10-Q 1 h08191e10vq.txt STERLING BANCSHARES, INC.- JUNE 30, 2003 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 ----------- FORM 10 - Q ------------ [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarter ended June 30, 2003 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to _______________ to _______________ Commission File Number: 0-20750 STERLING BANCSHARES, INC. (Exact name of registrant as specified in its charter) TEXAS 74-2175590 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 2550 NORTH LOOP WEST, SUITE 600 HOUSTON, TEXAS 77092 (Address of principal executive office) (Zip Code) 713-466-8300 (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 and Exchange Act of 1934 ("Act") during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Act). Yes [X] No [ ] As of August 7, 2003, there were outstanding 44,184,552 shares of common stock, par value $1.00 per share, of the registrant. ================================================================================ PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS STERLING BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands)
JUNE 30, DECEMBER 31, 2003 2002 ------------ ------------ (UNAUDITED) ASSETS Cash and cash equivalents $ 156,674 $ 139,209 Interest-bearing deposits in financial institutions 1,239 1,302 Trading assets 137,784 142,803 Available-for-sale securities, at fair value 225,785 251,165 Held-to-maturity securities, at amortized cost 53,473 61,889 Loans held for sale 604,337 701,301 Loans held for investment 2,042,149 1,910,565 Allowance for credit losses (31,574) (27,248) ----------- ----------- Loans held for investment, net 2,010,575 1,883,317 Accrued interest receivable 12,125 15,637 Real estate acquired by foreclosure 4,736 3,358 Premises and equipment, net 46,688 49,860 Goodwill, net 50,354 55,666 Other assets 99,987 178,407 Assets related to discontinued operations 41,409 98,831 ----------- ----------- TOTAL ASSETS $ 3,445,166 $ 3,582,745 =========== =========== LIABILITIES AND SHAREHOLDERS' EQUITY Demand deposits: Noninterest-bearing $ 1,030,942 $ 991,271 Interest-bearing 869,760 867,942 Certificates of deposit and other time deposits 693,114 673,689 ----------- ----------- Total deposits 2,593,816 2,532,902 Other borrowed funds 402,800 509,590 Notes payable 18,694 21,430 Subordinated debt 49,254 - Accrued interest payable and other liabilities 5,561 16,750 Liabilities related to discountinued operations 33,527 172,746 ----------- ----------- Total liabilities 3,103,652 3,253,418 COMPANY-OBLIGATED MANDITORILY REDEEMABLE TRUST PREFERRED SECURITIES OF SUBSIDIARY TRUSTS 80,000 80,000 Shareholders' equity: Convertible preferred stock, $1 par value, 1 million shares authorized 20 59 Common stock, $1 par value, 100 million shares authorized 44,159 43,983 Capital surplus 45,611 44,633 Retained earnings 168,576 156,664 Accumulated other comprehensive income--net unrealized gain on available-for-sale securities, net of tax 3,148 3,988 ----------- ----------- Total shareholders' equity 261,514 249,327 ----------- ----------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 3,445,166 $ 3,582,745 =========== ===========
SEE NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS WHICH ARE AN INTEGRAL PART OF THESE INTERIM CONSOLIDATED FINANCIAL STATEMENTS. 2 STERLING BANCSHARES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data)
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, 2003 2002 2003 2002 -------------------- ------------------- (UNAUDITED) (UNAUDITED) Interest income: Loans, including fees $ 41,053 $ 36,515 $ 80,533 $ 70,712 Securities: Taxable 2,201 3,767 4,925 7,650 Tax-exempt 595 739 1,244 1,520 Federal funds sold 39 124 86 339 Trading assets 871 917 1,733 1,967 Deposits in financial institutions 17 30 36 59 -------- -------- -------- -------- Total interest income 44,776 42,092 88,557 82,247 Interest expense: Demand and savings deposits 1,264 2,176 2,621 4,384 Certificates and other time deposits 3,807 3,677 7,739 7,797 Other borrowed funds 1,578 995 2,926 1,721 Note payable 155 197 320 400 Subordinated debt 716 - 716 - -------- -------- -------- -------- Total interest expense 7,520 7,045 14,322 14,302 -------- -------- -------- -------- NET INTEREST INCOME 37,256 35,047 74,235 67,945 Provision for credit losses 6,098 3,088 10,548 5,711 -------- -------- -------- -------- NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES 31,158 31,959 63,687 62,234 Noninterest income: Customer service fees 3,908 3,749 7,871 7,418 Other 3,179 3,187 6,618 5,833 -------- -------- -------- -------- Total noninterest income 7,087 6,936 14,489 13,251 Noninterest expense: Salaries and employee benefits 15,998 15,116 32,810 29,668 Occupancy expense 3,931 3,739 7,602 7,323 Technology 1,229 1,265 2,421 2,409 Postage and delivery charges 515 528 1,081 1,059 Supplies 328 277 660 618 Professional fees 1,286 1,237 1,980 1,838 Minority interest expense: Company-obligated mandatorily redeemable trust preferred securities of subsidiary trusts 1,549 1,325 3,101 2,655 Other 4,136 3,724 8,106 7,351 -------- -------- -------- -------- Total noninterest expense 28,972 27,211 57,761 52,921 INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES 9,273 11,684 20,415 22,564 Provision for income taxes 3,047 3,727 6,675 7,111 -------- -------- -------- -------- INCOME FROM CONTINUING OPERATIONS 6,226 7,957 13,740 15,453 INCOME (LOSS) FROM DISCONTINUED OPERATIONS BEFORE INCOME TAXES (2,588) 2,404 3,357 3,778 Provision (benefit) for income taxes (1,003) 978 1,219 1,550 -------- -------- -------- -------- INCOME (LOSS) FROM DISCONTINUED OPERATIONS (1,585) 1,426 2,138 2,228 -------- -------- -------- -------- NET INCOME $ 4,641 $ 9,383 $ 15,878 $ 17,681 ======== ======== ======== ======== EARNINGS PER SHARE: Basic $ 0.11 $ 0.21 $ 0.36 $ 0.40 ======== ======== ======== ======== Diluted $ 0.10 $ 0.21 $ 0.36 $ 0.40 ======== ======== ======== ======== EARNINGS PER SHARE FROM CONTINUING OPERATIONS: Basic $ 0.14 $ 0.18 $ 0.31 $ 0.35 ======== ======== ======== ======== Diluted $ 0.14 $ 0.18 $ 0.31 $ 0.35 ======== ======== ======== ========
SEE NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS WHICH ARE AN INTEGRAL PART OF THESE INTERIM CONSOLIDATED FINANCIAL STATEMENTS. 3 STERLING BANCSHARES, INC. AND SUBSIDIARIES STATEMENTS OF CASH FLOWS (In thousands)
SIX MONTHS ENDED JUNE 30, 2003 2002 ----------- ----------- (UNAUDITED) CASH FLOWS FROM OPERATING ACTIVITIES: Income from continuing operations $ 13,740 $ 15,453 Adjustments to reconcile income from continuing operations to net cash provided by (used in) operating activities: Amortization and accretion of premiums and discounts on securities, net 3,182 56 Net gain on the sale of assets (382) (100) Net gain on the sale of trading assets (974) (309) Provision for credit losses 10,548 5,711 Write-downs, less gains on sale, of real estate acquired by foreclosure and repossessed assets (239) 34 Depreciation and amortization 4,440 4,460 Net decrease (increase) in loans held for sale 96,964 (173,129) Net decrease in accrued interest receivable and other assets 87,469 15,368 Net decrease in accrued interest payable and other liabilities (11,876) (305) --------- --------- NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES FROM CONTINUING OPERATIONS 202,872 (132,761) CASH FLOWS FROM INVESTING ACTIVITIES: Net decrease in securities purchased under agreements to resell - 9,514 Proceeds from maturity and paydowns of held-to-maturity securities 8,333 10,196 Proceeds from the sale of available-for-sale securities 16,870 6,810 Proceeds from maturity and paydowns of available-for-sale securities 100,490 57,294 Purchases of available-for-sale securities (95,990) (53,482) Proceeds from the sale of trading assets 259,867 253,491 Purchases of trading assets (255,965) (237,805) Proceeds from principal paydowns of trading securities 2,091 5,767 Net increase in loans held for investment (142,226) (97,763) Proceeds from sale of real estate acquired by foreclosure 3,281 890 Net decrease in interest-bearing deposits in financial institutions 63 159 Proceeds from sale of premises and equipment 731 1,307 Purchase of premises and equipment (1,770) (4,154) --------- --------- NET CASH USED IN INVESTING ACTIVITIES FROM CONTINUING OPERATIONS (104,225) (47,776) CASH FLOWS FROM FINANCING ACTIVITIES: Net increase in deposit accounts 60,914 53,194 Repayment of notes payable (2,736) - Issuance of subordinated debt 49,940 - Net decrease (increase) in repurchase agreements/funds purchased (106,790) 106,671 Proceeds from issuance of common stock and preferred stock 1,116 1,515 Dividends paid (3,967) (3,510) --------- --------- NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES FROM CONTINUING OPERATIONS (1,523) 157,870 NET CASH USED IN DISCONTINUED OPERATIONS (79,659) (2,008) NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 17,465 (24,675) CASH AND CASH EQUIVALENTS: Beginning of period 139,209 141,399 --------- --------- End of period $ 156,674 $ 116,724 ========= ========= SUPPLEMENTAL INFORMATION: Income taxes paid $ 14,489 $ 5,800 ========= ========= Interest paid $ 14,418 $ 16,546 ========= ========= Noncash investing and financing activities: Acquisitions of real estate through foreclosure of collateral $ 4,420 $ 1,455 ========= =========
SEE NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS WHICH ARE AN INTEGRAL PART OF THESE INTERIM CONSOLIDATED FINANCIAL STATEMENTS. 4 STERLING BANCSHARES, INC., AND SUBSIDIARIES NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS JUNE 30, 2003 (Unaudited) 1. BASIS OF PRESENTATION: The accompanying unaudited interim consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and in accordance with the instructions to Form 10-Q as prescribed by the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been included. Operating results for the six-month period ended June 30, 2003, are not necessarily indicative of the results that may be expected for the entire year or any interim period. For further information, refer to the consolidated financial statements and notes thereto included in the Annual Report on Form 10-K of Sterling Bancshares, Inc. (the "Company") for the year ended December 31, 2002. Certain reclassifications have been made to prior year amounts to conform to current year presentation. All reclassifications have been applied consistently for the periods presented and had no effect on net income or stockholders' equity. 2. EARNINGS PER COMMON SHARE Earnings per common share ("EPS") were computed based on the following (in thousands, except per share amounts):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, 2003 2002 2003 2002 --------------------------- ------------------------- AMOUNT AMOUNT AMOUNT AMOUNT ---------- ---------- -------- --------- Income from continuing operations $ 6,226 $ 7,957 $ 13,740 $ 15,453 Income (loss) from discontinued operations (1,585) 1,426 2,138 2,228 -------- -------- -------- -------- Net income $ 4,641 $ 9,383 $ 15,878 $ 17,681 ======== ======== ======== ======== Basic: Weighted average shares outstanding 44,101 43,849 44,044 43,814 Diluted: Add incremental shares for: Assumed exercise of outstanding options 622 850 636 828 Assumed conversion of preferred stock 21 98 40 89 -------- -------- -------- -------- Total 44,744 44,797 44,720 44,731 ======== ======== ======== ======== Earnings per share from continuing operations: Basic $ 0.14 $ 0.18 $ 0.31 $ 0.35 ======== ======== ======== ======== Diluted $ 0.14 $ 0.18 $ 0.31 $ 0.35 ======== ======== ======== ======== Earnings per share: Basic $ 0.11 $ 0.21 $ 0.36 $ 0.40 ======== ======== ======== ======== Diluted $ 0.10 $ 0.21 $ 0.36 $ 0.40 ======== ======== ======== ========
5 3. SHAREHOLDERS' EQUITY The following table displays the changes in shareholders' equity for the three-month and six-month periods ended June 30, 2003 and 2002 (in thousands):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, 2003 2002 2003 2002 -------------------- -------------------- ---------------------- --------------------- Equity, beginning of period $ 258,394 $ 224,002 $ 249,327 $ 217,369 Comprehensive income: Net income $ 4,641 $ 9,383 $ 15,878 $ 17,681 Net change in net unrealized gains on available-for-sale securities (558) 1,166 (840) 717 --------- --------- --------- --------- Total comprehensive income 4,083 10,549 15,038 18,398 Issuance of common stock 1,022 978 1,116 1,273 Issuance of preferred stock - - - 242 Cash dividends paid (1,985) (1,757) (3,967) (3,510) --------- --------- --------- --------- Equity, end of period $ 261,514 $ 233,772 $ 261,514 $ 233,772 ========= ========= ========= =========
4. SEGMENTS The Company has two reportable operating segments: commercial banking and mortgage banking. Sterling Bank (the "Bank") has an 80 percent ownership interest in Sterling Capital Mortgage Company ("SCMC") and reports its financial position and results of operations on a consolidated basis. The commercial banking and mortgage banking segments are managed separately because each business requires different marketing strategies and each offers different products and services. On July 16, 2003, the Company and the Bank entered into a definitive agreement with RBC Mortgage Company to sell the Bank's 80% indirect interest in SCMC. The business related to SCMC is accounted for as discontinued operations and therefore, the results of operations and cash flows have been removed from the Company's results of continuing operations for all periods presented in this document. In addition, the assets and liabilities of SCMC are stated separately as discontinued operations. Details of SCMC's results of operations are disclosed in footnote 5. 5. DISCONTINUED OPERATIONS On July 16, 2003, the Company and the Bank entered into a definitive agreement with RBC Mortgage Company to sell the Bank's 80% indirect interest in SCMC. The remaining 20% interest is owned by management and employees of SCMC. The gross proceeds to the Company are estimated to be approximately $83 million at closing. Net of tax and transaction costs, the Company expects to realize net cash proceeds of approximately $49 million. The sale consists of all of the stock of SCMC. In addition, effective July 16, 2003, the Bank purchased from SCMC its mortgage servicing portfolio of $15.5 million at June 30, 2003. The purchase price paid by the Bank for the mortgage servicing portfolio was approximately $15.5 million. It is anticipated that the Bank, in a separate transaction, will sell the mortgage servicing portfolio to a third party prior to the consummation of the sale of SCMC. On May 8, 2003, the Bank sold three banking offices in south Texas to an investor group headed by the current executive officers of the three locations. Assets of $16.6 million, loans of $15.2 million and deposits of $42.1 million were sold in the transaction. On March 20, 2003, the Bank sold its banking office located in Eagle Pass, Texas to South Texas National Bank of Laredo. Assets of $18.7 million, loans of $16.8 million and deposits of $95.7 million were sold in the transaction. 6 The business related to SCMC and the four banking offices is accounted for as discontinued operations and therefore, the results of operations and cash flows have been removed from the Company's results of continuing operations for all periods presented in this document. The results of SCMC and the four banking offices are presented as discontinued operations in a separate category on the income statement following results from continuing operations. The income from discontinued operations for the six months ended June 30, 2003 and 2002, respectively, is as follows (in thousands):
SIX MONTHS ENDED JUNE 30, 2003 SIX MONTHS ENDED JUNE 30, 2002 ---------------------------------- ---------------------------------- COMMERCIAL MORTGAGE COMMERCIAL MORTGAGE BANKING BANKING COMBINED BANKING BANKING COMBINED ---------------------------------- ---------------------------------- (UNAUDITED) (UNAUDITED) Interest income $ 663 $ - $ 663 $ 1,239 $ - $ 1,239 Interest expense 442 - 442 1,075 - 1,075 -------- -------- -------- -------- -------- -------- Net interest income 221 - 221 164 - 164 Provision for credit losses - 3,708 3,708 - - - -------- -------- -------- -------- -------- -------- Net interest income (loss) after provision for credit losses 221 (3,708) (3,487) 164 - 164 Noninterest income: Customer service fees 429 - 429 834 - 834 Gain on sale of mortgage loans - 25,384 25,384 - 11,670 11,670 Mortgage origination income - 17,595 17,595 - 9,006 9,006 Other 3,349 5,175 8,524 226 4,384 4,610 -------- -------- -------- -------- -------- -------- Total noninterest income 3,778 48,154 51,932 1,060 25,060 26,120 Noninterest expense: Salaries and employee benefits 523 16,141 16,664 870 11,775 12,645 Occupancy expense 110 6,064 6,174 189 3,460 3,649 Mortgage servicing rights amortization and impairment - 15,460 15,460 - 1,842 1,842 Technology 8 579 587 23 121 144 Postage and delivery charges 38 833 871 60 407 467 Supplies 26 925 951 30 579 609 Professional fees 3 432 435 26 182 208 Minority interest expense: Sterling Capital Mortgage Company - 37 37 - 581 581 Other 227 3,682 3,909 169 2,192 2,361 -------- -------- -------- -------- -------- -------- Total noninterest expense 935 44,153 45,088 1,367 21,139 22,506 Income (loss) from discontinued operations before income taxes 3,064 293 3,357 (143) 3,921 3,778 Provision (benefit) for income taxes 1,072 147 1,219 (47) 1,597 1,550 -------- -------- -------- -------- -------- -------- Income (loss) from discontinued operations $ 1,992 $ 146 $ 2,138 $ (96) $ 2,324 $ 2,228 ======== ======== ======== ======== ======== ========
Included in income from discontinued operations for the six months ended June 30, 2003 is a before-tax net gain of $3.2 million related to the sale of the Eagle Pass office. Additionally, a before-tax expense of $8.2 million was recorded by SCMC in June 2003 to reflect an impairment to the mortgage servicing rights. 7 The assets and liabilities of SCMC are stated separately as discontinued operations as of June 30, 2003 and December 31, 2002 on the Consolidated Balance Sheet. While the assets and liabilities relating to the Carrizo Springs, Crystal City, Pearsall and Eagle Pass banking offices were separately stated as discontinued operations on the Consolidated Balance Sheet as of December 31, 2002, these assets and liabilities were not included in the June 30, 2003 Consolidated Balance Sheet due to the consummation of the sales on May 8, 2003 and March 20, 2003. The major asset and liability categories of discontinued operations are as follows (in thousands):
JUNE 30, DECEMBER 31, 2003 2002 -------- ------------ (UNAUDITED) Cash and cash equivalents $ - $ 7,791 Loans held for investment - 32,996 Premises and equipment, net 7,042 5,059 Mortgage servicing rights 15,480 26,467 Goodwill, net 6,202 5,618 Other assets 12,685 20,900 -------- -------- Assets related to discontinued operations $ 41,409 $ 98,831 ======== ======== Demand deposits: Noninterest-bearing $ - $ 25,547 Interest-bearing - 51,535 Certificates of deposit and other time deposits - 63,088 -------- -------- Total deposits - 140,170 Other liabilities 28,417 27,502 Minority interest in Sterling Capital Mortgage Company 5,110 5,074 -------- -------- Liabilities related to discontinued operations $ 33,527 $172,746 ======== ========
6. STOCK OPTIONS The Company accounts for its employee stock options using the intrinsic value-based method. If the compensation cost for the Company's stock-based compensation plan had been determined based on the fair value at the grant dates for awards, there would have been no material impact on the Company's reported net income or earnings per share. Pro forma information regarding net income and earnings per share is required under Statement of Financial Accounting Standard No. 123 ("SFAS 123"), "Accounting for Stock-Based Compensation" and has been determined as if the Company accounted for its employee stock option plans under the fair value method of SFAS 123. The fair value of options was estimated using a Black-Scholes option pricing model. Option valuation models require use of highly subjective assumptions. Also, employee stock options have characteristics that are significantly different from those of traded options, including vesting provisions and trading limitations that impact their liquidity. 8 The following table shows information related to stock-based compensation in both the reported and pro forma earnings per share amounts (dollars in thousands except for per share amounts):
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, 2003 2002 2003 2002 ----------- ----------- --------- --------- Net income, as reported $ 4,641 $ 9,383 $15,878 $17,681 Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects 224 261 483 521 ------- ------- ------- ------- Pro Forma net income $ 4,417 $ 9,122 $15,395 $17,160 ======= ======= ======= ======= Earnings per share: Basic - as reported $ 0.11 $ 0.21 $ 0.36 $ 0.40 ======= ======= ======= ======= Basic - pro forma $ 0.10 $ 0.21 $ 0.35 $ 0.39 ======= ======= ======= ======= Diluted - as reported $ 0.10 $ 0.21 $ 0.36 $ 0.40 ======= ======= ======= ======= Diluted - pro forma $ 0.10 $ 0.20 $ 0.34 $ 0.38 ======= ======= ======= =======
7. INTANGIBLE ASSETS The changes in the carrying amount of goodwill for the year ended December 31, 2002 and the six months ended June 30, 2003 are as follows (in thousands):
SOUTH (Unaudited) HOUSTON SAN ANTONIO DALLAS TEXAS TOTAL --------- ----------- -------- --------- --------- Balance, January 1, 2002 $ 29,641 $ 15,079 $ - $ 5,312 $ 50,032 Purchase price adjustment (28) - - - (28) Eagle National acquisition - - 5,662 - 5,662 ---------------------------------------------------------- Balance, December 31, 2002 29,613 15,079 5,662 5,312 55,666 Sale of Eagle Pass office - - - (3,570) (3,570) Sale of South Texas offices - - - (1,742) (1,742) -------- -------- -------- -------- -------- Balance, June 30, 2003 $ 29,613 $ 15,079 $ 5,662 $ - $ 50,354 ======== ======== ======== ======== ========
The changes in the carrying amounts of intangible assets other than goodwill for the year ended December 31, 2002 and six months ended June 30, 2003 are as follows (in thousands):
CORE DEPOSIT (Unaudited) INTANGIBLE -------------- Balance, January 1, 2002 $ 2,036 Amortization (426) Eagle National acquisition 486 ------------- Balance, December 31, 2002 2,096 Amortization (228) ------------- Balance, June 30, 2003 $ 1,868 =============
8. RECENT ACCOUNTING PRONOUNCEMENTS On January 17, 2003, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 46 ("FIN 46") "Consolidation of Variable Interest Entities", which addresses consolidation by business enterprises of variable interest entities. FIN No. 46 clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements", to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the 9 entity to finance its activities without additional subordinated financial support from other parties. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. In its current form, Fin 46 may require the Corporation to de-consolidate its investment in Sterling Bancshares Capital Trust II ("Capital Trust II"), Sterling Bancshares Capital Trust III ("Capital Trust III") and Sterling Bancshares Statutory Trust One ("Statutory Trust One"). The potential de-consolidation of subsidiary trusts of bank holding companies formed in connection with the issuance of trust preferred securities, such as Capital Trust I, Capital Trust II and Statutory Trust One, appears to be an unintended consequence of FIN 46. It is currently unknown if, or when, the FASB will address this issue. In July 2003, the Board of Governors of the Federal Reserve System issued a supervisory letter instructing bank holding companies to continue to include the trust preferred securities in their Tier 1 capital for regulatory capital purposes until notice is given to the contrary. The Federal Reserve intends to review the regulatory implications of any accounting treatment changes and, if necessary or warranted, provide further appropriate guidance. There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier 1 capital for regulatory capital purposes. If the trust preferred securities were no longer allowed to be included in Tier 1 capital, the Company would, subject to the conditions applicable thereto, also be permitted to redeem the trust preferred securities. In April 2003, FASB issued Statement No. 149, "Amendment of Statement 133 on Derivative Instruments and Hedging Activities" ("SFAS 149"). SFAS 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The amendments (i) reflect decisions of the Derivatives Implementation Group process that effectively required amendments to SFAS 133, (ii) reflect decisions made by the Financial Accounting Standards Board in connection with other board projects dealing with financial instruments, and (iii) address implementation issues related to the application of the definition of a derivative. SFAS 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003, with all provisions applied prospectively. The Company does not believe the adoptions of SFAS 149 will have a significant impact on its financial statements. In May 2003, FASB issued FASB Statement No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity" ("SFAS 150"). SFAS 150 establishes standards for how an issuer classifies, measures and discloses in its financial statements certain financial instruments with characteristics of both liabilities and equity. SFAS 150 requires that an issuer classify financial instruments that are within its scope as liabilities, in some circumstances. Such financial instruments include (i) financial instruments that are issued in the form of shares that are mandatorily redeemable; (ii) financial instruments that embody an obligation to repurchase the issuer's equity shares, or are indexed to such an obligation, and that require the issuer to settle the obligation by transferring assets; (iii) financial instruments that embody an obligation to repurchase the issuer's equity shares if, at inception, the monetary value of the obligation is predominantly based on a fixed amount, variations in something other than the fair value of the issuer's equity shares or variations inversely related to changes in the fair value of the issuer's equity shares; and (iv) certain free standing financial instruments. SFAS 150 is effective for contracts entered into or modified after May 31 2003, and is otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a significant impact on the Company's financial statements. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS This Quarterly Report on Form 10-Q, including Management's Discussion and Analysis of Financial Condition and Results of Operations, contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements discuss future expectations, activities or events and by their nature, they are subject to risks and uncertainties. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as "believe," "expect," "anticipate," "intend," "plan," "estimate," or words of similar meaning, or future or conditional verbs such as "will," "would," "should," "could," or "may." Forward-looking statements speak only as of the date they are made. The Company will not update these forward-looking statements to reflect circumstances or events that occur after the date the forward-looking statements are made. Many possible factors could affect the Company's future financial performance and actual results may differ materially from what is expressed in any forward-looking statement. Important factors that could cause actual results to differ materially from estimates or projections contained in forward-looking statements include, but are not limited to, the following: general business and economic conditions in the markets the Company serves may be less favorable than anticipated which could decrease the demand for loan, deposit and other financial services and increase loan delinquencies and defaults; changes in market rates and prices may adversely impact the value of securities, loans, deposits and other financial instruments; the Company's liquidity requirements could be adversely affected by changes in its assets and liabilities; legislative or regulatory developments including changes in laws concerning taxes, banking, securities, insurance and other aspects of the financial securities industry; competitive factors, including product and pricing pressures among financial services organizations, may increase; and changes in fiscal and governmental policies of the United States federal government could have an adverse effect on the Company's business. For additional discussion of such risks, uncertainties and assumptions, see the Company's Annual Report on Form 10-K for the year ended December 31, 2002, filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934. CRITICAL ACCOUNTING POLICIES The Company's accounting policies are integral to understanding the results reported. Accounting policies are described in detail in Note A to the consolidated financial statements in the 2002 Annual Report. The Company believes that of its significant accounting policies, the allowance for credit losses may involve a higher degree of judgment and complexity Allowance for credit losses - The allowance for credit losses is a valuation allowance for probable losses incurred on loans. Loans are charged to the allowance when the loss actually occurs or when a determination is made that a probable loss has occurred. Recoveries are credited to the allowance at the time of recovery. Throughout the year, management estimates the probable level of losses to determine whether the allowance for credit losses is adequate to absorb losses in the existing portfolio. Based on these estimates, an amount is charged to the provision for credit losses and credited to the allowance for credit losses in order to adjust the allowance to a level determined to be adequate to absorb losses. Management's judgment as to the level of probable losses on existing loans involves the consideration of current economic conditions and their estimated effects on specific borrowers; an evaluation of the existing relationships among loans, potential credit losses and the present level of the allowance; results of examinations of the loan portfolio by regulatory agencies; and management's internal review of the loan portfolio. In determining the collectibility of certain loans, management also considers the fair value of any underlying collateral. The amount ultimately realized may differ from the carrying value of these assets because of economic, operating or other conditions beyond the Company's control. Please refer to the 11 subsequent discussion of "Allowance for Credit Losses" below as well as Note A to the consolidated financial statements in the annual report for additional insight into management's approach and methodology in estimating the allowance for credit losses. SIGNIFICANT DEVELOPMENTS On July 16, 2003, the Company and the Bank entered into a definitive agreement with RBC Mortgage Company to sell the Bank's 80% indirect interest in SCMC. The remaining 20% interest is owned by management and employees of SCMC. The gross proceeds to the Bank are estimated to be approximately $83 million at closing. Net of tax and transaction costs, the Bank expects to realize net cash proceeds of approximately $49 million. The sale consists of all of the stock of SCMC. In addition, effective July 16, 2003, the Bank purchased from SCMC its mortgage servicing portfolio of $15.5 million at June 30, 2003. The purchase price paid by the Bank for the mortgage servicing portfolio was approximately $15.5 million. It is anticipated that the Bank, in a separate transaction, will sell the mortgage servicing portfolio to a third party prior to the consummation of the sale of SCMC. On May 8, 2003, the Bank sold three banking offices in south Texas to an investor group headed by the current executive officers of the three locations. Assets of $16.6 million, loans of $15.2 million and deposits of $42.1 million were sold in the transaction. On March 20, 2003, the Bank sold its banking office located in Eagle Pass, Texas to South Texas National Bank of Laredo. Assets of $18.7 million, loans of $16.8 million and deposits of $95.7 million were sold in the transaction. During April, 2003, the Bank raised approximately $50 million through a private offering of subordinated unsecured notes. The subordinated notes issued by the Bank bear interest at a fixed rate of 7.375% and mature over a ten year period ending April 15, 2013, with semi-annual interest payment. These subordinated notes are not convertible or redeemable. In June 2003, the Bank entered into an interest rate swap agreement in which the Bank swapped $50 million fixed rate subordinated debt to floating rate debt. Under the terms of the agreement, the Bank will receive the fixed coupon rate of 7.375% associated with the subordinated debt and will pay its swap counterparty a variable interest rate equal to the three-month London Inter-Bank Rate ("LIBOR"), that is reset on a quarterly basis, plus 3.62%. This swap is designated as a fair-value hedge and qualifies for "short-cut" hedge accounting treatment under SFAS 133 such that changes in the fair value of the swap will not be reflected in the income statement. NON-GAAP PRESENTATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains financial information determined by methods other than in accordance with Generally Accepted Accounting Principles ("GAAP"). Management uses these non-GAAP measures in their analysis of the business and its performance. In particular, net interest income and net interest margin as reflected in the Consolidated Yield Analysis table are calculated on both a GAAP based measurement and on a fully tax-equivalent basis ("FTE"). Management believes that these measures calculated on a FTE basis provide a useful picture of net interest income and net interest margin for comparative purposes. The GAAP based measures do not take into consideration the tax-exempt status of certain income. Net interest income and net interest margin calculated on a FTE basis are determined by adjusting net interest income to reflect tax-exempt interest income on an equivalent before-tax basis. Non-GAAP information presented by other companies may not be comparable to that presented herein, since each company may define non-GAAP measured differently. RESULTS OF OPERATIONS A discussion of the Company's results of operations is presented below. Certain reclassifications have been made to make prior periods comparable. In 2002, the Company entered into two separate agreements for the sale of four banking offices in South Texas. The Company completed the sale of its banking office located in Eagle Pass, Texas in March 2003. 12 In May 2003, the Company completed the sale of its banking offices in Carrizo Springs, Crystal City and Pearsall. In July 2003, the Company and the Bank entered into a definitive agreement to sell the Bank's 80% indirect interest in SCMC. Revenues, operating costs and expenses, and other non-operating results from the discontinued operations of the four banking offices and SCMC are excluded from the Company's results from continuing operations at and for the periods ending June 30, 2003 and December 31, 2002. The assets and liabilities of the four banking offices and SCMC are presented in the Company's Consolidated Balance Sheets in the line items "Assets related to discontinued operations" and "Liabilities related to discontinued operations" at December 31, 2002. However, these line items at June 30, 2003 only include the assets and liabilities of SCMC since the sales of the four banking offices were completed before June 30, 2003. The financial results of these four banking offices and SCMC are presented in the Company's Consolidated Statements of Income under the line items "Income (loss) from discontinued operations before income taxes" and "Income (loss) from discontinued operations" and in the Company's Consolidated Statements of Cash Flows as "Net cash used in discontinued operations" for each of the periods ending June 30, 2003 and December 31, 2002. SIX MONTHS ENDED JUNE 30, 2003 COMPARED TO SAME PERIOD IN 2002 NET INCOME - Net income for the six-month period ended June 30, 2003 was $15.9 million as compared to $17.7 million for the same period in 2002, a decrease of approximately $1.8 million or 10.2%. Included in net income is a before-tax net gain of $3.2 million related to the sale of the Eagle Pass office. Also a before-tax expense of $8.2 million was recorded by SCMC in June 2003 to reflect an impairment to the mortgage servicing rights. The impairment charge is included in loss from discontinued operations. Income from continuing operations for the six-month period ended June 30, 2003 was $13.7 million as compared to $15.5 million for the same period in 2002, a decrease of approximately $1.7 million or 11.1%. The decrease was due, in part, to a higher loan loss provision during the quarter ended June 30, 2003. NET INTEREST INCOME - Net interest income for the six-month period ended June 30, 2003, was $74.2 million, as compared to $67.9 million for the same period in 2002, an increase of $6.3 million or 9.3%. The increase is primarily due to the average loan growth of 30.9%. The growth in average loans that was related to the acquisition of Eagle National was 2.6%. While average earning assets for the period ended June 30, 2003 increased over a year ago, the average yield decreased 93 basis points from 6.93% for the six-month period ended June 30, 2002, to 6.00% for the same period in 2003. As of June 30, 2003, average interest bearing liabilities were $2.0 billion, an increase of $464.1 million or 29.8% from June 30, 2002. Average interest bearing deposits at June 30, 2003 were $1.5 billion, an increase of 14.3% from June 30, 2002. The increase in average interest bearing deposits related to the acquisition of Eagle National was 2.9%. The cost of interest bearing liabilities decreased 42 basis points from 1.85% for the six months ended June 30, 2002 to 1.43% during the same period in 2003. The Company's 5.03% net interest margin for the six months ended June 30, 2003 decreased from the 5.73% net interest margin recorded during the same period in 2002. Additionally, the Company's 5.08% tax equivalent net interest margin for the six months ended June 30, 2003 decreased from the 5.80% tax equivalent net interest margin recorded during the same period in 2002. In November 2002 and June 2003, the Federal Reserve Bank decreased the discount rate 50 basis points and 25 basis points, respectively. Since the Company's balance sheet is asset sensitive, the interest earning assets generally reprice more quickly than the interest bearing liabilities. Thus, the Company's net interest margin tends to increase in periods of rising interest rates in the market and decrease in periods of declining interest rates. 13 The following schedule gives a comparative analysis of the Company's daily average interest-earning assets and interest-bearing liabilities for the six-month periods ended June 30, 2003 and 2002, respectively: CONSOLIDATED YIELD ANALYSIS SIX MONTHS ENDED JUNE 30, (DOLLARS IN THOUSANDS)
2003 2002 --------------------------------- ----------------------------------- AVERAGE AVERAGE AVERAGE AVERAGE BALANCE INTEREST YIELD BALANCE INTEREST YIELD ---------- -------- ------- ----------- -------- ------- INTEREST EARNING ASSETS: Interest bearing deposits in financial institutions $ 1,220 $ 36 5.95% $ 2,266 $ 59 5.25% Federal funds sold and securities purchased under agreements to resell 15,119 86 1.15% 35,617 339 1.92% Trading assets 114,244 1,733 3.06% 101,821 1,967 3.90% Investment securities (taxable) 250,865 4,925 3.96% 242,626 7,650 6.36% Investment securities (tax-exempt) 56,601 1,244 4.43% 70,215 1,520 4.37% Loans held for sale (taxable) 567,100 15,604 5.55% 269,961 9,798 7.32% Loans held for investment (taxable) 1,967,773 64,782 6.64% 1,665,609 60,780 7.36% Loans (tax-exempt) 4,636 147 6.39% 4,320 134 6.26% ---------- -------- ---- ---------- -------- ---- Total Interest Earning Assets 2,977,558 88,557 6.00% 2,392,435 82,247 6.93% NONINTEREST EARNING ASSETS: Cash and due from banks 97,780 90,681 Premises and equipment, net 48,513 50,012 Other assets 230,113 179,142 Allowance for credit losses (28,756) (24,014) Assests related to discontinued operations 73,431 78,564 ---------- ---------- Total Noninterest Earning Assets 421,081 374,385 ---------- ---------- TOTAL ASSETS $3,398,639 $2,766,820 ========== ========== INTEREST BEARING LIABILITIES: Demand and savings deposits 875,894 $ 2,621 0.60% $ 826,200 $ 4,384 1.07% Certificates and other time deposits 667,601 7,739 2.34% 524,474 7,797 3.00% Other borrowed funds 435,603 2,926 1.35% 186,275 1,721 1.86% Notes payable 20,252 320 3.19% 20,879 400 3.86% Subordinated debt 22,621 716 6.38% - - 0.00% ---------- -------- ---- ---------- -------- ---- Total Interest Bearing Liabilities 2,021,971 14,322 1.43% 1,557,828 14,302 1.85% NONINTEREST BEARING LIABILITIES: Demand deposits 918,685 759,037 Other liabilities 13,375 14,385 Liabilities related to discontinued operations 104,840 150,864 ---------- ---------- Total Noninterest Bearing Liabilities 1,036,900 924,286 Trust preferred securities 80,000 57,500 Shareholders' equity 259,768 227,206 ---------- ---------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $3,398,639 $2,766,820 ========== ========== NET INTEREST INCOME & MARGIN $ 74,235 5.03% $ 67,945 5.73% ======== ==== ======== ==== NET INTEREST INCOME & MARGIN (TAX EQUIVALENT) (1) $ 74,936 5.08% $ 68,763 5.80% ======== ==== ======== ====
(1) In order to present pretax income and resultant yields on tax-exempt investments and loans on a comparable basis to those on taxable investments and loans, a tax-equivalent adjustment has been made equally to interest income and income tax expense with no effect on after tax income. The tax equivalent adjustment has been computed using a federal income tax rate of 35%. 14 PROVISION FOR CREDIT LOSSES - The provision for credit losses for the six months ended June 30, 2003 was $10.5 million, as compared to $5.7 million for the same period in 2002, an increase of $4.8 million. A provision for credit losses of $1.0 million was recorded in the first quarter of 2003 for loans purchased with Eagle National. The increase in the provision for credit losses was due to a moderate deterioration of the loan portfolio quality and the addition of certain loans to the Bank's monitored loan list. The Company's allowance for credit losses increased by $4.3 million from $27.2 million at December 31, 2002, to $31.6 million on June 30, 2003. The increase in the allowance for credit losses is primarily due to the $10.5 million provision for credit losses offset by $5.9 million in net charge-offs. Please refer to the subsequent discussion of ALLOWANCE FOR CREDIT LOSSES and RISK ELEMENTS for additional insight to management's approach and methodology in estimating the allowance for credit losses. NONINTEREST INCOME - Total noninterest income for the six months ended June 30, 2003 was $14.5 million, as compared to $13.3 million for the same period in 2002, an increase of $1.2 million or 9.3%. Noninterest income for the six months ended June 30, 2003 and 2002, respectively, is summarized as follows (in thousands):
FOR THE SIX MONTHS ENDED JUNE 30, 2003 JUNE 30, 2002 ------------- ------------- Customer service fees $ 7,871 $ 7,418 Bank owned life insurance 1,012 1,029 Debit card income 741 512 Gain on the sale of trading assets 627 309 Gain on the sale of securities 374 - Sale of Community charter - 150 Other 3,864 3,833 ------- ------- $14,489 $13,251 ======= =======
Customer service fees for the six-month period ended June 30, 2003 increased $453 thousand or 6.1% as a result in the growth in deposit transaction accounts and the acquisition of Eagle National in September 2002. During the six months ended quarter of 2003, the Bank had a gain on the sale of securities of $374 thousand. Also the Bank had an increase of $318 thousand in gains on the sale of trading assets. In June 2002, the Company sold the charter for Community Bank to Sabine State Bank & Trust Company for $150 thousand. NONINTEREST EXPENSE - Noninterest expense increased $4.8 million or 9.1%, to $57.8 million for the six-month period ending June 30, 2003 as compared to $52.9 million for the same period in 2002. Noninterest expense for the six months ended June 30, 2003 and 2002, respectively, is summarized as follows (in thousands):
FOR THE SIX MONTHS ENDED JUNE 30, 2003 JUNE 30, 2002 ------------- ------------- Salaries and employee benefits $ 32,810 $ 29,668 Occupancy expense 7,602 7,323 Net (gain) loss and carrying costs of real estate acquired by foreclosure (211) 71 FDIC assessment 213 189 Technology 2,421 2,409 Postage and delivery charges 1,081 1,059 Supplies 660 618 Professional fees 1,980 1,838 Minority interest expense: Company obligated mandatorily redeemable trust preferred securities of subsidiary trusts 3,101 2,655 Marketing 1,157 524 Other 6,947 6,567 -------- -------- $ 57,761 $ 52,921 ======== ========
15 Salaries and employee benefits for the six-month period ended June 30, 2003 were $32.8 million, as compared to $29.7 million for the same period in 2002, an increase of $3.1 million or 10.6%. The increase is primarily related to merit increases, increased payroll taxes and increased hospital and medical insurance expenses. Additionally, salaries and employee benefits expenses related to the acquisition of Eagle National were $561 thousand. Minority interest expense increased $446 thousand or 16.8% from the six months ended June 30, 2002 as compared to the same period in 2003. The increase is related to the interest due on the additional trust preferred securities issued in August 2002 and September 2002 offset by the redemption of trust preferred securities in November 2002. The Company has increased its marketing and branding efforts through increased television and radio programming. As a result of these efforts, marketing expenses for the six-month period ended June 30, 2003 were $1.2 million, an increase of $633 thousand or 120.8% from $524 thousand for the same period in 2002. PROVISION FOR INCOME TAXES - The provision for income taxes as a percent of net income before taxes increased from 33.2% for the six months of 2002 to 32.9% for the same period in 2003. The provision of income taxes as a percent of income from continuing operations before taxes was 31.5% for the six months ended June 30, 2002 as compared to 32.7% for the same period in 2003. THREE MONTHS ENDED JUNE 30, 2003 COMPARED TO SAME PERIOD IN 2002 NET INCOME - Net income for the three-month period ended June 30, 2003 was $4.6 million as compared to $9.4 million for the same period in 2002, a decrease of approximately $4.7 million or 50.5%. Income from continuing operations for the three-month period ended June 30, 2003 was $6.2 million as compared to $8.0 million for the same period in 2002, a decrease of approximately $1.7 million or 21.8%. The decrease was due, in a large part, to a higher loan loss provision during the quarter ended June 30, 2003. NET INTEREST INCOME - Net interest income for the three-month period ended June 30, 2003, was $37.3 million, as compared to $35.0 million for the same period in 2002, an increase of $2.2 million or 6.3%. The increase is primarily due to the average loan growth of 30.5%. The growth in average loans related to the acquisition of Eagle National was 2.3%. While average earning assets for the period ended June 30, 2003 increased over a year ago, the average yield decreased 100 basis points from 6.91% for the three-month period ended June 30, 2002, to 5.91% for the same period in 2003. As of June 30, 2003, average interest bearing liabilities were $2.1 billion, an increase of $502.6 million or 31.7% from June 30, 2002. Average interest bearing deposits at June 30, 2003 were $1.6 billion, an increase of 14.7% from June 30, 2002. The increase in average interest bearing deposits that was related to the acquisition of Eagle National was 2.7%. The cost of interest bearing liabilities decreased 34 basis points from 1.78% for the three months end June 30, 2002 to 1.44% during the same period in 2003. The Company's 4.92% net interest margin for the three months ended June 30, 2003 decreased from the 5.75% net interest margin recorded during the same period in 2002. Additionally, the Company's 4.96% tax equivalent net interest margin for the three months ended June 30, 2003 decreased from the 5.82% tax equivalent net interest margin recorded during the same period in 2002. In November 2002 and June 2003, the Federal Reserve Bank decreased the discount rate 50 basis points and 25 basis points, respectively. Since the Company's balance sheet is asset sensitive, the interest earning assets generally reprice more quickly than the interest bearing liabilities. Thus, the Company's net interest margin tends to increase in periods of rising interest rates in the market and decrease in periods of declining interest rates. 16 The following schedule gives a comparative analysis of the Company's daily average interest-earning assets and interest-bearing liabilities for the three-month periods ended June 30, 2003 and 2002, respectively: CONSOLIDATED YIELD ANALYSIS THREE MONTHS ENDED JUNE 30, (Dollars in thousands)
2003 2002 ----------------------------------- ------------------------------------ AVERAGE AVERAGE AVERAGE AVERAGE BALANCE INTEREST YIELD BALANCE INTEREST YIELD ---------- -------- ------- ----------- --------- ------- INTEREST EARNING ASSETS: Interest bearing deposits in financial institutions $ 1,291 $ 17 5.28% $ 2,276 $ 30 5.29% Federal funds sold and securities purchased under agreements to resell 13,958 39 1.12% 27,221 124 1.83% Trading assets 107,383 871 3.25% 100,396 917 3.66% Investment securities (taxable) 240,922 2,201 3.66% 238,422 3,767 6.34% Investment securities (tax-exempt) 54,889 595 4.35% 67,824 739 4.37% Loans held for sale (taxable) 617,822 8,462 5.49% 311,533 5,722 7.37% Loans held for investment (taxable) 1,996,281 32,518 6.53% 1,691,365 30,730 7.29% Loans (tax-exempt) 4,774 73 6.13% 4,286 63 5.90% ---------- -------- ---- ---------- -------- ---- Total Interest Earning Assets 3,037,320 44,776 5.91% 2,443,323 42,092 6.91% NONINTEREST EARNING ASSETS: Cash and due from banks 95,030 88,053 Premises and equipment, net 47,674 49,818 Other assets 229,038 183,690 Allowance for credit losses (29,240) (24,267) Assests related to discontinued operations 60,793 80,503 ---------- ---------- Total Noninterest Earning Assets 403,295 377,797 ---------- ---------- TOTAL ASSETS $3,440,615 $2,821,120 ========== ========== INTEREST BEARING LIABILITIES: Demand and savings deposits 876,513 $ 1,264 0.58% $ 833,140 $ 2,176 1.05% Certificates and other time deposits 675,745 3,807 2.26% 520,164 3,677 2.84% Other borrowed funds 470,633 1,578 1.34% 210,922 995 1.89% Notes payable 19,792 155 3.14% 20,879 197 3.78% Subordinated debt 44,994 716 6.38% - - 0.00% ---------- -------- ---- ---------- -------- ---- Total Interest Bearing Liabilities 2,087,677 7,520 1.44% 1,585,105 7,045 1.78% NONINTEREST BEARING LIABILITIES: Demand deposits 944,883 781,539 Other liabilities 12,672 13,092 Liabilities related to discontinued operations 51,635 152,886 ---------- ---------- Total Noninterest Bearing Liabilities 1,009,190 947,517 Trust preferred securities 80,000 57,500 Shareholders' equity 263,748 230,998 ---------- ---------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $3,440,615 $2,821,120 ========== ========== NET INTEREST INCOME & MARGIN $ 37,256 4.92% $ 35,047 5.75% ======== ==== ======== ==== NET INTEREST INCOME & MARGIN (TAX EQUIVALENT) (1) $ 37,592 4.96% $ 35,445 5.82% ======== ==== ======== ====
(1) In order to present pretax income and resultant yields on tax-exempt investments and loans on a comparable basis to those on taxable investments and loans, a tax-equivalent adjustment has been made equally to interest income and income tax expense with no effect on after tax income. The tax equivalent adjustment has been computed using a federal income tax rate of 35%. 17 PROVISION FOR CREDIT LOSSES - The provision for credit losses for the second quarter of 2003 was $6.1 million, as compared to $3.1 million for the same period in 2002, an increase of $3.0 million. The increase in the provision for credit losses was due to a moderate deterioration of the loan portfolio quality and the addition of certain loans to the Bank's monitored loan list. The Company's allowance for credit losses increased by $3.2 million from $28.4 million at March 31, 2003, to $31.6 million on June 30, 2003. The increase in the allowance for credit losses is primarily due to the $6.1 million provision for credit losses offset by $3.0 million in net charge-offs. Please refer to the subsequent discussion of ALLOWANCE FOR CREDIT LOSSES and RISK ELEMENTS for additional insight to management's approach and methodology in estimating the allowance for credit losses. NONINTEREST INCOME - Total noninterest income for the quarter ended June 30, 2003 was $7.1 million, as compared to $6.9 million for the same period in 2002, an increase of $151 thousand or 2.2%. Noninterest income for the three months ended June 30, 2003 and 2002, respectively, is summarized as follows (in thousands):
FOR THE THREE MONTHS ENDED JUNE 30, 2003 JUNE 30, 2002 ------------- ------------- Customer service fees $3,908 $3,749 Bank owned life insurance 507 520 Debit card income 405 277 Gain on the sale of trading assets 280 188 Sale of Community charter - 150 Other 1,987 2,052 ------ ------ $7,087 $6,936 ====== ======
Customer service fees increased $159 thousand as a result in the growth in deposit transaction accounts and the acquisition of Eagle National in September 2002. In June 2002, the Company sold the charter for Community Bank to Sabine State Bank & Trust Company for $150 thousand. NONINTEREST EXPENSE - Noninterest expense increased $1.8 million or 6.5%, to $29.0 million for the three-month period ending June 30, 2003 as compared to $27.2 million for the same period in 2002. Noninterest expense for the three months ended June 30, 2003 and 2002, respectively, is summarized as follows (in thousands):
FOR THE THREE MONTHS ENDED JUNE 30, 2003 JUNE 30, 2002 ------------- ------------- Salaries and employee benefits $ 15,998 $ 15,116 Occupancy expense 3,931 3,739 Net (gain) loss and carrying costs of real estate acquired by foreclosure (205) 5 FDIC assessment 105 137 Technology 1,229 1,265 Postage and delivery charges 515 528 Supplies 328 277 Professional fees 1,286 1,237 Minority interest expense: Company obligated mandatorily redeemable trust preferred securities of subsidiary trusts 1,549 1,325 Marketing 518 287 Other 3,718 3,295 -------- -------- $ 28,972 $ 27,211 ======== ========
Salaries and employee benefits for the three-month period ended June 30, 2003 were $16.0 million, as compared to $15.1 million for the same period in 2002, an increase of $882 thousand or 5.8%. The increase is primarily related to merit increases, increased payroll taxes and increased hospital and medical 18 insurance expenses. Additionally, increased salaries and employee benefits expenses related to the acquisition of Eagle National were $226 thousand. Minority interest expense increased $224 thousand or 16.9% from the three months ended June 30, 2002 as compared to the same period in 2003. The increase is related to the interest due on the additional trust preferred securities issued in August 2002 and September 2002 offset by the redemption of trust preferred securities in November 2002. PROVISION FOR INCOME TAXES - The provision for income taxes as a percent of net income before taxes decreased from 33.4% for the second quarter of 2002 to 30.6% for the same period in 2003. The provision for income taxes as a percent of income from continuing operations before taxes increased from 31.9% to 32.9% for the same period in 2003. FINANCIAL CONDITION TOTAL ASSETS - The total consolidated assets of the Company decreased $137.6 million from $3.6 billion at December 31, 2002 to $3.4 billion at June 30, 2003. The assets of the Eagle Pass, Carrizo Springs, Crystal City and Pearsall banking offices are stated separately as discontinued operations as of December 31, 2002 on the Consolidated Balance Sheet. These assets are not included in the June 30, 2003 Consolidated Balance Sheet because these sales were consummated before June 30, 2003. Assets sold with the Eagle Pass office in March 2003 totaled $18.7 million. Assets sold with the banking offices located in Carrizo Springs, Crystal City and Pearsall in May 2003 totaled $16.6 million. CASH AND CASH EQUIVALENTS - The Company had cash and cash equivalents of $156.7 million at June 30, 2003. Comparatively, the Company had $139.2 million in cash and cash equivalents on December 31, 2002, an increase of $17.4 million. TRADING ASSETS - The Company trades SBA 7(a) government guaranteed loans and pools. Trading assets as of June 30, 2003 were $137.8 million, a decrease of $5.0 million from December 31, 2002. These assets are generally held up to 120 days. The trading assets are carried at fair market value. The realized and unrealized gains and losses on these assets are included in income. SECURITIES - The Company's securities portfolio as of June 30, 2003, totaled $279.3 million, as compared to $313.1 million on December 31, 2002, a decrease of $33.8 million or 10.8%. During the first quarter of 2003, the Bank sold $16.5 million of securities. The remaining decrease is due to principal paydowns and maturities. At June 30, 2003, the unrealized gain on the available for sale securities was $4.8 million. LOANS HELD FOR SALE - Total loans held for sale decreased from $701.3 million at December 31, 2002 to $604.3 million at June 30, 2003, a decrease of $97.0 million, or 13.8%. The majority of these loans represent loans funded by the Bank through a mortgage warehouse line to SCMC. Upon closing of the sale of SCMC, this warehouse facility is expected to run off and not be replaced. LOANS HELD FOR INVESTMENT - As of June 30, 2003, loans held for investment were $2.04 billion which was a $131.6 million increase from the balance of $1.91 billion at December 31, 2002. At June 30, 2003, loans held for investment as a percentage of total assets and total deposits were 59.3% and 78.7%, respectively. 19 The following table summarizes the Company's loan portfolio by type of loan as of June 30, 2003 (in thousands):
PERCENT OF AMOUNT TOTAL ---------- ---------------- Commercial, financial and industrial $ 628,638 23.75% Real estate - commercial 690,867 26.11% Real estate - residential mortgage 200,145 7.56% Real estate - construction 385,295 14.56% Foreign commercial and industrial 6,602 0.25% Consumer and other 130,602 4.93% Unearned discounts - 0.00% ---------- ------ Total loans held for investment 2,042,149 77.16% Loans held for sale 604,337 22.84% ---------- ------ Total loans $2,646,486 100.00% ========== ======
ALLOWANCE FOR CREDIT LOSSES - The following is a summary of the changes in the allowance for credit losses for the six months ended June 30, 2003 and June 30, 2002, respectively, (in thousands):
SIX MONTHS ENDED JUNE 30, ---------------------------- 2003 2002 ---------- ---------- Allowance for credit losses, January 1, $ 27,248 $ 22,927 Charge-offs (6,793) (5,372) Recoveries 924 951 Provision for credit losses 10,548 5,711 Allowance related to Eagle Pass divestiture (353) - -------- -------- Allowance for credit losses, June 30, $ 31,574 $ 24,217 ======== ======== Net charge-offs as a percentage of average loans (annualized) 0.47% 0.46% ======== ======== Provision for credit losses as a percentage of average loans (annualized) 0.84% 0.59% ======== ========
The following is a summary of the relationship of the allowance for credit losses to total loans at June 30, 2003, and December 31, 2002 (in thousands):
JUNE 30, DECEMBER 31, 2003 2002 ---------- ---------- Loans at period-end $2,646,486 $2,611,866 Allowance for credit losses $ 31,574 $ 27,248 Allowance as a percent of period-end loans 1.19% 1.04%
In order to determine the adequacy of the allowance for credit losses, management considers the risk classification and delinquency status of loans and other factors. Management also establishes specific allowances for credits which management believes require allowances greater than those allocated according to their risk classification. An unallocated allowance is also established based on the Company's historical charge-off experience. The Company will continue to monitor the adequacy of the allowance for credit losses to determine the appropriate accrual for the Company's provision for credit losses. 20 RISK ELEMENTS - Nonperforming, past-due, and restructured loans are fully or substantially secured by assets, with any excess of loan balances over collateral values specifically allocated in the allowance for credit losses. Thirty-four properties make up the $4.7 million of other real estate owned ("ORE") at June 30, 2003. All properties are carried at the lower of cost or fair market value. The Company defines potential problem loans as those loans for which information known by management indicates serious doubt that the borrower will be able to comply with the present payment terms. Management identifies these loans through its continuous loan review process and defines potential problem loans as those loans classified as "substandard", "doubtful", or "loss". As of June 30, 2003, the Company has no material foreign loans outstanding or loan concentrations. The following table summarizes total nonperforming assets and potential problem loans at June 30, 2003 and at December 31, 2002:
JUNE 30, DECEMBER 31, 2003 2002 -------- ------------ (IN THOUSANDS) Nonaccrual loans $20,089 $19,654 Other real estate ("ORE") and other foreclosed assets 4,825 3,425 ------- ------- Total nonperforming assets $24,914 $23,079 ======= ======= Total nonperforming assets as a % of loans, ORE and other foreclosed assets 0.94% 0.88% Allowance for credit losses as a percentage of nonperforming assets 126.73% 118.06% Accruing loans past due 90 days or more $ 110 $ 984 Potential problem loans, other than those shown above as nonperforming $80,687 $62,189
PREMISES AND EQUIPMENT - The Company's premises and equipment, net of depreciation and discontinued operations, as of June 30, 2003, was $46.7 million, as compared to $49.9 million as of December 31, 2002, a decrease of $3.2 million. DEPOSITS - Total deposits as of June 30, 2003, were $2.59 billion, as compared to $2.53 billion on December 31, 2002, an increase of $60.9 million. The percentage of noninterest bearing deposits to total deposits as of June 30, 2003 was 39.7%. CAPITAL RESOURCES AND LIQUIDITY SHAREHOLDERS' EQUITY - At June 30, 2003, shareholders' equity totaled $261.5 million, as compared to $249.3 million at December 31, 2002. The Company's risk-based capital ratios remain above the levels designated by regulatory agencies for the Company to be considered as "well capitalized" on June 30, 2003, with Tier 1 capital, total risk-based capital, and leverage capital ratios of 10.34%, 13.33%, and 8.38%, respectively. LIQUIDITY - Effective management of balance sheet liquidity is necessary to fund growth in earning assets and to pay liability maturities, depository withdrawals and shareholders' dividends. The Company has instituted asset/liability management policies, including but not limited to a computer simulation model, to improve liquidity controls and to enhance its management of interest rate risk and financial condition. The 21 Company has numerous sources of liquidity including a significant portfolio of short-term assets, marketable investment securities (excluding those presently classified as "held-to-maturity"), loans available-for-sale, core deposits and access to borrowing arrangements. Available borrowing arrangements maintained by the Company include federal funds lines with other commercial banks and Federal Home Loan Bank ("FHLB") advances. Also in 2002, the Bank began accepting brokered certificates of deposits to assist in funding the growth of the held for sale loan portfolio. During April, 2003, the Bank raised approximately $50 million through a private offering of subordinated unsecured notes. The subordinated notes issued by the Bank bear interest at a fixed rate of 7.375% and mature over a ten year period ending April 15, 2013, with semi-annual interest payment. These subordinated notes are not convertible or redeemable. In June 2003, the Bank entered into an interest rate swap agreement in which the Bank swapped $50 million fixed rate subordinated debt to floating rate debt. Under the terms of the agreement, the Bank will receive the fixed coupon rate of 7.375% associated with the subordinated debt and will pay its swap counterparty a variable interest rate equal to the three-month LIBOR that is reset on a quarterly basis, plus 3.62%. This swap is designated as a fair-value hedge and qualifies for "short-cut" hedge accounting treatment under SFAS 133, such that changes in the fair value of the swap will not be reflected in the income statement. As of June 30, 2003, the Company had $18.3 million outstanding under a term loan with Wells Fargo Bank, National Association ("Wells Fargo"). The term note bears interest at a rate per annum of 1.95% above the federal funds rate from time to time. The federal funds rate is a fluctuating interest rate per annum set daily by Wells Fargo as the rate at which funds are offered to Wells Fargo by federal funds brokers. The indebtedness evidenced by the term note is payable in quarterly installments with a final maturity date of February 1, 2006. The Credit Agreement requires the Company and the Bank to maintain certain financial ratios and includes other restrictive covenants. At June 30, 2003, the Company and Bank were in compliance with all related financial covenants for this credit facility. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company's profitability, as with most financial institutions, is greatly dependent upon net interest income. The Company actively manages its overall exposure to changes in interest rates. While the Company has entered into the interest rate swap agreement described below, the Company believes that there have been no material changes in market risk faced by the Company since December 31, 2002. For more information regarding quantitative and qualitative disclosures about market risk, please refer to the Company's Annual Report on Form 10-K as of and for the year ended December 31, 2002. In June 2003, the Bank entered into an interest rate swap agreement in which the Bank swapped $50 million fixed rate subordinated debt to floating rate debt. Under the terms of the agreement, the Bank will receive the fixed coupon rate of 7.375% associated with the subordinated debt and will pay its swap counterparty a variable interest rate equal to the three-month LIBOR that is reset on a quarterly basis, plus 3.62%. This swap is designated as a fair-value hedge and qualifies for "short-cut" hedge accounting treatment under SFAS 133, such that changes in the fair value of the swap will not be reflected in the income statement. ITEM 4. CONTROLS AND PROCEDURES. Evaluation of disclosure controls and procedures - Based on their evaluation of the Company's disclosure controls and procedures as of the end of the period covered by this report, the Chief Executive Officer and Chief Financial Officer of the Company have concluded that the disclosure controls and procedures are effective in insuring that the information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act is recorded, processed, summarized and report within the time periods specified in the Securities and Exchange Commission's rules and forms. Changes in internal control over financial reporting - There were no changes in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter that have 22 materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS. Not applicable. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. Not applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. Not applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. The Company's Annual Meeting of Stockholders was held on April 28, 2003, to consider and vote on the following proposals: Proposal 1: The Election of Directors The following individuals were nominated and elected as Class II directors to hold office until the 2006 annual meeting of the stockholders of the Company or until their successors have been duly elected and qualified.
For Withheld J. Downey Bridgwater 31,957,414 913,069 David L. Hatcher 32,566,308 304,175 James J. Kearney 32,575,138 295,345 G. Edward Powell 32,468,080 402,403 Raimundo Riojas E. 32,575,138 295,345
Harold L. Campbell was nominated and elected as a Class I director to hold office until the 2005 annual meeting of the stockholders of the Company or until his successor has been duly elected and qualified.
For Withheld Harold L. Campbell 32,468,567 401,916
The following directors continued in office after the annual meeting: George Martinez, Chairman Glenn H. Johnson George Beatty, Jr. Paul Michael Mann, M.D. Anat Bird Thomas A. Reiser John H. Buck Steven F. Retzloff James D. Calaway Howard T. Tellepsen Bruce J. Harper 23 Proposal 2: Approval of the 2003 Stock Incentive and Compensation Plan: For 28,838,733 Against 3,997,111 Abstain 34,636 Proposal 3: Ratification of the appointment of Deloitte & Touche LLP as the Company's independent public accountants for its fiscal year ending December 31, 2003. For 32,022,170 Against 836,896 Abstain 11,417 ITEM 5. OTHER INFORMATION. Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: 4.1 -- Fiscal and Paying Agency Agreement dated April 10, 2003 between Sterling Bank and Deutsche Bank Trust Company Americas. [Incorporated by reference to Exhibit 4.1 of the Company's Report on Form 8-K filed on April 15, 2003 (File No. 000-20750.] 4.2 -- Form of Global Certificate representing Sterling Bank's 7.375% Subordinated Notes due 2013. [Incorporated by reference to Exhibit 4.2 of the Company's Report on Form 8-K filed on April 15, 2003 (File No. 000-20750).] 10.1 -- Sterling Bancshares, Inc. 2003 Stock Incentive and Compensation Plan. [Incorporated by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-8 (File No. 333-105307).] 10.2 -- Purchase Agreement dated April 3, 2003 among Sterling Bank, Lehman Brothers Inc. and Keefe, Bruyette & Woods, Inc. [Incorporated by reference to Exhibit 10.1 of the Company's Report on Form 8-K filed on April 15, 2003 (File No. 000-20750.) 11 -- Statement Regarding Computation of Earnings Per Share (included as Note (2) to Interim Consolidated Financial Statements on page 5 of this Quarterly Report on Form 10-Q). *31.1-- Certification of J. Downey Bridgwater, President and Chief Executive Officer, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *31.2-- Certification of Stephen C. Raffaele, Executive Vice President and Chief Financial Officer, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *32.1-- Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *32.2-- Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ------- *As filed herewith. (b) Reports on Form 8-K: (1) Current Report on Form 8-K filed April 15, 2003 announcing the private placement of $50 million of subordinated unsecured notes. (2) Current Report on Form 8-K filed April 17, 2003 announcing the release of Sterling Bancshares' preliminary earnings report for the three months ended March 31, 2003. 24 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused the report to be signed on its behalf by the undersigned thereunto duly authorized. STERLING BANCSHARES, INC. ------------------------- (Registrant) DATE: August 12, 2003 BY: /s/ J. Downey Bridgwater --------------------------------- J. DOWNEY BRIDGWATER PRESIDENT AND CHIEF EXECUTIVE OFFICER DATE: August 12, 2003 BY: /s/ Stephen C. Raffaele --------------------------------- STEPHEN C. RAFFAELE EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER 25 EXHIBIT INDEX EXHIBIT DESCRIPTION 4.1-- Fiscal and Paying Agency Agreement dated April 10, 2003 between Sterling Bank and Deutsche Bank Trust Company Americas. [Incorporated by reference to Exhibit 4.1 of the Company's Report on Form 8-K filed on April 15, 2003 (File No. 000-20750).] 4.2-- Form of Global Certificate representing Sterling Bank's 7.375% Subordinated Notes due 2013. [Incorporated by reference to Exhibit 4.2 of the Company's Report on Form 8-K filed on April 15, 2003 (File No. 000-20750).] 10.1-- Sterling Bancshare, Inc. 2003 Stock Incentive and Compensation Plan. [Incorporated by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-8 (File No. 333-105307).] 10.2-- Purchase Agreement dated April 3, 2003 among Sterling Bank, Lehman Brothers Inc. and Keefe, Bruyette & Woods, Inc. [Incorporated by reference to Exhibit 10.1 of the Company's Report on Form 8-K filed on April 15, 2003 (File No. 000-20750).] 11-- Statement Regarding Computation of Earnings Per Share (included as Note (2) to Interim Consolidated Financial Statements on page 5 of this Quarterly Report on Form 10-Q). *31.1-- Certification of J. Downey Bridgwater, President and Chief Executive Officer, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *31.2-- Certification of Stephen C. Raffaele, Executive Vice President and Chief Financial Officer, as required pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. *32.1-- Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. *32.2-- Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ------- *As filed herewith. 26