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VIA EDGAR
Securities and Exchange Commission
450 Fifth Street, N. W.
Washington, D.C. 20549
RE: FNB Financial Services Corporation (the "Company") Annual Report on Form
10-K for the Fiscal Year Ended December 31, 2002
Ladies and Gentlemen:
On behalf of FNB Financial Services Corporation, enclosed for filing is the
Company's Annual Report on Form 10-K for the fiscal year ended December 31,
2002. The financial statements contained in the enclosed report do not reflect a
change from the previous year in any accounting principles or practices, or in
the method of applying any such principles or practices.
Please call Michael W. Shelton, the Company's Chief Financial Officer at (336)
634-4775 if you have any questions or if you require additional information.
Sincerely,
/s/Michael W. Shelton
- ---------------------
Michael W. Shelton
FNB Financial Services Corporation
U.S. Securities and Exchange Commission
Washington, D.C. 20549
Form 10-K
|X| Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended December 31, 2002
|_| Transition Report Under Section 13 or 15(d) of the Securities Exchange Act
of 1934
For the transition period from ______________ to ______________
Commission file number 0-13086
FNB Financial Services Corporation
202 South Main Street
Reidsville, North Carolina 27320
(336) 342-3346
Incorporated in the State of North Carolina
IRS Employer Identification No. 56-1382275
Securities Registered Pursuant to Section 12(b) of the Exchange Act:
None
Securities Registered Pursuant to Section 12(g) of the Exchange Act:
Common Stock, Par Value $1.00 Per Share
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers in response to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |X|
The aggregate market value of the registrant's Common Stock at March 19,
2003, held by those persons deemed by the registrant to be non-affiliates, based
on the average bid and asked price of the Common Stock on that day, was
approximately $73.7 million.
As of March 19, 2003 (the most recent practicable date), the registrant
had outstanding 4,432,237 shares of Common Stock, $1.00 par value.
DOCUMENTS INCORPORATED BY REFERENCE
Document Where Incorporated
- -------- ------------------
1. Proxy Statement for the Annual Meeting of Part III
Shareholders to be held May 15, 2003 to be
mailed to shareholders within 120 days of
December 31, 2002.
FNB Financial Services Corporation
Form 10-K
Table of Contents
Index Page
- ----- ----
PART I
Item 1. Business .................................................................. 1
Item 2. Properties ................................................................ 16
Item 3. Legal ..................................................................... 17
Item 4. Submission of Matters to a Vote of Security Holders ....................... 17
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters ..... 18
Item 6. Selected Financial Data ................................................... 19
Item 7. Management's Discussion and Analysis
of Financial Condition and Results of Operations ..................... 20
Item 7A. Quantitative and Qualitative Disclosures About Market Risk ................ 30
Item 8. Financial Statements and Supplementary Data ............................... 41
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure ............................... 66
PART III
Item 10. Directors and Executive Officers of the Registrant ........................ 66
Item 11. Executive Compensation .................................................... 66
Item 12. Security Ownership of Certain Beneficial Owners and Management ............ 66
Item 13. Certain Relationships and Related Transactions ............................ 66
Item 14. Controls and Procedures ................................................... 66
PART IV
Item 15. Exhibits, the Financial Statement Schedules, and Reports on Form 8-K ...... 68
Signatures ................................................................ 72
Certification of the Chief Executive Officer
Certification of the Chief Financial Officer
PART I
Item 1. Business
General
FNB Financial Services Corporation (the "Company") is a North Carolina
financial holding company with consolidated assets of $734.0 million, deposits
of $605.0 million and shareholders' equity of $64.3 million, each as of December
31, 2002. The Company was organized in 1984 as a North Carolina bank holding
company, although its predecessor and wholly-owned subsidiary, FNB Southeast
(the "Bank" or "Subsidiary Bank"), opened as Rockingham Savings Bank and Trust
in 1910 and was chartered as a national bank in 1918 under the name of First
National Bank of Reidsville. In May 1997, the Bank changed its name to First
National Bank Southeast to reflect its expansion into new markets. Effective
March 15, 1999, the Bank changed its charter from a national bank to a North
Carolina state bank and changed its name to FNB Southeast. The Company became a
financial holding company, effective February 12, 2001, under the
Gramm-Leach-Bliley Act. A financial holding company is permitted to engage in
activities that are financial in nature or incidental to a financial activity.
The permitted activities of a financial holding company are broader than for a
bank holding company.
Historically, the Company has served the Rockingham County area of North
Carolina through three branches in Reidsville and two in Eden, North Carolina.
In 1995, the Company initiated a strategic growth plan beginning with the hiring
of a new chief executive officer. On August 31, 1999, the Company acquired Black
Diamond Savings Bank, FSB ("Black Diamond"), a federal savings bank
headquartered in Norton, Virginia. By the end of 2002, FNB Southeast had
increased its number of North Carolina branches from five to thirteen by closing
a branch in Eden and opening nine new branches in the Rockingham County towns of
Eden, Ruffin and Madison and in the new markets of Greensboro, Burgaw and
Wilmington. The acquisition of Black Diamond added branches in Norton,
Harrisonburg, Pennington Gap and Richlands, Virginia.
The Bank is community oriented and focuses primarily on offering
commercial, real estate and consumer loans, and deposit and other financial
services to individuals, small to medium-sized businesses and other
organizations in its market areas. The Company emphasizes its individualized
services and community involvement, while at the same time providing its
customers with the financial sophistication and array of products typically
offered by larger banks. The Company competes successfully with larger banks
located within and outside North Carolina and Virginia by retaining its
personalized approach and community focus.
Under the leadership of Ernest J. Sewell, who became President and Chief
Executive Officer in January 1995, the Company adopted the following three-part
strategy: (1) increase market share and geographic reach through opportunistic
acquisitions in markets where the mix of economic, operational, cultural and
other factors are favorable; (2) position the Company to manage its planned
growth by adding experienced personnel and upgrading its internal systems and
procedures; and (3) generate internal growth at its existing banking offices by
offering new and complementary services and products. To accomplish these
objectives, during the past eight years the Company has: (a) increased the
number of its North Carolina banking offices to thirteen by opening new offices
in Eden, Ruffin, Madison, Greensboro (three offices), Burgaw and Wilmington (two
offices); (b) expanded the number of its full-time personnel by adding new
employees, including several senior executives; (c) completed the merger with
Black Diamond to extend the Company's reach into selected Virginia markets; (d)
completed a systematic review and revision of its loan administration, loan
policy and credit procedures; and (e) enhanced its mix of products and services
by forming investment services and mortgage banking subsidiaries.
1
The Company plans to continue to pursue these objectives by strengthening
its presence in existing markets and opportunistically reaching into new markets
in North Carolina and Virginia. On September 25, 2002, the Bank announced it had
entered into an agreement to acquire the Harrisonburg, Virginia branch of
Guaranty Bank. This purchase was completed on January 24, 2003. The Company
intends to hire additional qualified personnel to help manage its planned growth
and to develop new products that are consistent with the Company's customer
service orientation. The Company also plans, where appropriate, to continue to
upgrade its systems and procedures and refine its ability to offer customers
sophisticated services without sacrificing its personalized approach.
Strategy
Expand Banking Operations. Throughout most of its 93-year history, the
Company's banking activities were centered near Reidsville, North Carolina, in
the north central part of the State. Beginning in 1995, however, the Company
initiated a growth strategy to further penetrate markets in which it had an
existing market share and expand into and develop new markets, such as
Wilmington and Greensboro in North Carolina and into Virginia. Management
selects its target markets based on a number of factors, including market size
and growth potential, banking relationships developed by members of management
during their careers and the ability to integrate the targeted market into the
Company's community oriented culture.
The Company's expansion strategy, both within and outside of its existing
markets, involves three key elements: (i) ascertain which markets may be
underserved by financial institutions whose primary focus is to cater to the
individualized needs of the customer; (ii) install high-quality, well-trained
management to serve the market; and (iii) find reasonably priced facilities.
Management believes that it has been successful in implementing these strategic
elements in its expansion program to date.
In August 1999, the Company acquired Black Diamond which had offices in
Norton, Harrisonburg, Pennington Gap and Richlands, Virginia. These branches
serve the market areas of Wise, Tazewell, Russell, Lee, Rockingham and Augusta
Counties in Virginia. In December 1999, the Company opened a full service
banking office in Burgaw, North Carolina. This office serves the Pender County
market plus the surrounding area and compliments the Company's presence in
adjacent New Hanover County. In April 2000, a second office was opened in
Wilmington, North Carolina. This office primarily services the residential
construction market. The Company also opened two additional branches in
Greensboro, North Carolina, during April 2000. These two facilities supplement
the existing office, and the Company now has three full service offices in this
dynamic market.
Seize Market Expansion Opportunities. The Company intends to continue to
capitalize on opportunities to enter new and contiguous markets which it
believes are underserved as a result of banking consolidation and in which the
Company's community oriented philosophy and culture might flourish. The Company
believes that there is value to be added by providing the opportunity for
greater personalized banking relationships that exist with larger commercial
banks in its markets, although the Company also recognizes the need to carefully
analyze markets that are already well served by numerous institutions. The
Company will continue to distinguish itself by emphasizing high quality,
sophisticated services in a hometown environment.
Establish a Platform for Future Growth. The Company seeks to position
itself to manage its expected growth in two fundamental ways: (1) attract,
retain and reward experienced personnel who are committed both to conducting
business in a friendly and personable manner and to serving the communities in
which they work and live; and (2) continue to upgrade, modify and expand its
internal systems, procedures, equipment and software to improve operating
efficiencies. The Company will continue to analyze technological developments in
the banking industry for opportunities to improve or augment its services and
products; however, management will continue to make every effort to maintain the
Company's personalized approach.
2
Maintain a Friendly Environment for Employees and Customers. The Company
has instituted various programs to instill high morale among its employees,
which the Company believes translates into exceptional customer service. The
Company holds weekly sales meetings to elicit ideas about featured products and
services and to develop and communicate ideas for expanding banking
relationships with existing and potential customers. The Company believes that
the overall effect of these type programs is to improve morale, customer service
and financial performance.
Market Areas
For operational purposes, the Company groups its markets into four
regions: the Triad and Wilmington regions of North Carolina, and the Norton and
Harrisonburg regions of Virginia. The Company's deposit market share in
Rockingham County, North Carolina as of June 2002, the most recent date for
which data are available, was 27.2%, which ranked first among banks and thrift
institutions. The following table summarizes the banking offices and deposit
totals for the Company's offices, categorized by city.
Region and City Deposits at December 31,
----------------------------------
2002 2001 2000
-------- -------- --------
(In thousands)
Triad Region:
Reidsville (1) .......................... $226,819 $198,885 $219,474
Eden (2) ................................ 45,333 50,873 55,417
Madison ................................. 22,482 22,302 23,387
Ruffin .................................. 10,872 11,152 10,793
Greensboro (1) .......................... 77,548 72,749 57,109
-------- -------- --------
Subtotal ...................... 383,054 355,961 366,180
-------- -------- --------
Wilmington Region:
Wilmington (2) .......................... 55,259 52,489 47,051
Burgaw .................................. 25,247 26,496 21,125
-------- -------- --------
Subtotal ...................... 80,506 78,985 68,176
-------- -------- --------
Norton Region:
Norton .................................. 58,551 67,545 57,936
Pennington Gap .......................... 22,933 26,103 26,772
Richlands ............................... 22,174 26,203 26,258
-------- -------- --------
Subtotal ...................... 103,658 119,851 110,966
-------- -------- --------
Harrisonburg Region:
Harrisonburg (3) ........................ 37,787 31,963 24,129
-------- -------- --------
Total deposits ................ $605,005 $586,760 $569,451
======== ======== ========
- ------------------------
(1) Includes three banking offices for all years.
(2) Includes two banking offices for all years.
(3) Includes one banking office for 2002 and 2001, and two offices for 2000.
The following is a summary description of the Company's market areas.
Triad Region - Rockingham County. Rockingham County is located in the
north central area of North Carolina. It has a land area of 565 square miles and
a population of approximately 90,000. Surrounding counties are Guilford to the
south, Caswell to the east, and Stokes to the west. The county is bordered on
the north by Virginia. Piedmont Triad International Airport is located twenty
miles away, and Norfolk Southern has two rail connection lines in the county.
The area is served by U.S. Highways 29, 158 and 220. The county, which consists
of several community oriented towns, provides a full range of municipal services
and extends financial support to certain boards, agencies, and commissions to
assist its effort to serve its citizens. The North Carolina
3
Employment Security Commission reported a December 2002 unemployment rate of
8.5% for Rockingham County. Business and government leaders in the county have
made progress in diversifying the area's economy to make up for job losses in
the textile and tobacco industries.
Triad Region - Greensboro. Greensboro has a diverse economy attributable to
a blend of trade, manufacturing and service businesses. Local industry is
characterized by the production of a wide range of products, including textiles,
apparel, tobacco, machinery, pharmaceuticals, microchips and electronics
equipment. Guilford County, with a population of approximately 420,000, has
access to major domestic and international markets from Interstate Highways 40
and 85; U.S. Highways 29, 70, 220 and 421; major rail connections; and the
Piedmont Triad International Airport. According to the North Carolina Employment
Security Commission, Guilford County reported an unemployment rate of 5.8% for
December 2002, compared to a statewide unemployment rate of 6.1%.
Wilmington Region. Wilmington is the county seat and industrial center of
New Hanover County, located on the southeast coast of North Carolina. The total
population of New Hanover County is approximately 160,000. The county is served
by Interstate Highway 40 and U.S. Highways 17 and 74, as well as major rail
connections. This area is serviced by national and regional airlines through
facilities at the New Hanover International Airport located near Wilmington. The
area has experienced extensive industrial development and service/trade sector
growth over the past twenty years. Industries in the region produce fiber optic
cables for the communications industry, aircraft engine parts, pharmaceuticals,
nuclear fuel components and various textile products. The New Hanover County
area economy has become broadly diversified and has developed into a major
resort area, a busy sea port (one of North Carolina's two deep water ports), a
light manufacturing center, chemical manufacturing center and the distribution
hub of southeastern North Carolina. The North Carolina Employment Security
Commission reported a December 2002 unemployment rate of 5.8% for New Hanover
County.
Norton Region. Norton is located in southwestern Virginia in the midst of
the Appalachian Mountains. The mining, retail and service industries of this
region operate from an abundant natural resource base that includes natural gas,
coal, timber and mineral deposits. The area is served by several U.S. Highways
and by major rail connections. The Bank operates branches in Norton (Wise
County), Pennington Gap (Lee County) and Richlands (Tazewell County). For
December 2002, the Virginia Employment Commission reported the unemployment rate
in Wise County was 5.5%.
Harrisonburg Region. Rockingham County, Virginia is centrally located in
the Shenandoah Valley in west central Virginia. Harrisonburg, the county seat
with a population of 40,000, is an important educational, industrial, retail,
tourism, commercial, agricultural and governmental center. The area is served by
Interstate Highway 81, several primary U. S. highways, the Shenandoah Valley
Regional Airport and a major rail connection. The Bank operates one branch in
Harrisonburg, serving the counties of Rockingham and Augusta. The Bank has added
a second branch in this market with the completion of the branch purchase from
Guaranty Bank on January 24, 2003. According to the Virginia Employment
Commission, the December 2002 unemployment rate for Harrisonburg was 1.3%
compared to a statewide unemployment rate of 3.6%.
Lending Activities
General. The Company offers a broad array of lending services, including
real estate, commercial and consumer loans, to individuals and small to
medium-sized business and other organizations that are located in or conduct a
substantial portion of their business in the Company's market areas. The Company
has also established niche markets such as residential construction lending in
local markets and airplane lending in markets throughout the southeastern United
States. The Company's total loans at December 31, 2002, were $563.6 million, or
76.8% of total assets. The Company also makes secured construction loans to
homebuilders and residential mortgages, which are often secured by first and
second real estate mortgages. At December 31, 2002, the Company had no large
loan concentrations (exceeding ten percent of its portfolio) in any particular
industry.
4
Loan Composition. The following table summarizes, at the dates indicated,
the composition of the Company's loan portfolio and the related percentage
composition.
(In thousands) As of December 31,
------------------------------------------------------------------
2002 2001 2000
------------------ ------------------ ------------------
Real estate:
Commercial $170,657 30.3% $168,419 31.5% $119,584 23.9%
Residential 119,316 21.2 130,264 24.4 150,825 30.1
Construction 87,696 15.6 55,861 10.4 66,148 13.2
-------- ----- -------- ----- -------- -----
Total real estate 377,669 67.1% 354,544 66.3% 336,557 67.2%
Commercial, financial and
agricultural 87,458 15.5% 90,858 17.0% 74,981 15.0%
-------- ----- -------- ----- -------- -----
Consumer:
Direct 34,074 6.0% 37,112 6.9% 46,463 9.3%
Home equity 54,073 9.6 46,169 8.6 39,204 7.8
Revolving 10,326 1.8 6,662 1.2 3,432 0.7
-------- ----- -------- ----- -------- -----
Total consumer 98,473 17.4% 89,943 16.7% 89,099 17.8%
-------- ----- -------- ----- -------- -----
Total loans $563,600 100.0% $535,345 100.0% $500,637 100.0%
======== ===== ======== ===== ======== =====
Real Estate Loans. Loans secured by real estate for a variety of purposes
constituted $377.7 million or 67.1%, of the Company's total loans at December
31, 2002. These real estate loans are of various sizes ranging up to $6.8
million, and are secured by office buildings, retail establishments, warehouses,
motels, restaurants and other types of property. Loan terms are typically
limited to five years, with payments through the date of maturity generally
based on a 15-year amortization schedule. Interest rates may be fixed or
adjustable, based on market conditions, and the Company generally charges an
origination fee. Management has attempted to reduce credit risk in the real
estate portfolio by emphasizing loans on owner occupied office and retail
buildings where the loan to value ratio, established by independent appraisals,
does not exceed 80%, and net projected cash flow available for debt service
amounts to at least 120% of the debt service requirement. The Company also often
requires personal guarantees of the principal owners of the property and obtains
personal financial statements of the principal owners in such cases. The Company
experienced net recoveries on commercial real estate loans of $18,000 in 2002
and net charge-offs of $7,000 in 2001, and $346,000 in 2000.
The Company originates residential loans for its portfolio on single and
multi-family properties, both owner occupied and non-owner occupied, and at
December 31, 2002, it held $119.3 million of such loans. Loan terms are
typically limited to five years, with payments through the date of maturity
generally based on a 15 or 30 year amortization schedule. Rates may be fixed or
variable, and the Company typically charges an origination fee. The Company
attempts to minimize credit risk by requiring a loan to value ratio of 80% or
less. The Company experienced net charge-offs on residential real estate loans
of $43,000 in 2002, $36,000 in 2001, and $13,000 in 2000.
The Company also originates residential loans for sale into the secondary
market. Through its mortgage banking activities, the Company originates both
fixed and variable rate residential mortgage loans for sale with servicing
released. The Company is able to generate loan origination fees, typically
ranging from 1.0% to 1.5% of the loan balance, which are recognized as income
when the loan is sold. During 2002, 2001, and 2000, the Company earned loan
origination fees from these types loans of $746,000, $376,000, and $264,000,
respectively. At December 31, 2002, it held $3.2 million of such loans for sale,
and during 2002 it sold an aggregate of $28.0 million of such loans. The Company
sells these loans on a non-recourse basis.
5
The Company's current lending strategy is for the majority of construction
and development loans on commercial and residential projects to be in the range
of $0.3 million to $4.0 million. At December 31, 2002, 2001, and 2000, the
Company held $87.7 million, $55.9 million, and $66.1 million, respectively, of
such loans. To reduce credit risk associated with such loans, the Company limits
its lending to projects involving small commercial centers that have strong
anchor tenants and are substantially pre-leased, or residential projects built
in strong, proven markets. The leases on commercial projects must generally
result in a loan to appraised value of 80% and a net cash flow to debt service
at no less than 120%. The Company historically has required a personal guarantee
from the developer or builder. Loan terms are typically twelve to fifteen
months, although the Company occasionally will make a "mini-permanent" loan for
purposes of construction and development of up to a five year term. Rates are
typically variable, and the Company typically charges an origination fee. The
Company experienced no net charge-offs from construction and development loans
during 2002, 2001, or 2000.
Commercial Loans. The Company makes loans for commercial purposes to
various types of businesses. At December 31, 2002, the Company held $87.5
million of commercial loans, or 15.5% of its total loan portfolio. Equipment
loans are typically made on terms up to five years at fixed or variable rates,
with the financed equipment pledged as collateral to the Company. The Company
attempts to reduce its credit risk on these loans by limiting the loan to value
ratio to 80%. Working capital loans are made on terms typically not exceeding
one year. These loans may be secured or unsecured, but the Company attempts to
limit its credit risk by requiring the borrower to demonstrate its capacity to
produce net cash flow available for debt service equal to 110% to 150% of its
debt service requirements. The Company experienced net charge-offs from
commercial loans of $803,000 in 2002, $485,000 in 2001, and $62,000 in 2000.
Consumer Loans. The Company makes a variety of loans to individuals for
personal and household purposes, including (i) secured and unsecured installment
and term loans originated directly by the Company; (ii) home equity revolving
lines of credit; and (iii) unsecured revolving lines of credit. The home equity
loans and certain of the direct loans are secured by the borrower's residence.
At December 31, 2002, the Company held $98.5 million of consumer loans,
including home equity lines of credit. During 2002, 2001, and 2000,
respectively, the Company experienced net consumer charge-offs of $133,000,
$336,000, and $258,000.
Loan Approval and Review. The Company has adopted various levels of
officer lending authority in connection with its loan approval policies. When
the aggregate outstanding loans to a single borrower exceed that individual
officer's lending authority, the loan request must be considered and approved by
an officer with a higher lending limit. Branch loan officers typically have
retail lending limits ranging from $75,000 to $250,000. Community executives can
generally approve commercial relationships up to $750,000. If the lending
request exceeds the community executive's lending limit, the loan must be
submitted to and approved by the senior credit officer. The senior credit
officer has authority to approve commercial relationships to $1,000,000. Under
joint approval, the senior credit officer and selected regional executives may
approve loans up to $1,750,000 million. All loans in excess of $1,750,000
million must be approved by the President and Chief Executive Officer, who may
approve loans up to $2,500,000.
The Company has a loan review procedure involving multiple officers of the
Company which is designed to promote early identification of credit quality
problems through its credit management committee. All loan officers are charged
with the responsibility of reviewing on an annual basis all credit relationships
in excess of $250,000 in their respective portfolios. Loan officers also review
all criticized and classified assets in their portfolio quarterly with the
senior loan officers of the Company. The loan officers are responsible for
implementing, where appropriate, approved action plans with respect to such
criticized and classified assets designed to improve the Company's credit
position for an early resolution of the problem loan. As part of its overall
strategy to improve policies and procedures, the Company also periodically
engages a third party consultant to review its loan portfolio. The Company has
used the findings of the previous examinations to further enhance credit quality
through improved credit administration policies and procedures.
6
The Company's credit review system supplements the Company's loan rating
system, pursuant to which the Company may place a loan on its criticized asset
list or may classify a loan in one of various other classification categories. A
specified minimum percentage of loans in each adverse asset classification
category, based on the historical loss experience of the Company in each such
category, is issused to determine the adequacy of the Company's allowance for
credit losses quarterly. These loans are also individually reviewed by senior
credit officers of the Company to determine whether a greater allowance
allocation is justified due to the facts and circumstances of a particular
adversely classified loan.
See also Note 4 in the Notes to Consolidated Financial Statements on page
55 of this Annual Report on Form 10-K.
Investments
The Company seeks to maintain an investment portfolio consistent with the
overall financial needs of the Company. The following items may be considered in
the purchase or sale of investment securities: liquidity, maturity, credit
quality, income or other factors. The portfolio consists of federal agency and
municipal securities, mortgage-backed securities and other investment
securities.
See also Note 3 in the Notes to Consolidated Financial Statements on page
54 of this Annual Report on Form 10-K.
Deposits
The Company offers a variety of deposit products to individuals and to
small and medium-sized businesses and other organizations at interest rates
generally competitive with local market conditions. The following table sets
forth the mix of depository accounts at the Company as a percentage of total
deposits at the dates indicated.
As of December 31,
------------------------------
2002 2001 2000
------ ------ ------
Non-interest bearing demand ................ 10.2% 10.0% 9.6%
Savings, NOW, MMI .......................... 16.5 15.9 14.5
Certificates of deposit .................... 73.3 74.1 75.9
------ ------ ------
100.0% 100.0% 100.0%
====== ====== ======
The Company accepts deposits at its 17 banking offices, 15 of which have
automated teller machines ("ATMs"). The Company's memberships in the "STAR",
"CIRRUS" and "PLUS" networks allow customers access to their depository accounts
from regional ATM facilities. The Company charges competitive fees for the use
of its ATM facilities by those who are not depositors with the Company. The
Company controls deposit flows primarily through the pricing of such deposits
and, to a certain extent, through promotional activities. Such promotional
activities include the Company's "Prestige" and "Priority" accounts for deposit
relationships of $25,000 and $75,000, respectively, and the "FNB Club", which
extends special privileges and sponsors group excursions to sites and
performances of interest to account holders in certain markets over the age of
55. At December 31, 2002, the Company had $257.4 million in certificates of
deposit of $100,000 or more. The Bank has joined an electronic network which
allows it to post interest rates and attract certificates of deposit nationally.
The investors are generally credit unions or commercial banks and amounts are
typically just under $100,000 to assure FDIC insurance coverage. The Company
also utilizes brokered deposits to supplement in-market deposit growth.
Management believes these deposits provide effective funding sources and serve
to broaden the
7
Company's funding base. The table below presents the scheduled
maturities of time deposits of $100,000 or more at December 31, 2002.
Scheduled maturity of time deposits of $100,000 or more Amount
------------------------------------------------------- -------------
(In thousands)
Less than three months ................................. $ 59,022
Three through six months ............................... 38,400
Seven through twelve months ............................ 102,248
Over twelve months ..................................... 57,727
--------
Total time deposits ............................... $257,397
========
See also Note 7 in the Notes to Consolidated Financial Statements on page
57 of this Annual Report on Form 10-K.
Investment Services
In April 2000, the Company established FNB Southeast Investment Services,
Inc. as a wholly-owned subsidiary of FNB Southeast. FNB Southeast Investment
Services, Inc. employs two investment advisors who split their time among the
Company's branches and are available to current customers and potential
customers of the Company. The advisors offer a complete line of investment
products and services. The Company receives a commission based on the advisors'
sales. The Company benefits by earning additional fee income and by attracting
additional people to its branches that may become customers of the Bank. The
subsidiary generated revenues of $308,000 in 2002, and $203,000 in 2001.
Mortgage Banking
In June 2001, the Company established FNB Southeast Mortgage Corporation
as a wholly-owned subsidiary of FNB Southeast. At inception, the new subsidiary
purchased selected assets of Airlie Mortgage Company, Inc., a successful
mortgage brokerage company operating three offices in the coastal area near
Wilmington, North Carolina. The Company expanded the subsidiary during 2002 by
hiring additional mortgage loan originators. As a result of this strategy, fee
income generated by the subsidiary increased to $1,144,000 in 2002 compared to
$144,000 in 2001.
Marketing
The Company currently markets its services through advertising campaigns
and in printed material, such as newspapers, magazines and direct mailings, as
well as through promotional items, such as caps, pens, pencils and shirts. The
Company's officers are also heavily involved in local civic affairs and
philanthropic organizations in order to focus customers on products and services
at a personal level. The Company occasionally sponsors community events and
holds grand opening ceremonies for its new branches to which local dignitaries
are invited to speak and participate in the festivities. The Company has a full
time marketing professional on staff and engages a marketing firm to assist with
creative design, research, public relations, media placement, etc. as well as
assisting with promoting the overall image of the Company to the general public
and investment community.
o Value. Among other things, the Company offers attractive rates
for its financial products, including its certificates of
deposit and checking accounts. This pricing structure has been
successful in attracting depositors who are motivated by the
Company's rates, as well as by the variety of individualized
services the Company promotes and offers.
8
o Convenience and Service. All personnel of the Company aim
toward serving the individual needs of the Company's
customers. For example, senior personnel are accessible on
very short notice, even after normal banking hours, by way of
mobile phones and other means.
Management intends to continue to market the Company's services through a
combination of advertising campaigns, public relations activities and local
affiliations. In most of its markets, the Company has established local advisory
boards, comprised of community leaders, to promote the Company. While the key
messages of value, convenience, service and reliability will continue to play a
major role in the Company's marketing and public relations efforts, management
may also focus on targeted groups, such as professionals, in addition to small
to medium-sized local businesses.
A vital part of the Company's marketing plan is the execution of a public
relations strategy. Many traditional public relations methods are used in
promoting its services. Management pursues media coverage, including general
press, industry periodicals and other media covering banking and finance,
consumer issues and special interests. Press releases, quarterly shareholder
reports, media alerts and presentations are used to announce new banking
services as they are added.
Competition
Commercial banking in the southeastern portion of the United States is
extremely competitive, due in large part to interstate branching. Currently,
many of the Company's competitors are significantly larger and have greater
resources than the Company. The Company continues to encounter significant
competition from a number of sources, including bank holding companies,
financial holding companies, commercial banks, thrift institutions, credit
unions, and other financial institutions and financial intermediaries. The
Company competes in its market areas with some of the largest banking
organizations in the Southeast, several of which have numerous branches in North
Carolina and Virginia. The Company's competition is not limited to financial
institutions based in North Carolina and Virginia. The enactment of federal
legislation authorizing nationwide interstate banking has greatly increased the
size and financial resources of some of the Company's competitors. Consequently,
many of the Company's competitors have substantially higher lending limits due
to their greater total capitalization, and many perform functions for their
customers, such as trust services, that the Company generally does not offer.
The Company primarily relies on providing quality products and services at a
competitive price within the market area. As a result of recent interstate
banking legislation, the Company's market is open to future penetration by banks
located in other states provided that the other states allow their domestic
banking institutions to acquire North Carolina banking institutions, thereby
increasing competition.
In the Triad region of North Carolina as of June 2002, the Company
competed with 21 commercial banks and three savings institutions, as well as
numerous credit unions. For the same period, the Company competed with nine
commercial banks, two savings institution and several credit unions in the
Wilmington region of North Carolina. In the Norton region of Virginia as of June
2002, the Company competed with 19 commercial banks. For the same period, the
Company competed with 15 commercial banks in the Harrisonburg region of
Virginia.
Employees
On December 31, 2002, the Company had approximately 188 full-time and 10
part-time employees. None of the Company's employees are represented by a
collective bargaining unit. The Company considers its relations with its
employees to be good.
9
Supervision and Regulation
Bank holding companies and commercial banks are extensively regulated
under both federal and state law. The following is a brief summary of certain
statutes and rules and regulations that affect or will affect the Company, the
Bank and any subsidiaries. This summary is qualified in its entirety by
reference to the particular statute and regulatory provisions referred to below
and is not intended to be an exhaustive description of the statutes or
regulations applicable to the business of the Company and the Bank. Supervision,
regulation and examination of the Company and the Bank by the regulatory
agencies are intended primarily for the protection of depositors rather than
shareholders of the Company. Statutes and regulations which contain wide-ranging
proposals for altering the structures, regulations and competitive relationship
of financial institutions are introduced regularly. The Company cannot predict
whether or in what form any proposed statute or regulation will be adopted or
the extent to which the business of the Company and the Bank may be affected by
such statute or regulation.
General. There are a number of obligations and restrictions imposed on
bank holding companies and their depository institution subsidiaries by law and
regulatory policy that are designed to minimize potential loss to the depositors
of such depository institutions and the FDIC insurance funds in the event the
depository institution becomes in danger of default or in default. For example,
to avoid receivership of an insured depository institution subsidiary, a bank
holding company is required to guarantee the compliance of any insured
depository institution subsidiary that may become "undercapitalized" with the
terms of any capital restoration plan filed by such subsidiary with its
appropriate federal banking agency up to the lesser of (i) an amount equal to 5%
of the bank's total assets at the time the bank became undercapitalized or (ii)
the amount which is necessary (or would have been necessary) to bring the bank
into compliance with all acceptable capital standards as of the time the bank
fails to comply with such capital restoration plan. The Company, as a registered
bank holding company, is subject to the regulation of the Federal Reserve. Under
a policy of the Federal Reserve with respect to bank holding company operations,
a bank holding company is required to serve as a source of financial strength to
its subsidiary depository institutions and to commit resources to support such
institutions in circumstances where it might not do so absent such policy. The
Federal Reserve under the BHCA also has the authority to require a bank holding
company to terminate any activity or to relinquish control of a nonbank
subsidiary (other than a nonbank subsidiary of a bank) upon the Federal
Reserve's determination that such activity or control constitutes a serious risk
to the financial soundness and stability of any bank subsidiary of the bank
holding company.
In addition, insured depository institutions under common control are
required to reimburse the FDIC for any loss suffered by its deposit insurance
funds as a result of the default of a commonly controlled insured depository
institution or for any assistance provided by the FDIC to a commonly controlled
insured depository institution in danger of default. The FDIC may decline to
enforce the cross-guarantee provisions if it determines that a waiver is in the
best interest of the deposit insurance funds. The FDIC's claim for damages is
superior to claims of stockholders of the insured depository institution or its
holding company but is subordinate to claims of depositors, secured creditors
and holders of subordinated debt (other than affiliates) of the commonly
controlled insured depository institutions.
As a result of the Company's ownership of the Bank, the Company is also
registered under the bank holding company laws of North Carolina. Accordingly,
the Company is also subject to regulation and supervision by the Commissioner.
Capital Adequacy Guidelines for Holding Companies. The Federal Reserve has
adopted capital adequacy guidelines for bank holding companies and banks that
are members of the Federal Reserve system and have consolidated assets of $150
million or more. Bank holding companies subject to the Federal Reserve's capital
adequacy guidelines are required to comply with the Federal Reserve's risk-based
capital guidelines. Under these regulations, the minimum ratio of total capital
to risk-weighted assets is 8%. At least half of the total capital is required to
be "Tier I capital," principally consisting of common stockholders' equity,
noncumulative perpetual preferred stock, and a limited amount of
10
cumulative perpetual preferred stock, less certain goodwill items. The remainder
("Tier II capital") may consist of a limited amount of subordinated debt,
certain hybrid capital instruments and other debt securities, perpetual
preferred stock, and a limited amount of the general loan loss allowance. In
addition to the risk-based capital guidelines, the Federal Reserve has adopted a
minimum Tier I capital (leverage) ratio, under which a bank holding company must
maintain a minimum level of Tier I capital to average total consolidated assets
of at least 3% in the case of a bank holding company which has the highest
regulatory examination rating and is not contemplating significant growth or
expansion. All other bank holding companies are expected to maintain a Tier I
capital (leverage) ratio of at least 1% to 2% above the stated minimum.
Capital Requirements for the Bank. The Bank, as a North Carolina
commercial bank, is required to maintain a surplus account equal to 50% or more
of its paid-in capital stock. As a North Carolina chartered, FDIC-insured
commercial bank that is a member of the Federal Reserve System, the Bank is also
subject to capital requirements imposed by the Federal Reserve. Under Federal
Reserve regulations, member banks must maintain a minimum ratio of qualifying
capital to weighted risk assets equal to 8%. At least half of the total capital
is required to be Tier I Capital, with the remainder consisting of Tier II
Capital. In addition to the foregoing risk based capital guidelines, member
banks which receive the highest rating in the examination process and are not
anticipating or experiencing any significant growth, must maintain a minimum
level of Tier I Capital to total assets of 3%. Member banks which do not fall
within the foregoing standards are required to maintain higher capital ratios.
The Bank exceeded all applicable capital requirements as of December 31, 2002.
Dividend and Repurchase Limitations. The Company must obtain Federal
Reserve approval prior to repurchasing Common Stock for in excess of 10% of its
net worth during any twelve-month period unless the Company (i) both before and
after the redemption satisfies capital requirements for "well capitalized" state
member banks; (ii) received a one or two rating in its last examination; and
(iii) is not the subject of any unresolved supervisory issues.
Although the payment of dividends and repurchase of stock by the Company
are subject to certain requirements and limitations of North Carolina corporate
law, except as set forth in this paragraph, neither the Commissioner nor the
FDIC have promulgated any regulations specifically limiting the right of the
Company to pay dividends and repurchase shares. However, the ability of the
Company to pay dividends or repurchase shares may be dependent upon the
Company's receipt of dividends from the Bank.
North Carolina commercial banks, such as the Bank, are subject to legal
limitations on the amounts of dividends they are permitted to pay. Dividends may
be paid by the Bank from undivided profits, which are determined by deducting
and charging certain items against actual profits, including any contributions
to surplus required by North Carolina law. Also, an insured depository
institution, such as the Bank, is prohibited from making capital distributions,
including the payment of dividends, if, after making such distribution, the
institution would become "undercapitalized" (as such term is defined in the
applicable law and regulations).
Deposit Insurance Assessments. The Bank is subject to insurance
assessments imposed by the FDIC. Under current law, the insurance assessment to
be paid by members of the Bank Insurance Fund, such as the Bank, shall be as
specified in a schedule required to be issued by the FDIC. FDIC assessments for
deposit insurance range from 0 to 31 basis points per $100 of insured deposits,
depending on the institution's capital position and other supervisory factors.
Federal Home Loan Bank System. The FHLB system provides a central credit
facility for member institutions. As a member of the FHLB of Atlanta, the Bank
is required to own capital stock in the FHLB of Atlanta in an amount at least
equal to the greater of 1% of the aggregate principal amount of its unpaid
residential mortgage loans, home purchase contracts and similar obligations at
the end of each calendar year, or 5% of its outstanding advances (borrowings)
from the FHLB of Atlanta. On December 31, 2002, the Bank was in compliance with
this requirement.
11
Community Reinvestment. Under the Community Reinvestment Act ("CRA"), as
implemented by regulations of the FDIC, an insured institution has a continuing
and affirmative obligation consistent with its safe and sound operation to help
meet the credit needs of its entire community, including low and moderate income
neighborhoods. The CRA does not establish specific lending requirements or
programs for financial institutions, nor does it limit an institution's
discretion to develop, consistent with the CRA, the types of products and
services that it believes are best suited to its particular community. The CRA
requires the federal banking regulators, in connection with their examinations
of insured institutions, to assess the institutions' records of meeting the
credit needs of their communities, using the ratings of "outstanding,"
"satisfactory," "needs to improve," or "substantial noncompliance," and to take
that record into account in its evaluation of certain applications by those
institutions. All institutions are required to make public disclosure of their
CRA performance ratings. The Bank received a "satisfactory" rating in its last
CRA examination, which was conducted during July 2002.
Prompt Corrective Action. The FDIC has broad powers to take corrective
action to resolve the problems of insured depository institutions. The extent of
these powers will depend upon whether the institution in question is "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized," or "critically undercapitalized." Under the regulations, an
institution is considered "well capitalized" if it has (i) a total risk-based
capital ratio of 10% or greater, (ii) a Tier I risk-based capital ratio of 6% or
greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any
order or written directive to meet and maintain a specific capital level for any
capital measure. An "adequately capitalized" institution is defined as one that
has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier I
risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or
greater (or 3% or greater in the case of an institution with the highest
examination rating). An institution is considered (A) "undercapitalized" if it
has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I
risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than
4% (or 3% in the case of an institution with the highest examination rating);
(B) "significantly undercapitalized" if the institution has (i) a total
risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital
ratio of less than 3% or (iii) a leverage ratio of less than 3% and (c)
"critically undercapitalized" if the institution has a ratio of tangible equity
to total assets equal to or less than 2%. At December 31, 2002, the Bank had the
requisite capital levels to qualify as "well capitalized".
Changes in Control. The BHCA prohibits the Company from acquiring direct
or indirect control of more than 5% of the outstanding voting stock or
substantially all of the assets of any bank or savings bank or merging or
consolidating with another bank holding company or savings bank holding company
without prior approval of the Federal Reserve. Similarly, Federal Reserve
approval (or, in certain cases, non-disapproval) must be obtained prior to any
person acquiring control of the Company. Control is conclusively presumed to
exist if, among other things, a person acquires more than 25% of any class of
voting stock of the Company or controls in any manner the election of a majority
of the directors of the Company. Control is presumed to exist if a person
acquires more than 10% of any class of voting stock and the stock is registered
under Section 12 of the Securities Exchange Act of 1934 or the acquiror will be
the largest shareholder after the acquisition.
Federal Securities Law. The Company has registered its Common Stock with
the SEC pursuant to Section 12(g) of the Securities Exchange Act of 1934. As a
result of such registration, the proxy and tender offer rules, insider trading
reporting requirements, annual and periodic reporting and other requirements of
the Exchange Act are applicable to the Company.
Transactions with Affiliates. Under current federal law, depository
institutions are subject to the restrictions contained in Section 22(h) of the
Federal Reserve Act with respect to loans to directors, executive officers and
principal shareholders. Under Section 22(h), loans to directors, executive
officers and shareholders who own more than 10% of a depository institution (18%
in the case of institutions located in an area with less than 30,000 in
population), and certain affiliated entities of any of the foregoing, may not
exceed, together with all other outstanding loans to such person and affiliated
entities,
12
the institution's loans-to-one-borrower limit (as discussed below). Section
22(h) also prohibits loans above amounts prescribed by the appropriate federal
banking agency to directors, executive officers and shareholders who own more
than 10% of an institution, and their respective affiliates, unless such loans
are approved in advance by a majority of the board of directors of the
institution. Any "interested" director may not participate in the voting. The
FDIC has prescribed the loan amount (which includes all other outstanding loans
to such person), as to which such prior board of director approval is required,
as being the greater of $25,000 or 5% of capital and surplus (up to $500,000).
Further, pursuant to Section 22(h), the Federal Reserve requires that loans to
directors, executive officers, and principal shareholders be made on terms
substantially the same as offered in comparable transactions with non-executive
employees of the Bank. The FDIC has imposed additional limits on the amount a
bank can loan to an executive officer.
Loans to One Borrower. The Bank is subject to the Commissioner's loans to
one borrower limits which are substantially the same as those applicable to
national banks. Under these limits, no loans and extensions of credit to any
borrower outstanding at one time and not fully secured by readily marketable
collateral shall exceed 15% of the unimpaired capital and unimpaired surplus of
the bank. Loans and extensions of credit fully secured by readily marketable
collateral may comprise an additional 10% of unimpaired capital and unimpaired
surplus.
Gramm-Leach-Bliley Act. Federal legislation adopted by Congress during
1999, the Gramm-Leach-Bliley Act (the "GLB Act"), has dramatically changed
various federal laws governing the banking, securities, and insurance
industries. The GLB Act has expanded opportunities for banks and bank holding
companies to provide services and engage in other revenue-generating activities
that previously were prohibited to them.
In general, the GLB Act (i) expands opportunities to affiliate with
securities firms and insurance companies; (ii) overrides certain state laws that
would prohibit certain banking and insurance affiliations; (iii) expands the
activities in which banks and bank holding companies may participate; (iv)
requires that banks and bank holding companies engage in some activities only
through affiliates owned or managed in accordance with certain requirements; (v)
reorganizes responsibility among various federal regulators for oversight of
certain securities activities conducted by banks and bank holding companies; and
(vi) requires banks to adopt and implement policies and procedures for the
protection of the financial privacy of their customers, including procedures
that allow customers to elect that certain financial information not to be
disclosed to certain persons.
The GLB Act has expanded opportunities for the Bank to provide other
services and obtain revenues in the future but, at present, it has not had a
significant effect on our respective operations as they are presently conducted.
However, this expanded authority also may present us with new challenges as we
compete with larger financial institutions that expand their services and
products into the same areas that are now feasible for smaller,
community-oriented financial institutions. The economic effects of the GLB Act
on the banking industry, and on competitive conditions in the financial services
industry generally, may be profound.
USA PATRIOT Act. In response to the events of September 11th, President
George W. Bush signed into law the Uniting and Strengthening America by
Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of
2001, or the USA PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the
federal government new powers to address terrorist threats through many means,
including broadened anti-money laundering requirements. For example, by way of
amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act encourages
information sharing among banks, bank regulatory agencies, and law enforcement
bodies to prevent money laundering. Additionally, Title III of the USA PATRIOT
Act imposes several affirmative obligations on a broad range of financial
institutions, including banks, thrifts, brokers, dealers, credit unions, money
transfer agents, and parties registered under the Commodity Exchange Act.
13
Pursuant to Section 352 of the USA PATRIOT Act, all financial institutions
must establish anti-money laundering programs that include, at a minimum: (i)
internal policies, procedures, and controls, (ii) specific designation of an
anti-money laundering compliance officer, (iii) ongoing employee training
programs, and (iv) an independent audit function to test the anti-money
laundering program. Also, Section 326 of the Act requires certain minimum
standards with respect to customer identification and verification. Section 312
of the Act requires financial institutions that establish, maintain, administer,
or manage private banking accounts or correspondent accounts in the United
States for non-United States persons or their representatives (including foreign
individuals visiting the United States) to establish appropriate, specific, and,
where necessary, enhanced due diligence policies, procedures, and controls
designed to detect and report money laundering. Furthermore, effective December
25, 2001, financial institutions were prohibited from establishing, maintaining,
administering or managing correspondent accounts for foreign shell banks
(foreign banks that do not have a physical presence in any country), and are
subject to certain recordkeeping obligations with respect to correspondent
accounts of foreign banks. Bank regulators are directed to consider institutions
effectiveness in combating money laundering when ruling on Federal Reserve Act
and Bank Merger Act applications.
Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act of
2002 was signed into law and became some of the most sweeping federal
legislation addressing accounting, corporate governance and disclosure issues.
The impact of the Sarbanes-Oxley Act is wide-ranging as it applies to all public
companies and imposes significant new requirements for public company governance
and disclosure requirements. Some of the provisions of the Sarbanes-Oxley Act
became effective immediately while others will be implemented over the coming
months.
In general, the Sarbanes-Oxley Act mandates important new corporate
governance and financial reporting requirements intended to enhance the accuracy
and transparency of public companies' reported financial results. It establishes
new responsibilities for corporate chief executive officers, chief financial
officers and audit committees in the financial reporting process and creates a
new regulatory body to oversee auditors of public companies. It backs these
requirements with new SEC enforcement tools, increases criminal penalties for
federal mail, wire and securities fraud, and creates new criminal penalties for
document and record destruction in connection with federal investigations. It
also increases the opportunity for more private litigation by lengthening the
statute of limitations for securities fraud claims and providing new federal
corporate whistleblower protection.
The full impact of the Sarbanes-Oxley Act cannot be fully measured until
the SEC acts to implement the numerous provisions for which Congress has
delegated implementation authority. The economic and operational effects of this
new legislation on public companies, including the Bank, will be significant in
terms of the time, resources and costs associated with complying with the new
law. Because the Sarbanes-Oxley Act, for the most part, applies equally to
larger and smaller public companies, the Bank will be presented with additional
challenges as a smaller, community-oriented financial institution seeking to
compete with larger financial institutions in its market.
Other. Additional regulations require annual examinations of all insured
depository institutions by the appropriate federal banking agency, with some
exceptions for small, well-capitalized institutions and state chartered
institutions examined by state regulators, and establish operational and
managerial, asset quality, earnings and stock valuation standards for insured
depository institutions, as well as compensation standards.
The Bank is subject to examination by the Federal Reserve and the
Commissioner. In addition, the Bank is subject to various other state and
federal laws and regulations, including state usury laws, laws relating to
fiduciaries, consumer credit and equal credit, fair credit reporting laws and
laws relating to branch banking. The Bank, as an insured North Carolina
commercial bank, is prohibited from engaging as a principal in activities that
are not permitted for national banks, unless (i) the FDIC determines that the
activity would pose no significant risk to the appropriate deposit insurance
fund and (ii) the Bank is, and continues to be, in compliance with all
applicable capital standards.
14
Under Chapter 53 of the North Carolina General Statutes, if the capital
stock of a North Carolina commercial bank is impaired by losses or otherwise,
the Commissioner is authorized to require payment of the deficiency by
assessment upon the bank's shareholders, pro rata, and to the extent necessary,
if any such assessment is not paid by any shareholder, upon 30 days notice, to
sell as much as is necessary of the stock of such shareholder to make good the
deficiency.
Limits on Rates Paid on Deposits and Brokered Deposits. Regulations
promulgated by the FDIC place limitations on the ability of insured depository
institutions to accept, renew or roll-over deposits by offering rates of
interest which are significantly higher than the prevailing rates of interest on
deposits offered by other insured depository institutions having the same type
of charter in such depository institution's normal market area. Under these
regulations, "well capitalized" depository institutions may accept, renew or
roll-over such deposits without restriction, "adequately capitalized" depository
institutions may accept, renew or roll-over such deposits with a waiver from the
FDIC (subject to certain restrictions on payments of rates) and
"undercapitalized" depository institutions may not accept, renew, or roll-over
such deposits. The regulations contemplate that the definitions of "well
capitalized," "adequately capitalized" and "undercapitalized" will be the same
as the definitions adopted by the FDIC to implement the corrective action
provisions discussed below.
Only a "well capitalized" (as defined in the statute as significantly
exceeding each relevant minimum capital level) depository institution may accept
brokered deposits without prior regulatory approval. "Adequately capitalized"
banks may accept brokered deposits with a waiver from the FDIC (subject to
certain restrictions on payment of rates), while "undercapitalized" banks may
not accept brokered deposits. The regulations contemplate that the definitions
of "well capitalized," "adequately capitalized" and "undercapitalized" are the
same as the definitions adopted by the agencies to implement the prompt
corrective action provisions discussed below.
The Bank does not believe that these regulations have had or will have a
material adverse effect on its current operations.
Taxation. Federal Income Taxation. Financial institutions such as the Bank
are subject to the provisions of the Internal Revenue Code of 1986, as amended
(the "Code") in the same general manner as other corporations. However, banks
which meet certain definitional tests and other conditions prescribed by the
Code may benefit from certain favorable provisions regarding their deductions
from taxable income for annual additions to their bad debt reserve. The Bank may
compute its addition to the bad debt reserve under the specific charge-off
method or the reserve method. Under the reserve method, the addition to bad
debts from losses on loans is computed by use of the experience method. Use of
the experience method requires minimum additions to the reserve based on the
amount allowable under a six-year moving average. The Code also provides annual
limits on the amount the Bank can add to its reserves for loan losses.
State Taxation. Under North Carolina law, the Bank is subject to corporate
income taxes at a 6.90% rate and an annual franchise tax at a rate of 0.15%.
Future Requirements. Statutes and regulations which contain wide-ranging
proposals for altering the structures, regulations and competitive relationships
of financial institutions are introduced regularly. Neither the Company nor the
Bank can predict whether or what form any proposed statute or regulation will be
adopted or the extent to which the business of the Company or the Bank may be
affected by such statute or regulation.
15
Item 2. Properties
The Company leases or owns 17 banking offices, as shown in the following
table:
Location Owned or Leased Deposits (1) ATM (2) Year Opened/Purchased
-------- --------------- ------------ ------- ---------------------
202 South Main Street
Reidsville, North Carolina Owned (3) $151,150 Yes 1910(4)
1646 Freeway Drive
Reidsville, North Carolina Owned 37,111 Yes 1972
202 Turner Drive
Reidsville, North Carolina Owned 38,558 Yes 1969
801 South Van Buren Road
Eden, North Carolina Owned 29,608 Yes 1996
151 North Fieldcrest Road
Eden, North Carolina Leased (expires 2008) 15,725 No 1996
605 North Highway Street
Madison, North Carolina Owned 22,482 Yes 1997
9570 US 29 Business
Ruffin, North Carolina Leased (expires 2004) 10,872 No 1997
2132 New Garden Road
Greensboro, North Carolina Owned 39,704 Yes 1997
4638 Hicone Road
Greensboro, North Carolina Owned 21,630 Yes 2000
3202 Randleman Road
Greensboro, North Carolina Owned 16,214 Yes 2000
704 South College Road
Wilmington, North Carolina Leased (expires 2007) 54,062 Yes 1997
7210 Wrightsville Avenue
Wilmington, North Carolina Leased (expires 2003) 1,197 Yes 2000
301 East Fremont Street
Burgaw, North Carolina Leased (expires 2004) 25,247 Yes 1999
600 Trent Street
Norton, Virginia Owned 58,551 Yes 1973
2302 Second Street
Richlands, Virginia Owned 22,174 Yes 1977
700 East Morgan Avenue
Pennington Gap, Virginia Owned 22,933 Yes 1979
440 South Main Street
Harrisonburg, Virginia Owned 37,787 Yes 1988
(1) Deposits as of December 31, 2002, in thousands of dollars.
(2) Each of the ATMs situated at a banking office is a drive-up ATM.
(3) Consists of 27,000 square feet in a two story building and includes the
Company's executive offices.
(4) Original office opened in different location in 1910. Current office
opened in 1980.
16
Item 3. Legal Proceedings
In the ordinary course of operations, the Company is a party to various
legal proceedings. In the opinion of management, neither the Company nor the
Bank is involved in any pending legal proceedings other than routine,
non-material proceedings occurring in the ordinary course of business.
Item 4. Submission of Matters To a Vote of Security Holders
There were no matters submitted to a vote of the security holders of the
Company during the fourth quarter of the Company's fiscal year ended December
31, 2002.
17
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
Market Prices and Dividend Policies
The Company's Common Stock is traded on The Nasdaq Stock Market National
Market System under the symbol "FNBF." The following table shows the high and
low sale price of the Company's Common Stock on The Nasdaq Stock Market National
Market System, based on published financial sources, for each of the last two
fiscal years. The table also reflects the per share amount of cash dividends
paid for each share during the fiscal quarters for each of the last two fiscal
years. Only one cash dividend was paid during each of the fiscal quarters
listed.
Calendar Period High Low Dividends Paid
--------------- ---- --- --------------
Quarter ended March 31, 2001 $15.52 $10.00 $ 0.12
Quarter ended June 30, 2001 14.20 11.50 0.13
Quarter ended September 30, 2001 15.23 12.70 0.13
Quarter ended December 31, 2001 15.06 13.00 0.13
Quarter ended March 31, 2002 $14.73 $13.08 $ 0.13
Quarter ended June 30, 2002 17.25 14.05 0.13
Quarter ended September 30, 2002 17.49 15.50 0.13
Quarter ended December 31, 2002 17.24 15.25 0.14
As of March 19, 2003, there were approximately 1,613 beneficial owners of
the Company's common stock, including 1,225 holders of record of the Company's
common stock. For a discussion as to any restrictions on the Company or the
Bank's ability to pay dividends, reference Item 1 - Supervision and Regulation
of the Company and the Bank.
See also Note 18 in the Notes to Consolidated Financial Statements on page
63 of this Annual Report on Form 10-K. See also "Supervision and Regulation -
Regulation of the Company, Dividend and Repurchase Limitations" and "Regulation
of the Bank - Dividends."
Recent Sales of Unregistered Securities
The Company did not sell any securities in the fiscal year ended December
31, 2002 in offerings that were not registered under the Securities Act of
1933, as amended.
Item 6. Selected Financial Data
The annual selected historical financial data presented below are derived
from the audited consolidated financial statements for FNB Financial Services
Corporation, FNB Southeast, FNB Southeast Mortgage Corporation and FNB Southeast
Investment Services, Inc. The audited consolidated financial statements of the
Company have been restated for the years prior to 1999 to reflect the
acquisition of Black Diamond on August 31, 1999, in a transaction accounted for
as a pooling of interests. As this information is only a summary, you should
read it in conjunction with the historical financial statements (and related
notes) of the Company and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" included elsewhere herein.
18
Table 1. Selected Financial Data
(In thousands, except per share, ratio and other data) At and For the Year Ended December 31,
----------------------------------------------------------------
2002 2001 2000 1999 1998
-------- -------- -------- -------- --------
Income Statement Data:
Net interest income $ 23,753 $ 21,705 $ 22,659 $ 20,427 $ 18,378
Provision for credit losses 1,300 1,278 2,525 1,401 1,171
Other income 5,285 4,740 2,891 2,977 3,085
Other expenses 17,429 15,838 16,100 15,193 12,872
Net income 6,782 6,478 4,602 4,248 5,022
Balance Sheet Data:
Assets $734,032 $704,825 $685,904 $588,419 $549,746
Loans (1) 563,600 535,345 500,637 414,011 362,252
Allowance for credit losses 7,059 6,731 6,311 4,436 3,452
Deposits 605,005 586,760 569,451 484,242 459,595
Other borrowings 52,500 30,000 41,000 31,500 17,500
Shareholders' equity 64,333 62,708 56,392 50,730 53,631
Per Common Share Data:
Net income, basic $ 1.49 $ 1.43 $ 1.03 $ 0.95 $ 1.19
Net income, diluted (2) 1.46 1.41 1.02 0.93 1.13
Cash dividends declared 0.53 0.51 0.45 0.46 0.30
Book value 14.40 13.72 12.56 11.30 11.81
Tangible book value 14.35 13.65 12.47 11.20 11.68
Other Data:
Branch offices 17 17 18 15 14
Full-time employees 188 204 196 189 184
Performance Ratios:
Return on average assets 0.97% 0.91% 0.72% 0.76% 0.97%
Return on average equity 10.63 10.75 8.96 8.49 11.21
Net interest margin (tax equivalent) 3.57 3.25 3.83 3.88 3.78
Dividend payout 35.55 35.94 44.42 47.98 25.37
Efficiency (3) 59.71 59.05 62.20 64.50 59.50
Asset Quality Ratios:
Allowance for credit losses to period end loans 1.25% 1.26% 1.26% 1.07% 0.95%
Allowance for credit losses to period end
non-performing loans (4) 191.87 297.04 195.87 338.00 221.00
Net charge-offs to average loans 0.18 0.17 0.14 0.11 0.26
Non-performing assets to period end loans
and foreclosed property (4) 0.94 0.92 0.84 0.45 0.85
Capital and Liquidity Ratios:
Average equity to average assets 9.09% 8.45% 8.07% 9.06% 8.69%
Leverage capital 8.53 8.64 8.22 9.30 10.30
Tier 1 risk based capital 11.20 11.58 11.28 13.20 15.30
Total risk based capital 12.45 12.83 12.53 14.30 16.30
Average loans to average deposits 96.17 85.96 87.91 83.49 79.31
Average loans to average deposits
and borrowings 86.85% 79.63% 79.22% 77.34% 74.47%
(1) Loans net of unearned income, before allowance for losses.
(2) Assumes the exercise of outstanding options to acquire common stock. See
Note 14 to the Company's consolidated financial statements.
(3) Computed by dividing non-interest expense by the sum of taxable equivalent
net interest income and non-interest income.
(4) Non-performing loans and non-performing assets include loans past due 90
days or more that are still accruing interest.
19
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion provides information about the major components
of the results of operations and financial condition, liquidity and capital
resources of the Company and should be read in conjunction with the Company's
Consolidated Financial Statements and Notes thereto. See also "Forward Looking
Statements" on page 72 of this Annual Report on Form 10-K.
Overview
The Company earned $6.78 million in 2002, a 4.7% increase over the $6.48
million earned in 2001. Diluted net income per share of $1.46 for 2002
represents a 3.5% increase over diluted net income per share of $1.41 in 2001.
Total assets at December 31, 2002 stood at $734.0 million compared to $704.8
million one year earlier. The increase in assets is primarily attributable to a
$28.3 million increase in gross loans. Gross loans at December 31, 2002 totaled
$563.6 million, up from $535.3 million at year-end 2001. Investment securities
available for sale, which is the next largest component of assets, increased
1.0% to $124.9 from $123.6 million over the same respective periods.
During 2002, deposits increased 3.1% to $605.0 million at December 31,
2002. Total purchased funds at December 31, 2002 totaled $60.8 million compared
to $49.7 million at the prior year-end. Shareholders' equity increased 2.6% to
$64.3 million at year-end 2002. Book value per share was $14.40 compared to
$13.72 one year earlier.
The Company's subsidiary bank, FNB Southeast, is a North Carolina
chartered commercial bank that, as of December 31, 2002, operated thirteen
banking offices in North Carolina and four banking offices in Virginia. On
January 24, 2003, the Bank completed the acquisition of the Harrisonburg,
Virginia, branch of another financial institution, bringing its total branches
to 18. FNB Southeast operates two wholly owned subsidiaries. FNB Southeast
Investment Services, Inc. was formed in 2000 to provide retail investment
products and services. FNB Southeast Mortgage Corporation was formed in 2001 and
acquired certain assets of Airlee Mortgage Corporation, and provides mortgage
banking services.
Results of Operations
Net interest income represents the gross profit from the lending and
investment activities of a banking organization and is the most significant
factor affecting the earnings of the Company. Net interest income is influenced
by changes in interest rates, volume and the mix of these various components.
Net interest income on a fully taxable equivalent basis for 2002 was $23.9
million, which represented a 8.3% increase from the previous year. In 2001,
taxable equivalent net interest income decreased to approximately $22.1 million
from approximately $23.0 million in 2000. Actual net interest income for 2002
was $23.8 million, a 9.4% increase from $21.7 million recorded in 2001. The
increase in net interest income is attributable to reduced volumes of time
deposits and lower overall rates paid on time deposits. The net effect was to
increase the interest rate spread, which is the average yield on earning assets
minus the average rate paid on interest bearing liabilities. While the average
yield on earning assets declined in 2002, that decline was more than offset by
the reduction in average rates paid on interest bearing liabilities. Average
loans outstanding during the 2002 fiscal year were $547.8 million compared to
$515.3 million in 2001, an increase of 6.3%. In the previous year, average loans
outstanding were 12.1% higher than 2000. Average investment securities during
2002 were $110.3 million compared to $157.4 million in 2001 and $135.8 million
in 2000.
Trends in interest rates remained downward for the year, as the Federal
Reserve decreased the federal funds rate by 50 basis points in November of 2002,
which followed numerous interest rate reductions in 2001. As a result, the prime
lending rate declined to 4.25% at December 31, 2002 from 4.75% at December 31,
2001 and 9.50% at December 31, 2000. This had the effect of decreasing both the
earning asset yield and the interest bearing liability rate. During the year the
decline in the interest
20
bearing liability rate outpaced the decline in the earning asset yield.
Additionally, the decline in interest rates resulted in an increase in the fair
market value of the Company's investment portfolio. The increased fair value
resulted in increased liquidity, due to securities being called and the sale of
securities at a gain.
The weighted average yield on earning assets decreased 127 basis points to
6.48% for 2002 compared to 7.75% for 2001 and 8.73% for 2000. This decrease in
the asset yield in 2002 was primarily attributable to the decreased yield on
loans. This was partially offset by an increase of approximately $32 million in
average loans outstanding from the lower yielding investments. During the
current year, the yield on loans decreased 157 basis points to 6.79% from 8.36%
in 2001. This decline is due to variable rate loans that repriced lower during
the year in response to decreases in the underlying index.
The weighted average rate paid on interest bearing liabilities declined
177 basis points to 3.41% in 2002 from 5.18% in 2001 and 5.58% in 2000. Average
interest bearing deposits for 2002 totaled $511.9 million, a 5.9% decrease from
$544.1 million in 2001. The average balance in 2000 was $472.1 million. The
overall rate for interest bearing deposits decreased 167 basis points to 3.52%
in 2002 compared to 5.19% in the prior year.
The overall rate on purchased funds decreased 246 basis points during
2002. Average purchased funds totaled $61.1 million in 2002, an increase of
$13.5 million from $47.6 million in 2001. This increase was primarily
attributable to higher levels of FHLB advances utilized during 2002. In 2000,
average purchased funds totaled $57.4 million. Average FHLB borrowings for 2002
were $46.1 million compared to $34.4 million in 2001. The average rate paid on
purchased funds was 2.51%, 4.97% and 6.47% for 2002, 2001 and 2000,
respectively.
Table 2 on page 32 summarizes net interest income and average yields
earned and rates paid for the years indicated, on a tax equivalent basis. Table
3 on page 33 presents the changes in interest income and interest expense
attributable to volume and rate changes between 2002 and 2001, and between 2001
and 2000.
Non-interest Income and Expense
Non-interest income of $5.3 million in 2002 was $545,000, or 11.5%, more
than the previous year amount of $4.7 million. In 2000, non-interest income was
$2.9 million. One category of noninterest income, gain on sale of securities,
experienced a significant increase in 2001 but declined in 2002. Gains on sale
of securities for 2002 totaled $318,000, down from $1.8 million in 2001 and
$60,000 in 2000. Service charges on deposit accounts increased to $2.8 million
from $2.2 million in 2001 and $2.1 million in 2000. The Company was able to
capitalize on increased fees and increased volume of demand deposits and other
accounts with service charges. In May 2002, the Company introduced a new
service, overdraft privilege, that contributed to the increase in service
charges on deposit accounts.
Personnel expense of $9.8 million in 2002, exceeded the previous year
expense of $9.3 million by $506,000, or 5.5%. Personnel expense in 2000 was $8.7
million. At December 31, 2002, the Company had approximately 188 full-time and
10 part-time employees, compared with 204 full-time and 8 part-time employees at
December 31, 2001. Occupancy expenses totaled $1.1 million for 2002, which was
up 1.9% from $1.0 million in 2001. Furniture and equipment expenses totaled $1.9
million in the current year, a 4.4% increase from $1.8 million recorded in 2001.
The efficiency ratio, which measures non-interest expense as a percentage of net
interest income plus non-interest income, was 59.7% in 2002 versus a 59.0%
efficiency ratio posted in 2001 and 62.2% in 2000. Other expenses were $3.7
million compared to $2.8 million in 2001. Part of the year-over-year increase
was attributable to the reversal of $260,000 of other expenses in 2001 of a
$350,000 expense recorded in 2000. The expense was recorded in 2000 based on the
best estimate of cost to cancel a contract with a third party data processing
service provider. The contract was cancelled during 2001 and the actual cost was
approximately $90,000.
21
Income tax expense in 2002 was $3.5 million, an increase from $2.9 million
in 2001. The effective tax rate in 2002 increased to 34.2% from 30.6% in 2001.
The increase in the effective tax rate for 2002 is primarily due to the
increased current expense required to provide adequate income tax provision at
the year-end 2002. Income tax expense in 2000 was $2.3 million, with an
effective rate of 33.5%.
Financial Condition
The Company's consolidated assets of $734.0 million at year end increased
4.1% over the previous year, following an increase of 2.8% in 2001. Total
average assets decreased 1.7% to $701.5 million in 2002, compared to $713.5
million in 2001. During 2002, the Company experienced a 1.5% decrease in average
earning assets. Average earning assets totaled $670.6 million in 2002 compared
to $680.5 million in 2001. The decrease in 2002 was primarily attributable to a
reduction in the average investment securities balance, which was partly offset
by an increase in average outstanding loans. The reduction in the average
balance of securities was due to a combination of strong loan growth with a 3.2%
decline in average interest bearing deposits. Average non-interest bearing
deposits increased 4.2% in 2002.
During the fourth quarter of 2001 through the second quarter of 2002, the
Company implemented an asset liability strategy to reduce higher costing funding
sources with funds generated primarily from investment securities called by
issuers and the sales of other investment securities. Instead of reinvesting the
funds from investment calls and sales during historical lows in the interest
rate cycle, the Company elected to reduce the higher costing funding sources.
This strategy resulted in a shrinking of the balance sheet and increased
interest rate margins, as planned, since the reductions occurred in the least
attractive rate structures. Starting in the third quarter of 2002, the Company
returned to a more traditional strategy of attracting new deposits (primarily
certificates of deposit) and using the proceeds to fund loans and investment
growth.
Gross loan growth during 2002 was $28.3 million, with outstanding loans up
5.3% at year-end, which followed increases of 6.9% in 2001 and 20.9% in 2000.
Loans secured by real estate increased to $377.7 million in 2002 and represented
67.0% of total loans, compared with 66.3% at year end 2001. Within this
category, commercial real estate loans increased 1.3% during fiscal 2002 to a
level of $170.7 million, while residential real estate loans decreased 8.4% to
$119.3 million and construction loans increased 57.0% to $87.7 million.
Commercial, financial and agricultural loans totaled $87.5 million and
represented 15.5% of total loans, compared with 17.0% last year-end. Consumer
loans increased 9.5% during 2002, led by increased home equity loans. Management
believes the Company is not dependent on any single customer or group of
customers concentrated in a particular industry, the loss of whose deposits or
whose insolvency would have a material adverse effect on operations.
Investment securities (at amortized cost) of $126.4 million at year-end
2002 were up $1.3 million, or 1.0%, from $125.1 million at year-end 2001. U.S.
Government agency securities continue to represent the major share of the total
portfolio, and totaled $115.3 million, or 91.2% of the portfolio at year-end
2002, compared to $112.5 million, or 89.9% of the portfolio one year earlier.
Management believes that the additional risk of owning agency securities over
U.S. Treasury securities is negligible and has capitalized on the favorable
spreads available on the former. State and municipal obligations decreased $1.3
million and amounted to at $7.0 million at year-end. The Company's investment
strategy is to achieve acceptable total returns, while investing in securities
with relatively short maturity dates as necessary to fund loan growth. To this
end, the Company has consistently categorized the entire portfolio as "Available
for Sale," which it believes offers the greatest amount of flexibility in
managing a total return concept. Table 4 on page 34 presents the composition of
the securities portfolio for the last three years, as well as information about
cost, fair value and weighted average yield.
22
Total deposits increased $18.2 million to $605.0 million at December 31,
2002. This is a 3.1% increase over $586.8 million in deposits one year earlier.
This increase was driven by an $8.5 million, or 2.0% increase in time deposits,
a $2.8 million, or 4.8% increase in demand deposits and a $6.9 million, or 7.4%
increase in savings, NOW and MMI accounts.
The market for deposits remains fiercely competitive and the Company
relies on appropriate pricing and quality customer service to retain and
increase its retail deposit base. During the year, the Company had several
featured products to generate new deposits and increase the customer base. For
commercial customers, the Company is focused on building a total relationship,
which will foster growth in both loans and deposits. In addition to traditional
checking accounts, the Company offers a cash management sweep account, with
outstanding balances of $8.3 million at year end.
In order to attract additional deposits, the Company maintains membership
in an electronic network that allows it to post interest rates and attract
deposits nationally. As of December 31, 2002, FNB Southeast had approximately 77
of such certificates of deposit totaling $11.5 million, with an overall rate of
3.54% for this portfolio. This certificate portfolio decreased by $9.2 million
during 2002. The Company also held $44.5 million in brokered certificates of
deposit at December 31, 2002 compared to $17.0 million one year earlier. The
brokered certificates have an original term of twelve to twenty-four months with
maturities of $34.5 million in 2003, and $10.0 million in 2004.
The Company also has a credit facility available with the Federal Home
Loan Bank of Atlanta. Borrowing capacity is established at 17% of the subsidiary
banks' total assets as submitted on regulatory financial reports. The Company
also utilized a portion of its approximately $124 million line with the Federal
Home Loan Bank of Atlanta to fund earning assets. FHLB borrowings totaled $52.5
million at year-end. Management continues to believe this is a cost effective
and prudent alternative to deposit balances, since a particular amount, term and
structure may be selected to meet its current needs.
Asset Quality
Management places great emphasis on maintaining the Company's asset
quality. 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 loan portfolio is analyzed on an ongoing basis to evaluate current
risk levels, and risk grades are adjusted accordingly. 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. 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. The provisions of Statement of Financial Accounting
Standard No. 114 ("SFAS No. 114"), Accounting by Creditors for Impairment of a
Loan, and related pronouncements are applied to individually significant loans.
Finally, individual reserves may be recorded based on a review of loans on the
"watch list."
Commercial loans. All commercial loans within the portfolio are risk
graded among nine risk grades based on management's evaluation of the overall
credit quality of the loan, including the payment history, the financial
position of the borrower, the underlying collateral value, an internal credit
risk assessment and examination results. There is an increased reserve
percentage for each successively higher risk grade. As a result, the allowance
is adjusted upon any migration of a loan to a higher risk grade within the
commercial loan portfolio. The following table details the risk-graded portfolio
at December 31, 2002 and 2001.
23
Risk Percent of Commercial General
Grade Description Loans by Risk Grade Reserve Percentage
- ----- ----------- --------------------- ------------------
2002 2001 2002 2001
---- ---- ---- ----
Risk 1 Low Risk 0.22% 0.62% 0.00% 0.00%
Risk 2 Lower Than Average Risk 0.53 1.09 0.40 0.25
Risk 3 Average Risk 12.15 15.33 0.65 0.45
Moderately Higher
Risk 4 Than Average Risk 81.59 76.50 1.00 0.80
Higher Than
Risk 5 Average Risk 1.84 2.23 1.50 1.25
Risk 6 Special Mention 0.83 1.31 2.50 2.50
Risk 7 Substandard 2.83 2.90 15.00 15.00
Risk 8 Doubtful 0.00 0.03 50.00 50.00
Risk 9 Loss 0.00 0.00 100.00 100.00
The reserve percentages utilized have been determined by management to be
appropriate based on historical loan loss levels and the risk for each
corresponding risk grade. During 2002, the Company reviewed the reserve
percentages for commercial risk graded loans. The change in the reserve
percentages in risk grade 2 through risk grade 5 was made to better reflect the
historical charge-off experience of the Company. The general reserve percentage
was increased by 0.15% for risk grade 2 loans, 0.20% for risk grade 3 and risk
grade 4 loans, and by 0.25% for risk grade 5 loans. The Company had 96.3% of
total commercial loans in risk grade 1 through 5 in 2002 compared to 95.8% in
2001. The reserve percentages for risk grade 6, risk grade 7, risk grade 8 and
risk grade 9 remained consistent with the prior year. The net effect in 2002,
compared to 2001, was to reserve a higher percentage for risk grade 1 through
risk grade 5.
Mortgage, home equity, and credit lines. Reserves are calculated on
mortgage, home equity, and credit lines based on historical loss experience and
current economic conditions. The average rolling eight-quarter net loss
percentage is calculated for each of these loan categories. The reserve
requirement also includes a reserve percentage for current economic conditions.
The sum of these two components is applied to the dollar balance of loans in
each of these categories to determine the required reserve.
Retail loans. The retail loans are pooled together to determine the
reserve requirement. The average rolling eight-quarter net loss percentage is
calculated for this loan category. The reserve requirement also includes a
reserve percentage for current economic conditions. The sum of these two
components is applied to the dollar balance of retail loans to determine the
required reserve for current loans and loans past due less than 90 days. A
separate reserve is calculated for loans past due 90 days or more. A reserve
amount equal to 25.0% of all retail loans past due 90 days or more is added to
the above mentioned requirement to determine the total reserve requirement for
retail loans.
Specific impairment under SFAS No. 114. Management evaluates individually
significant loans in risk grade 7 and risk grade 8 on an individual basis for
impairment. The specific allowance is calculated based upon a review of these
loans and the estimated losses at the balance sheet date. At December 31, 2002
and 2001, the recorded investment in loans considered impaired was approximately
$10,567,000 and $6,857,000, respectively. Impaired loans at December 31, 2002
consisted of $818,000 of retail loans past due 90 days or more, and $9,749,000
of risk grade 7 and risk grade 8 commercial loans. Calculated reserves for
impaired loans at December 31, 2002 totaled $1,904,000 and $1,748,000 one year
earlier.
24
Risk grade 9 loans are evaluated on an individual basis. Since these loans
are considered a loss, a reserve percentage of 100% of the outstanding balance
is required. The Company had no loans risk graded 9 at December 31, 2002.
Watch list review. Specific allowances may be determined based on a review
of specific watch list loans. Specific losses are estimated at each measurement
date. The Company has established a monthly procedure to review all loans placed
on the watch list. The watch list primarily consist of loans classified as
special mention, substandard and doubtful. An estimated loss amount and action
plan is established for each watch list loan. By reviewing these watch list
loans, the Company is able to update original probable loss amounts in light of
developing conditions. This serves to reduce the differences between estimated
and actual observed losses.
The 2002 provision for credit losses of $1.3 million represented a 1.7%
increase from the level in 2001. As of December 31, 2002, nonperforming assets
totaled $5.3 million, primarily comprised of $3.6 million in non-accrual loans
and $1.7 million in other real estate owned. Those figures compare to year-ago
figures of $5.0 million for nonperforming assets, which consisted of $2.3
million in non-accrual loans and $2.7 million in other real estate owned. Net
charge-offs increased in 2002 to $972,000 or 0.18% of average loans outstanding,
compared with $858,000 or 0.17% of average loans outstanding in the prior year.
At December 31, 2002 the allowance for credit losses as a percentage of year end
loans was 1.25% versus 1.26% at December 31, 2001.
During 2002 and at December 31, 2002, the Company observed a migration in
the risk graded commercial loan portfolio to risk grades indicative of higher
credit risk. Specifically, as indicated in the table above, there was a
migration from risk grade 3 to risk grade 4. During 2002, there was also a $3.7
million increase in impaired loans. This migration was partially offset by a
decrease in retail loans past due 90 days or more from $924,000 at December 31,
2001 to $818,000 at December 31, 2002.
Risk grade loans classified special mention, substandard and doubtful
decreased from $13.1 million at year-end 2001 to $12.6 million at year-end 2002.
The reserve requirement for this category of loans totaled $2.1 million for 2001
and decreased to $1.7 million for 2002. Retail loans past due 90 days or more at
December 31, 2002 were $818,000, with a $323,000 reserve requirement. This
compares to $924,000 in retail loans past due 90 days or more and a reserve
requirement of $391,000 at December 31, 2001.
The table below summarizes the Company's allowance as a percentage of
total loans outstanding and net charge-off percentage for the past five years.
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Allowance percentage 1.25% 1.26% 1.26% 1.07% 0.95%
Net charge-off percentage 0.18% 0.17% 0.14% 0.11% 0.26%
Non-performing assets include non-accrual loans, accruing loans
contractually past due ninety days or more, restructured loans, and other real
estate. Loans are placed on non-accrual status when: (i) management has concerns
relating to the ability to collect the loan principal and interest and (ii)
generally when such loans are ninety days or more past due. No assurance can be
given, however, that economic conditions will not adversely affect borrowers and
result in increased credit losses.
25
Capital Resources
Banks and financial holding companies, as regulated institutions, must
meet required levels of capital. The Federal Reserve has 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 its
assets in accordance with the guidelines. As shown in Table 7 on page 37, the
Company and the Subsidiary Bank both maintained capital levels exceeding the
minimum levels to be "well capitalized" for the three years presented. The Bank
will continue to be required to meet certain levels of capital.
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. The investment portfolio at December 31, 2002,
held securities with call features, whereby the issuer of such a security has
the option to repay the purchaser of said instrument and cancels the instrument
before the contractual maturity date. Due to the interest rate on the original
instrument and current market rates on such instruments, the Company anticipates
that certain debt instruments in the portfolio may be called in the upcoming
year.
During 2002, the Company deployed cash flow from operating and financing
activities to fund increases in the loan portfolio. Overall, cash and cash
equivalents increased by $851,000 to $24.5 million at December 31, 2002.
As presented in the consolidated statement of cash flows, the Company
generated $5.6 million in operating cash flow during 2002, down 19.7% from $6.9
million in 2001. This decrease was primarily attributable to the funding of
loans held for sale in excess of proceeds from the sale of such loans, although
an increase in noninterest expense and income taxes paid also contributed to the
decline. These declines were partly offset by an increase in the amount that
interest received exceeded interest paid in each year. In 2002, interest
received in excess of interest paid was $23.8 million, while in 2001, interest
received in excess of interest paid was $20.7 million. This change resulted from
the growth in earning assets and improving net interest margin in 2002.
In 2002, the Company had a net increase of $27.8 million in loans compared
to $37.2 million in 2001. In 2002, the Company received $92.3 million from sales
and calls of securities, while purchasing $92.4 million. The turnover in the
security portfolio was attributable to the reduction in interest rates during
the year. In 2001, the Company purchased $149.4 million of securities, while
receiving $154.4 million from sales and calls and $20.6 million from maturities.
The Company's major financing sources during 2002 were a $9.7 million
increase in savings, NOW and MMI deposits, an $8.5 million increase in time
deposits and a $22.5 million increase in other borrowings, for a combined total
of $40.7 million versus a combined total of $6.3 million during 2001. In total,
cash flows from growth in deposits were $18.2 million in 2002, versus $17.3
million in 2001. Partially offsetting these cash inflows in 2002 was a decrease
of $11.4 million in federal funds and repurchase agreements and repurchases of
$4.1 million of the Company's common stock.
Liquidity is further enhanced by an approximately $124 million line of
credit with the Federal Home Loan Bank of Atlanta (FHLB) collateralized by FHLB
stock, investment securities, qualifying one to four 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.
26
The Company also has unsecured overnight borrowing lines totaling $19
million available through four financial institutions. These lines are used to
manage the day-to-day, short-term liquidity needs of the Company. Each overnight
line has a requirement to repay the line in full on a frequent basis, typically
within five to ten business days.
The Company also projects future cash flow requirements based on scheduled
loan and deposit maturities, borrowing maturities, capital expenditures and
other factors. At December 31, 2002 and for the upcoming twelve month period,
the Company had scheduled loan maturities of $162.8 million, securities
maturities of $200,000 and $345.6 million in maturing time deposits. The Company
also has $100.0 million in deposits with no contractual maturity, and $61.7
million in demand deposit accounts that are subject to withdrawal during 2002.
The Company has $20.0 million of borrowings that are scheduled for repayment in
2003. Anticipated capital expenditures during 2003 are approximately $1.4
million. Internal analysis indicated the Company is positioned to meet expected
liquidity requirements during the upcoming twelve-month period.
The Company also has off-balance sheet arrangements with customers that
may impact the overall liquidity needs. These commitments and contingent
liabilities are commitments to extend credit and standby letters of credit. The
following table presents commitments and contingent liabilities at December 31,
2002.
One Year Over One
(Dollars in thousands) and Less Year Total
-------- -------- --------
Commitments to extend credit $102,779 $4,679 $107,458
Standby letters of credit 283 -- 283
-------- ------ --------
Total commitments and contingent liabilities $103,062 $4,679 $107,741
======== ====== ========
Market Risk
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.
For a complete discussion on market risk and how the Company addresses
this risk, see Item 7A on page 30 of this Annual Report on Form 10-K.
Effects of Inflation
Inflation affects financial institutions in ways that are different from
most commercial and industrial companies, which have significant investments in
fixed assets and inventories. The effect of inflation on interest rates can
materially impact bank operations, which rely on net interest margins as a major
source of earnings. Non-interest expenses, such as salaries and wages, occupancy
and equipment cost, are also negatively affected by inflation.
27
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 of the Company's 2002 Annual
Report. 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.
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.
New Accounting Pronouncements
The Financial Accounting Standards Board (FASB) has issued Statement of
Financial Accounting Standards (SFAS) No. 141, "Business Combinations", and No.
142, "Goodwill and Other Intangible Assets." SFAS 141 supersedes Accounting
Principles Board (APB) Opinion No. 16, "Business Combinations", and SFAS No. 38,
"Accounting for P