10-Q 1 form10q-76853_fnb.htm FORM 10-Q
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 
Washington, D.C. 20549
 
FORM 10-Q
 
 
Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
 
For the quarterly period ended:
 
June 30, 2006
 
Commission File Number: 000-13086

FNB Financial Services Corporation
(Exact name of Registrant as specified in its Charter)

   
North Carolina
56-1382275
(State of Incorporation)
(I.R.S. Employer Identification No.)
   
1501 Highwoods Boulevard, Suite 400
 
Greensboro, North Carolina
27410
(Address of principal executive offices)
(Zip Code)

(336) 369-0900
(Registrant's telephone number, including area code)

 
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.   Yes  x   No  o
 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See the definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One)

Large accelerated filer o
 
Accelerated filer x
 
Non-accelerated filer o
 
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  o   No  x 
 
At July 31, 2006, 7,051,124 shares of the registrant's common stock, $1.00 stated value, were outstanding.
 



 




FNB FINANCIAL SERVICES CORPORATION

FORM 10-Q




           
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Item
  
 
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2
  
 
  
 
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FNB Financial Services Corporation and Subsidiary
(Dollars in thousands except per share data)

   
June 30,
2006
(Unaudited)
  
December 31,
2005 *
  
ASSETS
              
               
Cash and due from banks
  
$
33,139
  
$
27,148
  
Investment securities:
              
Securities available for sale
    
204,855
    
195,926
  
Federal Home Loan Bank and Federal Reserve Bank Stock
    
7,016
    
5,964
  
Federal funds sold
    
5,530
    
-
  
Loans, net of allowance for credit losses of $18,239 at
             
June 30, 2006 and $19,142 at December 31, 2005
    
732,486
    
738,825
  
Premises and equipment, net
    
15,884
    
14,307
  
Accrued income and other assets
    
28,917
    
25,236
  
               
Total assets
  
$
1,027,827
  
$
1,007,406
  
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
              
               
Deposits:
              
Noninterest bearing
  
$
90,116
  
$
92,884
  
Interest bearing
    
756,668
    
731,747
  
Total deposits
    
846,784
    
824,631
  
               
Short-term borrowings
    
7,327
    
7,305
  
Long-term debt
    
100,774
    
100,774
  
Accrued expenses and other liabilities
    
3,579
    
7,462
  
               
Total liabilities
    
958,464
    
940,172
  
               
Shareholders’ Equity:
              
Preferred stock no stated value; authorized 10,000,000 shares;
              
none issued
   
-
    
-
  
Common stock, $1.00 stated value; authorized 75,000,000
             
shares; outstanding 7,048,976 at June 30, 2006 and
              
and 7,038,110 at December 31, 2005
    
7,049
    
7,038
  
Paid-in capital
    
22,290
    
21,957
  
Retained earnings
    
43,824
    
40,483
  
Accumulated other comprehensive loss
    
(3,800
)
  
(2,245
)
               
Total shareholders’ equity
    
69,363
    
67,233
  
 
              
Total liabilities and shareholders’ equity
  
$
1,027,827
  
$
1,007,406
  
               
               
               
See notes to unaudited consolidated financial statements. 
* Derived from audited consolidated financial statements.


FNB Financial Services Corporation and Subsidiary
(Unaudited; dollars in thousands, except per share data)


   
Three Months Ended
June 30,
  
Six Months Ended
June 30,
  
   
2006
  
2005
  
2006
  
2005
  
Interest income
                          
Loans
  
$
15,814
  
$
13,629
  
$
31,571
  
$
25,732
  
Federal funds sold and overnight deposits
    
63
    
61
    
148
    
127
  
Investment securities
                          
Taxable
   
1,625
    
976
    
3,201
    
1,799
  
Tax exempt
   
405
    
318
    
777
    
637
  
Other
   
111
    
77
    
209
    
143
  
                           
Total interest income
    
18,018
    
15,061
    
35,906
    
28,438
  
                           
Interest expense
                          
Deposits
   
6,977
    
5,253
    
13,496
    
9,536
  
Short-term borrowings
    
188
    
141
    
245
    
241
  
Long-term debt
    
1,314
    
581
    
2,524
    
1,062
  
                           
Total interest expense
    
8,479
    
5,975
    
16,265
    
10,839
  
                       
Net interest income
    
9,539
    
9,086
    
19,640
    
17,599
  
Provision for credit losses
    
365
    
638
    
1,120
    
1,318
  
                           
Net interest income after provision for credit losses
    
9,174
    
8,448
    
18,520
    
16,281
  
Noninterest income
                          
Service charges on deposit accounts
    
968
    
964
    
1,841
    
1,788
  
Net loss on sale of securities
    
-
    
(3
)
  
-
    
(5
)
Income from investment services
    
84
    
95
    
212
    
233
  
Mortgage banking fees
    
199
    
618
    
441
    
1,622
  
Other noninterest income
    
60
    
141
    
150
    
315
  
                           
Total noninterest income
    
1,311
    
1,815
    
2,643
    
3,953
  
                           
Noninterest expense
                         
Salaries and employee benefits
    
4,012
    
3,428
    
8,165
    
6,895
  
Occupancy
    
381
    
394
    
796
    
796
  
Furniture and equipment
    
753
    
789
    
1,528
    
1,547
  
Telecommunications
    
169
    
152
    
321
    
311
  
Marketing
    
228
    
220
    
417
    
482
  
Printing and supplies
    
149
    
174
    
270
    
347
  
Other noninterest expense
    
1,153
    
1,888
    
2,406
    
3,559
  
                           
Total noninterest expense
    
6,845
    
7,045
    
13,903
    
13,937
  
                           
Income before provision for income taxes
    
3,640
    
3,218
    
7,261
    
6,297
  
Provision for income taxes
    
1,250
    
1,083
    
2,493
    
2,119
  
                           
Net income
   
2,390
    
2,135
    
4,768
    
4,178
  
Other comprehensive income (loss)
    
(940
)
  
604
    
(1,555
)
  
(369
)
Comprehensive income
  
$
1,450
  
$
2,739
  
$
3,213
  
$
3,809
  
Per share data
                          
Net income, basic
  
$
0.34
  
$
0.30
  
$
0.68
  
$
0.60
  
Net income, diluted
  
$
0.33
  
$
0.29
  
$
0.66
  
$
0.58
  
Cash dividends
  
$
0.12
  
$
0.11
  
$
0.24
  
$
0.22
  
Weighted average shares outstanding, basic
    
7,074,254
    
6,991,912
    
7,057,701
    
6,974,376
  
Weighted average shares outstanding, diluted
    
7,237,182
    
7,229,261
    
7,237,525
    
7,215,780
  

See notes to unaudited consolidated financial statements.



FNB Financial Services Corporation and Subsidiary
(Unaudited; dollars in thousands)

   
Six Months Ended
June 30,
  
   
2006
  
2005
  
           
Cash flows from operating activities:
              
Net income
  
$
4,768
  
$
4,178
  
Adjustments to reconcile net income to net cash provided by (used in)
              
operating activities:
              
Depreciation, accretion, and amortization
    
534
    
634
  
Provision for credit losses
    
1,120
    
1,318
  
Stock based compensation expense
    
263
    
-
  
Loss on sale of securities available for sale
    
-
    
5
  
Realized loss on disposal of premises and equipment
    
31
    
3
  
Realized loss on disposal of other real estate
    
8
    
-
  
Net change in warehouse line of credit
    
(409
)
  
3,229
  
Changes in assets and liabilities:
              
Increase in other assets
    
(3,400
)
  
(4,391
)
Increase (decrease) in other liabilities
    
(3,400
)
  
1,934
  
Net cash provided by (used in) operating activities
    
(485
)
  
6,910
  
               
Cash flows from investing activities:
              
Proceeds from sales, maturities, or calls of securities available for sale
    
7,130
    
10,956
  
Purchase of securities available for sale
    
(18,534
)
  
(26,366
)
Purchase of premises and equipment
    
(2,459
)
  
(1,089
)
Proceeds from disposal of premises and equipment
    
7
    
111
  
Proceeds from sale of other real estate owned
    
339
    
-
  
(Increase) decrease in other real estate owned
    
(134
)
  
3,005
  
Net (increase) decrease in loans
    
5,314
    
(98,398
)
Net cash used in investing activities
    
(8,337
)
  
(111,781
)
               
Cash flows from financing activities:
              
Net increase in deposits
    
22,154
    
87,080
  
Net increase in long-term debt
    
-
    
20,000
  
Net increase in short-term borrowings
    
22
    
2,618
  
Excess tax benefits from share-based arrangements
     276      -  
Repurchase of common stock
    
(1,222
)
  
(627
)
Proceeds from issuance of common stock
    
804
    
853
  
Cash dividends paid
    
(1,691
)
  
(1,557
)
Net cash provided by financing activities
    
20,343
    
108,367
  
               
Net increase in cash and cash equivalents
   
11,521
    
3,496
  
Cash and cash equivalents, January 1
    
27,148
    
24,246
  
               
Cash and cash equivalents, June 30
  
$
38,669
  
$
27,742
  
               
               

See notes to unaudited consolidated financial statements.


FNB Financial Services Corporation and Subsidiary
(Unaudited)

1.
Basis of presentation

The accompanying unaudited consolidated financial statements of FNB Financial Services Corporation (the “Company” or “FNB”) have been prepared in accordance with accounting principles generally accepted in the United States of America and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, these statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six-month periods ended June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. For further information refer to the consolidated financial statements and footnotes thereto included in FNB Financial Services Corporation’s 2005 Annual Report on Form 10-K. Certain reclassifications have been made to the prior period consolidated financial statements to place them on a comparable basis with the current period consolidated financial statements. These reclassifications have no effect on net income or shareholders’ equity as previously reported.

2.
Per share data

Basic and diluted net income per share amounts have been computed based upon net income as presented in the accompanying statements of income divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized. 

   
Three Months Ended
June 30,
  
Six Months Ended
June 30,
  
   
2006
  
2005
  
2006
  
2005
  
                   
Weighted average number of shares
                          
used in basic EPS
    
7,074,254
    
6,991,912
    
7,057,701
    
6,974,376
  
Effect of dilutive stock options
    
162,928
    
237,349
    
179,824
    
241,404
  
                           
Weighted average number of common
                          
shares and dilutive potential common
                          
shares used in dilutive EPS
    
7,237,182
    
7,229,261
    
7,237,525
    
7,215,780
  
 
For the three-month periods ended June 30, 2006 and 2005, there were 608,862 and 131,875 options, respectively, that were antidilutive since the exercise price exceeded the average market price for the period and were omitted from the calculation of diluted earnings per share for their respective periods. For the six-month periods ended June 30, 2006 and 2005, there were 624,980 and 131,875 options, respectively, that were antidilutive since the exercise price exceeded the average market price for the period and were omitted from the calculation of diluted earnings per share for their respective periods.

3.
Stock based compensation

Effective January 1, 2006, the Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123(r)”) which was issued by the FASB in December 2004. SFAS No. 123(r) revises SFAS No. 123, “Accounting for Stock Based Compensation,” and supersedes APB No. 25, “Accounting for Stock Issued to Employees,” and its related interpretations. SFAS No. 123(r) requires recognition of the cost of employee services received in exchange for an award of equity instruments in the financial statements over the period the employee is required to perform the services in exchange for the award (presumptively the vesting period). SFAS No. 123(r) also requires measurement of the cost of employee services received in exchange for an award based on the grant-date fair value of the award. SFAS No. 123(r) also amends SFAS No. 95, “Statement of Cash Flows,” to require that excess tax benefits


be reported as financing cash inflows, rather than as a reduction of taxes paid, which is included within operating cash flows.

The Company adopted SFAS No. 123(r) using the modified prospective application as permitted under SFAS No. 123(r). Accordingly, prior period amounts have not been restated. Under this application, the Company is required to record compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption.

Prior to the adoption of SFAS No. 123(r), the Company used the intrinsic value method as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and thus recognized no compensation expense for options granted with exercise prices equal to the fair market value of the Company’s common stock on the date of grant.

The Company has one share-based compensation plan, which is described below. The compensation cost that has been charged against income for this plan was approximately $263,000 and $0 for the six-month periods ended June 30, 2006 and 2005, respectively. The income tax benefit recognized for share-based compensation arrangements was approximately $91,000 and $0 for the six-month periods ended June 30, 2006 and 2005, respectively.

In May 1997, the Company implemented the Omnibus Equity Compensation Plan (the “Plan”). The Plan authorizes the Board of Directors to grant nonqualified stock options to directors, executives, and key employees of the Company. Options granted under the Plan have a term of up to ten years and generally vest over a four-year period beginning on the date of the grant. Options under the Plan must be granted at a price not less than the fair market value at the date of grant. If an award granted under the Plan is forfeited, or otherwise expires, terminates or is canceled without the delivery of shares, then the shares covered by the forfeited, expired, terminated or canceled award will again be available to be delivered pursuant to awards under the Plan.

The fair value of each option award is estimated on the date of grant using the Black-Scholes option pricing model. No options were granted for the six month period ended June 30, 2006. The risk-free interest rate is based upon a U.S. Treasury instrument with a life that is similar to the expected life of the option grant. Expected volatility is based upon the historical volatility of the Company’s stock based upon the previous three years of trading history. The expected life of the options is based upon the average life of previously granted stock options. The expected dividend yield is based upon current yield on date of grant. The following table illustrates the assumptions for the Black-Scholes model used in determining the fair value of options granted to employees for the six months ended June 30, 2005.

 
 
 
 
 
 
Six Months Ended
 
 
 
June 30, 2005
 
       
Dividend yield
 
2.29%
 
Risk-free interest rate
 
3.94% - 4.47%
 
Volatility
 
0.18
 
Expected life
 
7.0 years
 

A summary of option activity under the stock option plans as of June 30, 2006, and changes during the six month period ended June 30, 2006 is presented in the accompanying table:
 
   
Shares
  
Weighted
Average
Exercise
Price
  
Weighted
Average
Remaining Contractual
Term
  
Aggregate
Intrinsic
Value
  
Outstanding at December 31, 2005
    
1,134,471
  
$
13.61
              
Exercised
    
(92,444
)
  
8.70
              
Authorized
    
-
    
-
              
Forfeited
    
(73,246
)
  
15.42
              
Granted
    
-
    
-
              
 
                          
Outstanding at June 30, 2006
    
968,781
  
$
13.94
    
6.16 years
  
$
2,053,496
  
                           
Exercisable at June 30, 2006
    
565,431
  
$
12.32
    
4.26 years
  
$
1,895,241
  


 
 

The following table sets forth the exercise prices, the number of options outstanding and the number of options exercisable at June 30, 2006:

Exercise Price
Range
  
Number of
Options
Outstanding
  
Weighted
Average
Exercise
Price
  
Weighted
Average
Contractual
Life
Remaining
(Years)
  
Number of
Options
Exercisable
  
Weighted
Average
Exercise
Price
  
$7.04 - $8.01
    
81,833
  
$
7.58
    
3.71
    
81,833
  
$
7.58
  
$8.28 - $14.52
    
278,086
   
10.04
   
5.00
    
239,406
   
9.93
 
$15.31 - $16.16
    
262,572
   
15.96
   
4.41
    
206,472
   
15.97
 
$16.32 - $18.11
    
346,290
   
17.05
   
8.91
    
37,720
   
17.78
 
                                 
     
968,781
 
$
13.94
    
6.16
    
565,431
 
$
12.32
  

For the six months ended June 30, 2006 and 2005, respectively, the intrinsic value of options exercised was approximately $220,000 and $198,000. The fair value of options vested during the periods was approximately $263,000 and $173,000, respectively.

Cash received from options exercised under all share-based payment arrangements for the six month period ended June 30, 2006 was $804,000. The actual benefit realized for the tax deductions from option exercise of the share-based arrangements totaled $276,000 for the six months ended June 30, 2006.
 
As of June 30, 2006, there was $983,622 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under all of the Company's stock benefit plans. That cost is expected to be recognized over a weighted-average period of 2.16 years.

The adoption of SFAS No. 123(r) and its fair value compensation cost recognition provisions are different from the nonrecognition provisions under SFAS 123 and the intrinsic value method for compensation cost allowed under APB 25. The effect (increase / (decrease)) of the adoption of SFAS No. 123(r) is as follows:

Income before income tax expense
 
$
(263,000
)
Net income
 
$
(173,000
)
         
Cash flow from operating activities
 
$
(276,000
)
Cash flow provided by financing activities
 
$
276,000
  
         
Basic earnings per share
 
$
(0.02
)
Diluted earnings per share
 
$
(0.02
)


The following illustrates the effect on net income available to common shareholders if the Company had applied the fair value recognition provisions of SFAS No. 123(r) to the three and six month periods ended June 30, 2005:

(Dollars in thousands, except per share data)
  
Three months
  
Six Months
  
Net income, as reported
  
$
2,135
  
$
4,178
  
Less: Stock based compensation as calculated per fair value method, net of tax effect
    
(92
)
  
(183
)
Proforma net income
  
$
2,043
  
$
3,995
  
 
Earnings per share:
              
Basic - as reported
  
$
0.30
  
$
0.60
  
Basic - proforma
  
$
0.29
  
$
0.58
  
Diluted - as reported
  
$
0.29
  
$
0.58
  
Diluted - proforma
  
$
0.28
  
$
0.56
  

4.
Loans

Loan Category:
(Dollars in thousands)
  
June 30, 2006
  
December 31, 2005
  
 
          
Real estate - commercial
  
$
172,279
  
$
177,986
  
Real estate - residential
    
136,170
    
145,972
  
Real estate - construction
    
245,871
    
213,506
  
Commercial, financial and agricultural
    
63,223
    
77,007
  
Consumer
   
137,258
    
147,163
  
               
Subtotal loans
   
754,801
    
761,634
  
 
Less: Warehouse line of credit
    
4,076
    
3,667
  
 
Gross Loans
 
$
750,725
  
$
757,967
  

Allowance for credit losses:
   
June 30, 2006
  
December 31, 2005
  
 
(Dollars in thousands)
  
 
 
 
Allowance
  
% of Loans
in Each
Category to
Total Loans
  
 
 
 
Allowance
  
% of Loans
in Each
Category to
Total Loans
  
Balance at end of period applicable to:
                         
                           
Real estate - construction
  
$
-
    
33
%
$
3
    
28
%
Real estate - mortgage
    
76
    
41
    
81
    
42
  
Commercial
    
15,470
    
8
    
16,124
    
10
  
Consumer
    
2,693
    
18
    
2,934
    
20
  
                           
Total
 
$
18,239
    
100
%
$
19,142
    
100
%






Rollforward - allowance for credit losses:
   
Six Months Ended
June 30,
  
(Dollars in thousands)
  
2006
  
2005
  
           
Balance, beginning of period
  
$
19,142
  
$
7,353
  
Charge-offs
    
2,225
    
503
  
Recoveries
    
(202
)
  
(212
)
Net charge-offs
    
2,023
    
291
  
Provision for credit losses
    
1,120
    
1,318
  
Balance, end of period
  
$
18,239
  
$
8,380
  
               
Annualized net charge-offs during the
              
period to average loans outstanding
              
during the period
    
0.53
%
  
0.08
%
Allowance for credit losses to
             
period end loans
    
2.43
%
  
1.10
%
 

Nonperforming assets:
 
(Dollars in thousands)
  
June 30,
2006
  
December 31, 2005
  
           
Nonaccrual
  
$
14,490
  
$
10,356
  
Past due 90 days or more and still accruing interest
    
-
    
30
  
Other real estate
    
1,609
    
1,483
  
Renegotiated troubled debt
   
-
    
-
  
 
5.
Employee benefit plans

The accompanying table details the components of pension expense recognized in the Company’s Consolidated Statements of Income and Comprehensive Income:


   
For the three months
ended June 30,
  
For the six months
ended June 30,
  
(Dollars in thousands)
  
2006
  
2005
  
2006
  
2005
  
Service cost
  
$
191
  
$
174
  
$
382
  
$
348
  
Interest cost
    
122
   
109
   
244
    
217
  
Expected return on plan assets
    
(137
)
  
(131
)
  
(274
)
  
(262
)
Amortization of prior service cost
    
39
    
5
    
78
    
10
  
Net periodic pension cost
  
$
215
  
$
157
  
$
430
  
$
313
  
 
For the 2006 Plan Year, a maximum tax-deductible contribution of $1,001,748 is allowed.

6.
Shareholders’ equity

The balances in FNB’s shareholders’ equity accounts totaled $69,363,000 at June 30, 2006, compared to $67,233,000 at December 31, 2005, an increase of $2,130,000. The exercise of stock options produced additions of $92,000 and $712,000 respectively, in common stock and paid-in capital. The income tax benefit related to the exercise of stock options increased paid-in capital by $762,000. Retained earnings experienced a net increase of $3,340,000 during the first six months of 2006. The increase is


attributed to net income year to date through June 30, 2006 of $4,768,000, as well as an outflow of $1,691,000 in dividends paid to shareholders. Accumulated other comprehensive losses for the first six months of 2006 amounted to $1,555,000, compared to losses of $369,000 for the same period a year ago.

7.
Memorandum of Understanding

On February 23, 2006, the Company and the Bank entered into a Memorandum of Understanding (the “MOU”) with the Federal Reserve Bank of Richmond (the “Reserve Bank”) and the Office of the North Carolina Commissioner of Banks (the “Commission”). The MOU generally requires:

 
§
The creation of a Compliance Committee by the Boards of Directors of the Company and FNB Southeast (the “Bank”) to oversee compliance by the Company and the Bank with the MOU.
 
§
The engagement of an independent consultant to advise the Boards on the characteristics, composition, and structure of the Boards and the structure and composition of management.
 
§
The adoption of a written plan to strengthen the Bank’s loan administration capacity through supplementing and improving its lending and credit administration staffing, management information systems, reporting procedures, lending policies, and internal loan review function.
 
§
The adoption of a written plan to address its risk position with respect to certain loans identified by its internal reviews and by its independent consultants and also by the Reserve Bank.
 
§
An increased focus upon compliance with federal regulations concerning real estate appraisal procedures and federal guidelines concerning loans in excess of certain loan-to-value standards.
 
§
Increased resources and staffing for the Bank’s internal audit function.

During the period that an MOU, having the general provisions discussed above, is in effect, the financial institution is discouraged from seeking to expand through acquisitions or requesting approval to open additional branches. Accordingly, the Bank will defer pursuit of its strategy of expanding its current markets or entering into new markets through acquisition or branching until the MOU is terminated such earlier time as the Reserve Bank and the Commission state that such expansion is no longer discouraged. The Company and the Bank are taking prompt and aggressive actions to address the elements of the MOU in a complete and timely manner.




The following presents management’s discussion and analysis of our financial condition and results of operations and should be read in conjunction with the financial statements and related notes included elsewhere in this quarterly report. This discussion may contain forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in forward-looking statements as a result of various factors. The following discussion is intended to assist in understanding the financial condition and results of operations of the Company. 

Information set forth below contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which statements represent the Company’s judgment concerning the future and are subject to risks and uncertainties that could cause the Company’s actual operating results to differ materially. Such forward-looking statements can be identified by the use of forward-looking terminology, such as “may”, “will”, “expect”, “anticipate”, “estimate”, “believe”, or “continue”, or the negative thereof or other variations thereof or comparable terminology. The Company cautions that such forward-looking statements are further qualified by important factors that could cause the Company’s actual operating results to differ materially from those in the forward-looking statements.

Application of Critical Accounting Policies

The Company's accounting policies are fundamental to understanding management's discussion and analysis of results of operations and financial condition. The Company's significant accounting policies are discussed in detail in Note 1 of the consolidated financial statements included in the Company's 2005 Annual Report on Form 10-K. The following is a summary of the allowance for credit losses, one of the most complex and judgmental accounting policies of the Company.

The allowance for credit losses, which is utilized to absorb actual losses in the loan portfolio, is maintained at a level consistent with management’s best estimate of probable credit losses incurred as of the balance sheet date. The Company’s allowance for credit losses is also analyzed quarterly by management. This analysis includes a methodology that separates the total loan portfolio into homogeneous loan classifications for purposes of evaluating risk, as well as analysis of certain individually identified loans. The required allowance is calculated by applying a risk adjusted reserve requirement to the dollar volume of loans within a homogenous group. Major loan portfolio subgroups include: risk graded commercial loans, mortgage loans, home equity loans, retail loans and retail credit lines. Management also analyzes the loan portfolio on an ongoing basis to evaluate current risk levels, and risk grades are adjusted accordingly. While management uses the best information to make evaluations, future adjustments may be necessary, if economic or other conditions differ substantially from the assumptions used.

Memorandum of Understanding

In June 2005, the Bank discovered that its lending activities in its Harrisonburg Region were not being operated in compliance with the Bank’s policies and procedures and certain regulatory guidelines. The Bank began internal investigations and engaged independent consultants to review the Harrisonburg loan portfolio and aspects of the Bank’s credit and credit administration operations.

Upon the commencement in October 2005 of the Reserve Bank’s periodic safety and soundness examination of the Bank, the Bank advised the Reserve Bank of the findings of its internal investigations and of its independent consultants. In its examination, the Reserve Bank identified additional items of concern.

As a result of these reviews and the examination and a review of certain loans in the Bank’s Rockingham County (NC) Region, the Bank made special provisions in 2005 for credit losses totaling


$900,000 in its third quarter and $13.6 million in its fourth quarter. The Bank believes these provisions adequately addressed the risks identified in these reviews and the examination.

On February 23, 2006, the Company and the Bank entered into a Memorandum of Understanding (the “MOU”) with the Reserve Bank and the Office of the North Carolina Commissioner of Banks (the “Commission”). The MOU generally requires (in a number of instances the Boards of the Company and the Bank had undertaken the required action in advance of the MOU):
 
§
The creation of a Compliance Committee by the Boards of Directors of the Company and the Bank to oversee compliance by the Company and the Bank with the MOU. This committee was established in February 2006.
 
§
The engagement of an independent consultant to advise the Boards on the characteristics, composition, and structure of the Boards and the structure and composition of management. An independent consultant to perform these functions was engaged by the Boards in November 2005.
 
§
The adoption of a written plan to strengthen the Bank’s loan administration capacity through supplementing and improving its lending and credit administration staffing, management information systems, reporting procedures, lending policies, and internal loan review function. The Bank began this process in August 2005 as a result of its internal investigations and reviews by independent consultants. As a consequence, the Company believes that its compliance with the MOU’s requirements in these areas has been significantly enhanced and that the process is nearing completion.
 
§
The adoption of a written plan to address its risk position with respect to certain loans identified by its internal reviews and by its independent consultants and also by the Reserve Bank. The Bank began this process in August 2005 and believes that significant progress in reducing its risks on these loans has been made.
 
§
An increased focus upon compliance with federal regulations concerning real estate appraisal procedures and federal guidelines concerning loans in excess of certain loan-to-value standards. The Bank adopted policies addressing these matters in January 2006.
 
§
Increased resources and staffing for the Bank’s internal audit function. The Bank has met this requirement.

During the period that an MOU, having the general provisions discussed above, is in effect, the financial institution is discouraged from seeking to expand through acquisitions or requesting approval to open additional branches. Accordingly, the Bank will defer pursuit of its strategy of expanding its current markets or entering into new markets through acquisition or branching until the MOU is terminated such earlier time as the Reserve Bank and the Commission state that such expansion is no longer discouraged.

The Company and the Bank took prompt and aggressive actions to address the issues discovered in the Bank’s internal reviews and through independent consultants. The Company and the Bank have also taken prompt and aggressive actions to respond to additional concerns raised by the Reserve Bank. Although no assurance can be given as to the duration of the MOU, the Company and the Bank believe that following the planned joint safety and soundness examination of the Company and the Bank by the Reserve Bank and the Commission currently expected to commence in October 2006, the Company and the Bank will be found to have fulfilled the requirements of the MOU and the MOU will be terminated.

For a complete discussion of the actions taken with respect to the Company’s lending activities, please reference the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

Executive Summary

FNB Financial Services Corporation (the “Company”) is a North Carolina bank holding company. The Company’s wholly owned subsidiary, FNB Southeast (the “Bank”), is a North Carolina chartered commercial bank. As of June 30, 2006, the Bank operated thirteen banking offices in North Carolina and four banking offices in Virginia. The Bank has two wholly owned subsidiaries: FNB Southeast Investment Services, Inc. and FNB Southeast Mortgage Corporation.


Assets at June 30, 2006 were $1.03 billion, an increase of $20.4 million since December 31, 2005. A $10.0 million increase in net investments, combined with a $6.0 million increase in cash and due from banks, were the principal factors impacting this overall increase during the first six months of 2006. Over the past six months, interest-bearing deposits rose $24.9 million due to promotional campaigns, while noninterest-bearing deposits declined $2.8 million, resulting in a 2.7% net increase in total deposits for the period. The Company’s second quarter earnings were $2.39 million in 2006 and $2.14 million in 2005. Earnings per diluted share were $0.33 for the second quarter of 2006, compared to $0.29 for the same period in 2005.

Financial Condition

Since December 31, 2005, the Company’s assets have increased $20.4 million, rising from $1.01 billion at yearend 2005 to $1.03 billion at June 30, 2006. The principal factors impacting this overall increase during the first six months of 2006 were a $10.0 million increase in net investments, combined with a $6.0 million increase in cash and due from banks. Loans at June 30, 2006 totaled $750.7 million, compared to $758.0 million at yearend 2005, a decrease of 1.0%. This small decline in the loan portfolio was primarily a result of management’s focus being shifted from new loan production to reviewing the quality of the existing portfolio in connection with the MOU. Investment securities of $211.9 million at June 30, 2006 were 4.9% higher than the $201.9 million balance at December 31, 2005.

Deposits totaled $846.8 million at June 30, 2006, compared to $824.6 million at December 31, 2005. At the end of the second quarter 2006, noninterest-bearing deposits were $90.1 million, or 10.6%, of total deposits. Borrowings at the Federal Home Loan Bank of Atlanta (“FHLB”) totaled $75.0 million at June 30, 2006 and December 31, 2005. Federal funds purchased and retail repurchase agreements totaled $7.3 million at June 30, 2006 and December 31, 2005. Trust preferred securities of $25.77 million were outstanding at June 30, 2006 and December 31, 2005.

Shareholders’ equity remains strong, with all of our regulatory capital ratios at levels that classify the Company as “well capitalized” under bank regulatory capital guidelines. Shareholders’ equity increased to $69.4 million at the end of the second quarter 2006, compared to $67.2 million at December 31, 2005. The Company paid dividends of $0.12 per share during the quarter ended June 30, 2006, a 9.1% increase over the $0.11 per share dividend rate for the second quarter of 2005.

Asset Quality

The Company’s allowance for credit losses is analyzed quarterly by management. This analysis includes a methodology that segments the loan portfolio into homogeneous loan classifications and considers the current status of the portfolio, historical charge-off experience, current levels of delinquent, impaired and nonperforming loans, as well as economic and other risk factors. It is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology employed and other analytical measures in comparison to a group of peer banks. Management believes the allowance for loan losses is sufficient to absorb known risk in the portfolio. No assurances can be given that future economic conditions will not adversely affect borrowers and result in increased losses. Management also continues to follow the extensive procedures begun in the 4th quarter of 2005 to address risk grade issues noted in the MOU (see “Memorandum of Understanding”).

The allowance for credit losses was 2.43% of outstanding loans at June 30, 2006, 2.53% at December 31, 2005, and 1.10% at June 30, 2005. For the second quarter of 2006, provision charges against earnings totaled $365,000 compared to $638,000 in the second quarter of 2005. Net charge-offs for the second quarter of 2006 totaled $791,000, or a 0.42% annualized loss ratio based on average loans outstanding. This is an increase from the net charge-offs for the second quarter of 2005 totaling $102,000, or 0.06% annualized loss ratio. During the fourth quarter of 2005 the Bank recorded provisions totaling $13.6 million related to loans which were downgraded for credit risk. The higher level of charge-offs during the second quarter of 2006 resulted primarily from the charge-off of a portion of these loans. Management anticipates continued charge-offs of such loans in upcoming quarters, thereby resulting in charge-off ratios higher than prior years.

 


Nonperforming loans totaled $14.5 million at June 30, 2006, compared to $10.4 million at yearend 2005 and $4.0 million at June 30, 2005. The increase in nonperforming loans occurred primarily as a result of loans that were considered impaired at yearend moving into a nonaccrual status at June 30, 2006. Other real estate owned (“OREO”) was $1.6 million at June 30, 2006, $1.5 million at December 31, 2005, and $2.6 million at June 30, 2005. Approximately $388,000 has been transferred from loans into OREO and approximately $347,000 of such assets were disposed of during the first six months of 2006. A net loss of $7,660 has been recorded on disposition of OREO in the current year, compared to $535,000 in net losses on disposition or write downs for the same period a year ago. The Company had no write downs in the first six months of 2006, compared to $524,000 in OREO write downs during the first six months of 2005.

Total nonperforming assets (comprised of nonperforming loans and OREO) increased to $16.1 million, or 1.6% of total assets, at June 30, 2006, from $11.9 million, or 1.2% of total assets, at December 31, 2005 and $6.6 million, or 0.7% of total assets, a year ago.

Results of Operations for the Three Months Ended June 30, 2006 and 2005

Interest Income and Interest Expense

Total interest income was $18.0 million for the second quarter of 2006, compared to $15.1 million for the same period a year ago. Average earning assets for the current quarter were $977.0 million, an increase of 8.6% over the second quarter average of $899.5 million a year ago. Interest income from loans was $15.8 million, up 16.0% from $13.6 million in the second quarter of 2005. The increase in interest income was driven by an increase in average loans outstanding, combined with a rising interest rate environment. Average loans of $760.0 million were 3.0% higher than the $737.7 million last year. Interest income on investment securities totaled $2.14 million for the three months ended June 30, 2006, compared to $1.37 million for the second quarter of 2005. The average balance of the investment portfolio was $209.0 million for the quarter ended June 30, 2006, a 36.3% increase from the average balance of $153.4 million for the second quarter of the prior year. The increase in the investment portfolio is primarily attributable to management’s efforts to achieve the desired balance among earning assets, combined with the utilization of the proceeds from the issuance of junior subordinated notes during the third quarter of 2005.

Second quarter total interest expense was $8.48 million, compared to $5.98 million from the second quarter of last year, a 41.9% increase. Average interest bearing deposits increased 5.8%, to $734.6 million, from $694.5 for the second quarter of 2005. The average balance of federal funds purchased, borrowed funds and securities sold under agreements to repurchase was $118.9 million for the second quarter of 2006 and $87.2 million for the same period in 2005. The Company primarily utilized the growth in deposits as funding sources to support balance sheet growth.

During the three months ended June 30, 2006, net interest income increased to $9.54 million, or 5.0%, over the same period a year ago. Net interest income benefited from solid growth in average earning assets which rose from $899.5 million for the second quarter of 2005 to $977.0 million for the second quarter of 2006, an 8.6% increase. The average yields on total interest earning assets for the same periods increased 69 basis points, from 6.79% to 7.48%. Average interest bearing liabilities for the second quarter of 2006 increased 9.2%, to $853.5 million, from $781.7 million for the second quarter of 2005. The average cost of interest bearing liabilities for the same periods increased 91 basis points from 3.07% to 3.98%. The net result was a decrease in the interest rate spread from 3.72% for the three months ended June 30, 2005 to 3.50% for the same period in 2006. Management anticipates continued increases in funding costs during the current year.
 
 
Net Interest Income and Rate / Volume Analysis
                                              
For the Three Months Ended June 30, 2006 and 2005
                                              
                                               
   
Average Balance  
  
 Yield / Rate  
  
 Income / Expense  
  
 Increase
  
 Change due to  
  
Fully Taxable Equivalent - (Dollars in thousands)
  
2006
  
 2005
  
 2006
  
 2005
  
 2006
  
 2005
  
(Decrease) 
  
 Rate
  
 Volume
  
                                               
Assets
                                                        
Securities(1):
                                                        
Taxable investment securities
  
$
159,290
  
$
114,686
   
4.09
%
  
3.41
%
$
1,625
 
$
976
 
$
649
 
$
(8,422
)
$
9,071
 
Tax-exempt investment securities
    
41,161
   
32,134
   
5.98
   
6.02
   
614
   
482
   
132
   
258
   
(126
)
Other securities
    
8,590
   
6,591
   
5.18
   
4.69
   
111
   
77
   
34
   
0
   
0
 
                                                         
Total securities 
    
209,041
   
153,411
   
4.51
   
4.01
   
2,350
   
1,535
   
815
   
(8,164
)
  
8,945
 
Other earning assets(2)
    
8,041
   
8,376
   
3.14
   
2.92
   
63
   
61
   
2
   
(82
)
  
84
 
Loans and leases, net(3)(4)
    
759,949
   
737,735
   
8.35
   
7.41
   
15,814
   
13,629
   
2,185
   
14,392
   
(12,207
)
                                                         
Total earning assets 
    
977,031
   
899,522
   
7.48
   
6.79
   
18,227
   
15,225
   
3,002
   
6,146
   
(3,178
)
                                                         
Non-earning assets 
    
45,236
   
55,266
                                           
                                                         
 Total assets
  
$
1,022,267
  
$
954,788
                                           
                                                         
Liabilities and Shareholders' Equity
                                                        
Interest-bearing deposits:
                                                        
Savings deposits
  
$
52,362
  
$
52,850
   
0.32
   
0.24
   
42
   
31
   
11
   
(12
)
  
23
 
Money market deposits
    
116,530
   
127,787
   
3.65
   
2.58
   
1,060
   
823
   
237
   
(3,342
)
  
3,579
 
Time deposits
    
565,739
   
513,857
   
4.16
   
3.43
   
5,874
   
4,399
   
1,475
   
17,353
   
(15,878
)
                                                         
Total interest-bearing deposits 
    
734,631
   
694,494
   
3.81
   
3.03
   
6,976
   
5,253
   
1,723
   
13,999
   
(12,276
)
Short-term borrowings
    
18,131
   
23,334
   
4.18
   
2.42
   
189
   
141
   
48
   
(1,930
)
  
1,978
 
Long-term debt
    
100,774
   
63,835
   
5.23
   
3.65
   
1,314
   
581
   
733
   
(13,341
)
  
14,074
 
                                                         
Total interest-bearing liabilities 
    
853,536
   
781,663
   
3.98
   
3.07
   
8,479
   
5,975
   
2,504
   
(1,272
)
  
3,776
 
                                                         
Demand deposits 
    
89,311
   
88,550
                                           
Other liabilities 
    
10,523
   
12,420
                                           
Shareholders' equity 
    
68,897
   
72,155
                                           
                                                         
Total liabilities and 
                                                        
 shareholders' equity
  
$
1,022,267
  
$
954,788
                                           
Average interest rate spread
                
3.50
%
  
3.72
%
                              
Net yield on earning assets
                
4.00
   
4.12
 
$
9,748
 
$
9,250
 
$
498
 
$
7,418
 
$
(6,954
)
                                                         
Taxable equivalent adjustment
                          
$
209
 
$
164
                   
                                                         
 
_____________________________
(1)
Yields related to investment securities, loans and leases exempt from both federal and state income taxes, federal income taxes only or state income taxes only are stated
 
on a taxable equivalent basis assuming tax rates in effect for the periods presented.
(2)
Includes federal funds sold and securities purchased under resale agreements or similar arrangements.
(3)
Loan fees, which are not material for either of the periods shown, have been included for rate calculation purposes.
(4)
Nonaccrual loans have been included in the average balances. Only the interest collected on such loans has been included as income.
(5)
Includes assets which were held for sale.


 


Provision for Credit Losses

A provision for credit losses is charged against earnings in order to maintain the allowance for credit losses at a level that reflects management’s evaluation of the incurred losses inherent in the portfolio. The amount of the provision is based on continuing assessments of nonperforming and “watch list” loans, analytical reviews of loan loss experience in relation to outstanding loans, loan charge-offs, nonperforming asset trends and management’s judgment with respect to current and expected economic conditions and their impact on the existing credit portfolio (see “Memorandum of Understanding”).

The provision for credit losses in the second quarter of 2006 was $365,000, compared to $638,000 in 2005. The allowance for credit losses as a percent of gross loans outstanding was 2.43% at June 30, 2006, 2.53% at December 31, 2005, and 1.10% at June 30, 2005. Annualized net credit losses, as a percent of average loans, was 0.42% and 0.06% for the quarters ended June 30, 2006 and 2005, respectively.

Noninterest Income and Expense

Noninterest income in the second quarter of 2006 was $1.31 million, compared to $1.82 million in the same period last year. Deposit service charges were $968,000 for the second quarter of 2006, compared to $964,000 in the second quarter of 2005. There were no gains or losses on sales of securities available for sale during the second quarter of 2006; however, sales of securities during the same period in 2005 resulted in a loss of $3,000. Noninterest income in the second quarter of 2006 included $199,000 in mortgage banking fees and $84,000 in investment service fees compared to revenues of $618,000 and $95,000, respectively, for the same period a year ago. The rising interest rate environment has dampened the demand for mortgage loans which resulted in a decline in fees associated with the generation of mortgage loans.

Noninterest expense for the second quarter of 2006 was $6.85 million, a 2.8% decline from the $7.05 million expense in the second quarter of 2005. Salaries and employee benefits increased $584,000 because of higher costs associated with additional headcount, the employment of individuals with increased educational background and experience, and the recognition of stock option expense during 2006, combined with higher insurance and retirement costs. Marketing expense was relatively flat in the second quarter 2006, compared to the same period a year ago, primarily because of increased efforts to centralize marketing efforts and improve the efficiency of those efforts. Other expense for the second quarters of 2006 and 2005 totaled $1.15 million and $1.89 million, respectively. The decline in other expenses is the result, primarily, of a strategic effort to reduce noninterest expenses and improve efficiency.

Provision for Income Taxes

The Company’s provision for income taxes totaled $1.25 million for the second quarter of 2006 and $1.08 million for the same period in 2005. The Company’s effective tax rate was 34.4% for the three-month period ended June 30, 2006, compared to 33.7% for the second quarter of 2005. The increase in the provision for 2006, compared to the prior year, results primarily from the increase in taxable income. Overall, the effective tax rate is attributable to the current expense required to provide an adequate provision for income taxes for the quarters ended June 30, 2006 and 2005.

Results of Operations for the Six Months Ended June 30, 2006 and 2005

Interest Income and Interest Expense

Total interest income was $35.91 million for the first six months of 2006, compared to $28.44 million for the same period a year ago. Average earning assets for the six months ended June 30, 2006 totaled $975.8 million, an increase of 12.0% over the average of $871.0 million for the same period a year ago. Interest income from loans was $31.57 million, up 22.7% from $25.73 million in the first six months of 2005. The increase in interest income was driven by an increase in average loans outstanding, combined with a rising interest rate environment. Average loans of $760.0 million were 5.9% higher than the $717.6 million last year. Interest income on investment securities totaled $4.19 million for the six months ended June 30, 2006, compared to $2.58 million for the same period a year ago. The average balance of the investment portfolio was $206.8 million for the six months ended June 30, 2006, a 40.0% increase from the average balance of $147.7 million for the prior year first six months. The increase in the investment portfolio resulted primarily from management’s efforts to achieve the desired balance among earning assets, combined with the utilization of the proceeds from the issuance of junior subordinated notes during the third quarter of 2005.

Total interest expense for the first six months of 2006 was $16.27 million, compared to $10.84 million from the same period last year, a 50.1% increase. Average interest bearing deposits increased 8.9%, to $737.9 million, from $677.3 for the first six months of 2005. The average balance of federal funds purchased, borrowed funds and securities sold under agreements to repurchase was $114.3 million for the  first half of 2006 and $81.7 million for the same period in 2005. The Company primarily utilized the growth in deposits as funding sources to support balance sheet growth.

During the six months ended June 30, 2006, net interest income increased 11.6% over the same period a year ago, to $19.64 million. Net interest income benefited from strong growth in average earning assets which rose from $874.0 million for the first six months of 2005 to $975.8 million for the first six months of 2006, an 11.7% increase. The average yields on total interest earning assets for the same periods increased 86 basis points, from 6.64% to 7.50%. Average interest bearing liabilities for the first six months of 2006 increased 12.3%, to $852.1 million, from $759.0 million for the same period in 2005. The average cost of interest bearing liabilities for the same periods increased 97 basis points, from 2.88% to 3.85%. The net result was a decrease in the interest rate spread from 3.76% for the six months ended June 30, 2005, to 3.65% for the same period in 2006. Management anticipates continued increases in funding costs during the current year.
Net Interest Income and Rate / Volume Analysis
                                              
For the Six Months Ended June 30, 2006 and 2005
                                              
                                               
   
Average Balance  
  
 Yield / Rate  
  
 Income / Expense  
  
 Increase
  
 Change due to  
  
Fully Taxable Equivalent - (Dollars in thousands)
  
2006
  
 2005
  
 2006
  
 2005
  
 2006
  
 2005
  
 (Decrease)
  
 Rate
  
 Volume
  
                                               
Assets
                                                        
Securities(1):
                                                        
Taxable investment securities
  
$
158,787
  
$
109,169
   
4.07
%
  
3.32
%
$
3,201
 
$
1,799
 
$
1,402
 
$
(18,643
)
$
20,045
 
Tax-exempt investment securities
    
39,807
   
32,231
   
5.96
   
6.03
   
1,177
   
963
   
214
   
639
   
(425
)
Other securities
    
8,173
   
6,319
   
5.16
   
4.56
   
209
   
143
   
66
   
0
   
0
 
                                                         
Total securities 
    
206,767
   
147,719
   
4.47
   
3.97
   
4,587
   
2,905
   
1,682
   
(18,004
)
  
19,620
 
Other earning assets(2)
    
9,061
   
8,686
   
3.29
   
2.95
   
148
   
127
   
21
   
191
   
(170
)
Loans and leases, net(3)(4)
    
759,988
   
717,586
   
8.38
   
7.23
   
31,571
   
25,732
   
5,839
   
55,721
   
(49,882
)
                                                         
Total earning assets 
    
975,816
   
873,991
   
7.50
   
6.64
   
36,306
   
28,764
   
7,542
   
37,908
   
(30,432
)
                                                         
Non-earning assets 
    
43,234
   
53,098
                                           
                                                         
 Total assets
  
$
1,019,050
  
$
927,089
                                           
                                                         
Liabilities and Shareholders' Equity
                                                        
Interest-bearing deposits:
                                                        
Savings deposits
  
$
52,210
  
$
52,795
   
0.32
   
0.19
   
84
   
51
   
33
   
(28
)
  
61
 
Money market deposits
    
130,104
   
124,499
   
3.47
   
2.41
   
2,239
   
1,488
   
751
   
3,045
   
(2,294
)
Time deposits
    
555,535
   
499,966
   
4.06
   
3.23
   
11,172
   
7,997
   
3,175
   
36,316
   
(33,141
)
                                                         
Total interest-bearing deposits 
    
737,849
   
677,260
   
3.69
   
2.84
   
13,495
   
9,536
   
3,959
   
39,333
   
(35,374
)
Short-term borrowings
    
13,509
   
21,784
   
3.67
   
2.23
   
246
   
241
   
5
   
(5,676
)
  
5,681
 
Long-term debt
    
100,774
   
59,939
   
5.05
   
3.57
   
2,524
   
1,062
   
1,462
   
(24,860
)
  
26,322
 
                                                         
Total interest-bearing liabilities 
    
852,132
   
758,983
   
3.85
   
2.88
   
16,265
   
10,839
   
5,426
   
8,797
   
(3,371
)
                                                         
Demand deposits 
    
88,248
   
85,498
                                           
Other liabilities 
    
10,118
   
11,117
                                           
Shareholders' equity 
    
68,552
   
71,491
                                           
                                                         
Total liabilities and 
                                                        
 shareholders' equity
  
$
1,019,050
  
$
927,089
                                           
Average interest rate spread
                
3.65
%
  
3.76
%
                              
Net yield on earning assets
                
4.14
   
4.14
 
$
20,041
 
$
17,925
 
$
2,116
 
$
29,111
 
$
(27,061
)
                                                         
Taxable equivalent adjustment
                          
$
400
 
$
327
                   
 
(1)
Yields related to investment securities, loans and leases exempt from both federal and state income taxes, federal income taxes only or state income taxes only are stated
 
on a taxable equivalent basis assuming tax rates in effect for the periods presented.
(2)
Includes federal funds sold and securities purchased under resale agreements or similar arrangements.
(3)
Loan fees, which are not material for either of the periods shown, have been included for rate calculation purposes.
(4)
Nonaccrual loans have been included in the average balances. Only the interest collected on such loans has been included as income.
(5)
Includes assets which were held for sale.

Provision for Credit Losses

A provision for credit losses is charged against earnings in order to maintain the allowance for credit losses at a level that reflects management’s evaluation of the incurred losses inherent in the portfolio. The amount of the provision is based on continuing assessments of nonperforming and “watch list” loans, analytical reviews of loan loss experience in relation to outstanding loans, loan charge-offs, nonperforming asset trends and management’s judgment with respect to current and expected economic conditions and their impact on the existing credit portfolio (see “Memorandum of Understanding”).

The provision for credit losses in the second quarter of 2006 was $1.1 million, compared to $1.3 million in 2005. The allowance for credit losses as a percent of gross loans outstanding was 2.43% at June 30, 2006, 2.53% at December 31, 2005, and 1.10% at June 30, 2005. Annualized net credit losses, as a percent of average loans, was 0.53% and 0.08% for the six months ended June 30, 2006 and 2005, respectively. Management anticipates the net charge-off ratio to continue at an elevated rate during the upcoming quarters.

Noninterest Income and Expense

Noninterest income in the first six months of 2006 was $2.64 million, compared to $3.95 million in the same period last year. Deposit service charges were $1.84 million for the six months ended June 30, 2006, compared to $1.79 million for the same period of 2005. There were no gains or losses on sales of securities available for sale during the first half of 2006; however, sales of securities during the same period in 2005 resulted in a loss of $5,000. Noninterest income in the first six months of 2006 included $441,000 in mortgage banking fees and $212,000 in investment service fees compared to revenues of $1.62 million and $233,000, respectively, for the same period a year ago. The rising interest rate environment has dampened the demand for mortgage loans which resulted in a decline in fees associated with the generation of mortgage loans.

Noninterest expense for the first six months of 2006 was $13.90 million, a 0.2% decrease compared to the $13.94 million expense in the first half of 2005. Salaries and employee benefits increased $1.27 million because of higher costs associated with additional headcount, the employment of individuals with increased educational background and experience, and the recognition of stock option expense during 2006, combined with higher insurance and retirement costs. Marketing expense decreased $65,000 in the first half 2006, compared to the same period a year ago, primarily because of increased efforts to centralize marketing efforts and improve the efficiency of those efforts. Other expense for the first six months of 2006 and 2005 totaled $2.41 million and $3.56 million, respectively. The decline in other expenses is the result, primarily, of a strategic effort to reduce noninterest expenses and improve efficiency.
 
Provision for Income Taxes

The Company’s provision for income taxes totaled $2.49 million for the first six months of 2006 and $2.12 million for the same period in 2005. The Company’s effective tax rates were 34.3% for the six-month period ended June 30, 2006, compared to 33.7% for the first six months of 2005. The increase in the provision for 2006, compared to the prior year, results primarily from the increase in taxable income. Overall, the effective tax rate is attributable to the current expense required to provide an adequate provision for income taxes for the six months ended June 30, 2006 and 2005.

Capital Resources

Banks and financial holding companies, as regulated institutions, must meet required levels of capital. The Office of the Commissioner of Banks in North Carolina and the Board of Governors of the Federal Reserve, which are the primary regulatory agencies for the Bank and the Company, respectively, have adopted minimum capital regulations or guidelines that categorize components and the level of risk associated with various types of assets. Financial institutions are required to maintain a level of capital commensurate with the risk profile assigned to their assets in accordance with the guidelines.

As shown in the accompanying table, the Company and its wholly owned banking subsidiary have capital levels exceeding the minimum levels for “well capitalized” banks and bank holding companies as of June 30, 2006.

   
Regulatory Guidelines
          
   
Well
Capitalized
  
Adequately
Capitalized
  
 
Company
  
FNB Southeast
  
                   
Total Capital
   
10.0
%
  
8.0
%
  
13.30
%
  
13.00
%
Tier 1 Capital
    
6.0
    
4.0
    
11.95
    
11.73
  
Leverage Capital
    
5.0
    
4.0
    
9.34
    
9.16
  

Liquidity Management

Liquidity management refers to the ability to meet day-to-day cash flow requirements based primarily on activity in loan and deposit accounts of the Company’s customers. Deposit withdrawals, loan funding and general corporate activity create a need for liquidity for the Company. Liquidity is derived from sources such as deposit growth; maturity, calls, or sales of investment securities; principal and interest payments on loans; access to borrowed funds or lines of credit; and profits.

During the first six months of 2006, the Company had net cash used by operating activities of $485,000, compared to $6.9 million of net cash provided by operating activities in the first six months of 2005. This is primarily attributable to a decrease in other liabilities of $3.4 million for the first six months of 2006, compared to the $1.9 million increase during the same period of 2005. Other assets increased by $3.4 million for the period ended June 30, 2006, compared with an increase of $4.4 million for the same period of 2005. Also contributing to this variance was a $409,000 decrease in the warehouse line of credit in 2006, compared to a $3.2 million increase during the six months ended June 30, 2005.

Net cash used in investing activities in the first six months of 2006 totaled $8.3 million, a decrease of $103.4 million from the six months ended June 30, 2005. This decrease in cash used in investing activities is primarily attributable to a net decrease in loans outstanding of $5.3 million, compared to a net increase of $98.4 million during the first six months of 2005. Purchases of investment securities in the current year totaled $18.5 million and proceeds from sales, calls, or maturities of securities were $7.1 million. This compares to the first six months of 2005 when purchases of investment securities totaled $26.4 million and proceeds from sales, calls, or maturities of securities totaled $11.0 million, leading to net cash used in investment activities of $8.3 million. Purchases of premises and equipment used $2.5 million in 2006, compared to $1.1 million in 2005.



During the six months ended June 30, 2006, financing activities provided $20.3 million compared to $108.4 million during the same six months in 2005. This change in financing activities is based primarily on a $22.2 million rise in deposits during the first six months of 2005, compared to an $87.1 million rise in deposits and cash inflows from other borrowings of $20.0 million during the first six months of 2005.

Overall cash and cash equivalents totaled $38.7 million at June 30, 2006, compared to $27.1 million at December 31, 2005 and $27.7 million at June 30, 2005.

Liquidity is further enhanced by a line of credit with the FHLB collateralized by FHLB stock, investment securities and qualifying 1-4 family residential mortgage loans, and qualifying commercial real estate loans. The Company provides various reports to the FHLB on a regular basis throughout the year to maintain the availability of the credit line. Each borrowing request to the FHLB is initiated through an advance application that is subject to approval by the FHLB before funds are advanced under the credit agreement.

The Company also has unsecured overnight borrowing lines available through five financial institutions. These lines are used to manage the day-to-day, short-term liquidity needs of the Company. Each Federal funds line has a requirement to repay the line in full on a frequent basis, typically within five to ten business days. The Company has also established a wholesale repurchase agreement with a regional brokerage firm. The Company can access this additional source of liquidity by pledging investment securities with the brokerage firm.


Market risk is the possible chance of loss from unfavorable changes in market prices and rates. These changes may result in a reduction of current and future period net interest income, which is the favorable spread earned from the excess of interest income on interest-earning assets, over interest expense on interest-bearing liabilities.

The Company considers interest rate risk to be its most significant market risk, which could potentially have the greatest impact on operating earnings. The Company is asset sensitive, which means that falling interest rates could result in a reduced amount of net interest income. The monitoring of interest rate risk is part of the Company’s overall asset/liability management process. The primary oversight of asset/liability management rests with the Company’s Asset and Liability Committee. The Committee meets on a regular basis to review asset/liability activities and to monitor compliance with established policies.

The Company has not experienced any substantive changes in portfolio risk during the six months ended June 30, 2006.


Evaluation of disclosure controls and procedures

The Company’s management, including its Chief Executive Officer (“CEO”), Chief Financial Officer (“CFO”), and Chief Accounting Officer (“CAO”), evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of June 30, 2006. Based upon that evaluation, the Company’s CEO, CFO, and CAO each concluded that as of June 30, 2006, the end of the period covered by this Quarterly Report on Form 10-Q, the Company did not maintain effective disclosure controls and procedures.

Changes in internal control over financial reporting


As of the end of the period covered by this report, the Company has not fully remediated the material weakness in the Company’s internal control over financial reporting relating to the allowance for credit losses.
 
There have been no changes to the Company’s internal control over financial reporting that occurred since the beginning of the Company’s second quarter of 2006 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
 
 
None.
 
 
No material changes.
 
 
The accompanying table details, by month, the information related to the share repurchase program approved by the Company’s Board of Directors in July 2004 authorizing the repurchase of up to 343,905 shares of the Company’s outstanding common stock. The program was publicly announced in the month of approval.



Stock Repurchase Program - Approved July 2004
 
 
 
Period                
(a)
Total Number of
Shares
Purchased
(b)
 
Average Price
Paid Per Share
(c)
 
Cumulative Number of
Shares Purchased
(d)
Maximum Number
of Shares that May Yet Be
Purchased
April 1, 2006 to
April 30, 2006
-
-
143,338
200,567
         
May 1, 2006 to May 31, 2006
65,515
$15.11
208,853
135,052
         
June 1, 2006 to
June 30, 2006
15,362
$15.10
224,215
119,690
         
Total
80,877
$15.11
    

 
Not Applicable.
 

 
 
On May 18, 2006, at the Annual Meeting of the Company’s shareholders, the following proposals were voted on by shareholders:
 
Proposal
 
To elect three persons who will serve as members of the Board of Directors until the 2009 annual meeting of shareholders or until their successors are duly elected and qualified:
 
 
Nominee
For
Withheld
 
Alex A. Diffey, Jr.
5,308,629
168,395
 
C. Arnold Britt
5,179,764
297,259
 
Barry Z. Dodson
5,179,384
297,640




 

The following directors remain in office: Gary G. Blosser, Joseph H. Kinnarney, Kenan C. Wright, Pressley A. Ridgill, Robbie Perkins, and E. Reid Teague.
 
Proposal
 
To ratify the appointment of Dixon Hughes, PLLC (“Dixon Hughes”) as the Corporation’s independent registered public accounting firm for the year ending December 31, 2006:
 
 
For
Against
Abstain
 
5,330,162
95,545
51,317
 
Proposal
 
To approve the FNB Financial Services Corporation Long-Term Stock Incentive Plan:
 
 
For
Against
Abstain
 
2,603,203
1,170,605
378,953
 
 
None.
 
 
 
Exhibit No.
Description
     
 
3.01 (1)
Amended and Restated Articles of Incorporation.
 
3.02 (1)
Bylaws of Company, as amended.
 
4.01 (2)
Specimen Common Stock Certificate.
 
4.02 (14)
Amended and Restated Trust Agreement, regarding Trust Preferred Securities, dated August 23, 2005.
 
4.03 (14)
Guarantee Agreement, regarding Trust Preferred Securities, dated August 23, 2005.
 
4.04 (14)
Indenture, regarding Trust Preferred Securities, dated August 23, 2005.
 
10.01 (3)
Stock Compensation Plan of the Registrant approved April 11, 1989, by the shareholders of the Registrant, with forms of stock option and stock bonus agreements attached.
 
10.02 (4)
Omnibus Equity Compensation Plan of the Registrant.
 
10.03 (5)
Severance Policy for Senior Officers of the Registrant (employed for five years or more).
 
10.04 (6)
Revised Severance Plan for Senior Officers of the Registrant (employed for five years or more).
 
10.05 (7)
Severance Policy for Senior Officers of the Registrant (employed for less than five years).
 
10.06 (1)
Change of Control Severance Plan
 
10.07 (8)
Benefit Equivalency Plan of the Registrant effective January 1, 1994.
 
10.08 (8)
Long Term Incentive Plan of the Registrant.
 
10.09 (10)
Long Term Incentive Plan of the Registrant for certain senior management employees.
 
10.10 (8)
Employment Agreement dated May 18, 1995, between the Registrant, as employer, and Ernest J. Sewell, former President and Chief Executive Officer of the Registrant.
 
10.11 (9)
Split-Dollar Agreement dated January 27, 1995, between the Registrant and Ernest J. Sewell.
 
10.12 (9)
Split-Dollar Agreement dated January 27, 1995, between the Registrant and C. Melvin Gantt.
 
 
 
10.13 (9)
Split-Dollar Agreement dated December 8, 1995, between the Registrant and Richard L. Powell.
 
10.14 (11)
Amendment to Benefit Equivalency Plan of the Registrant effective January 1, 1998.
 
10.15 (9)
Split-Dollar Agreement, dated March 20, 1998, between the Registrant and Ernest J. Sewell.
 
10.16 (12)
Second Amendment, dated May 19, 2004, to the Employment Agreement, dated May 18, 1995, between the Registrant, as employer, and Ernest J. Sewell, former President and Chief Executive Officer of the Registrant.
 
10.17 (13)
Employment and Change of Control Agreement dated July 1, 2004, between the Registrant, as employer, and Pressley A. Ridgill, Executive Vice President and Chief Operating Officer of the Registrant.
 
10.18 (12)
Third Amendment to Employment Agreement and First Amendments to Split-Dollar Agreements and Collateral Agreements with Ernest J. Sewell effective January 1, 2004.
 
10.20 (14)
Fourth Amendment to Employment Agreement with Ernest J. Sewell, executed on October 20, 2005 and effective February 1, 2006.
 
10.21 (14)
Independent Contractor Consulting Agreement with Ernest J. Sewell, executed October 20, 2005 and effective February 1, 2006.
 
10.22 (15)
2006 Annual Management Incentive Plan of the Registrant.
 
10.23 (15)
Long Term Incentive Plan of the Registrant for certain senior management employees.
 
31.01
 
31.02
 
32.01
 
Exhibit references:

 
(1)
Incorporated herein by reference to the Registrant’s Current Report on Form 8-K, dated May 25, 2005, filed with the Securities and Exchange Commission.
 
(2)
Incorporated herein by reference to the Registrant’s Quarterly Report on Form 10-Q for the fiscal quarter ended March 31, 1998, filed with the Securities and Exchange Commission.
 
(3)
Incorporated herein by reference to the Registrant’s Statement on Form S-8 (No. 33-33186), filed with the Securities and Exchange Commission.
 
(4)
Incorporated herein by reference to the Registrant’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1996, filed with the Securities and Exchange Commission.
 
(5)
Incorporated herein by reference to the Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 1989, filed with the Securities and Exchange Commission.
 
(6)
Incorporated herein by reference to the Registrant’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1994, filed with the Securities and Exchange Commission.
 
(7)
Incorporated herein by reference to the Registrant’s Quarterly Report, on Form 10-QSB for the fiscal quarter ended June 30, 1995, filed with the Securities and Exchange Commission.
 
(8)
Incorporated herein by reference to the Registrant’s Statement on Form S-2 (File No. 333-47203) filed with the Securities and Exchange Commission on March 3, 1998.
 
(9)
Incorporated herein by reference to the Registrant’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1997, filed with the Securities and Exchange Commission.
 
(10)
Incorporated herein by reference to the Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002, filed with the Securities and Exchange Commission
 
(11)
Incorporated herein by reference to the Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 1998, filed with the Securities and Exchange Commission.
 
(12)
Incorporated herein by reference to the Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004, filed with the Securities and Exchange Commission.
 
(13)
Incorporated herein by reference to the Registrant’s Quarterly Report, on Form 10-Qfor the fiscal quarter ended September 30, 2004, filed with the Securities and Exchange Commission.
 
(14)
Incorporated herein by reference to the Registrant’s Quarterly Report, on Form 10-Q for the fiscal quarter ended September 30, 2005, filed with the Securities and Exchange Commission.
 
(15)
Incorporated herein by reference to the Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005, filed with the Securities and Exchange Commission.
 


SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


   
 
FNB FINANCIAL SERVICES CORPORATION
 
(Registrant)
   
   
   
August 9, 2006
/s/ K. Dwight Willoughby
 
K. Dwight Willoughby
 
(Senior Vice President, Chief Accounting Officer, and Controller)


25