 (28,500) 1,471,500 (28,500)
------------- ------------- ------------- ------------- ------------- -------------
Subtotal, debt
securities 38,884,534 (757,042) 65,774,211 (2,105,778) 104,658,745 (2,862,820)
------------- ------------- ------------- ------------- ------------- -------------
Total temporarily
impaired securities $ 38,884,534 $ (757,042) $ 65,774,211 $ (2,105,778) $ 104,658,745 $ (2,862,820)
============= ============= ============= ============= ============= =============
December 31, 2004
-----------------------------------------------------------------------------------------------
Less than 12 months 12 months or more Total
----------------------------- ----------------------------- -----------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Discription of Securities Value Loss Value Loss Value Loss
- --------------------------- ------------- ------------- ------------- ------------- ------------- -------------
US government agencies $ 25,079,444 $ (220,009) $ 2,962,754 $ (37,246) $ 28,042,198 $ (257,255)
Municipals 1,006,887 (348) 1,382,271 (7,118) 2,389,158 (7,466)
Federal agency mortgage
backed securities 20,930,494 (132,840) 42,036,013 (745,376) 62,966,507 (878,216)
Corporate bonds 1,940,000 (60,000) - - 1,940,000 (60,000)
------------- ------------- ------------- ------------- ------------- -------------
Subtotal, debt
securities 48,956,825 (413,197) 46,381,038 (798,740) 95,337,863 (1,202,937)
------------- ------------- ------------- ------------- ------------- -------------
Total temporarily
impaired securities $ 48,956,825 $ (413,197) $ 46,381,038 $ (798,740) $ 95,337,863 $ (1,202,937)
============= ============= ============= ============= ============= =============
Management considers all of the unrealized losses that have been
outstanding for 12 or more months to be temporary impairments since these
impairments are primarily due to changes in interest rates. Management has the
ability and intent to hold these securities until they are no longer considered
to be impaired, which may be maturity.
Effective December 31, 2004, management determined that unrealized losses
on $2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0
million in perpetual preferred stock issued by Freddie Mac were
"other-than-temporary" impairments. As a result, management recorded a noncash,
pretax loss of $983,000. The unrealized losses on these securities were
considered to be "other-than-temporary" by management for the following reasons:
1) both
53
Fannie Mae and Freddie Mac had experienced recent accounting irregularities that
have resulted in restated financial results from prior periods; 2) the yield on
perpetual preferred stock recently issued by Fannie Mae is much higher than the
yield of the preferred stock held by the Company, which decreased the value of
the Company's security; 3) the preferred stock for Fannie Mae was downgraded and
the preferred stock for both Companies are on a negative watch list; 4) the
Freddie Mac preferred stock repriced in December 2004, yet it continued to have
significant unrealized losses at year end; 5) neither of the preferred stock
issues had stated maturity dates, so the recovery of the unrealized losses is
not expected to occur in the foreseeable future. The credit issues facing Fannie
Mae and Freddie Mac only affect the performance of the Company's perpetual
preferred stock. The Company does not have any other perpetual preferred stock
on its books at December 31, 2005.
NOTE 4 - LOANS AND ALLOWANCE FOR LOAN LOSSES
The following is a summary of loans outstanding by category at December 31:
2005 2004
----------------- -----------------
Real estate:
One-to-four family residential $ 98,635,067 $ 91,714,382
Multi-family residential 24,594,348 10,632,018
Construction 62,687,466 25,033,055
Nonresidential 185,319,132 114,550,662
Commercial 30,127,560 14,001,972
Consumer 72,236,879 61,245,859
----------------- -----------------
Gross loans 473,600,452 317,177,948
Less:
Deferred loan fees, net 264,898 21,862
Allowance for loan losses 5,103,528 3,029,108
----------------- -----------------
Net loans $ 468,232,026 $ 314,126,978
================= =================
The Company evaluates impairment of its residential mortgage and consumer
loans on a collective basis. Commercial loans individually evaluated and
considered impaired under SFAS No. 114 at December 31, 2005 and 2004 were
immaterial.
Changes in the allowance for loan losses for the years ended December 31,
2005, December 31, 2004 and December 31, 2003 were as follows:
Year Ended Year Ended Year Ended
December December December
2005 2004 2003
------------- ------------- -------------
Balance at beginning of year $ 3,029,108 $ 2,968,510 $ 2,994,576
Provision for loan losses 985,000 330,000 60,000
Loans charged off (421,603) (277,818) (94,008)
Recoveries on loans previously charged off 21,176 8,416 7,942
Allowances acquired in acquisition 1,489,847 - -
------------- ------------- -------------
Balance at end of year $ 5,103,528 $ 3,029,108 $ 2,968,510
============= ============= =============
54
Directors, executive officers, and associates of such persons are customers
of and had transactions with the Bank in the ordinary course of business.
Included in such transactions are outstanding loans and commitments, all of
which were made under normal credit terms and did not involve more than normal
risk of collection. The aggregate amounts of these loans were $12,794,210 and
$11,487,133 at December 31, 2005 and 2004, respectively. During the year ended
December 31, 2005, new loans of $4,100,501 were made and payments totaled
$2,793,424. During the year ended December 31, 2004, new loans of $5,071,988
were made and payments totaled $1,215,026.
The Bank held no loans for sale at December 31, 2005 and 2004.
NOTE 5 - PREMISES AND EQUIPMENT
Premises and equipment at December 31 are summarized as follows:
2005 2004
----------------- ----------------
Land $ 5,057,767 $ 4,206,470
Buildings 13,724,317 12,194,563
Leasehold Improvements 234,807 0
Land Improvements 286,756 260,944
Furniture and equipment 4,795,834 3,823,638
----------------- -----------------
24,099,481 20,485,615
Less: accumulated depreciation 4,280,503 3,122,790
----------------- -----------------
$ 19,818,978 $ 17,362,825
================= =================
NOTE 6 - BANK OWNED LIFE INSURANCE
The Company owns bank-owned life insurance to fund certain employee benefit
plans. No purchases of bank-owned life insurance were made during the years
ended December 31, 2005, and December 31, 2004. However, Trinity Bank did own
$1,378,877 of bank-owned life insurance at the time they were acquired by the
Company. The bank-owned life insurance policies are recorded in other assets at
their cash surrender values of $14,827,784 and $12,885,164 at December 31, 2005
and 2004, respectively.
NOTE 7 - INTANGIBLE ASSETS
Amortized intangible assets at December 31, 2005 and 2004 are summarized as
follows:
December 31, 2005 December 31, 2004
----------------- -----------------
Core deposit intangible $ 4,767,000 $ 2,447,000
Mortgage servicing rights ("MSRs") 673,896 673,896
----------------- -----------------
5,440,896 3,120,896
Less: accumulated amortization 2,641,906 2,231,906
----------------- -----------------
$ 2,798,990 $ 888,990
================= =================
The acquisition of Trinity resulted in an increase of $2,320,000 in the
unamortized core deposit intangible in 2005. This core deposit intangible is
being amortized over an eight-year period on an accelerated basis. The
amortization of this core deposit intangible is expected to be $518,000 in 2006,
$449,000 in 2007, $380,000 in 2008, $314,000 in 2009, and $244,000 in 2010. The
fair value of MSRs at December 31, 2005 and 2004 approximated carrying value.
The total amount of loans serviced for others at December 31, 2005, December 31,
2004, and December 31, 2003 were $9,855,390, $12,640,595, and $17,550,135,
respectively. The Company sold its portfolio of loans serviced for others during
the first quarter of 2006 for approximately the book value of the unamortized
MSR at the time of the sale.
55
Amortization expense for all intangible assets subject to amortization was
$408,907 during the year ended December 31, 2005, $424,808 during the year ended
December 31, 2004, and $674,184 during the year ended December 31, 2003.
Estimated amortization expense for the next five succeeding years ending
December 31 are as follows:
2006 $ 734,000
2007 $ 629,000
2008 $ 512,000
2009 $ 314,000
2010 $ 244,000
The balance of goodwill was $29,625,128 at December 31, 2005, and
$6,670,522 at December 31, 2004. The acquisition of Trinity resulted in an
increase of $22,954,606 of goodwill in 2005.
NOTE 8 - DEPOSITS
Deposit balances and interest expense and average rates paid for the years
ended December 31, 2005, December 31, 2004, and December 31, 2003 are summarized
as follows:
December 31, December 31,
2005 2004
---------------------------------------------- ----------------------------------------------
Actual Interest Average Actual Interest Average
Balance Expense Rate Balance Expense Rate
------------- ------------- ------------- ------------- ------------- -------------
Noninterest bearing $ 35,225,404 $ - - $ 19,734,227 $ - -
Interest bearing checking 50,262,906 210,499 0.57% 32,949,447 103,320 0.31%
Money market deposit 104,420,774 1,791,093 2.29% 77,924,198 841,817 1.42%
Savings 23,654,258 158,721 0.61% 29,174,129 164,700 0.50%
Certificates of deposit 303,980,459 6,816,566 2.95% 214,962,427 5,017,535 2.27%
------------- ------------- ------------- ------------- ------------- -------------
$ 517,543,801 $ 8,976,879 2.41% $ 374,744,428 $ 6,127,372 1.77%
============= ============= ============= ============= ============= =============
December 31,
2003
----------------------------------------------
Actual Interest Average
Balance Expense Rate
------------- ------------- -------------
Noninterest bearing $ 12,906,002 $ - -
Interest bearing checking 30,779,656 91,383 0.32%
Money market deposit 48,188,873 549,917 1.28%
Savings 36,754,570 305,298 0.77%
Certificates of deposit 213,816,575 5,554,763 2.56%
------------- ------------- -------------
$ 342,445,676 $ 6,501,361 1.98%
============= ============= =============
Contractual maturities of certificates of deposit as of December 31, 2005
and 2004 are as follows:
2005 2004
----------------- -----------------
Under 1 year $ 224,227,624 $ 156,125,605
1 to 2 years 51,180,555 30,933,304
2 to 3 years 9,530,957 14,871,833
3 to 4 years 12,225,554 4,318,059
4 years or greater 6,815,769 8,713,626
----------------- -----------------
$ 303,980,459 $ 214,962,427
================= =================
Certificates of deposit in excess of $100,000 totaled $106,989,220 and
$62,511,274 at December 31, 2005 and 2004, respectively, and may not be fully
insured by the FDIC. Interest paid on deposits and other borrowings was
$10,453,919, for the year ended December 31, 2005, $7,566,978 for the year ended
December 31, 2004, and $8,941,122 for the year ended December 31, 2003.
56
Directors, executive officers, and associates of such persons are customers
of and had transactions with the Bank in the ordinary course of business.
Included in such transactions are deposit accounts, all of which were made under
normal terms. The aggregate amount of these deposit accounts was $3,448,155 and
$539,837 at December 31, 2005 and 2004, respectively.
The deposits of the Bank are insured by the Savings Association Insurance
Fund (SAIF), one of two funds administered by the FDIC. The Bank's annual SAIF
premium rates were $0.014, $0.015, and $0.016 per $100 of deposits for the years
ended December 31, 2005, December 31, 2004 and December 31, 2003, respectively.
NOTE 9 - BORROWED MONEY
The Company had $61.5 million in advances from the FHLB of Atlanta that
were obtained pursuant to a line of credit. These advances are collateralized by
a lien on qualifying first mortgage loans in an amount necessary to satisfy
outstanding indebtedness plus accrued interest. The total amount available on
the line of credit is 25% of total assets of the Bank, or approximately $175
million. The unused portion of the line of credit available to the Company at
December 31, 2005 was approximately $113 million. These advances had interest
rates ranging from 2.02% to 6.25% at December 31, 2005 and 1.15% to 6.25% at
December 31, 2004. In addition, the Company had a mark-to-market adjustment on
advances acquired in the Trinity acquisition which had a balance of ($192,000)
at December 31, 2005, which is considered to be due in less than one year.
Interest rates on certain FHLB convertible advances may be reset on certain
dates at the option of the FHLB in accordance with the terms of the note. The
Bank has the option of repaying the outstanding advance or converting the
interest rate from a fixed rate to a floating rate at the time the advance is
called by the FHLB. These convertible advances totaled $11.5 million at December
31, 2005 and $10.0 million at December 31, 2004.
The Company also had $11.0 million in repurchase agreements from JP Morgan
Chase Bank, NA ("JP Morgan"). These borrowings are collateralized by various US
Government agency investment and mortgage-backed securities in an amount equal
to at least 105% of the outstanding amount of the repurchase agreement. These
repurchase agreements had interest rates ranging from 3.66% to 4.48% at December
31, 2005. Two of these repurchase agreements have a two-year one-time call
option with a ten-year maturity date. One of these advances, totaling $5.0
million, has an adjustable interest rate tied to the three month LIBOR minus 50
basis points for a period of two years. After the two-year period, the
repurchase agreement may be called at the option of JP Morgan or the repo may be
converted to a fixed rate at 3.98% for the remaining eight years. The other
convertible repo, which totals $3.0 million, has a fixed interest rate of 3.66%.
After the two-year period, the repurchase agreement may be called by JP Morgan,
or it may remain outstanding for the remaining eight-year period at the original
interest rate of 3.66%. The remaining repurchase agreement has a balance of $3.0
million and has a fixed rate of 4.48% for five years.
Maturities of borrowed money at December 31 are as follows:
2005 2004
----------------- -----------------
Borrowed money due:
Less than 1 year $ 22,808,000 $ 13,000,000
1 to 2 years 6,000,000 18,000,000
2 to 3 years 13,000,000 2,500,000
3 to 4 years 8,000,000 8,500,000
4 to 5 years 8,000,000 3,000,000
5 to 10 years 14,500,000 10,000,000
After 10 years - -
----------------- -----------------
$ 72,308,000 $ 55,000,000
================= =================
57
NOTE 10 - SUBORDINATED DEBT
In order to provide financing for the cash portion of the Trinity
acquisition, on October 28, 2005, the Company completed a private placement of
an aggregate amount of $15,000,000 in trust preferred securities, liquidation
amount $1,000 per security (the "Preferred Securities"), through a newly formed
Delaware statutory trust subsidiary, CSBC Statutory Trust I (the "Trust").
In connection with the issuance of the Preferred Securities, on October 28,
2005, the Company entered into an Indenture (the "Indenture") by and between the
Company and Wilmington Trust Company, as trustee, and an Amended and Restated
Declaration of Trust (the "Trust Agreement") among the Company, as Sponsor,
Wilmington Trust Company, as Delaware and Institutional Trustee, and the
administrative trustees of the Trust. The information provided in Item 2.03 is
incorporated by reference herein.
On October 28, 2005, CSBC Statutory Trust I issued an aggregate of
$15,000,000 in trust preferred securities, liquidation amount $1,000 per
security. The Preferred Securities mature on December 15, 2035, but may be
redeemed beginning December 15, 2010 if the Company exercises its right to
redeem the Debentures, as described below. The Preferred Securities require
quarterly distributions by the Trust to the holders of the Preferred Securities,
initially at a fixed rate of 6.095% per annum through the interest payment date
in December 2010, and thereafter at a variable rate of three-month LIBOR plus
1.57% per annum, reset quarterly. Distributions are cumulative and will accrue
from the date of original issuance but may be deferred for a period of up to
twenty consecutive quarterly interest payment periods if the Company exercises
its right under the Indenture to defer the payment of interest on the
Debentures, as described below. In accordance with FIN No. 46R, the trust is not
consolidated with the financial statements of the Company.
The proceeds from the sale of the Preferred Securities received by the
Trust, combined with the proceeds of $464,000 received by the Trust from the
issuance of common securities (the "Common Securities") by the Trust to the
Company, were used to purchase $15,464,000 in principal amount of unsecured
junior subordinated deferrable interest debentures (the "Debentures") of the
Company, issued pursuant to the Indenture.
The issuance of the Preferred Securities and the Common Securities are
provided for in the Trust Agreement dated October 28, 2005, by and among the
Trustee, the Company, and the administrative trustees of the Trust. The
administrative trustees are the President and Chief Executive Officer, Executive
Vice President and Secretary, and Executive Vice President and Chief Financial
Officer.
The Debentures mature on December 15, 2035, but the Company may at its
option redeem the Debentures, in whole or in part, beginning on December 15,
2010 in accordance with the provisions of the Indenture. The Debentures bear
interest at a fixed rate equal to 6.095% per annum through the interest payment
date in December 2010, and thereafter at a variable rate, reset quarterly, of
three-month LIBOR plus 1.57% per annum. Interest is cumulative and will accrue
from the date of original issuance. However, so long as there is no event of
default, interest payments may be deferred by the Company at its option at any
time for a period of up to twenty consecutive quarterly interest payment
periods, but not beyond December 15, 2035 (each such extended interest payment
period, an "Extension Period"). No interest shall be due and payable during an
Extension Period, but each installment of interest that would otherwise have
been due and payable during such Extension Period shall bear additional interest
at an annual rate equal to the interest rate in effect for each Extension
Period. Furthermore, during any Extension Period, the Company may not declare or
pay any dividends on its capital stock, which includes its Common Stock, nor
make any payment or redeem debt securities that rank pari passu with the
Debentures.
Early Redemption. The Debentures may be redeemed at par at the option of
the Company beginning on December 15, 2010, and may be redeemed earlier than
such date following the occurrence of a "Special Event" (as defined in the
Indenture) at a price equal to 107.5% of the principal amount together with
accrued interest. The Trust will be required to redeem a like amount of
Preferred Securities if the Company exercises its right to redeem all or a
portion of the Debentures.
Acceleration of Maturity. Either the Trustee or the holders of at least 25%
of the aggregate principal amount of the outstanding Debentures may declare the
principal amount of, and all accrued interest on, all the Debentures to be due
and payable immediately, or if the holders of the Debentures fail to make such
declaration, the holders of at least a majority in aggregate liquidation amount
of the Preferred Securities outstanding shall have a right to make such
declaration, if an Event of Default occurs. An Event of Default generally
includes a default in payment of any interest for 30 days, a default in payment
upon maturity, a default in performance, or breach of any covenant or
representation, bankruptcy or insolvency of the Company or liquidation or
dissolution of the Trust. Any holder of the Preferred
58
Securities has the right, upon the occurrence of an Event of Default related to
payment of interest of principal, to institute suit directly against the Company
for enforcement of payment to such holder of principal of and any premium and
interest, including additional interest, on the Debentures having a principal
amount equal to the aggregate liquidation amount of the Preferred Securities
held by such holder. Additional information regarding the Preferred Securities
may be obtained by reviewing the Current Report on Form 8-K filed with the
Securities and Exchange Commission on November 3, 2005.
NOTE 11 - INCOME TAXES
The provision for income taxes is summarized below:
Year Ended Year Ended Year Ended
December December December
2005 2004 2003
------------- ------------- -------------
Currently payable
Federal $ 864,250 $ 971,417 $ 1,457,207
State 234,350 146,284 238,000
------------- ------------- -------------
1,098,600 1,117,701 1,695,207
Year Ended Year Ended Year Ended
December December December
2005 2004 2003
------------- ------------- -------------
Deferred
Federal 257,008 (35,339) (228,800)
State (32,796) (5,322) (9,000)
------------- ------------- -------------
224,212 (40,661) (238,800)
------------- ------------- -------------
Total income taxes $ 1,322,812 $ 1,077,040 $ 1,456,407
============= ============= =============
The reasons for the difference between consolidated income tax expense and
the amount computed by applying the statutory federal income tax rate of 34% to
income before income taxes were as follows:
Year Ended Year Ended Year Ended
December December December
2005 2004 2003
------------- ------------- -------------
Federal income taxes at statutory rate $ 1,562,477 $ 1,371,000 $ 1,648,000
State income taxes, net of federal benefit 133,026 86,000 151,000
Effect of federal tax exempt interest (135,946) (137,000) (112,000)
Effect of earnings on life insurance (202,601) (161,000) (161,000)
Other (34,144) (81,960) (69,593)
------------- ------------- -------------
$ 1,322,812 $ 1,077,040 $ 1,456,407
============= ============= =============
Effective tax rate 32.8% 26.7% 30.2%
============= ============= =============
59
Income taxes paid for the years ended December 31, 2005, 2004, and 2003
were $2,773,660, $1,978,000, and $2,119,000, respectively.
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and liabilities at December 31 are as follows:
2005 2004
----------------- -----------------
Deferred tax assets
Deferred compensation $ 762,481 $ 1,250,021
Unrealized loss on securities
Available-for-sale 1,006,938 268,951
Allowance for loan losses 1,955,469 1,209,925
Capital loss carryforward 374,099 -
Other 295,269 159,616
----------------- -----------------
Gross deferred tax assets 4,394,256 2,888,513
Deferred tax liabilities
Excess carrying value of assets acquired
for financial reporting purposes over
tax basis 1,592,882 1,275,184
Deferred loan fees 92,928 191,034
Other 127,848 -
----------------- -----------------
Gross deferred tax liabilities 1,813,658 1,466,218
----------------- -----------------
Net deferred tax asset $ 2,580,598 $ 1,422,295
================= =================
The Company, in accordance with SFAS No. 109, did not record a deferred tax
liability of approximately $3,140,000 as of December 31, 2005 related to the
cumulative special bad debt deduction for savings and loan associations
recognized for income tax reporting prior to September 30, 1988, Citizen South
Bank's base year.
Management believes that the Company will fully realize deferred tax assets
based on future taxable temporary differences, refundable income taxes from
carryback years, and current levels of operating income.
NOTE 12 - COMMITMENTS
Commitments to extend credit are agreements to lend as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require payment
of a fee. Since commitments may expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. These
commitments represent no more than normal lending risk that the Bank commits to
its borrowers and management believes that these commitments can be funded
through normal operations. Commitments to extend credit that include both fixed
and variable rates as of December 31 are as follows:
60
2005 2004
----------------- -----------------
Residential mortgage loan commitments $ 9,357,000 $ 3,397,000
Non-residential mortgage loan commitments 13,591,000 10,976,000
Commercial loan commitments 1,698,000 904,000
Consumer loan commitments 1,624,000 551,000
Unused lines of credit
Commercial 28,533,000 15,776,000
Consumer 54,152,000 46,621,000
The Company also has various leases in place to provide office space for
three full-service offices and one loan production office. The amount paid for
this leased office space totaled $122,876 for the year ended December 31, 2005,
$48,300 for the year ended December 31, 2004, and $3,825 for the year ended
December 31, 2003. Projected lease payments over the next five years are
expected to be $319,000 for 2006, $275,000 for 2007, $232,000 for 2008, $209,000
for 2009, and $57,000 for 2010.
NOTE 13 - REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered
by the federal banking agencies. Under the capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Bank must meet specific
capital guidelines that involve quantitative measures of assets, liabilities,
and certain commitments as calculated under regulatory accounting practices. The
capital amounts and classification are also subject to qualitative judgments by
the regulators about components, risk weightings and other factors. Failure to
meet minimum capital requirements can initiate certain mandatory, and possibly
discretionary, actions by regulators that, if undertaken, could have a direct
material effect on the Bank's financial statements.
The Bank is required to maintain: tangible capital of at least 1.5% of
adjusted total assets; core capital of at least 4.0% of adjusted total assets;
and total capital of at least 8.0% of risk weighted assets. At December 31,
2005, the Bank's tangible capital and core capital were both $63,262,000, or
9.47% of tangible assets, and total capital was $68,365,000, or 12.08% of
risk-weighted assets. The Company's primary regulator, the Office of Thrift
Supervision, informed the Bank that it was in the well-capitalized category as
of the most recent regulatory examination, and management is not aware of any
events that have occurred since that would have changed its classification.
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
----------------------------- ------------------------------ ------------------------------
Amount Ratio Amount Ratio Amount Ratio
------------- ------------- -------------- ------------- -------------- -------------
(dollars in thousands) (dollars in thousands) (dollars in thousands)
As of December 31, 2005
Total Risk-Based Capital
(to Risk-Weighted Assets) $ 68,365 12.08% 45,288 8.00% 56,609 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) 63,262 11.18% 22,643 4.00% 33,965 6.00%
Tier 1 Capital
(to Adjusted Total Assets) 63,262 9.47% 26,715 4.00% 33,394 5.00%
Tangible Capital
(to Adjusted Total Assets) 63,262 9.47% 10,018 1.50% 20,036 3.00%
As of December 31, 2004
Total Risk-Based Capital
(to Risk-Weighted Assets) $ 62,804 17.12% 29,346 8.00% 36,682 10.00%
Tier 1 Capital
(to Risk-Weighted Assets) 59,775 16.30% 14,673 4.00% 22,010 6.00%
Tier 1 Capital
(to Adjusted Total Assets) 59,775 11.95% 20,011 4.00% 25,014 5.00%
Tangible Capital
(to Adjusted Total Assets) 59,775 11.95% 7,504 1.50% 15,008 3.00%
61
On May 23, 2002, the MHC approved a Plan of Conversion and Reorganization.
As a result of the Conversion, the Bank established a memo liquidation account
in an amount equal to its equity at the time of the Conversion of approximately
$44 million for the benefit of eligible account holders and supplemental
eligible account holders who continue to maintain their accounts at the Bank
after the Conversion. In the event of a complete liquidation of the Bank, each
eligible account holder and supplemental eligible account holder will be
entitled to receive a distribution from the liquidation account in an amount
proportionate to the current adjusted qualifying balances for accounts then
held. As a result, stockholders' equity is substantially restricted at December
31, 2005 and 2004.
NOTE 14 - EMPLOYEE BENEFIT PLANS
The Bank provides supplemental benefits to substantially all employees
through a 401(k) savings plan. Eligible participants may contribute up to 75% of
eligible compensation, with the Bank providing matching contributions of 50% of
employee contributions up to 6% of eligible compensation. The plan also provides
for discretionary employer contributions. During 2005, 2004 and 2003, no
discretionary employer contributions were made to the 401(k) plan. Total expense
relating to this plan was $128,861 for the year ended December 31, 2005,
$104,591 for the year ended December 31, 2004, and $106,973 for the year ended
December 31, 2003.
The Bank also maintains nonqualified deferred compensation and/or
supplemental retirement plans for certain of its directors and executive
officers. The Bank also adopted nonqualified deferred compensation plans for key
employees and directors of Citizens Bank, a wholly-owned subsidiary of Innes
Street Financial Corporation, which was acquired by the Company on December 31,
2001. The deferred assets related to these plans are maintained in rabbi trusts,
which are included in Other Assets of the Company. The assets are accounted for
at market value in accordance with SFAS No. 115, Accounting for Certain
Investments in Debt and Equity Securities, with the resulting gains or losses in
value recorded in income. The corresponding change in fair value of the deferred
compensation obligation is recorded as compensation expense. Total expense for
the all of the plans was $457,756 for the year ended December 31, 2005, $505,822
for the year ended December 31, 2004, and $737,483 for the year ended December
31, 2003.
2003 Recognition and Retention Plan ("2003 RRP") - Pursuant to resolutions
of the Board of Directors of Citizens South Banking Corporation adopted on
August 18, 2003, and the subsequent approval by the stockholders of the Company
on October 23, 2003, the Company adopted and implemented the Citizens South
Banking Corporation 2003 Recognition and Retention Plan with a total of 210,398
shares. On November 3, 2003, awards of 196,560 shares of restricted stock were
made under the 2003 RRP. All shares vest over a seven-year period commencing on
the date of the award, at the rate of 30% on November 3, 2003, 10% on January 2,
2004, 10% on November 3, 2005, and 10% per year on November 3 of each year
thereafter. The fair market value of the restricted stock at the time of the
grant was $15.04 per share. During 2005, 16,303 shares vested, no additional
shares were granted, and 1,200 shares were forfeited. At December 31, 2005,
15,038 restricted shares remained unissued and available for grants under the
2003 RRP. Total expense for the 2003 RRP amounted to $279,816 in 2005, $281,025
in 2004, and $974,848 in 2003.
1999 Stock Option Plan - On April 12, 1999, the Company's shareholders
approved the Citizens South Bank 1999 Stock Option Plan that provided the
issuance of 211,335 options for directors and officers to purchase the Company's
common stock. Pursuant to the mutual holding company conversion and
reorganization completed on September 30, 2002, each share of the $1.00 par
value common stock of Citizens South Banking Corporation (the former Federal
corporation)
62
was exchanged for 2.1408 shares of $0.01 par value common stock of the Citizens
South Banking Corporation (the new Delaware Corporation), which preserved the
previous stockholders' interest in Citizens South Banking Corporation. Thus, the
options for 211,335 shares of common stock in the 1999 Stock Option Plan were
exchanged for options for 452,425 shares, with the exercise prices of previously
granted options adjusted according to the same ratio.
During 2005, there were no options granted, no reloads issued, 24,471
shares were exercised, and no shares were forfeited under the 1999 Stock Option
Plan. All of the 24,471 shares exercised were exercised for cash. At December
31, 2005, 1,612 options remained unissued and available for grants under the
1999 Stock Option Plan.
2003 Stock Option Plan - Pursuant to resolutions of the Board of Directors
of Citizens South Banking Corporation adopted on August 18, 2003, and the
subsequent approval by the stockholders of the Company on October 23, 2003, the
Company adopted and implemented the Citizens South Banking Corporation 2003
Stock Option Plan with a total of 525,995 options available for award. On
November 3, 2003, the following awards of stock options were made under the 2003
Stock Option Plan: Non-statutory options of 157,020 shares at $15.04 to
directors and advisory board members, vesting over a five-year period at 20% per
year, commencing on the initial date of the optionee's board service to the Bank
or its predecessor, Gaston Federal Bank (excluding service to the former
Citizens Bank, Inc.); incentive options of 360,000 shares at $15.04 to
employees, vesting over a five-year period at 20% per year, commencing on the
initial date of the optionee's employment with the Bank or its predecessor,
Gaston Federal Bank (excluding service to the former Citizens Bank, Inc.).
During 2005, there were 19,000 incentive options granted at the market price of
the stock on the date of grant to an employee, vesting over a five-year period
at 20% per year, commencing on the date of the grant, no reload options were
issued, no options were exercised, and 15,000 options were forfeited. At
December 31, 2005, 9,975 options remained unissued and available for grants
under the 2003 Stock Option Plan.
The following is a summary of stock option activity and related information
for the years ended December 31, 2005, 2004 and 2003.
Year Ended December 31, 2005 Year Ended December 31, 2004 Year Ended December 31, 2003
------------------------------- ------------------------------- -------------------------------
Weighted Avg. Weighted Avg. Weighted Avg.
Options Exercise Price Options Exercise Price Options Exercise Price
------------- -------------- ------------- -------------- ------------- --------------
Outstanding-
Beginning of period 793,151 $ 12.58 810,953 $ 12.45 380,401 $ 5.72
Granted 19,000 12.96 12,734 12.95 598,803 14.81
Exercised (24,471) 5.75 (16,695) 5.61 (168,251) 5.61
Forfeited (15,000) 15.04 (13,571) 14.30 - -
------------- -------------- ------------- -------------- ------------- --------------
Outstanding-end of
period 772,680 $ 12.22 793,151 $ 12.58 810,953 $ 12.45
============= ============== ============= ============== ============= ==============
Exercisable-end of
period 747,680 $ 12.20 708,495 $ 12.43 690,795 $ 12.27
============= ============== ============= ============== ============= ==============
Weighted average
fair value of
options granted
during the period $ 4.60 $ 3.90 $ 3.69
============== ============== ==============
Exercise prices for options outstanding as of December 31, 2005 ranged from
$5.14 to $15.06. Exercise prices for options outstanding as of December 31, 2004
ranged from $5.14 to $15.06. The weighted average remaining contractual life of
those options was approximately five years at December 31, 2005, and six years
at December 31, 2004.
Employee Stock Ownership Plan - The Bank established an Employee Stock
Ownership Plan (ESOP) in 1998. The ESOP is a tax-qualified retirement plan
designed to invest primarily in the Company's common stock. All full-time
employees of the Bank who have completed one year of service with the Bank are
eligible to participate in the ESOP. The ESOP utilized funds borrowed from the
Company totaling $1,690,680, to purchase approximately 8%, or 169,068 shares of
the Company's common stock issued in the 1998 Conversion. The ESOP utilized
funds borrowed from the Company totaling $1,051,980 to purchase 105,198
additional shares of the Company's common stock issued in the 2002 Conversion.
The loans to the ESOP will be primarily repaid with contributions from the Bank
to the ESOP over a period not to exceed 15 years
63
for each loan. Under the terms of the ESOP, the Bank makes contributions to the
ESOP sufficient to cover all payments of principal and interest as they become
due. The 1998 loan had an outstanding balance of $788,983 with an interest rate
of 7.25% and $901,695 with an interest rate of 5.25% at December 31, 2005 and
2004, respectively. The interest rate on the loan is based on the Bank's prime
rate. The 2002 loan had an outstanding balance of $771,452 with an interest rate
of 7.25% and $841,584 with an interest rate of 5.25% at December 31, 2005 and
2004, respectively. Unallocated shares, totaling 248,340 shares at December 31,
2005, are excluded for the calculation of earnings per share.
Shares purchased with the loan proceeds are held in a suspense account by
the trustee of the plan for future allocation among participants as the loan is
repaid. Contributions to the ESOP and shares released from the suspense account
are allocated among participants on the basis of compensation as described in
the plan. The number of shares released to participants will be determined based
upon the percentage of principal and interest payments made during the year
divided by the total remaining principal and interest payments including the
current year's payment. Participants will vest in the shares allocated to their
respective accounts over a period not to exceed five years. Any forfeited shares
are allocated to the then-remaining participants in the same proportion as
contributions. As of December 31, 2005, 185,762 shares have been allocated to
participants and 216,576 shares remain unallocated. The fair value of the
unallocated shares was $2,588,083 at December 31, 2005. The Company recognizes
compensation expense attributable to the ESOP ratably over the fiscal year based
upon the estimated number of ESOP shares to be allocated each December 31st. The
Company recognized $209,419, $223,231, and $219,333, as compensation expense in
the years ended December 31, 2005, December 31, 2004 and December 31, 2003,
respectively.
The trustee for the ESOP must vote all allocated shares held in the ESOP
trust in accordance with the instructions of the participants. Unallocated
shares held by the ESOP trust are voted by the trustee in a manner calculated to
most accurately reflect the results of the allocated ESOP shares voted, subject
to the requirements of the Employee Retirement Income Security Act of 1974, as
amended (ERISA).
NOTE 15 - FAIR VALUE OF FINANCIAL INSTRUMENTS
The following methods and assumptions were used by the Company in
estimating its fair value disclosures for financial instruments. In cases where
quoted market prices are not available, fair values are based on estimates using
present value or other valuation techniques. The estimates are significantly
affected by the assumptions used, including discount rates and estimates of
future cash flows. These estimates may differ substantially from amounts that
could be realized in an immediate sale or settlement of the instrument.
Fair value approximates book value for the following financial instruments
due to their short-term nature: cash and due from banks, interest-earning bank
balances, and advances from customers for taxes and insurance.
Fair value for investment securities and mortgage-backed and related
securities are based on quoted market prices. If a quoted market price is not
available, fair value is estimated using market prices for similar securities.
Fair value for variable rate loans that reprice frequently is based on the
carrying value reduced by an estimate of credit losses inherent in the
portfolio. Fair value for all other loans is estimated by discounting their
future cash flows using interest rates currently being offered for loans of
comparable terms and credit quality.
Fair value for demand deposit accounts and interest-bearing accounts with
no fixed maturity is equal to the carrying value. Certificate of deposit fair
values are estimated by discounting cash flows from expected maturities using
interest rates currently being offered for similar instruments.
The carrying amount of repurchase agreements approximates fair value due to
the short-term nature of the agreements.
Fair value for the advances from the Federal Home Loan Bank is based on
discounted cash flows using current interest rates.
At December 31, 2005 and 2004, the Company had outstanding unfunded
commitments to extend credit offered in the normal course of business. Fair
values of these commitments are based on fees currently charged for similar
instruments. At December 31, 2005 and 2004, the carrying amounts and fair values
of these off-balance sheet financial instruments were immaterial.
64
The Company has used management's best estimates of fair values of
financial instruments based on the above assumptions. This presentation does not
include certain financial instruments, nonfinancial instruments or certain
intangible assets such as customer relationships, deposit base intangibles, or
goodwill. Accordingly, the aggregate fair value amounts presented do not
represent the underlying value of the Company. The estimated fair values of
financial instruments as of December 31 were as follows:
2005 2004
--------------------------------- ---------------------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
--------------- --------------- --------------- ---------------
Financial assets
Cash and due from banks $ 8,863,423 $ 8,863,423 $ 5,799,611 $ 5,799,611
Interest-earning bank balances 17,790,015 17,790,015 5,790,650 5,790,650
Investments and mortgage-
backed securities 123,665,146 123,665,146 133,576,857 133,576,857
Loans 468,232,026 469,150,047 314,126,978 315,148,762
Financial liabilities
Deposits 517,543,801 501,632,157 374,744,428 366,115,439
Repurchase agreements 3,570,267 3,570,267 771,538 771,538
Borrowed money 87,772,000 87,219,210 55,000,000 55,467,576
NOTE 16 - EARNINGS PER SHARE
Earnings per share has been determined under the provisions of SFAS No.
128, Earnings Per Share. Basic earnings per share is computed by dividing net
income applicable to common stock by the weighted average number of common
shares outstanding during the period, without considering any dilutive items.
Diluted earnings per share is computed by dividing net income applicable to
common stock by the weighted average number of common shares and common stock
equivalents for items that are dilutive, net of shares assumed to be repurchased
using the treasury stock method. Common stock equivalents arise from the assumed
conversion of outstanding stock options.
The only potential stock of the Company as defined in SFAS No. 128, are
stock options granted to various directors and officers of the Bank and unvested
RRP shares. At December 31, 2005, the Company excluded 579,751 of the 772,680
outstanding options from the calculation of diluted earnings per share since
these options had a strike price in excess of the market value of the stock at
December 31, 2005. The following is a summary of the computation of basic and
diluted earnings per share:
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------- ------------- -------------
Net income $ 3,272,709 $ 2,955,421 $ 3,390,566
Weighted average outstanding shares 7,207,368 7,611,022 8,623,838
Basic earnings per share $ 0.45 $ 0.39 $ 0.39
Weighted average outstanding shares 7,207,368 7,611,022 8,623,838
Dilutive effect of stock options 90,851 101,648 138,707
------------- ------------- -------------
Weighted average diluted shares 7,298,219 7,712,670 8,762,545
Diluted earnings per share $ 0.45 $ 0.38 $ 0.39
65
In conjunction with the 2002 Conversion, as described in Note 1. of the
Notes to Consolidated Financial Statements, the Company had 9,062,727 shares on
common stock issued and outstanding on September 30, 2002. In March 2003, the
Company's Board of Directors announced the authorization to repurchase of up to
343,027 shares of outstanding common stock. The Company repurchased 342,200
shares of stock at an average price of $13.66 under this authority in October
2003. During October 2003 the Company's Board of Directors announced the
authorization to repurchase up to 879,900 shares, or 10% of the outstanding
common stock. The Company repurchased 877,235 shares of stock at an average
price of $13.80 under this authority by May 2004. During May 2004, the Company's
Board of Directors authorized the repurchase of up to 815,000 shares, or 10% of
the outstanding common stock. The Company repurchased 815,000 shares of stock at
an average price of $13.09 under this authority in February 2005. During
February 2005, the Board of Directors authorized the repurchase of 370,000
shares, or 5% of the outstanding common stock. As of December 31, 2005, the
Company had repurchased 354,923 shares of stock at an average price of $12.50
under this authorization and had 15,077 shares remaining.
As of December 31, 2005, a total of 2,389,358 shares, or 26.4% of the
outstanding shares of common stock, have been repurchased under these plans at
an average price of $13.35 per share.
NOTE 17 - PARENT-ONLY FINANCIAL INFORMATION
The earnings of the Bank are recognized by Citizens South Banking
Corporation using the equity method of accounting. Accordingly, undistributed
earnings of the Bank are recorded as increases in the Company's investment in
the Bank. The following are the condensed financial statements of the Company as
of December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004
and 2003.
Condensed Statements of Financial Condition
- -------------------------------------------
December 31, December 31,
2005 2004
----------------- -----------------
Assets
- ------
Cash and cash equivalents $ 1,331,266 $ 2,687,014
Investment in securities available-for-sale 2,311,005 2,476,936
Investment in subsidiary 95,566,533 66,828,552
Other assets 632,567 431,654
----------------- -----------------
Total assets $ 99,841,371 $ 72,424,156
================= =================
Liabilities and Stockholders' Equity
- ------------------------------------
Liabilities $ 15,583,723 $ 29,899
Stockholders' equity 84,257,648 72,394,257
----------------- -----------------
Total liabilities and stockholders' equity $ 99,841,371 $ 72,424,156
================= =================
Condensed Statements of Operations
- ----------------------------------
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------- ------------- -------------
Interest income $ 124,703 $ 238,212 $ 474,295
Interest expense (164,943) - -
Other noninterest income 7,567 163,800 10,177
Other noninterest expenses (725,991) (631,667) (980,671)
------------- ------------- -------------
Income before income taxes and undistributed
earnings from subsidiaries (758,664) (229,655) (496,199)
Income taxes 295,218 96,000 204,995
------------- ------------- -------------
Income before undistributed earnings from
subsidiaries (463,446) (133,655) (291,204)
Equity in undistributed earnings of subsidiaries 3,736,155 3,089,076 3,681,770
------------- ------------- -------------
Net income $ 3,272,709 $ 2,955,421 $ 3,390,566
============= ============= =============
66
Condensed Statements of Cash Flows
- ----------------------------------
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------- ------------- -------------
Operating activities
Net income $ 3,272,709 $ 2,955,421 $ 3,390,566
Adjustments to reconcile net income to net
Cash provided by operating activities
(Gain) on sale of investments (7,500) (163,800) -
Equity in undistributed (earnings) of
Subsidiaries (3,736,155) (3,089,076) (3,681,770)
Allocation of shares to ESOP 269,864 282,995 287,717
Vesting of shares issued for the RRP 279,816 281,025 974,848
(Increase) in other operating subsidiaries (623,845) (20,199) (14,772)
(Decrease) increase in other operating
liabilities - 6,102 (309,536)
------------- ------------- -------------
Net cash provided (used) by operating
activities (545,111) 252,468 647,053
Investing activities
Proceeds from the sale of investments 507,500 1,008,000 -
Purchase of investments available-for-sale (200,000) (347,282) (2,000,000)
------------- ------------- -------------
Net cash used in (provided by) investing
activities 307,500 660,718 (2,000,000)
Financing activities
Repurchase of common stock (5,654,999) (16,403,258) (9,801,707)
Contributed capital to bank subsidiary (15,000,000) - -
Dividends received from bank subsidiary 6,000,000 5,000,000 -
Increase in borrowed money 15,464,000 - -
Exercise of options 140,670 - 149,793
Dividends to stockholders (2,067,808) (2,013,560) (2,136,607)
------------- ------------- -------------
Net cash provided by financing
activities (1,118,137) (13,415,503) (11,788,521)
Net decrease in cash and cash equivalents (1,355,748) (12,503,632) (13,141,468)
Cash and cash equivalents, beginning of period 2,687,014 15,190,646 28,332,114
------------- ------------- -------------
Cash and cash equivalents, end of period $ 1,331,266 $ 2,687,014 $ 15,190,646
============= ============= =============
67
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
Under the supervision and with the participation of the Company's
management, including the Company's Chief Executive Officer and Chief Financial
Officer, the Company has evaluated the effectiveness of the design and operation
of its disclosure controls and procedures (as defined in Rule 13a-15(e) and
15d-15(e) under the Exchange Act) as of the end of the period covered by this
report. Based upon that evaluation, the Chief Executive Officer and Chief
Financial Officer concluded that, as of the end of the period covered by this
report, the Company's disclosure controls and procedures were effective to
ensure that information required to be disclosed in the reports that the Company
files or submits under the Exchange Act is recorded, processed, summarized and
reported, within the time periods specified in the SEC's rules and forms.
There has been no change in the Company's internal control over financial
reporting identified in connection with the quarterly evaluation that occurred
during the Company's last fiscal quarter that has materially affected, or is
reasonably likely to materially affect, the Company's internal control over
financial reporting.
MANAGEMENT'S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of Citizens South Banking Corporation (the "Company") is
responsible for establishing and maintaining adequate internal control over
financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the
Securities Exchange Act of 1934, as amended. The Company's internal control over
financial reporting is designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted accounting
principles. Management excluded the acquired Trinity Bank from its assessment of
internal controls over financial reporting due to the fact that the acquisition
of Trinity was not consummated until October 2005. The acquisition of Trinity
did not have a material impact on the earnings of the Company during 2005, due
to the fact that only two months of earnings were included in the 2005
consolidated earnings of the Company. The acquisition did, however, result in a
material change in the Company's statement of financial condition since at the
time of the acquisition, Trinity had total assets of $165.5 million, total loans
of $114.3 million, premises and equipment of $2.4 million, total deposits of
$135.6 million, borrowed money of $14.1 million and total equity of $13.3
million. There were no material changes to the Company's internal control over
financial reporting as a result of this acquisition.
The Company's internal control over financial reporting includes those
policies and procedures that:
o pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the
assets of the Company;
o provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance
with generally accepted accounting principles, and that material
receipts and expenditures of the Company are being made only in
accordance with the authorizations of management and directors of the
Company; and
o provide reasonable assurance regarding prevention or timely detection
of unauthorized acquisition, use, or disposition of the Company's
assets that could have a material effect on the financial statements
of the Company.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate. Management
assessed the effectiveness of the Company's internal control over financial
reporting as of December 31, 2005. In making this assessment, management used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in Internal Control-Integrated Framework.
68
Based on our assessment and those criteria, management believes that the
Company maintained effective internal control over financial reporting as of
December 31, 2005.
The Company's independent registered public accounting firm has issued an
attestation report on management's assessment of the Company's internal control
over financial reporting. That report is presented on the following page of this
report.
69
[LOGO OF CHERRY BEKAERT & HOLLAND]
REPORT OF INDEPENDENT REGISTERD PUBLIC ACCOUNTING FIRM
The Board of Directors
Citizens South Banking Corporation
Gastonia, North Carolina
We have audited management's assessment, included in the accompanying
Management's Annual Report on Internal Control Over Financial Reporting, that
Citizens South Banking Corporation and subsidiaries (the "Company") maintained
effective internal control over financial reporting as of December 31, 2005,
based on criteria established in Internal Control-Integrated Framework issued by
the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The
Company's management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
management's assessment and an opinion on the effectiveness of the company's
internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
aspects. Our audit included obtaining an understanding of internal control over
financial reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and performing such
other procedures as we considered necessary in the circumstances. We believe
that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with accounting principles generally accepted in the United States of America. A
company's internal control over financial reporting includes those policies and
procedures that (1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the
assets of the Company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with accounting principles generally accepted in the United States of
America, and that receipts and expenditures of the Company are being made only
in accordance with authorizations of management and directors of the Company;
and (3) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the Company's assets that could
have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
As indicated in Management's Annual Report on Internal Control Over Financial
Reporting, management's assessment of and conclusion on the effectiveness of
internal control over financial reporting did not include the internal controls
of Trinity Bank, which was acquired by the Company on October 31, 2005 and is
included in the consolidated financial statements of the Company as of December
31, 2005 and for the two-month period then ended. At the time of the
acquisition, Trinity Bank had total assets of $165.5 million, total loans of
$114.3 million, premises and equipment of $2.4 million, total deposits of $135.6
million, borrowed money of $14.1 million and total equity of $13.3 million.
Management did not assess the effectiveness of internal control over financial
reporting at Trinity Bank due to the fact that the acquisition of Trinity Bank
was not consummated until October 31, 2005. Our audit of internal control over
financial reporting of Citizens South Banking Corporation also did not include
an evaluation of the internal control over financial reporting at Trinity Bank.
70
In our opinion, management's assessment that the Company maintained effective
internal control over financial reporting as of December 31, 2005, is fairly
stated, in all material respects, based on criteria established in Internal
Control-Integrated Framework issued by COSO. Also in our opinion, the Company
maintained, in all material aspects, effective internal control over financial
reporting as of December 31, 2005, based on criteria established in Internal
Control-Integrated Framework issued by COSO.
We have also audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the consolidated statements of
condition of the Company as of December 31, 2005 and 2004 and the related
consolidated statements of operations, comprehensive income, changes in
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 2005 and our report dated March 3, 2006 expressed an
unqualified opinion on these consolidated financial statements.
/s/ Cherry, Bekaert & Holland, L.L.P.
Gastonia, North Carolina
March 3, 2006
71
ITEM 9B. OTHER INFORMATION
None.
PART III
- --------
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The "Proposal I - Election of Directors" section of the Registrant's
Definitive Proxy Statement dated April 3, 2006, (the "Proxy Statement") as filed
pursuant to Section 14 of the Securities Exchange Act of 1934 in connection with
the 2006 Annual Meeting of Shareholders is incorporated herein by reference. In
addition, the Item 1. "Executive Officers of the Registrant" section of the
Proxy Statement is incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The "Proposal I - Election of Directors" section of the Registrant's Proxy
Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The "Proposal I - Election of Directors" section of the Registrant's Proxy
Statement is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The "Proposal I - Election of Directors" section of the Registrant's Proxy
Statement is incorporated herein by reference.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The "Principal Accountant's Fees and Services" section of this Registrant's
Proxy Statement is incorporated herein by reference.
72
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
A. INDEX OF EXHIBITS
3.1 Certificate of Incorporation of Citizens South Banking Corporation
(incorporated herein by reference to the Registration Statement on
Form S-1 (File No. 333-91498), originally filed with the Commission on
June 28, 2002
3.2 Bylaws of Citizens South Banking Corporation (incorporated herein by
reference to the Registration Statement on Form S-1 (File No.
333-91498), originally filed with the Commission on June 28, 2002
4.1 Form of Common Stock Certificate of Citizens South Banking Corporation
(incorporated herein by reference to the Registration Statement on
Form S-1 (File No. 333-91498), originally filed with the Commission on
June 28, 2002
4.2 Indenture between Citizens South Banking Corporation and Wilmington
Trust Company, as trustee, dated October 28, 2005. (Incorporated by
reference to the Current Report on Form 8-K (File No. 0-23971), filed
with the Commission on November 3, 2005)
10.1 Employment Agreement with Kim S. Price dated May 17, 2004
10.2 Deferred Compensation and Income Continuation Agreement (incorporated
by reference to the Registration Statement on Form SB-2 (File No.
333-42951), originally filed with the Commission on December 22, 1997
10.3 Employee Stock Option Plan (incorporated by reference to the
Registration Statement on Form SB-2 (File No. 333-42951), originally
filed with the Commission on December 22, 1997
10.4 Supplemental Executive Retirement Plan (incorporated by reference to
the Registration Statement on Form SB-2 (File No. 333-42951),
originally filed with the Commission on December 22, 1997
10.5 Severance Agreement with Gary F. Hoskins dated May 17, 2004.
(Incorporated by reference to the Annual Report on Form 10-K (File No.
0-23971), filed with the Commission on March 16, 2005)
10.6 Severance Agreement with Paul L. Teem, Jr. dated May 17, 2004.
(Incorporated by reference to the Annual Report on Form 10-K (File No.
0-23971), filed with the Commission on March 16, 2005)
10.7 Severance Agreement with Michael R. Maguire dated May 17, 2004.
(Incorporated by reference to the Annual Report on Form 10-K (File No.
0-23971), filed with the Commission on March 16, 2005)
10.8 Severance Agreement with Daniel M. Boyd, IV dated May 17, 2004.
(Incorporated by reference to the Annual Report on Form 10-K (File No.
0-23971), filed with the Commission on March 16, 2005)
10.9 Severance Agreement with V. Burton Brinson, Jr. dated May 17, 2004.
(Incorporated by reference to the Annual Report on Form 10-K (File No.
0-23971), filed with the Commission on March 16, 2005)
10.10 Salary Continuation Agreement with Kim S. Price dated January 1, 2004.
(Incorporated by reference to the Annual Report on Form 10-K (File No.
0-23971), filed with the Commission on March 16, 2005)
10.11 Salary Continuation Agreement with Gary F. Hoskins dated January 1,
2004. (Incorporated by reference to the Annual Report on Form 10-K
(File No. 0-23971), filed with the Commission on March 16, 2005)
73
10.12 Salary Continuation Agreement with Paul L. Teem, Jr. dated January 1,
2004. (Incorporated by reference to the Annual Report on Form 10-K
(File No. 0-23971), filed with the Commission on March 16, 2005)
10.13 Salary Continuation Agreement with Michael R. Maguire dated January 1,
2004. (Incorporated by reference to the Annual Report on Form 10-K
(File No. 0-23971), filed with the Commission on March 16, 2005)
10.14 Salary Continuation Agreement with Daniel M. Boyd, IV dated January 1,
2004. (Incorporated by reference to the Annual Report on Form 10-K
(File No. 0-23971), filed with the Commission on March 16, 2005)
10.15 Salary Continuation Agreement with V. Burton Brinson, Jr. dated
January 1, 2004. (Incorporated by reference to the Annual Report on
Form 10-K (File No. 0-23971), filed with the Commission on March 16,
2005)
10.16 Endorsement Split Dollar Agreement with Kim S. Price dated January 1,
2004. (Incorporated by reference to the Annual Report on Form 10-K
(File No. 0-23971), filed with the Commission on March 16, 2005)
10.17 Endorsement Split Dollar Agreement with Gary F. Hoskins dated January
1, 2004. (Incorporated by reference to the Annual Report on Form 10-K
(File No. 0-23971), filed with the Commission on March 16, 2005)
10.18 Endorsement Split Dollar Agreement with Paul L. Teem, Jr. dated
January 1, 2004. (Incorporated by reference to the Annual Report on
Form 10-K (File No. 0-23971), filed with the Commission on March 16,
2005)
10.19 Endorsement Split Dollar Agreement with Michael R. Maguire dated
January 1, 2004. (Incorporated by reference to the Annual Report on
Form 10-K (File No. 0-23971), filed with the Commission on March 16,
2005)
10.20 Endorsement Split Dollar Agreement with Daniel M. Boyd, IV dated
January 1, 2004. (Incorporated by reference to the Annual Report on
Form 10-K (File No. 0-23971), filed with the Commission on March 16,
2005)
10.21 Endorsement Split Dollar Agreement with V. Burton Brinson, Jr. dated
January 1, 2004. (Incorporated by reference to the Annual Report on
Form 10-K (File No. 0-23971), filed with the Commission on March 16,
2005)
10.22 Amended Deferred Compensation and Income Continuation Agreement with
David W. Hoyle, Sr. dated March 15, 2004. (Incorporated by reference
to the Annual Report on Form 10-K (File No. 0-23971), filed with the
Commission on March 16, 2005)
10.23 Amended Deferred Compensation and Income Continuation Agreement with
Ben R. Rudisill, II dated March 15, 2004. (Incorporated by reference
to the Annual Report on Form 10-K (File No. 0-23971), filed with the
Commission on March 16, 2005)
10.24 Amended Deferred Compensation and Income Continuation Agreement with
James J. Fuller dated March 15, 2004. (Incorporated by reference to
the Annual Report on Form 10-K (File No. 0-23971), filed with the
Commission on March 16, 2005)
10.25 Amended Deferred Compensation and Income Continuation Agreement with
Charles D. Massey dated March 15, 2004. (Incorporated by reference to
the Annual Report on Form 10-K (File No. 0-23971), filed with the
Commission on March 16, 2005)
74
10.26 Amended Director Retirement Agreement with David W. Hoyle, Sr. dated
March 15, 2004. (Incorporated by reference to the Annual Report on
Form 10-K (File No. 0-23971), filed with the Commission on March 16,
2005)
10.27 Amended Director Retirement Agreement with Ben R. Rudisill, II dated
March 15, 2004. (Incorporated by reference to the Annual Report on
Form 10-K (File No. 0-23971), filed with the Commission on March 16,
2005)
10.28 Amended Director Retirement Agreement with James J. Fuller dated March
15, 2004. (Incorporated by reference to the Annual Report on Form 10-K
(File No. 0-23971), filed with the Commission on March 16, 2005)
10.29 Amended Director Retirement Agreement with Charles D. Massey dated
March 15, 2004. (Incorporated by reference to the Annual Report on
Form 10-K (File No. 0-23971), filed with the Commission on March 16,
2005)
10.30 Amended Director Retirement Agreement with Eugene R. Matthews, II
dated March 15, 2004. (Incorporated by reference to the Annual Report
on Form 10-K (File No. 0-23971), filed with the Commission on March
16, 2005)
10.31 Amended and Restated Declaration of Trust among Citizens South Banking
Corporation, Wilmington Trust Company, as Delaware and Institutional
Trustee, and the Administrative Trustees named therein, dated October
28, 2005. (Incorporated by reference to the Current Report on Form 8-K
(File No. 0-23971), filed with the Commission on November 3, 2005)
14 Code of Ethics Policy (incorporated herein by reference to the
"Proposal I - Election of Directors" section of the Registrant's Proxy
Statement dated April 3, 2006
21 Subsidiaries of Registrant (incorporated herein by reference to the
Registration Statement on Form S-1 (File No. 333-91498), originally
filed with the Commission on June 28, 2002
23 Consent of Cherry, Bekaert & Holland, L.L.P.
24 Power of Attorney (set forth on signature page)
31 Certification of Chief Executive Officer and Chief Financial Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32 Statement of Chief Executive Officer and Chief Financial Officer
furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
75
SIGNATURES
Pursuant to the requirements of Section 13 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.
CITIZENS SOUTH BANKING CORPORATION
Date: March 13, 2006 By: /s/ Kim S. Price
------------------------------- ----------------------------------
Kim S. Price
President and Chief
Executive Officer
Pursuant to the requirements of the Securities Exchange of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
By: /s/ Kim S. Price By: /s/ Gary F. Hoskins
------------------------------- ----------------------------------
Kim S. Price Gary F. Hoskins
President, Chief Executive Executive Vice President,Treasurer
Officer and Director and Chief Financial Officer
(Principal Executive Officer) (Principal Financial and
Accounting Officer)
Date: March 13, 2006 Date: March 13, 2006
------------------------------- ----------------------------------
By: /s/ David W. Hoyle By: /s/ Ben R. Rudisill, II
------------------------------- ----------------------------------
David W. Hoyle Ben R. Rudisill, II
Chairman Vice Chairman
Date: March 13, 2006 Date: March 13, 2006
------------------------------- ----------------------------------
By: /s/ Eugene R. Matthews, II By: /s/ Charles D. Massey
------------------------------- ----------------------------------
Eugene R. Matthews, II Director Charles D. Massey Director
Date: March 13, 2006 Date: March 13, 2006
------------------------------- ----------------------------------
By: /s/ James J. Fuller By: /s/ David McGuirt
------------------------------- ----------------------------------
James J. Fuller Director David McGuirt Director
Date: March 13, 2006 Date: March 13, 2006
------------------------------- ----------------------------------
76