EX-13 9 v01989_ex13.txt 2003 Annual Report First South Bancorp =================== ------------------- TABLE OF CONTENTS Letter to Stockholders 1 Selected Consolidated Financial Information and Other Data 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 3 Report of Independent Auditors 15 Consolidated Statements of Financial Condition 16 Consolidated Statements of Operations 17 Consolidated Statements of Changes in Stockholders' Equity 18 Consolidated Statements of Cash Flows 19 Notes to Consolidated Financial Statements 20 Board of Directors 44 Executive Officers 44 Area Executives 44 City & Branch Executives 44 First South Bank Office Locations 45 First South Bank ATM Locations 45 First South Bank Products and Services 46 Stockholder Information 47 MISSION STATEMENT "Our mission is to become the premier community bank in eastern North Carolina. We will enhance shareholder value by serving the personal and business needs of our markets, providing superior customer service, investing in the communities that we serve, and enriching the lives of our employees." LETTER TO STOCKHOLDERS To Our Stockholders: I am pleased to report the 2003 operating results for First South Bancorp ("First South"). It was another excellent year with earnings setting a new record. We met our projected financial results and accomplished all of our strategic objectives. For the year ended December 31, 2003, we reported record earnings of $11.4 million representing a 20.0% increase over the $9.5 million earned in the year ended December 31, 2002. Basic earnings per share increased 26.1% to $2.75 per share for the year ended December 31, 2003 from $2.18 per share for the year ended December 31, 2002. Our 2003 earnings produced a return on average assets of 1.76% and a return on average stockholders' equity of 22.06%. Fundamentally, our financial position remains strong. The year ended December 31, 2003 was an eventful one for First South and First South Bank (the "Bank"). FORTUNE Small Business magazine ranked First South 39th in their listing of America's top 100 fastest growing small public companies; The News and Observer ranked us 44th among the top 100 publicly traded companies headquartered in North Carolina; and American Banker ranked us the 77th most efficient of the largest 500 banks in America. We are pleased with this recognition, as these rankings further exemplify the visibility of First South and the Bank among both the business and investment communities. In addition to the public recognition received, the Bank opened two new full service banking offices located in Hope Mills and Raleigh, North Carolina. During 2003, the Board of Directors increased the annual cash dividend by 17.7% to $.80 per share from $.68 per share in 2002. First South completed the private placement issuance of $10.0 million of trust preferred securities. During the quarter ended December 31, 2003, we announced an agreement reached with Central Carolina Bank, a division of National Bank of Commerce, to acquire two branch offices in Greenville and New Bern, North Carolina. This acquisition is expected to close during the first quarter of 2004, representing a continuation of the growth of our branch office network, and will allow us to expand our customer base in existing markets. The assets of First South increased to $675.8 million from $628.5 million at year end 2002. In addition, total loans and leases were $553.2 million, and total deposits were $583.2 million, with transaction and statement savings representing 42.55% of that amount at year end 2003. While internal growth was strong and the Bank successfully opened two new banking offices, the Bank's efficiency ratio was 48.30% for the 2003 year. Many of our future strategies will focus on enhancing the franchise value of First South. We will introduce new services and products such as on-line banking, bill paying and business free checking. We will continue to explore new markets and expand in existing markets and significant resources are being put into place to enhance the training of our personnel in order to better serve existing and new customers. As we continue our growth and success, it is apparent that our employees are our greatest asset. I want to thank them for their hard work, dedication, individual efforts, and commitment in making First South Bank so successful. Each member of your Board of Directors along with our officers and employees join me in thanking you for supporting First South Bancorp. As always, your comments or suggestions are welcomed and we look forward to your continued support. Sincerely, /s/ Tom Vann Tom Vann President and Chief Executive Officer 1 SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA
At or For the Years Ended December 31, 2003 and 2002, Three Months Ended December 31, 2001, and Years Ended September 30, 2001, 2000 and 1999 -------------------------------------------------------------------------------- 12/31/2003 12/31/2002 12/31/2001 9/30/2001 9/30/2000 9/30/1999 ---------- ---------- ---------- ---------- ---------- ---------- (dollars in thousands, except per share data) Selected Financial Condition Data --------------------------------- Total assets ~ $ 675,836 $ 628,473 $ 549,318 $ 541,195 $ 559,719 $ 292,305 Loans receivable, net ~ 553,200 490,914 405,613 374,087 366,210 212,054 Cash and investment securities ~ 84,996 90,259 75,745 95,191 59,927 12,435 Mortgage-backed securities ~ 11,715 23,526 43,904 48,603 108,519 56,326 Deposits ~ 583,173 526,327 475,589 471,939 471,942 234,618 Borrowings ~ 29,338 38,195 5,441 4,909 30,388 1,318 Stockholders' equity ~ 55,164 50,100 51,031 50,769 44,835 48,763 Selected Operations Data ------------------------ Interest income ~ $ 36,905 $ 36,826 $ 9,467 $ 42,159 $ 36,865 $ 23,129 Interest expense ~ 10,186 12,473 4,092 22,168 19,013 9,979 ---------- ---------- ---------- ---------- ---------- ---------- Net interest income ~ 26,719 24,353 5,375 19,991 17,852 13,150 Provision for loan losses ~ 988 1,756 0 830 977 120 Noninterest income ~ 10,502 8,462 1,625 6,776 3,432 2,874 Noninterest expenses ~ 17,979 16,337 3,832 16,047 14,100 10,255 ESOP Termination ~ 0 0 3,143 0 0 0 ---------- ---------- ---------- ---------- ---------- ---------- Income before income taxes ~ 18,254 14,722 25 9,890 6,207 5,649 Income taxes ~ 6,841 5,210 1,165 4,060 2,658 2,453 ---------- ---------- ---------- ---------- ---------- ---------- Net income ~ $ 11,413 $ 9,512 $ (1,140) $ 5,830 $ 3,549 $ 3,196 ========== ========== ========== ========== ========== ========== Earnings per share - basic (1) $ 2.75 $ 2.18 $ (0.26) $ 1.34 $ 0.76 $ 0.60 Earnings per share - diluted (1) 2.59 2.06 (0.26) 1.30 0.76 0.60 Dividends per share (1) 0.80 0.68 0.12 0.45 0.31 0.21 Selected Financial Ratios and Other Data ---------------------------------------- Performance Ratios: Return on average assets (2) 1.76% 1.64% 1.46% 1.06% 0.76% 1.09% Return on average equity (2) 22.06 18.39 15.70 12.31 7.71 6.03 Interest rate spread ~ 4.46 4.43 4.05 3.67 3.73 3.95 Net interest margin ~ 4.49 4.54 4.24 3.90 4.05 4.69 Average earning assets/average ~ interest bearing liabilities ~ 114.16 116.03 116.27 114.06 115.51 131.01 Noninterest expense/average assets (3) 2.77 2.81 2.80 2.92 3.03 3.50 Efficiency ratio (3) 48.30 49.79 54.74 59.95 66.25 63.99 Dividend payout ratio (2) 29.09 31.19 25.71 33.33 40.35 34.07 Quality Ratios: Nonperforming assets/total assets ~ 0.41% 0.31% 0.35% 0.29% 0.33% 0.40% Nonperforming loans/total loans ~ 0.47 0.31 0.31 0.28 0.45 0.27 Loan loss reserves/total loans ~ 1.36 1.40 1.31 1.42 1.39 1.53 Provision for loan losses/total loans ~ 0.18 0.36 0.00 0.22 0.27 0.06 Capital Ratios and Other Data: Equity/total assets, end of period ~ 8.16% 7.97% 9.29% 9.38% 8.02% 16.69% Average equity/average assets ~ 7.96 8.90 9.33 8.62 9.89 18.09 Full service offices ~ 22 21 20 19 17 9 Loans serviced for others ~ $ 288,917 $ 262,504 $ 274,240 $ 295,216 $ 300,006 $ 275,255
-------------- (1) Adjusted for three-for-two stock splits on April 19, 2002 and August 19, 1998. (2) Based on net income of $2,003,494 earned before the $3,143,467 one-time ESOP termination charge in 12/31/01 period. (3) Excludes the $3,143,476 one-time ESOP termination charge in 12/31/01 period. 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL. First South Bancorp, Inc. (the "Company") was formed for the purpose of issuing common stock, owning 100% of First South Bank (the "Bank") and operating through the Bank a commercial banking business, therefore, this discussion of consolidated financial condition and results of operations relates principally to the Bank. The business of the Bank consists principally of attracting deposits from the general public and using them to originate secured and unsecured commercial and consumer loans, permanent mortgage and construction loans secured by single-family residences and other loans. The Bank's earnings depend primarily on its net interest income, the difference between interest earned on interest earning assets and interest paid on interest-bearing liabilities. The level of noninterest income and expenses also affects the Bank's earnings. Prevailing economic conditions, as well as federal and state regulations, affect the operations of the Bank. The Bank's cost of funds is influenced by interest rates paid on competing investments, rates offered on deposits by other financial institutions in the Bank's market area and by general market interest rates. Lending activities are affected by the demand for financing of real estate and various types of commercial and consumer loans, and by interest rates at which such financing may be offered. The Bank's business emphasis is to operate as a well-capitalized, profitable and independent community oriented financial institution dedicated to providing quality customer service and meeting the financial needs of the communities it serves. Management believes the Bank can be more effective in serving its customers than many larger competitors because of its ability to respond quickly and effectively to customer needs and inquiries. The Bank's ability to provide these services is enhanced by the stability of the Bank's senior management team. The Company's common stock is listed and trades on the Nasdaq Stock Market under the symbol FSBK. The Company is currently listed in the Russell 2000 (R) Index, helping maintain its visibility among the investment community. SUBSEQUENT EVENT. On February 20, 2004, the Bank completed the purchase of two branch offices located in Greenville and New Bern, North Carolina, from Central Carolina Bank, a division of National Bank of Commerce ("CCB"). This acquisition was accounted for using the purchase method of accounting and the Bank assumed the deposits of the two CCB branch offices for a premium of approximately 1.5% of the assumed deposits. Summary financial information related to the CCB branches purchase was as follows (Unaudited): cash - $15.8 million; loans receivable - $2.2 million; deposits - $18.4 million; and identifiable intangibles - $314,000. This acquisition enabled the Company to leverage its capital base, represents continued growth in the Bank's branch office network, and is expected to benefit the Company's earnings. LIQUIDITY AND CAPITAL RESOURCES. As a state chartered commercial bank, the Bank must meet certain liquidity requirements established by the North Carolina Office of the Commissioner of Banks (the "Commissioner"). The Bank's regulatory liquidity ratio was 14.3% at December 31, 2003 and 18.6% at December 31, 2002. The Bank's primary sources of funds are deposits, principal and interest payments on loans, proceeds from loan and securities sales, and advances from the Federal Home Loan Bank of Atlanta (the "FHLB"). While maturities and scheduled amortization of loans are predictable sources of funds, deposit flows and loan prepayments are influenced by interest rates, economic conditions and local competition. The Bank's primary investing activity is the origination of commercial, consumer and mortgage loans and lease financing receivables. During fiscal 2003 and 2002, originations of loans held for sale and investment, net of principal repayments, were $206.8 million and $176.5 million, respectively. The Bank's primary financing activities are the attraction of checking, certificate and savings deposits, and obtaining FHLB advances. The levels of cash and cash equivalents depend on the Bank's operating, financing, lending and investing activities during any given period. At December 31, 2003 and 2002, cash and cash equivalents totaled $34.9 million and $34.5 million, respectively. The Bank has other sources of liquidity if a need for additional funds arises. Investment and mortgage-backed securities available for sale totaled $61.8 million at December 31, 2003 and $79.3 million at December 31, 2002. During the years ended December 31, 2003 and 2002, the Bank sold or exchanged real estate loans of $145.8 million and $87.2 million, respectively. Borrowings consisting of FHLB advances, junior subordinated debentures and retail repurchase agreements were $29.3 million at December 31, 2003 compared to $38.2 million at December 31, 2002. The Bank has pledged its FHLB Atlanta stock and certain loans as collateral for actual or potential FHLB advances. At December 31, 2003 the Bank had an additional $46.0 million of current secured credit available with the FHLB, and an additional $69.5 million available credit limit subject to the pledge of additional collateral. 3 On September 26, 2003, the Company completed the private placement in a pooled offering of $10,000,000 of trust preferred securities, issued by First South Preferred Trust I, a Delaware statutory trust. The trust preferred securities bear interest at a rate of 2.95% over three-month LIBOR payable quarterly, have a 30-year maturity and are redeemable after 5 years with certain exceptions. For regulatory purposes, the $10.0 million total of trust preferred securities qualifies as Tier 1 capital for the Bank only, in accordance with regulatory reporting requirements. The Company used the proceeds to support loan growth and for general corporate purposes. For additional information, see Note 20 of Notes to Consolidated Financial Statements. As a North Carolina chartered commercial bank and a Federal Deposit Insurance Corporation (the "FDIC") insured institution, the Bank is required to meet various state and federal regulatory capital standards. The Bank's stand-alone equity was $64.1 million at December 31, 2003, compared to $50.0 million at December 31, 2002. The Commissioner requires the Bank to maintain a capital surplus of not less than 50% of common capital stock. The FDIC requires the Bank to meet a minimum leverage capital requirement of Tier I capital (consisting of retained earnings and common stockholders' equity, less any intangible assets) to assets ratio of at least 4%, and a total capital to risk-weighted assets ratio of 8%, of which 4% must be in the form of Tier I capital. The Bank was in compliance with all regulatory capital requirements at December 31, 2003 and 2002. At December 31, 2003, stockholders' equity was $55.2 million, compared to $50.1 million at December 31, 2002. Net income for fiscal 2003 was $11.4 million, compared to $9.5 million for fiscal 2002. At December 31, 2003 there were 4,190,335 shares of common stock outstanding, net of 2,355,513 treasury shares. OFF-BALANCE SHEET ARRANGEMENTS. The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet its customers financing needs. These financial instruments include commitments to extend credit and involve elements of credit and interest rate risk in excess of amounts recognized on the balance sheet. The Bank's exposure to credit loss in the event of non-performance by the customer is represented by the contractual amount of those commitments. The Bank uses the same credit underwriting standards and policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Commitments to extend credit are agreements to lend to a customer 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 fee payment. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management's credit evaluation of the borrower. A summary of the contractual amounts of the Bank's exposure to off-balance sheet risk as of December 31, 2003 and 2002 is as follows:
December 31, 2003 December 31, 2002 ----------------- ----------------- (Dollars in thousands) Commitments to extend credit: Commitments to originate loans $ 109,859 $ 75,657 Undrawn balances on lines of credit and undrawn balances on credit reserves (overdraft protection) 53,594 48,483 ---------- ---------- Total commitments to extend credit $ 163,453 $ 124,140 ========== ==========
Included in the commitments to originate loans as of December 31, 2003 and 2002, are fixed interest rate loan commitments of $10.8 million and $8.3 million, respectively. The shorter duration of interest-sensitive liabilities, to the extent they are used to fund these fixed-rate loans, indicates the Bank is exposed to interest rates because in a rising rate environment liabilities will be repricing faster and at higher interest rates, thereby reducing the market value of fixed-rate long-term assets and net interest income. Since many of the commitments are expected to expire without being drawn upon, amounts do not necessarily represent future cash requirements. ASSET/LIABILITY MANAGEMENT. The Bank strives to maintain consistent net interest income and reduce its exposure to adverse changes in interest rates by matching the terms to repricing of its interest-sensitive assets and liabilities. Factors beyond the Bank's control, such as market interest rates and competition, may also impact interest income and interest expense. The Bank's net interest income will generally increase when interest rates rise over an extended period of time, and conversely, will decrease when interest rates decline. The Bank can significantly influence its net interest income by controlling the increases and decreases in its interest income and interest expense, which are caused by changes in market interest rates. See Table 1 below for additional information on the effects of net interest income caused by changes in interest rates. 4 The President of the Bank reports interest rate risk and trends, liquidity and capital ratio requirements to the Board on a regular basis. The Board reviews the maturities of the Bank's assets and liabilities and establishes policies and strategies designed to regulate the flow of funds and to coordinate the sources, uses and pricing of such funds. The first priority in structuring and pricing assets and liabilities is to maintain an acceptable interest rate spread while reducing the net effects of changes in interest rates. The Bank's management is responsible for administering the policies and determinations of the Board with respect to the Bank's asset and liability goals and strategies. A principal strategy in managing the Bank's interest rate risk has been to increase interest sensitive assets such as commercial loans, lease financing receivables and consumer loans. At December 31, 2003, the Bank had $399.5 million of commercial loans and lease receivables and $89.5 million of consumer loans, compared to $295.0 million and $81.9 million, respectively, at December 31, 2002. The Bank had $10.9 million of loans held for sale at December 31, 2003, compared to $38.7 million at December 31, 2002. Depending on conditions existing at a given time, the Bank may sell fixed-rate residential mortgage loans in the secondary market. In managing its portfolio of investment securities, all investment securities are held as available for sale, allowing the Bank to sell a security in a timely manner should an immediate liquidity need arise. The Bank had $61.8 million of investment and mortgage-backed securities classified as available for sale at December 31, 2003, compared to $79.3 million at December 31, 2002. MARKET RISK. Market risk reflects the risk of economic loss resulting from changes in market prices and interest rates. The risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods. Market risk arises primarily from interest rate risk inherent in lending and deposit taking activities. The Bank does not maintain a trading account for any class of financial instruments, nor does it engage in hedging activities or purchase high-risk derivative instruments. Furthermore, the Bank is not subject to foreign currency exchange risk or commodity price risk. The Bank measures interest rate risk by computing estimated changes in net interest income and the net portfolio value ("NPV") of its cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. The Bank's exposure to interest rates is reviewed on a quarterly basis by management and the Board. Exposure to interest rate risk is measured with the use of interest rate sensitivity analysis to determine the change in NPV in the event of hypothetical changes in interest rates, while interest rate sensitivity gap analysis is used to determine the repricing characteristics of assets and liabilities. If estimated changes to NPV and net interest income are not within the limits established by the Board, it may direct management to adjust the Bank's asset and liability mix to bring interest rate risk within Board approved limits. NPV represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the potential loss in risk sensitive instruments in the event of sudden and sustained 1% to 3% increases and decreases in market interest rates. The Board has adopted an interest rate risk policy that establishes maximum increases in NPV of 17%, 36% and 56% and decreases in NPV of 15%, 36% and 61% in the event of sudden and sustained 1% to 3% increases or decreases in market interest rates. Table 1 below presents the Bank's projected changes in NPV and net interest income in the event of sudden and sustained increases or decreases in market interest rates for the various rate shock levels at December 31, 2003. At December 31, 2003, the Bank's estimated changes in NPV and net interest income were within the targets established by the Board. TABLE 1 - PROJECTED CHANGE IN NPV AND NET INTEREST INCOME Net Portfolio Value Net Interest Income Change ------------------- ------------------- in Rates $Amount $Change %Change $Amount $Change %Change -------- ------- ------- ------- ------- ------- ------- (Dollars in thousands) + 300 bp $89,115 $ 3,528 4.1% $32,066 $ 4,242 15.2% + 200 bp 88,891 3,304 3.9 30,896 3,072 11.0 + 100 bp 87,641 2,054 2.4 29,430 1,606 5.8 Base 85,587 -- -- 27,824 -- -- - 100 bp 83,535 (2,052) (2.4) 26,162 (1,662) (6.0) - 200 bp 80,558 (5,029) (5.9) 23,300 (4,524) (16.3) - 300 bp 82,160 (3,427) (4.0) 21,739 (6,085) (21.9) 5 The NPV calculation is based on the net present value of discounted cash flows utilizing market prepayment assumptions. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions the Bank may undertake in response to changes in interest rates. Certain shortcomings are inherent in the method of analysis presented in Table 1. For example, although certain assets and liabilities may have similar maturities to repricing, they may react in differing degrees to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Certain assets, such as adjustable-rate loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. In addition, the proportion of adjustable-rate loans in the Bank's portfolio could decrease in future periods if market interest rates remain at or decrease below current levels due to refinance activity. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate from those assumed in the table. Also, the ability of many borrowers to repay their adjustable-rate debt may decrease in the event of an increase in interest rates. In addition, the Bank uses interest sensitivity gap analysis to monitor the relationship between the maturity and repricing of its interest-earning assets and interest-bearing liabilities, while maintaining an acceptable interest rate spread. Interest sensitivity gap is defined as the difference between the amount of interest-earning assets maturing or repricing within a specific time period and the amount of interest-bearing liabilities maturing or repricing within that time period. A gap is considered positive when the amount of interest-sensitive assets exceeds the amount of interest-sensitive liabilities, and is considered negative when the amount of interest-rate-sensitive liabilities exceeds the amount of interest-rate-sensitive assets. Generally, during a period of rising interest rates, a negative gap would adversely affect net interest income, while a positive gap would result in an increase in net interest income. Conversely, during a period of falling interest rates, a negative gap would result in an increase in net interest income, while a positive gap would negatively affect net interest income. The Bank's goal is to maintain a reasonable balance between exposure to interest rate fluctuations and earnings. RATE/VOLUME ANALYSIS. Net interest income can also be analyzed in terms of the impact of changing interest rates on average interest-earning assets and average interest-bearing liabilities, and the changing volume or amount of these assets and liabilities. Table 2 below represents the extent to which changes in interest rates and changes in the volume of average interest-earning assets and average interest-bearing liabilities have affected the Bank's interest income and interest expense during the periods indicated. For each category of average interest-earning asset and average interest-bearing liability, information is provided on changes attributable to: (i) changes in volume (changes in volume multiplied by old rate); (ii) changes in rate (change in rate multiplied by old volume); (iii) changes in rate-volume (changes in rate multiplied by the changes in volume); and (iv) net change (total of the previous columns). ANALYSIS OF NET INTEREST INCOME. Net interest income primarily represents the difference between income derived from interest-earning assets and interest expense on interest-bearing liabilities. Net interest income is affected by both the difference between the yield on earning assets and the average cost of funds ("interest rate spread"), and the relative volume of interest-earning assets, interest-bearing liabilities and noninterest-bearing deposits. Table 3 below sets forth certain information relating to the Bank's Statements of Financial Condition and Statements of Operations for the years ended December 31, 2003 and December 31, 2002, and the three months ended December 31, 2001, reflecting the yield on average earning assets and the average cost of funds for the periods indicated. Average balances are derived from month end balances. The Bank does not believe that using month end balances rather than average daily balances have caused any material difference in the information presented. 6 TABLE 2 - RATE/VOLUME ANALYSIS
Year Ended December 31, Year Ended December 31, ---------------------------------------- ---------------------------------------- 2003 vs. 2002 2002 vs. 2001 ---------------------------------------- ---------------------------------------- Increase (Decrease) Due to Increase (Decrease) Due to ---------------------------------------- ---------------------------------------- (In thousands) Rate/ Rate/ Volume Rate Volume Total Volume Rate Volume Total ------- ------- ------- ------- ------- ------- ------- ------- Interest income: Loans receivable $ 5,737 $(3,586) $ (666) $ 1,485 $ 5,280 $(5,454) $ (902) $(1,076) Investment securities (79) (62) 1 (140) 90 (97) (3) (10) Mortgage-backed securities (1,057) (126) 61 (1,122) (1,858) (120) 54 (1,924) Other interest-earning assets (114) (52) 22 (144) (372) (281) 133 (520) ------- ------- ------- ------- ------- ------- ------- ------- Total earning assets 4,487 (3,826) (582) 79 3,140 (5,952) (718) (3,530) ------- ------- ------- ------- ------- ------- ------- ------- Interest expense: Deposits 1,275 (3,369) (346) (2,440) 366 (7,300) (141) (7,075) FHLB advances 184 (17) (109) 58 (241) (174) 137 (278) Other interest-bearing liabilities 30 38 27 95 (21) (83) 13 (91) ------- ------- ------- ------- ------- ------- ------- ------- Total interest-bearing liabilities 1,489 (3,348) (428) (2,287) 104 (7,557) 9 (7,444) ------- ------- ------- ------- ------- ------- ------- ------- Change in net interest income $ 2,998 $ (478) $ (154) $ 2,366 $ 3,036 $ 1,605 $ (727) $ 3,914 ======= ======= ======= ======= ======= ======= ======= ======= Three Months Ended December 31, ---------------------------------------- 2001 vs. 2000 ---------------------------------------- Increase (Decrease) Due to ---------------------------------------- Rate/ Volume Rate Volume Total ------- ------- ------- ------- Interest income: Loans receivable $ 462 $(1,173) $ (64) $ (775) Investment securities 115 (93) (12) 10 Mortgage-backed securities (1,048) (46) 25 (1,069) Other interest-earning assets 200 (47) (123) 30 ------- ------- ------- ------- Total earning assets (271) (1,359) (174) (1,804) ------- ------- ------- ------- Interest expense: Deposits 25 (1,694) (6) (1,675) FHLB advances (513) (383) 380 (516) Other interest-bearing liabilities (13) (57) 10 (60) ------- ------- ------- ------- Total interest-bearing liabilities (501) (2,134) 384 (2,251) ------- ------- ------- ------- Change in net interest income $ 230 $ 775 $ (558) $ 447 ======= ======= ======= =======
7 TABLE 3 - YIELD/COST ANALYSIS
Year Ended December 31, Year Ended December 31, -------------------------------------- -------------------------------------- 2003 2002 -------------------------------------- -------------------------------------- (In thousands) Average Average Average Yield/ Average Yield/ Balance Interest Cost Balance Interest Cost (2) ---------- ---------- ---------- ---------- ---------- ---------- Interest earning assets: Loans receivable (1) $ 519,461 $ 32,394 6.24% $ 438,148 $ 30,909 7.05% Investment securities 53,302 3,321 6.23 54,542 3,461 6.35 Mortgage-backed securities 17,949 1,069 5.96 34,679 2,191 6.32 Other interest-earning assets 5,002 121 2.42 8,812 265 3.01 ---------- ---------- ---------- ---------- ---------- ---------- Total earning assets 595,714 36,905 6.20 536,181 36,826 6.87 ---------- ---------- ---------- ---------- Nonearning assets 54,064 44,896 ---------- ---------- Total assets $ 649,778 $ 581,077 ========== ========== Interest bearing liabilities: Time deposits $ 333,532 8,567 2.57 $ 306,636 10,261 3.35 Demand deposits 149,965 1,359 0.91 130,245 2,001 1.54 Savings 19,726 38 0.19 19,431 142 0.73 FHLB advances 11,092 86 0.78 1,469 28 1.90 Trust preferred securities 3,077 108 3.51 0 0 0.00 Repurchase agreements 4,432 28 0.63 4,344 41 0.94 ---------- ---------- ---------- ---------- ---------- ---------- Total interest-bearing liabilities 521,824 10,186 1.95 462,125 12,473 2.68 Noninterest bearing demand deposits 64,776 0 0.00 48,551 0 0.00 ---------- ---------- ---------- ---------- ---------- ---------- Total sources of funds 586,600 10,186 1.74 510,676 12,473 2.44 ---------- ---------- ---------- ---------- Other liabilities and stockholders'equity: Other liabilities 11,436 18,683 Stockholders' equity 51,742 51,718 ---------- ---------- Total liabilities and stockholders' equity $ 649,778 $ 581,077 ========== ========== Net interest income $ 26,719 $ 24,353 ========== ========== Interest rate spread (3) 4.46% 4.43% ========== ========== Net yield on earning assets (4) 4.49% 4.54% ========== ========== Ratio of earning assets to interest bearing liabilities 114.16% 116.03% ========== ========== Three Months Ended December 31, -------------------------------------- 2001 -------------------------------------- Average Average Yield/ Balance Interest Cost ---------- ---------- ---------- Interest earning assets: Loans receivable (1) $ 389,746 $ 7,715 7.92% Investment securities 54,583 865 6.34 Mortgage-backed securities 46,586 781 6.71 Other interest-earning assets 16,501 106 2.57 ---------- ---------- ---------- Total earning assets 507,416 9,467 7.46 ---------- ---------- Nonearning assets 39,658 ---------- Total assets $ 547,074 ========== Interest bearing liabilities: Time deposits $ 309,391 3,567 4.61 Demand deposits 102,827 465 1.81 Savings 19,126 48 1.00 FHLB advances 250 1 1.60 Trust preferred securities 0 0 0.00 Repurchase agreements 4,808 11 0.92 ---------- ---------- ---------- Total interest-bearing liabilities 436,402 4,092 3.75 Noninterest bearing demand deposits 43,035 0 0.00 ---------- ---------- ---------- Total sources of funds 479,437 4,092 3.41 ---------- ---------- Other liabilities and stockholders'equity: Other liabilities 16,584 Stockholders' equity 51,053 ---------- Total liabilities and stockholders' equity $ 547,074 ========== Net interest income $ 5,375 ========== Interest rate spread (3) 4.05% ========== Net yield on earning assets (4) 4.24% ========== Ratio of earning assets to interest bearing liabilities 116.27% ==========
(1) Includes classified loans. (2) Ratio calculations have been annualized. (3) Represents the difference between the yield on earning assets and the average cost of funds. (4) Represents the net interest income divided by average earning assets. 8 RESULTS OF OPERATIONS --------------------- COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2003 AND 2002 Total assets increased 7.5% to $675.8 million at December 31, 2003 from $628.5 million at December 31, 2002. Earning assets increased 7.1% to $617.7 million at December 31, 2003 from $576.6 million at December 31, 2002, reflecting growth in the commercial and consumer loan portfolio, growth in the Bank's leasing division and opening two new full service banking office. Earning assets were 91.3% of total assets at December 31, 2003, compared to 91.7% at December 31, 2002. Loans and lease receivables, net of loan loss reserves and deferred loan fees, increased 12.7% to $553.2 million at December 31, 2003 from $490.9 million at December 31, 2002. The Bank continues to emphasize the origination of both secured and unsecured commercial and consumer loans, in order to take advantage of shorter terms to maturity in managing its exposure to market and interest rate risk due to changes in interest rates. The Bank also sells selected mortgage loans in the secondary mortgage market in order to reduce interest rate and credit risk, while retaining servicing to generate additional fee income. The years ended December 31, 2003 and 2002 were advantageous periods selling mortgage loans due to increased origination and refinance volumes caused primarily by declining interest rates. Commercial loans and lease receivables increased 35.4% to $399.5 million at December 31, 2003 from $295.0 million at December 31, 2002. Consumer loans increased 9.3% to $89.5 million at December 31, 2003 from $81.9 million at December 31, 2002. This growth reflects the Bank's emphasis of structuring itself as a commercial banking entity. Commercial and consumer loans and lease receivables originations increased to $373.3 million during fiscal 2003, from $260.0 million during fiscal 2002. Residential real estate mortgage loans declined 40.2% to $72.9 million at December 31, 2003 from $122.0 million at December 31, 2002, reflecting the volume of loan sales, net of origination volume. The Bank sold $136.8 million of mortgage loans during fiscal 2003, compared to $87.2 million during fiscal 2002. Loans serviced for others were $288.9 million at December 31, 2003, compared to $262.5 million at December 31, 2002. During fiscal 2003, the Bank originated $172.4 million of residential mortgage loans, compared to $153.4 million during fiscal 2002. Investment securities and mortgage-backed securities declined 22.1% to $61.8 million at December 31, 2003, from $79.3 million at December 31, 2002. The Bank securitized $9.0 of million mortgage loans held for sale into mortgage-backed securities during fiscal 2003, compared to none securitized during fiscal 2002. The Bank sold $10.2 million of mortgage-backed securities during the 2003, compared to $6.2 million sold during fiscal 2002. In accordance with adopting new accounting standards, during fiscal 2002 the Company discontinued the amortization of its goodwill related to prior period acquisitions. Goodwill related to prior period acquisitions were $4.2 million at December 31, 2003 and 2002. The remaining unamortized balance of the Company's goodwill is tested for impairment at least annually. The Company has performed its annual impairment test and has determined that there has been no impairment of goodwill as of December 31, 2003 and December 31, 2002. Deposits increased 10.8% to $583.2 million at December 31, 2003 from $526.3 million at December 31, 2002. Certificates of deposit increased 8.9% to $335.0 million at December 31, 2003 from $307.8 million at December 31, 2002. The Bank continued to emphasize attracting lower cost core deposits, resulting in net checking account growth of 14.2% to $227.9 million at December 31, 2003 from $199.6 million at December 31, 2002. The Bank manages its cost of deposits by constantly monitoring the volume and rates being paid on maturing certificates of deposits in relationship to current funding needs and competitive market interest rates. During fiscal 2003 and 2002, the Bank has been repricing higher costing certificates of deposits at lower rates, and combined with the growth of lower costing core checking accounts, has provided an effective means of managing its deposit cost. Total borrowings were $29.3 million at December 31, 2003 compared to $38.2 million at December 31, 2002. FHLB advances and junior subordinated debentures, were $26.0 million at December 31, 2003, compared to $34.0 million of FHLB advances at December 31, 2002. Borrowings in the form of repurchase agreements were $3.3 million at December 31, 2003, compared to $4.2 million at December 31, 2002, representing funds held in cash management accounts for commercial banking customers. Stockholders' equity was $55.2 million at December 31, 2003, compared to $50.1 million at December 31, 2002. The consolidated equity to assets ratio was 8.2% and 8.0% at December 31, 2003 and December 31, 2002, respectively. 9 Accumulated other comprehensive income declined to $2.3 million at December 31, 2003 from $3.8 million at December 31, 2002, reflecting a decrease in unrealized gains on available for sale securities resulting from the sales of mortgage-backed securities discussed above. During the years ended December 31, 2003 and 2002, the Company declared four quarterly cash dividends each, totaling $0.80 and $0.68 per share respectively. These cash dividend payments reflect dividend payout ratios on basic earnings of 29.1% for fiscal 2003 and 31.2% for fiscal 2002. Future quarterly dividends will be determined at the discretion of the Board of Directors based upon earnings, the capital and financial condition of the Company, and general economic conditions. Pursuant to stock repurchase programs adopted by the Company during fiscal years 2003 and 2002, the Company acquired 100,982 and 260,450 shares of its common stock, respectively, through both open market and private purchases. Shares acquired under the repurchase program are being held as treasury stock, at cost. At December 31, 2003, treasury shares were 2,355,513 totaling $39.3 million, compared to 2,341,936 shares totaling $37.3 million at December 31, 2002. The Company believes the repurchase of its outstanding common stock will increase per share earnings and return on average equity, and decrease the potential dilutive effect caused by the exercise of stock options. During fiscal 2003 and 2002, 87,405 and 18,075 shares, respectively, were issued upon the exercise of stock options. COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2003 AND 2002 Net Income. Net income increased 20.0% to $11.4 million for the year ended December 30, 2003 from $9.5 million for the year ended December 31, 2002. Basic earnings per share increased 26.1% to $2.75 per share for the year ended December 31, 2003 from $2.18 per share for the year ended December 31, 2002. Diluted earnings per share increased 25.7% to $2.59 per share for the year ended December 31, 2003 from $2.06 per share for the year ended December 31, 2002. Weighted average basic shares outstanding were 4,153,719 and 4,364,925 and weighted average diluted shares outstanding were 4,402,928 and 4,628,434, respectively, for the years ended December 31, 2003 and 2002. Return on average assets and return on average equity were 1.8% and 22.1% respectively for fiscal 2003, compared to 1.6% and 18.4% for fiscal 2002. Interest Income. Interest income was $36.9 million for fiscal 2003 compared to $36.8 million for fiscal 2002. The decline in interest rates during 2003 offset by an increase in the volume of interest-earning assets enabled the Bank to maintain a consistent level of interest income. The average balance of interest-earning assets increased 11.1% to $595.7 million for fiscal 2003, from $536.2 million for fiscal 2002. The yield on average interest-earning assets declined to 6.2% for 2003 from 6.9% for 2002. Interest Expense. Interest expense declined 18.3% to $10.2 million for fiscal 2003 from $12.5 million for fiscal 2002. The decline in interest expense on deposits and borrowings reflects a lower cost of average interest-bearing liabilities due to the general decline in interest rates, offset by a significant growth in noninterest-bearing checking accounts. The average balance of interest-bearing liabilities increased 12.9% to $521.8 million for fiscal 2003 from $462.1 million for fiscal 2002. The average balance of noninterest-bearing deposits increased 33.4% to $64.8 million for fiscal 2003 from $48.6 million for fiscal 2002. The average cost of funds (including noninterest-bearing deposits) was 1.7% for 2003, compared to 2.4% for 2002, reflecting the general decline in interest rates during 2003. Net Interest Income. Net interest income increased 9.7% to $26.7 million for fiscal 2003 from $24.4 million for fiscal 2002. The increase in net interest income is attributable to the changes in interest rates during 2003, an increase in the volume of average interest-earning assets, and the increase in noninterest-bearing deposits. The net yield on interest-earning assets (net interest income divided by average interest-earning assets) was 4.5% for both fiscal 2003 and fiscal 2002. The Bank's interest rate spread (the difference between the effective yield on average interest-earning assets and the effective average cost of funds) was 4.5% for fiscal 2003, compared to 4.4% for fiscal 2002. See Table 2 - Rate/Volume Analysis and Table 3 - Yield/Cost Analysis above for additional information on interest income, interest expense, net interest income, average balances and yield/cost ratios. Provision for Loan Losses. The Bank maintains an allowance for losses on loans based upon management's evaluation of risk in the loan portfolio and past loan loss experience. The Bank provided $988,000 for loan losses during fiscal 2003, compared to $1.8 million for fiscal 2002. These provisions were necessary to absorb losses in the loan portfolio and to support the inherent risks associated with the growth in commercial and consumer loans discussed above. The allowance for loan losses was $7.6 million at December 31, 2003 and $7.0 million at December 31, 2002, which the Bank believes is adequate. The ratio of the allowance for loan losses to total loans was 1.4% at December 31, 2003 and December 31, 2002, respectively. 10 The Bank uses an analytical approach through a classification of assets program to determine the adequacy of its loan loss allowance and the necessary provision for loan losses. The loan portfolio is reviewed on a quarterly basis and delinquent loans are individually analyzed. Consideration is given to the loan status, payment history, repayment ability, probability of repayment, and loan-to-value percentages. Loans are classified in appropriate categories applicable to their circumstances as a result of this review and analysis. After reviewing current economic conditions, changes in delinquency status, and actual loan losses incurred by the Bank, management establishes an appropriate reserve percentage applicable to each category of assets, and provision for loan losses is recorded when necessary to bring the allowance to a level consistent with this analysis. The ratio of non-performing loans to total loans was .5% at December 31, 2003 and .3% at December 31, 2002. Noninterest Income. Noninterest income increased 24.1% to $10.5 million for fiscal 2003 from $8.5 million for fiscal 2002. Other income consists of fees and service charges on loans, service charges on deposit accounts, gains from sales of loans and mortgage backed securities, and other miscellaneous income. Loan fees and service charges increased 25.8% to $5.8 million for fiscal 2002 from $4.6 million for fiscal 2002, reflecting the growth of the commercial and consumer loan portfolios and the growth in checking accounts during fiscal 2003. Gains from sales of loans, investments and mortgage-backed securities increased 37.6% to $3.0 million for fiscal 2003 from $2.2 million for fiscal 2002. The volume of loans and mortgage-backed securities sold during fiscal 2003 was $153.7 million, compared to $92.9 million sold during fiscal 2002. These sales provided liquidity necessary to support the Bank's operating, financing and lending activities, as well as enabling the Bank to manage its interest rate exposure. Servicing fee income on loans serviced for others was $656,000 for fiscal 2003, compared to $691,000 for fiscal 2002. Noninterest Expenses. Noninterest expenses increased 10.0% to $18.0 million for fiscal 2003 from $16.3 million in fiscal 2002. The Company's efficiency ratio (noninterest expenses divided by net interest income plus noninterest income) improved to 48.3% for fiscal 2003 from 49.8% for fiscal 2002. The largest single component of these expenses is compensation and fringe benefits, which increased to $10.6 million for fiscal 2003 from $9.7 million for fiscal 2002. Full-time equivalent employees increased to 236 at December 31, 2003 from 228 at December 31, 2002. This growth is due to additional personnel resulting from opening two new full-service branch offices and administrative staff required to support the $47.4 million growth in assets during fiscal 2003. During fiscal 2002, the Company discontinued the amortization of goodwill related to prior period acquisitions. Therefore, no amortization expense was recorded during fiscal 2003 or fiscal 2002. The remaining $4.2 million unamortized balance of goodwill at December 31, 2003 has been tested for impairment on an annual basis. Data processing expense has grown proportionately with the growth in customer accounts and transaction activity primarily attributable to the growth in earning assets and deposits. Other noninterest expenses including advertising, deposit insurance, premises and equipment, repairs and maintenance, and office expenses have also grown proportionately from period to period with the growth in earning assets and deposit accounts. Income Taxes. The provision for income taxes increased 31.3% to $6.8 million for fiscal 2003 from $5.2 million for fiscal 2002. The increase in provision for income taxes is primarily the result of the 24.0% increase of pretax earnings to $18.3 million for fiscal 2003 from $14.7 million for fiscal 2002. The change in the amount of income tax provisions also reflects changes in other pretax income and expenses, the application of permanent and temporary differences, and the income tax rates in effect during each period. COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2002 AND 2001 Total assets increased 14.4% to $628.5 million at December 31, 2002 from $549.3 million at December 31, 2001. Earning assets increased 13.6% to $576.6 million at December 31, 2002 from $507.7 million at December 31, 2001, reflecting growth in the commercial loan and leasing portfolio and opening of a new full service banking office. Earning assets were 91.7% of total assets at December 31, 2002, compared to 92.4% at December 31, 2001. Loans and lease receivables, net of loan loss reserves and deferred loan fees, increased 21.0% to $490.9 million at December 31, 2002 from $405.6 million at December 31, 2001. Commercial loans and lease receivables increased 47.0% to $295.0 million at December 31, 2002 from $200.6 million at December 31, 2001. Consumer loans increased 5.3% to $81.9 million at December 31, 2002 from $77.8 million at December 31, 2001. This growth reflects the Bank's emphasis on commercial banking. Commercial and consumer loan originations increased to $255.7 million during fiscal 2002, from $122.3 million during fiscal 2001. 11 Residential real estate mortgage loans declined 8.6% to $122.0 million at December 31, 2002 from $133.4 million at December 31, 2001, reflecting sales and exchanges of loans, net of origination volume. The Bank sold or exchanged $87.2 million of mortgage loans during fiscal 2002, compared to $52.6 million during fiscal 2001. Loans serviced for others were $261.8 million at December 31, 2002, compared to $274.2 million at December 31, 2001. During fiscal 2002, the Bank originated $153.4 million of residential mortgage loans, compared to $115.6 million during fiscal 2001. Investment securities and mortgage-backed securities declined to $79.3 million at December 31, 2002, from $98.0 million at December 31, 2001. The Bank exchanged no mortgage loans held for sale into mortgage-backed securities during fiscal 2002, compared to $12.3 million exchanged in fiscal 2001. The Bank sold $6.2 million of mortgage-backed securities during the 2002, compared to $63.2 million sold during fiscal 2001. The mortgage-backed securities portfolio declined to $23.5 million at December 31, 2002 from $43.9 million at December 31, 2001. During fiscal 2002 the Company discontinued the amortization of its goodwill related to prior period acquisitions, pursuant to adopting new accounting standards. Goodwill related to prior period acquisitions was $4.2 million at December 31, 2002 and 2001. During the year ended December 31, 2002, no amortization expense was recorded, compared to $517,000 for the year ended December 31, 2001. The remaining unamortized balance of intangible assets of $4.2 million at December 31, 2002 will be tested annually for impairment. The Company performed its annual impairment test and determined there was no impairment of goodwill as of December 31, 2002. Deposits increased 10.7% to $526.3 million at December 31, 2002 from $475.6 million at December 31, 2001. Certificates of deposit increased to $307.8 million at December 31, 2002 from $304.2 million at December 31, 2001. The Bank emphasized growing lower costing core deposits, as checking accounts increased 30.8% to $199.6 million at December 31, 2002 from $152.6 million at December 31, 2001. During 2002, the Bank has managed its cost of deposits by allowing certain high rate certificates of deposit to mature amid increasingly competitive market interest rates, offset by the growth in checking accounts. The Bank also repriced higher costing certificates of deposits at lower rates, and combined with checking account growth, was effectively able to manage its deposit cost. Total borrowings were $38.2 million at December 31, 2002 compared to $5.4 million at December 31, 2001. FHLB advances used primarily to fund loan originations were $34.0 million at December 31, 2002, compared to $1.0 million at December 31, 2001. Borrowings in the form of repurchase agreements were $4.2 million at December 31, 2002, compared to $4.4 million at December 31, 2001. Stockholders' equity was $50.1 million at December 31, 2002, compared to $51.0 million at December 31, 2001. The ratio equity to total assets declined to 8.0% at December 31, 2002 from 9.3% at December 31, 2001, reflecting the Company's 14.4% asset growth, 47.0% commercial loan growth, and the impact of the stock repurchase program during fiscal 2002. Accumulated other comprehensive income was $3.8 million at December 31, 2002, compared to $2.6 million at December 31, 2001, reflecting an increase in unrealized gains on available for sale securities due primarily to declining market rates. During the years ended December 31, 2002 and 2001, the Company declared four quarterly cash dividends each, totaling $0.68 and $0.48 per share respectively. These cash dividend payments reflect dividend payout ratios on basic earnings of 31.2% for fiscal 2002 and 61.5% for fiscal 2001. These cash dividend payments, combined with the appreciation in the market price of the Company's common stock, resulted in total return to shareholders of 63.0% for fiscal 2002, compared to 46.7% for fiscal 2001. Pursuant to stock repurchase programs adopted by the Company, during fiscal years 2002 and 2001 the Company acquired 260,450 and 239,846 shares of its common stock, respectively, which are being held as treasury stock, at cost. At December 31, 2002, treasury shares were 2,341,936 totaling $37.3 million, compared to 2,099,561 shares totaling $28.7 million at December 31, 2001. During fiscal 2002 and 2001, 18,075 and 37,725 shares, respectively, were issued upon the exercise of stock options. COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 2002 AND 2001 (UNAUDITED) Effective as of December 31, 2001, the Company terminated its Employee Stock Ownership Plan ("ESOP") and incurred a one-time non-tax deductible charge of $3.1 million related to the ESOP termination. As a result of the ESOP termination, the Company reduced its ESOP expense to none for the year ended December 31, 2002 from $4.2 million for the year ended December 31, 2001. During the year ended December 31, 2001, the Company incurred $1.1 million of ESOP expense in 12 addition to the one-time termination charge. For future periods the Company will not incur any further charges related to the ESOP. The Company believes the benefits of the ESOP were not sufficient to justify the ongoing annual expense incurred to maintain it and the cost savings achieved in future periods will more than compensate for the one-time termination charge. Net Income. Net income increased to $9.5 million for the year ended December 30, 2002 from $3.3 million for the year ended December 31, 2001. Diluted earnings per share increased to $2.06 per share for the year ended December 31, 2002 from $.75 per share for the year ended December 31, 2001. Had the Company not incurred the one-time ESOP termination expense, net income for the year ended December 31, 2001 would have been $6.5 million and diluted earnings per share would have been $1.45 per share. The average number of diluted shares outstanding (net of treasury shares) was 4,628,434 and 4,472,062 for the years ended December 31, 2002 and 2001. Return on average assets and return on average equity were 1.6% and 18.4% respectively for fiscal 2002, compared to .6% and 6.9% for fiscal 2001. Return on average assets and return on average equity for fiscal 2001, excluding the ESOP termination, would have been 1.2% and 13.3%, respectively. Interest Income. Interest income declined 8.7% to $36.8 million for fiscal 2002 from $40.3 million for fiscal 2001. The decline in interest income on loans and investments during 2002 results from a lower yield on earning assets due to the general decline in interest rates. The average balance of interest-earning assets increased 5.3% to $536.2 million for fiscal 2002, from $509.1 million for fiscal 2001. The yield on average interest-earning assets declined to 6.9% for 2002 from 7.9% for 2001. Interest Expense. Interest expense declined 37.4% to $12.5 million for fiscal 2002 from $19.9 million for fiscal 2001. The decline in interest expense on deposits and borrowings reflects a lower cost of average interest-bearing liabilities due to the general decline in interest rates and the significant growth in lower costing core checking accounts discussed above. The average balance of interest-bearing liabilities increased 4.6% to $462.1 million for fiscal 2002 from $441.9 million for fiscal 2001. The average balance of noninterest-bearing deposits increased 20.8% to $48.6 million for fiscal 2002 from $40.2 million for fiscal 2001. The average cost of funds (including noninterest-bearing deposits) was 2.4% for 2002, compared to 4.1% for 2001, reflecting the general decline in interest rates during 2002. Net Interest Income. Net interest income increased 19.2% to $24.4 million for fiscal 2002 from $20.4 million for fiscal 2001. The increase in net interest income is primarily due to the decline in interest rates during 2002, an increase in the volume of average interest-earning assets, and the increase in noninterest-bearing deposits. The net yield on interest-earning assets was 4.5% for fiscal 2002, compared to 4.0% for fiscal 2001. The Bank's interest rate spread was 4.4% for fiscal 2002, compared to 3.8% for 2001. See Table 2 - Rate/Volume Analysis and Table 3 - Yield/Cost Analysis above for additional information on interest income, interest expense, net interest income, average balances and yield/cost ratios. Provision for Loan Losses. The Bank maintains an allowance for losses on loans based upon management's evaluation of risk in the loan portfolio, the Bank's past loan loss experience, and current economic conditions. The Bank provided $1.8 million for loan losses during fiscal 2002, compared to $590,000 for fiscal 2001. These provisions were necessary absorb losses in the loan portfolio, to support increased risks associated with a 47.0% growth in the commercial loan portfolio during fiscal 2002, and the overall increase in the loan portfolio. The allowance for loan losses was $7.0 million at December 31, 2002, compared to $5.4 million at December 31, 2001. The ratio of the allowance for loan losses to total loans was 1.4% at December 31, 2002 and 1.3% at December 31, 2001. The ratio of non-performing loans to total loans was .3% at December 31, 2002 and 2001. Noninterest Income. Noninterest income increased 19.2% to $8.5 million for fiscal 2002 from $7.1 million for fiscal 2001. Loan fees and service charges increased 24.7% to $4.6 million for fiscal 2002 from $3.7 million for fiscal 2001, reflecting the growth of the commercial and consumer loan portfolios and the growth in checking accounts during fiscal 2002. Gains from the sale of loans and mortgage-backed securities increased to $2.2 million for fiscal 2002 from $1.8 million for fiscal 2001. The volume of loans and mortgage-backed securities sold during 2002 was $92.9 million, compared to $115.5 million for 2001, reflecting the Bank's efforts of managing its interest rate exposure. Servicing fee income was $691,000 for 2002, compared to $763,000 for 2001, as loans serviced for others declined to $261.8 million at December 31, 2002 from $274.2 million at December 31, 2001. Noninterest Expenses. Noninterest expenses declined 15.4% to $16.3 million for fiscal 2002 from $19.3 million in fiscal 2001. The Company's efficiency ratio (noninterest expenses divided by net interest income plus noninterest income) improved to 49.8% for fiscal 2002 from 70.2% for fiscal 2001. Had the Company not incurred the one-time ESOP termination expense, the efficiency ratio for fiscal 2001 would have been 58.7%. 13 The largest single component of these expenses is compensation and fringe benefits, which was $9.7 million for both fiscal 2002 and 2001 respectively. During fiscal 2001, the Company incurred $1.1 million of ESOP expense in addition to the one-time termination charge. For future periods the Company will not incur any further charges related to the ESOP. Full-time equivalent employees increased to 228 at December 31, 2002 from 218 at December 31, 2001. This growth is due to additional personnel resulting from opening a new full-service branch office, a new loan production office and administrative staff required to support the 14.3% growth in asset during fiscal 2002. During fiscal 2002, the Company discontinued the amortization of intangible assets related to prior period acquisitions. No amortization expense was recorded during fiscal 2002, compared to $517,000 during 2001. Data processing expense has grown proportionately with the growth in customer accounts and transaction activity primarily attributable to the growth in earning assets and deposits from the prior year acquisitions. Other noninterest expenses including advertising, deposit insurance, premises and equipment, repairs and maintenance, and office expenses have also grown proportionately from period to period with the growth in earning assets and checking accounts. Income Taxes. The provision for income taxes increased to $5.2 million for fiscal 2002 from $4.3 million for fiscal 2001. The increase in provision for income taxes is the result of the increase of pretax earnings to $14.7 million for fiscal 2002 from $7.6 million for fiscal 2001, which included the $3.1 million one-time ESOP termination charge which was not tax deductible. The change in the amount of income tax provisions also reflects changes in other pretax income and expenses, the application of permanent and temporary differences, and the income tax rates in effect during each period. IMPACT OF INFLATION AND CHANGING PRICES. The financial statements of the Bank and accompanying footnotes have been prepared in accordance with generally accepted accounting principles. They 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 and due to inflation. The impact of inflation is reflected in the increased cost of the Bank's operations. Unlike most industrial companies, nearly all the assets and liabilities of the Bank are monetary. As a result, interest rates have a greater impact on the Bank's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the price of goods and services. FORWARD LOOKING STATEMENTS. The Private Securities Litigation Reform Act of 1995 states that the disclosure of forward looking information is desirable for investors and encourages such disclosure by providing a safe harbor for forward looking statements by corporate management. This Annual Report, including the Letter to Stockholders and Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward looking statements that involve risk and uncertainty. In order to comply with the terms of the safe harbor, the Company notes that a variety of risks and uncertainties could cause its actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company's forward looking statements. There are risks and uncertainties that may affect the operations, performance, development, growth projections and results of the Company's business. They include, but are not limited to, economic growth, interest rate movements, timely development of technology enhancements for products, services and operating systems, the impact of competitive products, services and pricing, customer requirements, regulatory changes and similar matters. Readers of this report are cautioned not to place undue reliance on forward looking statements that are subject to influence by these risk factors and unanticipated events. Accordingly, actual results may differ materially from management's expectations. 14 REPORT OF INDEPENDENT AUDITORS To the Board of Directors First South Bancorp, Inc. Washington, North Carolina In our opinion, the accompanying consolidated statements of financial condition and the related consolidated statements of operations, of changes in stockholders' equity and of cash flows present fairly, in all material respects, the financial position of First South Bancorp, Inc. and Subsidiary (the "Company") at December 31, 2003 and 2002, and the results of their operations and their cash flows for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PricewaterhouseCoopers, LLP March 4, 2004 15 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2003 AND 2002 --------------------------------------------------------------------------------
2003 2002 ASSETS Cash and due from banks $ 34,299,553 $ 30,540,790 Interest-bearing deposits in financial institutions 625,051 3,931,369 Investment securities - available for sale 50,071,520 55,786,842 Mortgage-backed securities - available for sale 11,715,052 23,526,435 Loans receivable, net Held for sale 10,924,148 38,664,967 Held for investment 542,275,778 452,248,942 Premises and equipment, net 7,922,588 7,825,003 Real estate owned 130,798 401,632 Federal Home Loan Bank of Atlanta stock, at cost which approximates market 2,127,200 2,402,500 Accrued interest receivable 3,073,093 3,403,195 Goodwill 4,218,576 4,218,576 Mortgage servicing rights 1,886,522 1,642,172 Prepaid expenses and other assets 5,313,528 2,544,807 Note receivable 1,252,703 1,336,194 ------------- ------------- Total assets $ 675,836,110 $ 628,473,424 ============= ============= LIABILITIES AND STOCKHOLDERS' EQUITY Deposits Demand $ 227,863,599 $ 199,615,945 Savings 20,292,472 18,950,380 Large denomination certificates of deposit 107,354,231 80,021,790 Other time 227,662,871 227,739,049 ------------- ------------- Total deposits 583,173,173 526,327,164 Borrowed money 19,338,059 38,194,727 Junior subordinated debentures 10,000,000 -- Deferred income taxes 1,114,567 -- Other liabilities 7,046,758 13,851,721 ------------- ------------- Total liabilities 620,672,557 578,373,612 Commitments and contingencies (Note 15) Common stock, $.01 par value, 8,000,000 shares authorized, 6,545,848 shares issued at December 31, 2003 and 2002 65,458 65,458 Additional paid-in capital 48,997,077 48,466,569 Retained earnings, substantially restricted 43,171,318 35,086,795 Treasury stock at cost, 2,355,513 and 2,341,936 shares at December 31, 2003 and 2002, respectively (39,326,931) (37,317,469) Accumulated other comprehensive income, net 2,256,631 3,798,459 ------------- ------------- Total stockholders' equity 55,163,553 50,099,812 ------------- ------------- Total liabilities and stockholders' equity $ 675,836,110 $ 628,473,424 ============= =============
The accompanying notes are an integral part of these consolidated financial statements. 16 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 2003 AND 2002, THREE MONTHS ENDED DECEMBER 31, 2001 AND YEAR ENDED SEPTEMBER 30, 2001 --------------------------------------------------------------------------------
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 Interest income Interest and fees on loans $ 32,394,236 $ 30,908,736 $ 7,714,883 $ 32,759,752 Interest and dividends on investments and deposits 4,510,861 5,917,460 1,752,656 9,399,416 ------------ ------------ ------------ ------------ Total interest income 36,905,097 36,826,196 9,467,539 42,159,168 ------------ ------------ ------------ ------------ Interest expense Interest on deposits 9,964,663 12,404,022 4,080,585 21,154,382 Interest on borrowings 113,742 69,513 11,630 1,013,660 Interest on junior subordinated notes 107,930 -- -- -- ------------ ------------ ------------ ------------ Total interest expense 10,186,335 12,473,535 4,092,215 22,168,042 ------------ ------------ ------------ ------------ Net interest income before provision for loan losses 26,718,762 24,352,661 5,375,324 19,991,126 Provision for loan losses 987,919 1,756,000 -- 830,000 ------------ ------------ ------------ ------------ Net interest income 25,730,843 22,596,661 5,375,324 19,161,126 ------------ ------------ ------------ ------------ Other income Loan fees and service charges 5,827,002 4,631,839 1,108,324 3,357,623 Loan servicing fees 655,759 691,197 198,358 766,301 Gain on sale of real estate, net 167,322 73,766 4,929 261,031 Gain on sale of mortgage loans and mortgage- backed securities 3,008,816 2,185,998 191,842 1,800,429 Other income 842,643 879,867 121,532 590,218 ------------ ------------ ------------ ------------ Total other income 10,501,542 8,462,667 1,624,985 6,775,602 ------------ ------------ ------------ ------------ General and administrative expenses Compensation and fringe benefits 10,601,978 9,720,932 2,236,299 9,667,115 ESOP termination expense -- -- 3,143,467 -- Federal insurance premiums 86,858 84,604 21,470 91,074 Premises and equipment 1,522,456 1,320,811 294,588 1,021,167 Advertising 204,614 210,403 25,989 208,950 Payroll and other taxes 955,050 861,618 179,738 737,267 Data processing 1,920,239 1,776,503 418,539 1,526,827 Amortization of mortgage servicing rights 242,012 152,087 26,674 62,668 Amortization of goodwill -- -- 129,358 517,410 Other 2,445,475 2,210,409 499,520 2,214,423 ------------ ------------ ------------ ------------ Total general and administrative expenses 17,978,682 16,337,367 6,975,642 16,046,901 ------------ ------------ ------------ ------------ Income before income taxes 18,253,703 14,721,961 24,667 9,889,827 Income taxes 6,840,707 5,210,349 1,164,640 4,059,535 ------------ ------------ ------------ ------------ NET INCOME (LOSS) 11,412,996 9,511,612 (1,139,973) 5,830,292 Other comprehensive income (loss), net of taxes (1,541,828) 1,149,963 (815,901) 4,726,804 ------------ ------------ ------------ ------------ Comprehensive income (loss) $ 9,871,168 $ 10,661,575 $ (1,955,874) $ 10,557,096 ------------ ------------ ------------ ------------ Net income (loss) per common share Basic $ 2.75 $ 2.18 $ (.26) $ 1.34 ------------ ------------ ------------ ------------ Diluted $ 2.59 $ 2.06 $ (.26) $ 1.30 ------------ ------------ ------------ ------------
The accompanying notes are an integral part of these consolidated financial statements. 17 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2003 AND 2002, THREE MONTHS ENDED DECEMBER 31, 2001 AND THE YEAR ENDED SEPTEMBER 30, 2001 --------------------------------------------------------------------------------
RETAINED ADDITIONAL EARNINGS, COMMON PAID-IN SUBSTANTIALLY TREASURY STOCK CAPITAL RESTRICTED STOCK -------------- --------------- -------------- -------------- BALANCE, SEPTEMBER 30, 2000 43,640 44,583,318 26,327,863 (23,039,101) Net income - - 5,830,292 - Other comprehensive income, net of taxes - - - - Exercise of stock options - (25,823) - 386,687 Acquisition of treasury shares - - - (4,253,215) Dividends ($.67 per share) - - (1,936,091) - Release of ESOP shares - 745,910 - - -------------- --------------- -------------- -------------- BALANCE, SEPTEMBER 30, 2001 43,640 45,303,405 30,222,064 (26,905,629) -------------- --------------- -------------- -------------- Net loss - - (1,139,973) - Other comprehensive loss, net of taxes - - - - Exercise of stock options - (10,235) - 110,610 Acquisition of treasury shares - - - (1,908,513) Dividends ($.18 per share) - - (533,581) - Release of ESOP shares - 3,201,097 - - -------------- --------------- -------------- -------------- BALANCE, DECEMBER 31, 2001 43,640 48,494,267 28,548,510 (28,703,532) -------------- --------------- -------------- -------------- Net income - - 9,511,613 - Other comprehensive income, net of taxes - - - - Exercise of stock options - (27,698) - 255,814 Acquisition of treasury shares - - - (8,869,751) Dividends ($.68 per share) - - (2,945,698) - 3 for 2 stock split 21,818 - (27,630) - -------------- --------------- -------------- -------------- BALANCE, DECEMBER 31, 2002 65,458 $48,466,569 $35,086,795 $(37,317,469) -------------- --------------- -------------- -------------- Net income 11,412,996 Other comprehensive income, net of taxes Exercise of stock options 530,508 1,454,189 Acquisition of treasury shares (3,463,652) Dividends ($.68 per share) (3,328,473) -------------- --------------- -------------- -------------- BALANCE, DECEMBER 31, 2003 65,458 $48,997,077 $43,171,318 $(39,326,931) -------------- --------------- -------------- -------------- ACCUMULATED OTHER UNEARNED COMPREHENSIVE ESOP INCOME (LOSS), SHARES NET TOTAL ----------------- ------------------ ------------- BALANCE, SEPTEMBER 30, 2000 (1,818,578) (1,262,407) 44,834,735 Net income - - 5,830,292 Other comprehensive income, net of taxes - 4,726,804 4,726,804 Exercise of stock options - - 360,864 Acquisition of treasury shares - - (4,253,215) Dividends ($.67 per share) - - (1,936,091) Release of ESOP shares 459,319 - 1,205,229 ----------------- ------------------ ------------- BALANCE, SEPTEMBER 30, 2001 (1,359,259) 3,464,397 50,768,618 ----------------- ------------------ ------------- Net loss - - (1,139,973) Other comprehensive loss, net of taxes - (815,901) (815,901) Exercise of stock options - - 100,375 Acquisition of treasury shares - - (1,908,513) Dividends ($.18 per share) - - (533,581) Release of ESOP shares 1,359,259 - 4,560,356 ----------------- ------------------ ------------- BALANCE, DECEMBER 31, 2001 - 2,648,496 51,031,381 ----------------- ------------------ ------------- Net income - - 9,511,613 Other comprehensive income, net of taxes - 1,149,963 1,149,963 Exercise of stock options - - 228,116 Acquisition of treasury shares - - (8,869,751) Dividends ($.68 per share) - - (2,945,698) 3 for 2 stock split - - (5,812) ----------------- ------------------ ------------- BALANCE, DECEMBER 31, 2002 $ - $ 3,798,459 $ 50,099,812 ----------------- ------------------ ------------- Net income 11,412,996 Other comprehensive income, net of taxes (1,541,828) (1,541,828) Exercise of stock options 1,984,697 Acquisition of treasury shares (3,463,652) Dividends ($.68 per share) (3,328,473) ----------------- ------------------ ------------- BALANCE, DECEMBER 31, 2003 $ - $ 2,256,631 $ 55,163,553 ----------------- ------------------ -------------
The accompanying notes are an integral part of these consolidated financial statements. 18 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 2003 AND 2002, THREE MONTHS ENDED DECEMBER 31, 2001 AND YEARS ENDED SEPTEMBER 30, 2001 --------------------------------------------------------------------------------
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 ------------- ------------- ------------- ------------- Operating activities Net income (loss) $ 11,412,996 $ 9,511,613 $ (1,139,973) $ 5,830,292 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities Provision for loan losses 987,919 1,756,000 -- 830,000 Depreciation 686,047 654,936 145,271 486,194 Impairment of servicing asset 680,622 246,073 Impairment of real estate owned 125,000 237,000 ESOP compensation -- -- 3,225,564 1,205,229 Amortization of discounts on securities, net (160,598) (186,528) -- (103,388) Benefit from deferred income taxes -- 477,214 (46,632) (376,950) Gain on disposal of premises and equipment and real estate owned (163,391) (158,375) (4,239) (261,031) Gain on loans held for sale and mortgage- backed securities (3,008,816) (2,185,998) (191,842) (1,800,429) Originations of loans held for sale, net (115,312,138) (94,692,353) (20,657,550) (36,102,872) Proceeds from sale of loans held for sale 136,817,940 87,194,106 12,016,957 37,087,531 Other operating activities (8,082,909) (5,200,274) 3,530,322 1,517,679 ------------- ------------- ------------- ------------- Net cash (used in) provided by operating activities 23,982,672 (2,346,586) (3,122,122) 8,312,255 ------------- ------------- ------------- ------------- Investing activities Proceeds from maturities of investment securities available for sale 4,000,000 -- 4,066,850 -- Purchases of investment securities -- -- -- (5,000,000) Proceeds from principal repayments and sales of mortgage-backed securities available for sale 20,444,317 20,982,429 -- 76,061,309 Originations of loans held for investment, net of principal repayments (91,482,955) (81,835,982) (23,020,190) (21,529,591) Proceeds from disposal of premises and equipment and real estate owned 781,975 1,286,890 187,570 705,310 Proceeds from sale of credit card portfolio -- 3,299,080 -- -- Sales (purchases) of FHLB stock 275,300 310,000 -- (61,200) Purchases of premises and equipment (788,182) (773,420) (158,498) (1,224,834) Repayment of note receivable 83,491 28,189 6,623 25,045 ------------- ------------- ------------- ------------- Net cash (used in) provided by investing activities (66,686,054) (56,702,814) (18,917,645) 48,976,039 ------------- ------------- ------------- ------------- Financing activities Net increase (decrease) in deposit accounts 56,846,009 50,738,659 3,649,597 (2,759) Proceeds from FHLB borrowings 219,400,000 84,500,000 1,000,000 72,200,000 Repayments of FHLB borrowings (237,400,000) (51,500,000) -- (96,200,000) Purchase of treasury shares (3,463,652) (8,875,563) (573,721) (4,253,215) Proceeds from junior subordinated notes 10,000,000 -- -- -- Proceeds from exercise of stock options 1,984,697 228,116 100,375 360,863 Cash dividends paid (3,328,473) (2,945,698) (518,511) (1,936,091) Net change in escrow accounts (26,087) (60,424) 83,823 (271,035) Net change in repurchase agreements (856,668) (246,613) (468,157) (1,478,054) ------------- ------------- ------------- ------------- Net cash provided by (used in) financing activities 43,155,827 71,838,477 3,273,406 (31,580,291) ------------- ------------- ------------- ------------- Increase (decrease) in cash and cash equivalents 452,445 12,789,077 (18,766,361) 25,708,003 Cash and cash equivalents, beginning of year 34,472,159 21,683,082 40,449,443 14,741,440 ------------- ------------- ------------- ------------- Cash and cash equivalents, end of year $ 34,924,604 $ 34,472,159 $ 21,683,082 $ 40,449,443 ------------- ------------- ------------- -------------
The accompanying notes are an integral part of these consolidated financial statements. 19 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- 1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES ORGANIZATION AND NATURE OF OPERATIONS First South Bancorp, Inc. (the "Company") is a bank holding company incorporated under the laws of the State of Virginia. First South Bank (the "Bank"), the wholly owned subsidiary of the Company, is organized and incorporated under the laws of the state of North Carolina. The Federal Reserve Board regulates the Company and the Federal Deposit Insurance Corporation and the North Carolina Office of the Commissioner of Banks regulate the Bank. The consolidated financial statements include the accounts of the Company, the Bank, and the Bank's wholly owned subsidiary, First South Leasing, LLC. All significant intercompany balances and transactions have been eliminated in consolidation. The Company follows accounting principles generally accepted in the United States of America and general practices within the financial services industry as summarized below: USE OF ESTIMATES The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS Cash and cash equivalents include demand and time deposits (with remaining maturities of ninety days or less at time of purchase) at other financial institutions and federal funds sold. Generally, federal funds are purchased and sold for one-day periods. INVESTMENTS AND MORTGAGE-BACKED SECURITIES Investments in certain securities are classified into three categories and accounted for as follows: (1) debt securities that the entity has the positive intent and the ability to hold to maturity are classified as held-to-maturity and reported at amortized cost; (2) debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings; (3) debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available for sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported as accumulated other comprehensive income, a separate component of equity. At December 31, 2003 and 2002, the Bank has classified all investments as available for sale. Premiums and discounts on debt securities are recognized as interest income using the interest method over the period to maturity. Mortgage-backed securities represent participating interests in pools of long-term first mortgage loans. Premiums and discounts are amortized using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments. Gains and losses on the sale of securities are determined using the specific identification method. 20 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES Loans receivable held for investment are stated at the amount of unpaid principal, reduced by an allowance for probable loan losses and net of deferred origination fees. Interest on loans is accrued based on the principal amount outstanding and is recognized using the interest method. Loan origination fees, as well as certain direct loan origination costs, are deferred. Such costs and fees are recognized as an adjustment to yield over the contractual lives of the related loans. Commitment fees to originate or purchase loans are deferred, and if the commitment is exercised, recognized over the life of the loan as an adjustment of yield. If the commitment expires unexercised, commitment fees are recognized in income upon expiration of the commitment. Fees for originating loans for other financial institutions are recognized as loan fee income. A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. The Bank uses several factors in determining if a loan is impaired. Internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payment status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, etc. At December 31, 2003, there were no individual loans material to the consolidated financial statements which were defined as impaired. At December 31, 2002, one loan with an outstanding balance of $124,000 was considered to be impaired. The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management's periodic evaluation of the adequacy of the allowance is based on the Bank's past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. While management believes that it has established the allowance in accordance with accounting principles generally accepted in the United States of America and has taken into account the views of its regulators and the current economic environment, there can be no assurance that in the future the Bank's regulators or risks in its portfolio will not require further increases in the allowance. LOANS HELD FOR SALE Loans originated and intended for sale are carried at the lower of cost or aggregate estimated market value. Net unrealized losses are recognized as charges to income. Gains and losses on sales of whole or participating interests in real estate loans are recognized at the time of sale and are determined by the difference between net sales proceeds and the Bank's carrying value of the loans sold, adjusted for the recognition of any servicing assets retained. INCOME RECOGNITION ON IMPAIRED AND NONACCRUAL LOANS Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as 21 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- doubtful or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of interest and principal. While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding, except in the case of loans with scheduled amortization where the payment is generally applied to the oldest payment due. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. MORTGAGE SERVICING RIGHTS When mortgage loans, or mortgage-backed securities, are sold, the proceeds are allocated between the related loans and the retained mortgage servicing rights based on their relative fair values. Servicing assets and liabilities are amortized over the average period of estimated net servicing income (if servicing revenue exceed servicing cots) or net servicing loss (if servicing costs exceed servicing revenues). All servicing assets or liabilities are assessed for impairment or increased obligation based on their fair value. The Company recorded impairment to servicing assets of $680,622 and $246,074 for prepayments during the years ended December 31, 2003 and 2002, respectively. There were no impairments recognized during the three months ended December 31, 2001 or the year ended September 30, 2001 related to mortgage servicing rights. PREMISES AND EQUIPMENT Premises and equipment are stated at cost less accumulated depreciation or amortization, if a capital lease. Depreciation and amortization are computed using the straight-line method based on the estimated service lives of the assets. Useful lives range from 10 to 40 years for substantially all premises and from 3 to 20 years for equipment and fixtures. REAL ESTATE OWNED Assets acquired through loan foreclosure are recorded as real estate owned at the lower of the estimated fair value of the property less estimated costs to sell at the date of foreclosure or the carrying amount of the loan plus unpaid accrued interest. The carrying amount is subsequently reduced by additional allowances which are charged to earnings if the estimated fair value declines below its initial value plus any capitalized costs. Costs related to the improvement of the property are capitalized, whereas costs related to holding the property are expensed. The Company recognized valuation adjustments of $125,000 and $237,000 during the years ended December 31, 2003 and 2002, respectively. 22 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- INVESTMENT IN FEDERAL HOME LOAN BANK STOCK The Bank is required to invest in stock of the Federal Home Loan Bank of Atlanta ("FHLB") in the amount of 1% of its outstanding home loans or 5% of its outstanding advances from the FHLB, whichever is greater. At December 31, 2003 and 2002, the Bank owned 21,272 and 24,025 shares of the FHLB's $100 par value capital stock, respectively. GOODWILL AND INTANGIBLE ASSETS Net assets of companies acquired in purchase transactions are recorded at fair value at the date of acquisition, as such, the historical cost basis of individual assets and liabilities are adjusted to reflect their fair value. Identified intangibles are amortized on a straight-line basis over the period benefited. Goodwill is not amortized, but is reviewed for potential impairment on an annual basis at the reporting unit level. The impairment test is performed in two phases. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of the reporting unit with its carrying amount, including goodwill. If the fair value of the reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired; however, if the carrying amount of the reporting unit exceeds its fair value an additional procedure must be performed. That additional procedure compares the implied fair value of the reporting unit's goodwill (as defined in SFAS No. 142) with the carrying amount of that goodwill. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. Other intangible assets are evaluated for impairment if events and circumstances indicate a possible impairment. Such evaluation of other intangible assets is based on undiscounted cash flow projections. INCOME TAXES The Company reports income taxes in accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes," ("SFAS No. 109") which requires the recognition of deferred tax assets and liabilities for the temporary difference between financial statement and tax basis of the Company's assets and liabilities using the enacted tax rates in effect in the years in which the differences are expected to reverse. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. ADVERTISING Advertising costs are expensed as incurred. For the years ended December 31, 2003 and 2002, the three months ended December 31, 2001, and the year ended September 30, 2001, the Company incurred advertising expense totaling $204,614, $210,403, $25,989, and $208,950, respectively. 23 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- COMPREHENSIVE INCOME The Company's other comprehensive income relates to unrealized gains (losses) on available for sale securities. Information concerning the Company's other comprehensive income (loss) for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001, is as follows:
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 ----------- ----------- ----------- ----------- Unrealized gains (losses) on securities available for sale $(2,195,082) $ 2,144,112 $(1,359,836) $ 8,299,802 Reclassification of net gains recognized in net income (291,738) (302,315) -- (421,792) Income tax (expense) benefit relating to unrealized (losses) gains on available for sale securities 944,992 (691,834) 543,935 (3,151,206) ----------- ----------- ----------- ----------- Other comprehensive income (loss), net $(1,541,828) $ 1,149,963 $ (815,901) $ 4,726,804 =========== =========== =========== ===========
SEGMENT INFORMATION The Company follows the provisions of SFAS No. 131, "Disclosure About Segments of an Enterprise and Related Information," which specifies guidelines for determining an entity's operating segments and the type and level of financial information to be disclosed. Based on these guidelines management has determined that the Bank operates in one business segment, the providing of general commercial financial services to customers located in its market areas. The various products are those generally offered by community banks. The allocation of Bank resources is based on overall performance of the Bank, rather than individual branches or products. NEW ACCOUNTING PRONOUNCEMENTS In April 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 149 "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS No. 149"). FASB Statements No. 133 "Accounting for Derivative Instruments and Hedging Activities" and No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities", establish accounting and reporting standards for derivative instruments including derivatives embedded in other contracts (collectively referred to as derivatives) and for hedging activities. SFAS No. 149 amends Statement 133 for certain decisions made by the Board as part of the Derivatives Implementation Group (DIG) process. This Statement contains amendments relating to FASB Concepts Statement No. 7, "Using Cash Flow Information and Present Value in Accounting Measurements", and FASB Statements No. 65, "Accounting for Certain Mortgage Banking Activities", No. 91 "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases", No. 95, "Statement of Cash Flows", and No. 126, "Exemption from Certain Required Disclosures about Financial Instruments for Certain Nonpublic Entities". The provisions of SFAS No. 149 are effective for contracts entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did not have any material impact on the Company's financial statements or results of operations. 24 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- In May 2003, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 150 "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS No. 150"). SFAS No. 150 establishes standards for classification and measurement in the statement of financial position of certain financial instruments with characteristics of both liabilities and equity. It requires classification of a financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise shall be effective on July 1, 2003. The adoption of SFAS No. 150 did not have any material impact on the Company's financial statements or results of operations. In January 2003, the Financial Accounting Standards Board issued Financial Accounting Series FASB Interpretation No. 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51" ("FIN No. 46"). The primary objective of the Interpretation is to provide guidance on the identification of, and financial reporting for, entities over which control is achieved through means other than voting rights; such entities are known as variable-interest entities (VIEs). FIN No. 46 has far-reaching effects and applies immediately to new entities created after January 31, 2003, as well as applies to existing entities in which an enterprise obtains an interest after that date. The provisions of FIN No. 46 are effective at the end of the first interim or annual period ending after December 15, 2003, to variable-interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 is the guidance that determines (1) whether consolidation is required under the "controlling financial interest" model of Accounting Research Bulletin No. 51, "Consolidated Financial statements", or other existing authoritative guidance, or, alternatively, (2) whether the variable-interest model under FIN No. 46 should be used to account for existing and new entities. The adoption of FIN No. 46 did not have any material impact on the Company's financial statements or results of operations. In December 2003, the FASB reissued FIN 46 with certain modifications and clarifications. Application of this guidance was effective for interests in certain VIEs commonly referred to as special-purpose entities (SPEs) as of December 31, 2003. Application for all other types of entities is required for periods ending after March 15, 2004, unless previously applied. During the fourth quarter of 2003, the Company applied the provisions of FIN 46R to a wholly-owned subsidiary trust that issued trust preferred securities to third-party investors. The application of FIN 46R resulted in the deconsolidation of the wholly-owned subsidiary trust. The assets and liabilities of the subsidiary trust that was deconsolidated totaled $10.2 million and $9.9 million, respectively. See Note 20 for further discussion of this trust and the Company's related obligations. 25 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- 2. INVESTMENT SECURITIES Investment securities at December 31, 2003 and 2002, are classified as available for sale according to management's intent and summarized as follows:
ESTIMATED AMORTIZED GROSS UNREALIZED MARKET COST GAINS LOSSES VALUE ----------- ----------- ----------- ----------- December 31, 2003: U.S. Treasury and Agency Notes $46,855,067 $ 3,216,453 $ -- $50,071,520 ----------- ----------- ----------- ----------- December 31, 2002: U.S. Treasury and Agency Notes $50,694,469 $ 5,092,373 $ -- $55,786,842 ----------- ----------- ----------- -----------
U.S. Treasury and Agency notes at December 31, 2003, are contractually scheduled to mature as follows: ESTIMATED AMORTIZED MARKET COST VALUE Due after one year through five years $ 46,855,067 $ 50,071,520 3. MORTGAGE-BACKED SECURITIES Mortgage-backed securities at December 31, 2003 and 2002, are classified as available for sale according to management's intent and summarized as follows:
ESTIMATED AMORTIZED GROSS UNREALIZED MARKET COST GAINS LOSSES VALUE ----------- ----------- ----------- ----------- December 31, 2003: FHLMC participation certificates, maturing from years 2005 to 2028 $11,173,371 $ 541,681 $ -- $11,715,052 ----------- ----------- ----------- ----------- December 31, 2002: FHLMC participation certificates, maturing from years 2003 to 2028 $22,373,855 $ 1,152,580 $ -- $23,526,435 ----------- ----------- ----------- -----------
26 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- Mortgage-backed securities at December 31, 2003, are contractually scheduled to mature as follows: ESTIMATED AMORTIZED MARKET COST VALUE ----------- ----------- Due after one year through five years $ 425,171 $ 452,150 Due after five years through ten years 5,023,936 5,227,977 Due after ten years 5,724,264 6,034,925 ----------- ----------- $11,173,371 $11,715,052 =========== =========== Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay obligations with or without call or prepayment penalties. Mortgage-backed securities with a carrying value of $10,159,883, $6,171,430, $0, and $63,181,244 were sold during the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and during the year ended September 30, 2001, respectively. Net realized gains on the sales of mortgage-backed securities were $291,738, $302,315, $0, and $421,792, during the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and during the year ended September 30, 2001, respectively. Mortgage-backed securities with an amortized cost of approximately $4,460,964 were pledged as collateral for deposits from public entities at December 31, 2002. Mortgage-backed securities with an amortized cost of approximately $291,144 and $318,600 were pledged as collateral for treasury, tax, and loan deposits from public entities at December 31, 2003 and 2002, respectively. 4. LOANS RECEIVABLE Loans receivable at December 31, 2003 and 2002, are summarized as follows: 2003 2002 ------------- ------------- Mortgage loans $ 72,873,505 $ 121,951,696 Consumer loans 89,478,738 81,862,401 Commercial loans 389,042,417 288,368,765 Leasing 10,422,211 6,624,404 ------------- ------------- Total 561,816,871 498,807,266 Less Allowance for loan losses (7,633,709) (6,958,587) Deferred loan fees (983,236) (934,770) ------------- ------------- Loans receivable, net $ 553,199,926 $ 490,913,909 ============= ============= The Bank has pledged its eligible real estate loans to collateralize actual or potential borrowings from the Federal Home Loan Bank of Atlanta (See Note 10). 27 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- During the years ended December 31, 2003 and September 30, 2001, the Bank exchanged loans with outstanding principal balances of $8,952,095 and $12,298,139, respectively, with the Federal Home Loan Mortgage Corporation ("FHLMC") for mortgage-backed securities of equal value. The Bank originates mortgage loans for portfolio investment or sale in the secondary market. During the period of origination, mortgage loans are designated as either held for sale or for investment purposes. Transfers of loans held for sale to the investment portfolio are recorded at the lower of cost or market value on the transfer date. Loans receivable held for sale at December 31, 2003 and 2002 are fixed rate mortgage loans with an estimated market value of approximately $11,400,000 and $40,300,000, respectively. Net gains on sales of loans receivable held for sale amounted to $2,717,078, $1,883,683, $191,842, and $1,378,637 for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001, and the year ended September 30, 2001, respectively. The changes in the allowance for loan losses for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001, and the year ended September 30, 2001, are as follows:
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 ----------- ----------- ----------- ----------- Balance at beginning of year $ 6,958,587 $ 5,370,820 $ 5,401,358 $ 5,159,353 Provisions for loan losses 987,919 1,756,000 -- 830,000 Loans charged off (357,836) (192,902) (42,376) (655,506) Recoveries 45,039 24,669 11,838 67,511 ----------- ----------- ----------- ----------- Balance at end of year $ 7,633,709 $ 6,958,587 $ 5,370,820 $ 5,401,358 ----------- ----------- ----------- -----------
The following is a summary of the principal balances of loans on nonaccrual status and loans past due ninety days or more:
DECEMBER 31, 2003 2002 ---------- ---------- Loans contractually past due 90 days or more and/or on nonaccrual status Residential $1,057,232 $ 603,414 Consumer and commercial 1,567,876 892,991 ---------- ---------- $2,625,108 $1,496,405 ---------- ----------
For the years ended December 31, 2003 and 2002, interest income of approximately $58,000 and $37,000, respectively, was not recorded related to loans accounted for on a nonaccrual basis. 28 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- 5. PREMISES AND EQUIPMENT Premises and equipment consist of the following: DECEMBER 31, 2003 2002 ----------- ----------- Land $ 2,575,825 $ 2,542,615 Office buildings 6,192,352 5,854,158 Furniture, fixtures and equipment 3,947,253 3,595,056 Vehicles 342,303 348,269 ----------- ----------- 13,057,733 12,340,098 Less accumulated depreciation 5,135,145 4,515,095 ----------- ----------- Total $ 7,922,588 $ 7,825,003 ----------- ----------- 6. GOODWILL The following table provides a reconciliation of reported net earnings (loss) for the prior-years to adjusted earnings had SFAS 142 been applied as of the beginning of fiscal 2001:
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31 DECEMBER 31, SEPTEMBER 31, 2003 2002 2001 2001 -------------- -------------- -------------- -------------- Reported net (loss) earnings 11,412,996 9,511,612 (1,139,973) 5,830,292 Add back amortization (net of tax) Goodwill -- -- 77,615 310,446 -------------- -------------- -------------- -------------- Adjusted (loss) earnings before the cumulative effect of accounting changes 11,412,996 9,511,612 (1,062,358) 6,140,738 -------------- -------------- -------------- -------------- Net income (loss) per common share (adjusted to add back goodwill amortization): Basic $ 2.75 $ 2.18 $ (0.25) $ 1.41 Diluted $ 2.59 $ 2.06 $ (0.25) $ 1.37
29 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- 7. EMPLOYEE BENEFIT PLANS The Company participates in a multi-employer defined benefit pension plan which covers substantially all employees. Effective January 31, 2002 the Company's Board of Directors approved a plan to freeze the accrual of future benefits. As such, no new employee shall become a participant in the plan after January 31, 2002. Employees who were participating in the plan as of January 31, 2002 shall continue to participate in accordance with the provisions of the plan, however, the accrual of future benefits will cease. Expenses of the plan for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001 were $0, $67,079, $69,000, and $69,017, respectively. The Company also participates in a multi-employer defined contribution plan which covers substantially all employees. Under the plan, employees may contribute from 1% to 15% of compensation, subject to an annual maximum as determined by the Internal Revenue Code. The Company makes matching contributions of 50% of employees' contributions up to 6% of the employees' salaries. The plan provides that employees' contributions are 100% vested at all times and the Bank's contributions vest 25% for each year of service. The expenses related to the Company's contributions to this plan for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001, were $244,474, $167,757, $32,305, and $115,174, respectively. Directors and certain officers participate in deferred compensation plans. These plans generally provide for fixed payments beginning at retirement. These payments are earned over service periods of up to ten years, and can include provisions for deferral of current payments. The expense related to these plans during the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001, aggregated $579,730, $609,976, $159,373, and $617,127, respectively. The plans generally include provisions for forfeitures of unvested portions of payments, and vesting in the event of death or disability. 8. EMPLOYEE STOCK OWNERSHIP PLAN Effective December 31, 2001, the Company terminated its Employee Stock Ownership Plan ("ESOP"). As a result of this termination, the Company recognized an additional $3,143,467 in related compensation expenses. Upon adoption, the ESOP acquired 523,710 shares of the Company's common stock financed by $3,491,400 in borrowings by the ESOP from the Company. This loan was secured by the shares of Common Stock purchased and earnings thereon. At December 31, 2001, 281,707 shares, had been allocated to participants' accounts. All allocated shares are considered outstanding for earnings per share purposes, while the unallocated shares are not included in the calculation. As a result of the termination there are no unallocated shares. As a result of the termination all debt outstanding has been repaid. The principal balance at September 30, 2001 was $1,359,259. The Bank used dividends declared on 2,447 unallocated shares totaling $24,467 and the sale of 39,785 unallocated shares totaling $1,334,792 to repay the outstanding debt. Dividends on allocated shares were treated as a reduction of retained earnings. Dividends on unallocated shares were treated only as debt service, and there was no reduction of retained earnings. Compensation expense related to the ESOP was based on the average fair 30 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- market value of shares during the period since the prior allocation date through the dates shares are committed to be released. The financial statements for the three months ended December 31, 2001 and the year ended September 30, 2001, include compensation expense of $3,225,564 and $1,205,229, respectively, related to the ESOP and its termination. 9. STOCK OPTION PLAN On April 8, 1998, the Shareholders of the Company approved the First South Bancorp, Inc. 1997 Stock Option Plan (the "Plan"). The purpose of this Plan is to advance the interests of the Company through providing selected key employees and Directors of the Bank and the Company with the opportunity to purchase shares. The Plan reserves 1,037,817 shares for grant within ten years of the effective date. The option price is required to be 100% of the stock's fair market value as defined, with an exception for any shareholder with more than a 10% ownership interest in the Company. The exercise price is required to be 110% of the stock's fair market value for these options holders. Vesting is determined on the date of the grant. Options have a 10-year life; however, there are additional limitations for shareholders with more than a 10% ownership interest in the Company. The Plan also has a change of control provision under which all options immediately vest if a change of control, as defined, occurs. The Company has adopted SFAS No. 123, "Accounting for Stock Based Compensation." As permitted by SFAS No. 123, the Company has chosen to apply APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Accordingly, no compensation cost has been recognized for options granted under the Plan. Had compensation cost for the Company's Plan been determined based on the fair value at the grant dates for awards under the Plan consistent with the methods of SFAS No. 123, the Company's net income and net income per share would have been reduced to the pro forma amounts indicated below:
YEAR ENDED YEAR ENDED DECEMBER 31, 2003 DECEMBER 31, 2002 AS REPORTED PRO FORMA AS REPORTED PRO FORMA Net income $ 11,412,996 $ 11,289,844 $ 9,511,612 $ 9,363,642 Earnings per common share - basic 2.75 2.72 2.18 2.15 Earnings per common share - diluted 2.59 2.56 2.06 2.02 THREE MONTHS ENDED YEAR ENDED DECEMBER 30, 2001 SEPTEMBER 30, 2001 AS REPORTED PRO FORMA AS REPORTED PRO FORMA Net income $ (1,139,973) $ (1,154,254) $ 5,830,292 $ 5,742,412 Earnings per common share - basic (.26) (.27) 1.34 1.32 Earnings per common share - diluted (.26) (.27) 1.30 1.28
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 grants for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001, respectively: dividend growth rate of 17%, 17%, 22%, and 22%; expected volatility of 21.2%, 26.3%, 18.5%, 18.9%; risk-free interest rates ranging from 3.65% to 4.49% during the year ended December 31, 2003, 3.79% to 5.12% during the year ended December 31, 2002 ; 4.75% during the three months ended December 31, 2001; 5.84%, 5.78%, and 5.05% during the year ended September 30, 2001; and expected lives of 7 years. 31 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- A summary of the status of the Plan as of December 31, 2003, 2002, and 2001 and September 30, 2001, and changes during the years then ended, including weighted-average exercise price ("Price"), is presented below:
YEAR ENDED YEAR ENDED DECEMBER 31, 2003 DECEMBER 31, 2002 SHARES PRICE SHARES PRICE Outstanding at beginning of year 635,630 $ 13.87 603,605 $ 12.45 Granted 27,750 35.39 53,100 29.72 Cancellations (94,905) 13.91 (21,075) 13.22 --------- ----------- Outstanding at year end 568,475 14.91 635,630 13.87 ========= =========== Weighted-average fair value of options granted during the year $ 7.08 $ 10.30 ========= ======== THREE MONTHS ENDED YEAR ENDED DECEMBER 31, 2001 SEPTEMBER 30, 2001 SHARES PRICE SHARES PRICE Outstanding at beginning of year 613,355 $ 12.36 619,955 $ 12.17 Granted 6,000 21.50 28,500 17.09 Cancellations (15,750) 12.17 (35,100) 12.23 ---------- ---------- Outstanding at year end 603,605 12.45 613,355 12.36 ========== ========== Weighted-average fair value of options granted during the year $ 4.59 $ 3.43 ======== =========
The following table summarizes additional information about the Plan at December 31, 2003, including weighted-average remaining contractual life ("Life") and Price:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE SHARES LIFE PRICE SHARES PRICE $ 12.17 - 12.38 470,825 4.29 $ 12.17 470,825 $ 12.17 $ 15.46 - 18.15 22,800 7.38 $ 17.58 15,300 $ 17.31 $ 20.75 - 24.33 21,750 7.83 $ 21.79 15,750 $ 21.01 $ 30.23 - 34.83 22,350 9.36 $ 33.77 72,450 $ 33.28 $ 35.51 - 37.37 30,750 9.16 $ 36.57 10,000 $ 36.04 -------------- -------------- 568,475 514,325 ============== ==============
10. BORROWED MONEY Borrowed money represents advances from the FHLB and repurchase agreements. Advances outstanding from the FHLB at December 31, 2003 and 2002 had a weighted average rate of 1.38% and 1.3%, respectively, and totaled $16,000,000 and $34,000,000, respectively. At December 31, 2003 and December 31, 2002, repurchase agreements outstanding had average rates of .58% and .53%, and totaled $3,338,059 and $4,194,727, respectively. At December 31, 2003 and 2002, repurchase agreements were collateralized by U.S. government agency obligations with a principal balance of $10,000,000 and $7,000,000, respectively. The Company has pledged all of its stock in the FHLB and certain loans secured by one to four family residential mortgages as collateral for actual or potential borrowings from the FHLB. At December 31, 2003 and 2002, the Company had approximately $46,000,000 and $91,600,000, respectively, of additional credit available with the FHLB. 32 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- 11. INCOME TAXES The components of income tax expense for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001, are as follows:
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 ---------------- ---------------- ---------------- ---------------- Current Federal $ 4,507,141 $ 4,091,587 $ 1,028,407 $ 3,877,218 State 746,935 641,548 136,233 559,267 ---------------- ---------------- ---------------- ---------------- 5,254,076 4,733,135 1,164,640 4,436,485 ---------------- ---------------- ---------------- ---------------- Deferred Federal 1,448,063 390,096 - (310,782) State 138,568 87,118 - (66,168) ---------------- ---------------- ---------------- ---------------- 1,586,631 477,214 - (376,950) ---------------- ---------------- ---------------- ---------------- Total $ 6,840,707 $ 5,210,349 $ 1,164,640 $ 4,059,535 ================ ================ ================ ================
Reconciliations of the expected income tax expense at statutory tax rates with income tax expense reported in the statements of operations for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001, are as follows:
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 ----------- ----------- ----------- ----------- Expected income tax expense at 34% $ 6,206,259 $ 5,005,467 $ 8,387 $ 3,362,541 State income taxes, net of federal income tax 689,292 680,155 144,153 325,445 Non-deductible ESOP, other expenses and other adjustments (54,843) (475,273) 1,012,100 371,549 ----------- ----------- ----------- ----------- $ 6,840,707 $ 5,210,349 $ 1,164,640 $ 4,059,535 =========== =========== =========== ===========
33 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- The components of deferred income tax assets and liabilities are as follows:
DECEMBER 31, 2003 2002 ----------- ----------- Deferred income tax assets Deferred directors' fees 600,867 $ 606,750 Allowance for loan losses $ 2,720,665 2,079,734 Employee benefits 744,128 696,865 Loans mark-to-market 187,646 616,091 Other -- 276,252 ----------- ----------- 4,253,307 4,275,692 ----------- ----------- Deferred income tax liabilities Unrealized gains on securities available for sale 1,501,502 2,446,494 Depreciation and amortization 2,057,001 993,871 Carrying value - land 386,200 386,200 Mortgage servicing rights 728,575 634,207 Deferred loan origination fees and costs 405,075 92,047 FHLB stock 195,801 195,801 FHLB stock 93,719 -- ----------- ----------- 5,367,874 4,748,620 ----------- ----------- Net deferred income tax (liability) asset $(1,114,567) $ (472,928) =========== ===========
12. REGULATORY CAPITAL REQUIREMENTS Dividend payments made by the Company are subject to regulatory restrictions under Federal Reserve Board policy as well as to limitations under applicable provisions of Virginia corporate law. The Federal Reserve Board may prohibit a bank holding company from paying any dividends if the holding company's bank subsidiary is classified as "undercapitalized." Under Virginia law, dividends may be paid out of surplus or, if there is no surplus, out of net profits for the fiscal year in which the dividend is declared and for the preceding fiscal year. Furthermore, under FDIC regulations, the Bank is prohibited from making any capital distributions if, after making the distribution, the Bank would have: (i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier 1 risk-based capital ratio of less than 4.0%; or (iii) a leverage ratio of less than 4.0%. The Bank is subject to various regulatory capital requirements administered by the federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios, as set forth in the table below. Management believes, as of December 31, 2003, that the Bank meets all capital adequacy requirements to which it is subject. 34 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- As of December 31, 2003, the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum amounts and ratios, as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank's category. The Bank's actual regulatory capital amounts and ratios as of December 31, 2003 and 2002, are presented in the table below (dollars in thousands):
TO BE WELL CAPITALIZED FOR CAPITAL UNDER PROMPT ACTUAL ADEQUACY PURPOSE ACTION PROVISIONS AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO December 31, 2003: Total Capital (to Risk Weighted Assets) $64,129 12.2% $ 42,046 8.0% $ 52,558 10.0% Tier I Capital (to Risk Weighted Assets) 57,474 10.9% 21,023 4.0% 31,535 6.0% Tier I Capital (to Average Assets) 57,474 8.7% 26,568 4.0% 33,209 5.0% December 31, 2002: Total Capital (to Risk Weighted Assets) $48,240 10.5% $ 36,763 8.0% $ 45,954 10.0% Tier I Capital (to Risk Weighted Assets) 42,481 9.2% 18,382 4.0% 27,572 6.0% Tier I Capital (to Average Assets) 42,481 7.0% 24,160 4.0% 30,200 5.0%
13. EARNINGS PER SHARE The following table provides a reconciliation of income available to common stockholders and the average number of shares outstanding (less unearned ESOP shares, unearned deferred stock awards and treasury shares) for the years ended December 31, 2003 and 2002, the three months ended December 31, 2002 and the year ended September 30, 2002. Options to purchase 568,475, 635,630, 603,605, and 613,355 shares of common stock were outstanding at December 31, 2003, 2002, 2001 and September 30, 2001, respectively. For the three months ended December 31, 2001, none of these options were included in the computation of diluted EPS because the per-share amounts calculated would be anti-dilutive because of the reported loss.
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 ----------- ----------- ----------- ----------- Net (loss) income (numerator) $11,412,996 $ 9,511,612 $(1,139,973) $ 5,830,292 =========== =========== =========== =========== Weighted average shares outstanding for basic EPS (denominator) 4,153,719 4,364,925 4,308,369 4,349,769 Dilutive effect of stock options 249,209 263,509 -- 128,370 ----------- ----------- ----------- ----------- Adjusted shares for diluted EPS 4,402,928 4,628,434 4,308,369 4,478,139 =========== =========== =========== ===========
35 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- 14. MORTGAGE BANKING ACTIVITIES Mortgage loans serviced for others are not included in the accompanying consolidated statements of financial condition. The unpaid principal balances of mortgage loans serviced for others were $288,917,000 and 261,823,000 at December 31, 2003 and 2002, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payment to investors and foreclosure processing. Loan servicing income is recorded on the accrual basis and includes servicing fees from investors and certain charges collected from borrowers, such as late payment fees. At December 31, 2003 and 2002, mortgage servicing rights reported in the consolidated statements of financial condition, net of amortization, were $1,886,522 and $1,642,172, respectively. During the years ended December 31, 2003 and 2002, respectively, the Company recorded additional servicing assets of $1,166,983 and $1,009,966 as a result of sales of loans or mortgage-backed securities. Amortization of servicing assets during the years ended December 31, 2003 and 2002 aggregated $242,012 and $152,087, respectively. The fair value of recognized servicing assets amounted to $1,886,522 and $1,642,173 as of December 31, 2003 and 2002, respectively. The Company's significant assumptions used to estimate their fair value include weighted average life, prepayment speeds, and expected costs to transfer servicing to a third party. 15. FINANCIAL INSTRUMENT WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT GROUP CONCENTRATION OF CREDIT RISK: The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheet. The Company's exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Commitments to extend credit are agreements to lend to a customer 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. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the borrower. 36 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- A summary of the contractual amounts of the Company's exposure to off-balance sheet risk as of December 31, 2003 and December 31, 2002, is as follows:
2003 2002 ------------ ------------ Commitments to extend credit Commitments to originate loans $109,859,000 $ 75,656,713 Undrawn balances on lines of credit and undrawn balances on credit reserves (overdraft protection) 53,594,000 48,483,675 ------------ ------------ $163,453,000 $124,140,388 ============ ============
Included in the commitments to originate loans as of December 31, 2003 and December 31, 2002, are fixed interest rate loan commitments of $10,839,264 and $8,275,646, respectively. The shorter duration of interest-sensitive liabilities, to the extent they are used to fund these fixed-rate loans, indicates that the Company is exposed to interest rate risk because, in a rising rate environment, liabilities will be repricing faster at higher interest rates, thereby reducing the market value of fixed-rate long-term assets and net interest income. The Company's lending is concentrated primarily in Beaufort, Craven, Cumberland, Edgecombe, Lenoir, Nash, Pasquotank, Pitt, Robeson, and surrounding counties in North Carolina. Credit has been extended to certain of the Company's customers through multiple lending transactions. Since many of the commitments are expected to expire without being drawn upon, amounts reported do ot necessarily represent future cash requirements. 37 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- 16. PARENT COMPANY FINANCIAL INFORMATION The Company's principal asset is its investment in the Bank. Condensed financial statements of the parent company as of December 31, 2003, 2002, 2001 and September 30, 2001, and for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001 and the year ended September 30, 2001, are as follows:
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 ------------ ------------ ------------ ------------ CONDENSED BALANCE SHEETS Cash $ 839,895 $ 847,452 $ 734,906 $ 1,902,285 Due from subsidiary -- -- 4,157,099 931,535 Investment in wholly-owned subsidiary 64,105,117 49,982,524 46,710,200 49,203,538 Other assets 132,197 3,945 28,620 8,856 ------------ ------------ ------------ ------------ Total assets $ 65,077,209 $ 50,833,921 $ 51,630,825 $ 52,046,214 ============ ============ ============ ============ Due to First South Preferred Trust I $ 10,000,000 $ -- $ -- $ -- Other liabilities 796,656 734,109 599,444 1,277,596 Stockholders' equity 54,280,553 50,099,812 51,031,381 50,768,618 ------------ ------------ ------------ ------------ Total liabilities and stockholders' equity $ 65,077,209 $ 50,833,921 $ 51,630,825 $ 52,046,214 ============ ============ ============ ============ CONDENSED STATEMENTS OF INCOME Interest income, net $ 499 $ -- $ 21,690 $ 166,623 Equity in earnings of subsidiary 11,530,584 9,572,855 (1,144,436) 5,772,653 Miscellaneous expenses 118,087 61,243 17,227 108,984 ------------ ------------ ------------ ------------ Net income (loss) $ 11,412,996 $ 9,511,612 $ (1,139,973) $ 5,830,292 ============ ============ ============ ============
38 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 --------------------------------------------------------------------------------
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 CONDENSED STATEMENTS OF CASH FLOWS Operating activities: Net income (loss) $ 11,412,996 $ 9,511,612 $ (1,139,973) $ 5,830,292 Adjustments to reconcile net income (loss) to net cash provided by operating activities Equity in undistributed earnings of subsidiary (5,944,592) (2,122,362) 1,144,436 (5,772,653) ESOP compensation -- -- 4,560,356 1,205,229 MRP compensation -- -- -- -- Other operating activities (65,705) 153,529 (697,915) 878,733 ------------ ------------ ------------ ------------ Net cash provided by operating activities 5,402,699 7,542,779 3,866,904 2,141,601 ------------ ------------ ------------ ------------ Investing activities: Payments for investments in and advances to subsidiary (9,875,000) -- -- -- Repayments of advances to subsidiary 155,172 4,157,100 (2,692,564) 4,533,752 ------------ ------------ ------------ ------------ Net cash provided by (used in) investing activities (9,719,828) 4,157,100 (2,692,564) 4,533,752 ------------ ------------ ------------ ------------ Financing activities: Proceeds from exercise of stock options 1,101,697 228,115 100,375 360,864 Proceeds from issuance of junior subordinated debentures 10,000,000 Purchase of treasury shares (3,463,652) (8,869,750) (1,908,513) (4,253,215) Dividends paid (3,328,473) (2,945,698) (533,581) (1,936,091) ------------ ------------ ------------ ------------ Net cash used in financing activities 4,309,572 (11,587,333) (2,341,719) (5,828,442) ------------ ------------ ------------ ------------ Net increase (decrease) in cash (7,557) 112,546 (1,167,379) 846,911 Cash at beginning of year 847,452 734,906 1,902,285 1,055,374 ------------ ------------ ------------ ------------ Cash at end of year $ 839,895 $ 847,452 $ 734,906 $ 1,902,285 ============ ============ ============ ============
39 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- 17. QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized unaudited quarterly financial data for the years ended December 31, 2003 and 2002 is as follows (in thousands): FOURTH THIRD SECOND FIRST 2003 Interest income $9,297 $9,217 $9,250 $9,141 Interest expense 2,333 2,427 2,684 2,742 Provision for loan losses 137 395 122 334 Noninterest income 1,941 2,955 2,686 2,920 Noninterest expense 4,457 4,597 4,506 4,419 Income tax expense 1,594 1,786 1,737 1,723 ------ ------ ------ ------ Net income $2,717 $2,967 $2,887 $2,843 ====== ====== ====== ====== Net income per common share Basic $ .65 $ .72 $ .70 $ .68 Diluted $ .61 $ .68 $ .66 $ .64 ====== ====== ====== ====== FOURTH THIRD SECOND FIRST 2002 Interest income $9,367 $9,226 $9,185 $9,048 Interest expense 2,872 3,043 3,198 3,361 Provision for loan losses 684 430 333 309 Noninterest income 2,626 2,122 1,911 1,804 Noninterest expense 4,518 4,085 3,993 3,741 Income tax expense 1,393 1,336 1,219 1,262 ------ ------ ------ ------ Net income $2,526 $2,454 $2,353 $2,179 ====== ====== ====== ====== Net income per common share Basic $ .60 $ .56 $ .53 $ .49 Diluted $ .56 $ .53 $ .50 $ .47 ====== ====== ====== ====== 18. FAIR VALUES OF FINANCIAL INSTRUMENTS Statement of Financial Accounting Standards No. 107, "Disclosures about Fair Value of Financial Instruments" ("SFAS No. 107"), requires the disclosure of estimated fair values for financial instruments. Quoted market prices, if available, are utilized as an estimate of the fair value of financial instruments. Because no quoted market prices exist for a significant part of the Company's financial instruments, the fair value of such instruments has been derived based on management's assumptions with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates with respect to future economic conditions, the amount and timing of future cash flows and estimated discount rates. Different assumptions could significantly affect these estimates. Accordingly, the net realizable value could be materially different from the estimates presented below. In addition, the estimates are only indicative of individual financial instruments' values and should not be considered an indication of the fair value of the Company taken as a whole. 40 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- Fair values have been estimated using data which management considers as the best available, and estimation methodologies deemed suitable for the pertinent category of financial instrument. The estimation methodologies, resulting fair values, and recorded carrying amounts at December 31, 2003 and 2002, were as follows: Cash and cash equivalents are by definition short-term and do not present any unanticipated credit issues. Therefore, the carrying amount is a reasonable estimate of fair value. The estimated fair values of investment securities and mortgage backed securities are provided in Notes 2 and 3 to the financial statements. These are based on quoted market prices, when available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The fair value of the net loan portfolio has been estimated using the present value of expected cash flows, discounted at an interest rate adjusted for servicing costs and giving consideration to estimated prepayment risk and credit loss factors, as follows:
DECEMBER 31, DECEMBER 31, 2003 2002 ESTIMATED CARRYING ESTIMATED CARRYING FAIR VALUE AMOUNT FAIR VALUE AMOUNT ------------ ------------ ------------ ------------ 1 - 4 family mortgages $ 72,328,722 $ 71,657,658 $123,608,167 $120,591,198 Consumer 87,052,356 88,462,850 80,398,723 80,772,516 Non-residential 393,079,418 393,079,418 289,550,195 289,550,195 ------------ ------------ ------------ ------------ $552,460,496 $553,199,926 $493,557,085 $490,913,909 ============ ============ ============ ============
The fair value of deposit liabilities with no stated maturities has been estimated to equal the carrying amount (the amount payable on demand), totaling $248,156,071 and $218,566,325 at December 31, 2003 and 2002, respectively. The fair value estimates for these products do not reflect the benefits that the Bank receives from the low-cost, long-term funding they provide. These benefits are considered significant. The fair value of certificates of deposits and advances from the FHLB is estimated by discounting the future cash flows using the current rates offered for similar deposits and advances with the same remaining maturities. The carrying value and estimated fair values of certificates of deposit and FHLB advances at December 31, 2003 and 2002, are as follows: 2003 2002 Certificates of deposits Carrying amount $335,017,102 $307,760,839 Estimated fair value 337,877,029 312,110,400 Advances for Federal Home Loan Bank: Carrying amount $ 16,000,000 $ 34,000,000 Estimated fair value 16,000,000 34,000,000 The carrying amount of repurchase agreements approximates the fair value. The interest rate on these agreements is a floating rate based on the federal fund's daily rate. 41 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- There is no material difference between the carrying amount and estimated fair value of off-balance sheet items totaling $137,570,000 and $97,687,000 at December 31, 2003 and 2002, respectively, which are primarily comprised of unfunded loan commitments. The Company's remaining assets and liabilities are not considered financial instruments. 19. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information for the years ended December 31, 2003 and 2002, the three months ended December 31, 2001, and the year ended September 30, 2001, is as follows:
THREE MONTHS YEAR ENDED YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 2003 2002 2001 2001 Real estate acquired in settlement of loans $ 468,201 $ 861,499 $ 326,515 $ 918,091 Exchange of loans for mortgage-backed securities 8,952,095 -- -- 12,298,139 Cash paid for interest 10,217,536 12,569,916 4,161,729 22,391,730 Cash paid for income taxes 6,935,904 5,819,151 1,360,075 3,350,211 Dividends declared, not paid 838,067 712,992 533,581 518,511 Repurchase of unearned ESOP shares -- -- 1,334,792 --
20. JUNIOR SUBORDINATED DEBENTURES OWED TO UNCONSOLIDATED SUBSIDIARY TRUST AND CORPORATION-OBLIGATED MANDATORILY REDEEMABLE PREFERRED TRUST SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY DEBENTURES OF THE COMPANY The Company has sponsored a trust, First South Preferred Trust I (the Trust), of which 100% of the common equity is owned by the Company. The Trust was formed for the purpose of issuing company-obligated preferred trust securities (the Preferred Trust Securities) to third-party investors and investing the proceeds from the sale of such Preferred Trust Securities solely in junior subordinated debt securities of the Company (the Debentures). The Debentures held by the Trust are the sole assets of the Trust. Distributions on the Preferred Trust Securities issued by the Trust are payable quarterly at a rate equal to the interest rate being earned by the Trust on the Debentures held by that Trust. The Preferred Trust Securities are subject to mandatory redemption, in whole or in part, upon repayment of the Debentures. The Company has entered into an agreement, which fully and unconditionally guarantees the Preferred Trust Securities subject to the terms of the guarantee. The Debentures held by the Trust are first redeemable, in whole or in part, by the Company on September 26, 2008. In the fourth quarter of 2003, as a result of applying the provisions of FIN 46R, governing when an equity interest should be consolidated, the Company was required to deconsolidate the subsidiary Trust from its financial statements. The deconsolidation of the net assets and results of operations of the Trust had virtually no impact on the Company's financial statements or liquidity position since the Company continues to be obligated to repay the Debentures held by the Trust and guarantees repayment of the Preferred Trust Securities issued by the Trust. The consolidated debt obligation related to the Trust increased from $10 million to $10.3 million upon 42 FIRST SOUTH BANCORP, INC. AND SUBSIDIARY NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 2003 AND 2002 -------------------------------------------------------------------------------- deconsolidation with the difference representing the Company's common ownership interest in the Trust. The Preferred Trust Securities held by the Trust qualify as Tier 1 capital for the Company under Federal Reserve Board guidelines. As a result of the issuance of FIN 46R, the Federal Reserve Board is currently evaluating whether deconsolidation of the Trust will affect the qualification of the capital securities as Tier 1 capital. Consolidated debt obligations related to a subsidiary Trust holding solely Debentures of the Company follows: DECEMBER 31, 2003 LIBOR + 2.95% junior subordinated debentures owed to First South Preferred Trust I due September 26, 2033 $10,000,000 LIBOR + 2.95% junior subordinated debentures owed to First South Preferred Trust I due September 26, 2033 310,000 ----------- Total junior subordinated debentures owed to unconsolidated subsidiary trust $10,310,000 =========== 21. SUBSEQUENT EVENT (UNAUDITED) On February 20, 2004, the Company completed the acquisition of two Central Carolina Bank (CCB) retail banking locations. This acquisition was accounted for using the purchase method of accounting and the Bank assumed the deposits of the two CCB branches for a premium of approximately 1.5% of the assumed deposits. The fair value of assets, including identifiable intangible assets, and liabilities assumed were as follows (in thousands): Loans receivable $ 2,212 Premises and equipment 75 Identifiable intangible assets 314 Deposits (18,373) -------- Net cash paid (received) for acquisitions $(15,772) ======== 43
BOARD OF DIRECTORS LINLEY H. GIBBS, JR. FREDERICK N. HOLSCHER EDMUND T. BUCKMAN, JR. FREDERICK H. HOWDY CHAIRMAN VICE CHAIRMAN Retired President Retired Partner Washington, NC Drs. Freshwater & Howdy, P.A. Washington, NC Rodman, Holscher, Francisco, Washington, NC & Peck, P.A. Washington, NC CHARLES E. PARKER, JR. H. D. REAVES, JR. MARSHALL T. SINGLETON THOMAS A. VANN Senior Vice President Former President and Co-Owner President and Robinson & Stith Insurance Chief Executive Officer B. E. Singleton & Sons Chief Executive Officer New Bern, NC Home Federal Savings & Washington, NC First South Bank Loan Washington, NC Fayetteville, NC EXECUTIVE OFFICERS THOMAS A. VANN JACK L. ASHLEY WILLIAM L. WALL MARY R. BOYD President and Senior Executive Vice President Executive Vice President Executive Vice President Chief Executive Officer Chief Operating Officer Chief Financial Officer and Loan Servicing Secretary ANNE R. COREY SHERRY L. CORRELL PAUL S. JABER KRISTIE W. HAWKINS Executive Vice President Executive Vice President Executive Vice President Treasurer Chief Credit Officer Deposit Operations Mortgage Operations Controller AREA EXECUTIVES ROBERT E. BRANCH JAMES F. BUCKMAN, IV G. LEONARD PITTMAN, JR. DONNIE L.G. BUNN Senior Vice President Senior Vice President Senior Vice President President Area Executive Area Executive Area Executive First South Leasing, LLC. Triangle Region Pamlico/Albemarle Region Tar River Region Washington CITY & BRANCH EXECUTIVES ALAN AVANT GEORGE R. HAMILTON RUSSELL A. LAY PHILIP W. MCCUMBEE Senior Vice President Senior Vice President Senior Vice President Senior Vice President City Executive Branch Executive City Executive Branch Executive Lumberton Rocky Mount Kill Devil Hills Tarboro DONALD B. STRICKLAND GUY P. WILLIAMS JR. T. SCOTT LEWIS D. MARK POPE Senior Vice President Senior Vice President Vice President Vice President City Executive City Executive Branch Executive City Executive Greenville New Bern Rocky Mount Kinston HECTOR N. RAY CLYDE F. SWANNER JR. WILLIAM T. WRENN Vice President Vice President Vice President City Executive City Executive City Executive Fayetteville/Hope Mills Washington/Chocowinity Elizabeth City
44
FIRST SOUTH BANK OFFICE LOCATIONS CHOCOWINITY LUMBERTON RALEIGH 2999 Highway 17 South 600 North Chestrnut Street 4800 Six Forks Road 252-940-4970 910-739-3274 919-783-5222 ELIZABETH CITY 3000 North Elm Street TARBORO 604 East Ehringhaus Street 910-608-5031 100 East Hope Lodge Street 252-335-0848 252-823-0157 NEW BERN FAYETTEVILLE 202 Craven Street WASHINGTON 241 Green Street 252-636-2997 1311 Carolina Avenue 910-438-3681 252-946-4178 1725 Glenburnie Road 3107 Raeford Road 252-636-3569 300 North Market Street 910-484-2116 252-940-4945 2019 South Glenburnie Road GREENVILLE 252-637-1111 1328 John Small Avenue 301 East Arlington Boulevard 252-940-5000 252-321-2600 ROCKY MOUNT 300 Sunset Avenue CREDIT ADMINISTRATION 3040 South Evans Street 252-972-9661 239 West Main Street 252-353-3112 252-946-4178 2901 Sunset Avenue HOPE MILLS 252-451-1259 OPERATIONS CENTER 3103 North Main Street 220 Creekside Drive 910-423-0952 1378 Benvenue Road 252-946-4178 252-442-8375 KILL DEVIL HILLS FIRST SOUTH LEASING, LLC 1906 South Croatan Drive 450 North Winstead Avenue 239 West Main Street 252-441-9935 252-937-1900 252-946-4178 KINSTON 3635 North Halifax Road 2430 Heritage Street 252-451-8700 252-523-9449 (In Smith's Red & White/Dortches) FIRST SOUTH BANK ATM* LOCATIONS CHOCOWINITY HOPE MILLS RALEIGH 2999 Highway 17 South 3103 North Main Street 4800 Six Forks Road ELIZABETH CITY KILL DEVIL HILLS ROCKY MOUNT 604 East Ehringhaus Street 1906 South Croatan Highway 300 Sunset Avenue 2901 Sunset Avenue FAYETTEVILLE KINSTON 1378 Benvenue Road 241 Green Street 2430 Heritage Street 450 North Winstead Avenue 3107 Raeford Road 3635 North Halifax Road LUMBERTON GREENVILLE 3000 North Elm Street TARBORO 301 East Arlington Boulevard 3551 Fayetteville Road 1202 Western Boulevard 3040 South Evans Street NEW BERN WASHINGTON 1725 Glenburnie Road 1311 Carolina Avenue 2019 South Glenburnie Road 300 North Market Street 1328 John Small Avenue
------------------------------- *Member FDIC *Member of Star and Cirrus ATM Networks 45 FIRST SOUTH BANK PRODUCTS AND SERVICES
PERSONAL BANKING SERVICES COMMERCIAL BANKING SERVICES CHECKING ACCOUNTS: CHECKING ACCOUNTS: Free Basic Checking Business Free Checking Free Senior Checking (age 50 and over) Business Interest Checking Basic Checking II Commercial Checking Executive Checking Commercial Money Market Checking Preferred Checking Simple Business Checking Money Market Checking Simple Business Plus Checking LENDING SERVICES: LENDING SERVICES: Consumer Loans Commercial Real Estate Loans Home Equity Loans Commercial Business Loans Mortgage Loans SBA Loans FHA/VA Financing Lines of Credit Reserve Lines VISA Credit Services OTHER COMMERCIAL BANKING SERVICES: Cash Management Sweep Products SAVINGS ACCOUNTS: Total Treasury Manager Regular Savings VISA Merchant Services Custodial Savings Letters of Credit Night Depository Wire Transfers OTHER PERSONAL BANKING SERVICES: Cash Services (Coin and Currency) AccessLine 24-Hour Telephone Banking Automated Teller Machines (ATMs) 24-Hour Banking Cards (ATM) Certificates of Deposit Individual Retirement Accounts VISA CheckCards Online Banking Bill Pay Drive-Thru Windows Night Depository Safe Deposit Boxes Wire Transfers OTHER FINANCIAL SERVICES FIRST SOUTH LEASING, LLC UVEST INVESTMENT SERVICES Through the efforts of First South Leasing, Through a partnership with UVEST Investment LLC, a wholly owned subsidiary of First South Services, First South Bank now offers Bank, the service of equipment leasing is made investment services. UVEST, which is available to the commercial markets of North headquartered in Charlotte, North Carolina, is Carolina, South Carolina, and Virginia. First a registered securities broker-dealer and a South Leasing, LLC specializes in tax and member of the National Association of non-tax equipment leasing. Recognizing the Securities Dealers (NASD) and the Securities growing presence of equipment leasing in the Investors Protection Corporation (SIPC), as banking sector, First South Bank applies its well as the Securities Industry Association resources to meet this demand. To find out (SIA). more, call toll-free at 1-800-845-6576. With an appointment, an investment consultant Advantages of Leasing include: can be available at any First South Bank o Leasing frees working capital for other location for a free, no obligation uses. consultation. Discuss a full range of o Leasing offers fixed payments. brokerage services including financial o Properly structured lease payments are analysis, professional money management, 100% tax deductible as a business stocks, bonds, mutual funds, annuities, and expense. more. For more information, contact Steve o Leasing provides a hedge against Wiggins (252-946-4178) or Tony Russ inflation: by paying off a lease with (252-451-0867), Investment Consultants, or tomorrow's dollars, a business can call toll-free at 1-800-946-4178. replace leased equipment before obsolescence reduces efficiency and --------------------------------------------- profits. Investment products are not FDIC insured, are not bank guaranteed, and may lose value. ---------------------------------------------
46 STOCKHOLDER INFORMATION CORPORATE HEADQUARTERS First South Bancorp, Inc. Telephone: 252-946-4178 1311 Carolina Avenue Fax: 252-946-3873 Washington, NC 27889 E-mail: info@firstsouthnc.com Website: www.firstsouthnc.com STOCK LISTING INFORMATION The Company's common stock is listed and trades on the Nasdaq Stock Market under the symbol FSBK. As of March 5, 2004, there were 900 stockholders of record. STOCK PRICE INFORMATION The following is the high and low trading price information and dividends declared per share for the periods indicated. Quarter Ended High Low Dividends ------------- ---- --- --------- March 31, 2002 (1) $26.00 $22.33 $.17 June 30, 2002 40.00 25.60 .17 September 30, 2002 37.97 34.25 .17 December 31, 2002 36.51 33.35 .17 March 31, 2003 36.74 32.60 .20 June 30, 2003 34.60 30.87 .20 September 30, 2003 39.48 32.09 .20 December 31, 2003 37.75 32.20 .20 ________________ (1) Adjusted for three-for-two stock split on April 19, 2002. REGISTRAR AND TRANSFER AGENT Inquiries regarding stock transfer, registration, lost certificates or changes in name and address should be directed to the Company's stock registrar and transfer agent: Registrar and Transfer Company, 10 Commerce Drive, Cranford, New Jersey 07016; via the Internet at www.rtco.com; or toll-free at (800) 866-1340. FORM 10-K The Annual Report on Form 10-K of the Company as filed with the Securities and Exchange Commission is available via the Internet on the Company's website at www.firstsouthnc.com under the heading "Financial Reports-EDGAR Online here". Shareholders will be provided a copy without charge by writing to the Corporate Secretary, William L. Wall, First South Bancorp, Inc., P. O. Box 2047, Washington, NC 27889. INVESTOR INFORMATION Shareholders, investors, and analysts interested in additional information may contact William L. Wall, Chief Financial Officer, First South Bancorp, Inc., P. O. Box 2047, Washington, NC 27889; or via email to bwall@firstsouthnc.com. ANNUAL MEETING The Annual Meeting of Stockholders of First South Bancorp, Inc. will be held Thursday, May 20, 2004 at 11:00 a.m., at the main office of First South Bank, 1311 Carolina Avenue, Washington, North Carolina.
GENERAL COUNSEL SPECIAL COUNSEL INDEPENDENT ACCOUNTANTS Rodman, Holscher, Francisco & Stradley Ronon Stevens PricewaterhouseCoopers LLP Peck, P.A. & Young, LLP Suite 2300 320 North Market Street Suite 600 150 Fayetteville Street Mall Washington, NC 27889 1220 19th Street, N.W. Raleigh, NC 27601 Washington, DC 20036
47 First South Bancorp =================== ------------------- 1311 Carolina Avenue P.O. Box 2047 Washington, North Carolina 27889 (252)946-4178 Fax (252)946-3873 www.firstsouthnc.com