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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2003
Commission File Number 0-15572
FIRST BANCORP
(Exact Name of Registrant as Specified in its Charter)
North Carolina 56-1421916
(State of Incorporation) (I.R.S. Employer Identification Number)
341 North Main Street, Troy, North Carolina 27371-0508
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (910) 576-6171
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act:
COMMON STOCK, NO PAR VALUE
(Title of each class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding twelve months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. |X| YES |_| NO
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy of information
statements incorporated by reference in Part III of the Form 10-K or any
amendment to the Form 10-K. |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). |X| YES |_| NO
The aggregate market value of the voting stock, Common Stock, no par
value, held by non-affiliates of the registrant, based on the average bid and
asked prices of the Common Stock as of the last trading day prior to June 30,
2003 as reported on the NASDAQ National Market System, was approximately
$209,719,000. Shares of Common Stock held by each officer and director and by
each person who owns 5% or more of the outstanding Common Stock have been
excluded in that such persons may be deemed to be affiliates. This determination
of affiliate status is not necessarily a conclusive determination for other
purposes.
The number of shares of the Registrant's Common Stock outstanding on
February 20, 2004 was 9,481,628.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement to be filed pursuant to
Regulation 14A are incorporated herein by reference into Part III.
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CROSS REFERENCE INDEX
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Page (s)
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PART I
Item 1 Business 4
Item 2 Properties 11
Item 3 Legal Proceedings 11
Item 4 Submission of Matters to a Vote of Shareholders 12
PART II
Item 5 Market for the Registrant's Common Stock and Related
Shareholder Matters 12
Item 6 Selected Consolidated Financial Data 12, 43
Item 7 Management's Discussion and Analysis of Results of
Operations and Financial Condition 12
Critical Accounting Policies 12
Merger and Acquisition Activity 14
Statistical Information
Net Interest Income 19, 44
Average Balances and Net Interest Income Analysis 19, 44
Volume and Rate Variance Analysis 19, 45
Provision for Loan Losses 21, 50
Noninterest Income 22, 45
Noninterest Expenses 23, 45
Income Taxes 24, 46
Distribution of Assets and Liabilities 25, 46
Securities 26, 46
Loans 27, 48
Nonperforming Assets 28, 49
Allowance for Loan Losses and Loan Loss Experience 30, 49
Deposits 32, 51
Borrowings 32
Liquidity, Commitments, and Contingencies 33, 52
Off-Balance Sheet Arrangements and Derivative Financial Instruments 35
Interest Rate Risk (Including Quantitative
and Qualitative Disclosures About Market Risk) 35, 52
Return on Assets and Equity 37, 53
Capital Resources and Shareholders' Equity 37, 53
Inflation 39
Current Accounting Matters 39
Item 7A Quantitative and Qualitative Disclosures About Market Risk 42
Forward-Looking Statements 42
Item 8 Financial Statements and Supplementary Data:
Consolidated Balance Sheets as of December 31, 2003 and 2002 55
Consolidated Statements of Income for each of the years in the
three-year period ended December 31, 2003 56
Consolidated Statements of Comprehensive Income for each of the
years in the three-year period ended December 31, 2003 57
2
Begins on
Page (s)
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Consolidated Statements of Shareholders' Equity for each of the years
in the three-year period ended December 31, 2003 58
Consolidated Statements of Cash Flows for each of the years
in the three-year period ended December 31, 2003 59
Notes to Consolidated Financial Statements 60
Independent Auditors' Report 95
Selected Consolidated Financial Data 43
Quarterly Financial Summary 54
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures 96
Item 9A Controls and Procedures 96
PART III
Item 10 Directors and Executive Officers of the Registrant; Compliance
with Section 16 (a) of the Exchange Act 96*
Item 11 Executive Compensation 96*
Item 12 Security Ownership of Certain Beneficial Owners and Management 96*
Item 13 Certain Relationships and Related Transactions 96*
Item 14 Principal Accountant Fees and Services
Part IV
Item 15 Exhibits, Financial Statement Schedules and Reports of Form 8-K 97
SIGNATURES 99
* Information called for by portions of Part III (Items 10 through 14) is
incorporated herein by reference to the Registrant's definitive Proxy
Statement for the 2004 Annual Meeting of Shareholders to be filed with the
Securities and Exchange Commission.
3
PART I
Item 1. Business
General Description
The Company
First Bancorp (the "Company") is a bank holding company. The principal
activity of the Company is the ownership and operation of First Bank (the
"Bank"), a state chartered bank with its main office in Troy, North Carolina.
The Company also owns and operates two nonbank subsidiaries: Montgomery Data
Services, Inc. ("Montgomery Data"), a data processing company and First Bancorp
Financial Services, Inc. ("First Bancorp Financial"), which owns and operates
various real estate. The Company is also the parent to three statutory business
trusts created under the laws of the State of Delaware, which have issued a
total of $40 million in trust preferred debt securities. All of the Company's
subsidiaries are fully consolidated for financial reporting purposes.
The Bank has two wholly owned subsidiaries, First Bank Insurance Services,
Inc. ("First Bank Insurance") and First Montgomery Financial Services
Corporation ("First Montgomery"). First Bank Insurance was acquired as an active
insurance agency in 1994 in connection with the Company's acquisition of a bank
that had an insurance subsidiary. On December 29, 1995, the insurance agency
operations of First Bank Insurance were divested. From December 1995 until
October 1999, First Bank Insurance was inactive. In October 1999, First Bank
Insurance began operations again as a provider of non-FDIC insured investments
and insurance products. Currently, First Bank Insurance's primary business
activity is the placement of property and casualty insurance coverage. First
Montgomery, a Virginia company incorporated on November 2, 2001, was formed to
acquire real estate in Virginia and lease the property to the Bank. First Troy
Realty Corporation ("First Troy") was incorporated on May 12, 1999 and is a
subsidiary of First Montgomery. First Troy allows the Bank to centrally manage a
portion of its residential, mortgage, and commercial real estate loan portfolio.
The Company was incorporated in North Carolina on December 8, 1983, as
Montgomery Bancorp, for the purpose of acquiring 100% of the outstanding common
stock of the Bank through stock-for-stock exchanges. On December 31, 1986, the
Company changed its name to First Bancorp to conform its name to the name of the
Bank, which had changed its name from Bank of Montgomery to First Bank in 1985.
The Bank was organized in 1934 and began banking operations in 1935 as the
Bank of Montgomery, named for the county in which it operated. As of December
31, 2003, the Bank operated in a 21 county area centered in Troy, North
Carolina. Troy, population 3,400, is located in the center of Montgomery County,
approximately 60 miles east of Charlotte, 50 miles south of Greensboro, and 80
miles southwest of Raleigh. The Bank conducts business from 57 branches located
within a 120-mile radius of Troy, covering principally a geographical area from
Latta, South Carolina to the southeast, to Wallace, North Carolina to the east,
to Mayodan, North Carolina to the north, to Wytheville, Virginia to the
northwest, and Harmony, North Carolina to the west. The Bank's newest branch,
which opened on January 20, 2004 in Abingdon, Virginia, brought the Bank's total
branch network to 58 branches, with 53 of the branches being in North Carolina,
three branches being in South Carolina (all in Dillon County), and two branches
in Virginia, where the Bank operates under the name "First Bank of Virginia."
Ranked by assets, the Bank was the 7th largest bank in North Carolina as of
December 31, 2003.
On September 14, 2000, the Company completed the merger acquisition of
First Savings Bancorp, Inc. ("First Savings"). The merger was accounted for as a
pooling-of-interests and accordingly, all financial results for prior periods
have been restated to include the combined results of the Company and First
Savings. At the time of the merger, First Savings had approximately $310 million
in assets, and in connection with the merger the Company issued approximately
4.4 million shares of stock, nearly doubling its number of shares outstanding.
For information about other merger and acquisition activity, see "Merger and
Acquisition Activity" under Item 7
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- - Management's Discussion and Analysis of Results of Operations and Financial
Condition.
The Bank provides a full range of banking services, including the
accepting of demand and time deposits, the making of secured and unsecured loans
to individuals and businesses, and the offering of credit cards and debit cards.
In 2003, as in recent prior years, the Bank accounted for substantially all of
the Company's consolidated net income.
The Company's principal executive offices are located at 341 North Main
Street, Troy, North Carolina 27371-0508, and its telephone number is (910)
576-6171. Unless the context requires otherwise, references to the "Company" in
this annual report on Form 10-K shall mean collectively First Bancorp and its
subsidiaries.
General Business
The Bank engages in a full range of banking activities, providing such
services as checking, savings, NOW and money market accounts and other time
deposits of various types; loans for business, agriculture, real estate,
personal uses, home improvement and automobiles; credit cards; debit cards;
letters of credit; IRAs; safe deposit box rentals; bank money orders; and
electronic funds transfer services, including wire transfers, automated teller
machines, and bank-by-phone capabilities. Because the majority of the Bank's
customers are individuals and small to medium-sized businesses located in the
counties it serves, management does not believe that the loss of a single
customer or group of customers would have a material adverse impact on the Bank.
There are no seasonal factors that tend to have any material effect on the
Bank's business, and the Bank does not rely on foreign sources of funds or
income. Because the Bank operates primarily within the central Piedmont region
of North Carolina, the economic conditions within that area could have a
material impact on the Company. See additional discussion below in the section
entitled "Territory Served and Competition."
Beginning in 1999, First Bank Insurance began offering non-FDIC insured
investment and insurance products, including mutual funds, annuities, long-term
care insurance, life insurance, and company retirement plans, as well as
financial planning services (the "investments division"). In May 2001, First
Bank Insurance added to its product line when it acquired two insurance agencies
that specialized in the placement of property and casualty insurance. In October
2003, the "investments division" of First Bank Insurance became a part the Bank.
The sole activity of First Bank Insurance is now the placement of property and
casualty insurance products.
Montgomery Data's primary business is to provide electronic data
processing services for the Bank. Ownership and operation of Montgomery Data
allows the Company to do all of its electronic data processing without paying
fees for such services to an independent provider. Maintaining its own data
processing system also allows the Company to adapt the system to its individual
needs and to the services and products it offers. Although not a significant
source of income, Montgomery Data has historically made its excess data
processing capabilities available to area financial institutions for a fee.
Montgomery Data now has four outside customers that provided gross revenues of
$333,000, $303,000, and $205,000 for the years ended December 31, 2003, 2002,
and 2001, respectively.
First Bancorp Financial was organized under the name of First Recovery in
September of 1988 for the purpose of providing a back-up data processing site
for Montgomery Data and other financial and non-financial clients. First
Recovery's back-up data processing operations were divested in 1994. First
Bancorp Financial now owns and leases the First Recovery building. First Bancorp
Financial periodically purchases parcels of real estate from the Bank that were
acquired through foreclosure or from branch closings. The parcels purchased
consist of real estate having various purposes. First Bancorp Financial actively
pursues the sale of these properties.
First Bancorp Capital Trust I was organized in October 2002 for the
purpose of issuing $20 million in debt securities. These borrowings are due on
November 7, 2032 and were structured as trust preferred capital securities,
which qualify as capital for regulatory capital adequacy requirements. These
debt securities are
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callable by the Company at par on any quarterly interest payment date beginning
on November 7, 2007. The interest rate on these debt securities adjusts on a
quarterly basis at a rate of three-month LIBOR plus 3.45%. This rate may not
exceed 12.50% through November 2007.
First Bancorp Capital Trust II and First Bancorp Capital Trust III were
organized in December 2003 for the purpose of issuing $20 million in debt
securities ($10 million were issued from each trust). These borrowings are due
on December 19, 2033 and were also structured as trust preferred capital
securities in order to qualify as regulatory capital. These debt securities are
callable by the Company at par on any quarterly interest payment date beginning
on January 23, 2009. The interest rate on these debt securities adjusts on a
quarterly basis at a weighted average rate of three-month LIBOR plus 2.70%.
First Montgomery was incorporated on November 2, 2001. First Montgomery's
business activities are currently limited to the selection and acquisition of
real estate in Virginia that is leased to the Bank for use as bank branches.
First Troy was incorporated on May 12, 1999 as a subsidiary of the Bank.
Upon the formation of First Montgomery as a subsidiary of the Bank, the Bank
contributed its interest in First Troy to First Montgomery, resulting in First
Troy becoming a subsidiary of First Montgomery. First Troy allows the Bank to
centrally manage a portion of its residential, mortgage, and commercial real
estate loan portfolio. First Troy has elected to be treated as a real estate
investment trust for tax purposes.
Territory Served and Competition
The Company's headquarters are located in Troy, Montgomery County, North
Carolina. The Company serves primarily the south central area of the Piedmont
region of North Carolina. The following table presents, for each county the
Company operates in, the number of bank branches operated by the Company within
the county, the approximate amount of deposits with the Company in the county as
of December 31, 2003, the Company's approximate market share, and the number of
bank competitors located in the county.
No. of Deposits Market Number of
County Branches (in millions) Share Competitors
----------------- -------- ------------- --------- -----------
Anson, NC 1 $ 11 4.9% 4
Cabarrus, NC 2 23 1.3% 8
Chatham, NC 2 39 7.4% 9
Davidson, NC 2 106 6.9% 8
Dillon, SC 3 62 25.2% 2
Duplin, NC 2 44 16.7% 6
Guilford, NC 1 32 0.5% 21
Harnett, NC 3 76 10.1% 7
Iredell, NC 1 21 1.4% 10
Lee, NC 4 99 15.3% 6
Montgomery, NC 5 84 34.9% 4
Moore, NC 10 294 25.0% 10
Randolph, NC 4 44 3.6% 13
Richmond, NC 1 22 5.5% 4
Robeson, NC 5 115 14.9% 9
Rockingham, NC 1 3 0.0% 8
Rowan, NC 2 38 3.4% 10
Scotland, NC 2 40 14.9% 5
Stanly, NC 4 71 9.7% 5
Wake, NC 1 9 0.1% 19
Wythe, VA 1 16 3.5% 8
---- ---------
Total 57 $ 1,249
==== =========
The Company's 57 branches and facilities are primarily located in small
communities whose economies are
6
based primarily on services, manufacturing and light industry. Although the
Company's market is predominantly small communities and rural areas, the area is
not dependent on agriculture. Textiles, furniture, mobile homes, electronics,
plastic and metal fabrication, forest products, food products and cigarettes are
among the leading manufacturing industries in the trade area. Leading producers
of lumber, socks, hosiery and area rugs are located in Montgomery County. The
Pinehurst area within Moore County is a widely known golf resort and retirement
area. The High Point area is widely known for its furniture market.
Additionally, several of the communities served by the Company are "bedroom"
communities serving Charlotte and Greensboro in addition to smaller cities such
as Albemarle, Asheboro, High Point, Pinehurst and Sanford.
As shown in the table above, approximately 24% of the Company's deposit
base is in Moore County, and, accordingly, material changes in competition, the
economy or population of Moore County could materially impact the Company. No
other county comprises more than 10% of the Company's deposit base.
The Company competes in its various market areas with, among others,
several large interstate bank holding companies that are headquartered in North
Carolina. These large competitors have substantially greater resources than the
Company, including broader geographic markets, higher lending limits and the
ability to make greater use of large-scale advertising and promotions. A
significant number of interstate banking acquisitions have taken place in the
past decade, thus further increasing the size and financial resources of some of
the Company's competitors, three of which are among the largest bank holding
companies in the nation. Moore County, which as noted above comprises a
disproportionate share of the Company's deposits, is a particularly competitive
market, with at least ten other financial institutions having a physical
presence. See "Supervision and Regulation" below for a further discussion of
regulations in the Company's industry that affect competition.
The Company competes not only against banking organizations, but also
against a wide range of financial service providers, including federally and
state chartered savings and loan institutions, credit unions, investment and
brokerage firms and small-loan or consumer finance companies. Competition among
financial institutions of all types is virtually unlimited with respect to legal
ability and authority to provide most financial services. The Company also
experiences competition from internet banks, particularly in the area of time
deposits.
However, the Company believes it has certain advantages over its
competition in the areas it serves. The Company seeks to maintain a distinct
local identity in each of the communities it serves and actively sponsors and
participates in local civic affairs. Most lending and other customer-related
business decisions can be made without delays often associated with larger
systems. Additionally, employment of local managers and personnel in various
offices and low turnover of personnel enable the Company to establish and
maintain long-term relationships with individual and corporate customers.
Lending Policy and Procedures
Conservative lending policies and procedures and appropriate underwriting
standards are high priorities of the Bank. Loans are approved under the Bank's
written loan policy, which provides that lending officers, principally branch
managers, have authority to approve loans of various amounts up to $100,000.
Each of the Bank's regional senior lending officers has discretion to approve
secured loans in principal amounts up to $350,000 and together can approve loans
up to $2,000,000. Lending limits may vary depending upon whether the loan is
secured or unsecured.
The Bank's board of directors reviews and approves loans that exceed
management's lending authority, loans to executive officers, directors, and
their affiliates and, in certain instances, other types of loans. New credit
extensions are reviewed daily by the Bank's senior management and at least
monthly by the board of directors.
The Bank continually monitors its loan portfolio to identify areas of
concern and to enable management to take corrective action. Lending officers and
the board of directors meet periodically to review past due loans and portfolio
quality, while assuring that the Bank is appropriately meeting the credit needs
of the communities it
7
serves. Individual lending officers are responsible for pursuing collection of
past-due amounts and monitoring any changes in the financial status of the
borrowers.
The Bank's internal audit department evaluates specific loans and overall
loan quality at individual branches as part of its regular branch reviews. The
Bank also contracts with an independent consulting firm to review new loan
originations meeting certain criteria, as well as to assign risk grades to
existing credits meeting certain thresholds. The consulting firm's observations,
comments, and risk grades, including variances with the Bank's risk grades, are
shared with the audit committee of the Company's board of directors, and are
considered by management in setting Bank policy, as well as in evaluating the
adequacy of the allowance for loan losses. For additional information, see
"Allowance for Loan Losses and Loan Loss Experience" under Item 7 below.
Investment Policy and Procedures
The Company has adopted an investment policy designed to optimize the
Company's income from funds not needed to meet loan demand in a manner
consistent with appropriate liquidity and risk objectives. Pursuant to this
policy, the Company may invest in federal, state and municipal obligations,
federal agency obligations, public housing authority bonds, industrial
development revenue bonds, Federal National Mortgage Association, Government
National Mortgage Association, Federal Home Loan Mortgage Corporation and
Student Loan Marketing Association securities. Additionally, during 2001 the
Company's board of directors approved limited investments in corporate bonds
(see below). Except for corporate bonds, the Company's investments must be rated
at least Baa by Moody's or BBB by Standard and Poor's. Securities rated below A
are periodically reviewed for creditworthiness. The Company may purchase
non-rated municipal bonds only if such bonds are in the Company's general market
area and determined by the Company to have a credit risk no greater than the
minimum ratings referred to above. Industrial development authority bonds, which
normally are not rated, are purchased only if they are judged to possess a high
degree of credit soundness to assure reasonably prompt sale at a fair value. In
2001, the Company's board of directors authorized the Company to invest a
portion of its security portfolio in high quality corporate bonds, with the
amount of bonds related to any one issuer not to exceed the Company's legal
lending limit. Prior to purchasing a corporate bond, the Company's management
performs due diligence on the issuer of the bond, and the purchase is not made
unless the Company believes that the purchase of the bond bears no more risk to
the Company than would an unsecured loan to the same company.
The Company's investment officers implement the investment policy, monitor
the investment portfolio, recommend portfolio strategies, and report to the
Company's investment committee. Reports of all purchases, sales, issuer calls,
net profits or losses and market appreciation or depreciation of the bond
portfolio are reviewed by the Company's board of directors each month. Once a
quarter, the Company's interest rate risk exposure is evaluated by the board of
directors. Once a year, the written investment policy is reviewed by the board
of directors and the Company's portfolio is compared with the portfolios of
other companies of comparable size.
Mergers and Acquisitions
As part of its operations, the Company has pursued an acquisition strategy
over the years to augment its internal growth and regularly evaluates the
potential acquisition of, or merger with, and holds discussions with, various
financial institutions. The Company's acquisitions to date have generally fallen
into one of three categories - 1) an acquisition of a financial institution or
branch thereof within a market in which the Company operates, 2) an acquisition
of a financial institution or branch thereof in a market contiguous to a market
in which the Company operates, or 3) an acquisition of a company that has
products or services that the Company does not currently offer.
The Company believes that by pursuing these types of acquisition
opportunities the Company can enhance its earnings by any combination or all of
the following: 1) achieving cost efficiencies, 2) enhancing the acquiree's
earnings or gaining new customers by introducing a more successful banking model
with more products and services to the acquiree's market base, 3) increasing
customer satisfaction or gaining new customers by providing
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more locations for the convenience of customers, and 4) leveraging the Company's
customer base by offering new products and services.
In the last three years, the Company has made acquisitions in all three of
the aforementioned categories of acquisitions. In 2001, acquisitions resulted in
the Company adding $116.2 million in loans and $204.6 million in deposits,
expansion into four contiguous markets (Lumberton, Pembroke, St. Pauls, and
Thomasville), provided another branch for customers in one of the Company's
newer markets (Salisbury), and gave the Company the ability to offer property
and casualty insurance coverage. In 2002, the Company completed the acquisition
of a branch within its market geography (Broadway, located in Lee County) with
approximately $8.4 million in deposits and $3.1 million in loans. In 2003, the
Company completed acquisitions that added approximately $72.5 million in loans
and $160.8 million in deposits that were in the contiguous or nearly contiguous
markets of Dillon County SC, Duplin County NC, Harmony NC, and Fairmont NC. In
2003, the Company also purchased another property and casualty insurance agency
that provides efficiencies of scale with the one purchased in 2001.
The Company plans to continue to evaluate acquisition opportunities that
could potentially benefit the Company and its shareholders. These opportunities
may include acquisitions that do not fit the categories discussed above. For a
further discussion of recent acquisition activity, see "Merger and Acquisition
Activity" under Item 7 below.
Employees
As of December 31, 2003, the Company had 505 full-time and 89 part-time
employees. The Company is not a party to any collective bargaining agreements
and considers its employee relations to be good.
Supervision and Regulation
As a bank holding company, the Company is subject to supervision,
examination and regulation by the Board of Governors of the Federal Reserve
System and the North Carolina Office of the Commissioner of Banks. The Bank is
subject to supervision and examination by the Federal Deposit Insurance
Corporation and the North Carolina Office of the Commissioner of Banks. For
additional information, see also Note 15 to the consolidated financial
statements.
Supervision and Regulation of the Company
The Company is a bank holding company within the meaning of the Bank
Holding Company Act of 1956, as amended, and is required to register as such
with the Board of Governors of the Federal Reserve System (the "Federal Reserve
Board"). The Company is also regulated by the North Carolina Office of
the Commissioner of Banks (the "Commissioner") under the Bank Holding Company
Act of 1984.
A bank holding company is required to file quarterly reports and other
information regarding its business operations and those of its subsidiaries with
the Federal Reserve Board. It is also subject to examination by the Federal
Reserve Board and is required to obtain Federal Reserve Board approval prior to
making certain acquisitions of other institutions or voting securities. The
Commissioner is empowered to regulate certain acquisitions of North Carolina
banks and bank holding companies, issue cease and desist orders for violations
of North Carolina banking laws, and promulgate rules necessary to effectuate the
purposes of the Bank Holding Company Act of 1984.
Regulatory authorities have cease and desist powers over bank holding
companies and their nonbank subsidiaries where their actions would constitute a
serious threat to the safety, soundness or stability of a subsidiary bank. Those
authorities may compel holding companies to invest additional capital into
banking subsidiaries upon acquisitions or in the event of significant loan
losses or rapid growth of loans or deposits.
9
In 1999, the U.S. enacted legislation that allowed bank holding companies
to engage in a wider range of non-banking activities, including greater
authority to engage in securities and insurance activities. Under the
Gramm-Leach-Bliley Act (the "Act"), a bank holding company that elects to become
a financial holding company may engage in any activity that the Federal Reserve
Board, in consultation with the Secretary of the Treasury, determines by
regulation or order is (i) financial in nature, (ii) incidental to any such
financial activity, or (iii) complementary to any such financial activity and
does not pose a substantial risk to the safety or soundness of depository
institutions or the financial system generally. This Act made significant
changes in U.S. banking law, principally by repealing certain restrictive
provisions of the 1933 Glass-Steagall Act. The Act lists certain activities that
are deemed to be financial in nature, including lending, exchanging,
transferring, investing for others, or safeguarding money or securities;
underwriting and selling insurance; providing financial, investment, or economic
advisory services; underwriting, dealing in or making a market in, securities;
and any activity currently permitted for bank holding companies by the Federal
Reserve Board under Section 4(c)(8) of the Holding Company Act. The Act does not
authorize banks or their affiliates to engage in commercial activities that are
not financial in nature. A bank holding company may elect to be treated as a
financial holding company only if all depository institution subsidiaries of the
holding company are well-capitalized, well-managed and have at least a
satisfactory rating under the Community Reinvestment Act. At the present time,
the Company does not anticipate applying for status as a financial holding
company under the Act.
National and state banks are also authorized by the Act to engage, through
"financial subsidiaries," in any activity that is permissible for a financial
holding company (as described above) and any activity that the Secretary of the
Treasury, in consultation with the Federal Reserve Board, determines is
financial in nature or incidental to any such financial activity, except (i)
insurance underwriting, (ii) real estate development or real estate investment
activities (unless otherwise permitted by law), (iii) insurance company
portfolio investments and (iv) merchant banking. The authority of a national or
state bank to invest in a financial subsidiary is subject to a number of
conditions, including, among other things, requirements that the bank be
well-managed and well-capitalized (after deducting from the bank's capital
outstanding investments in financial subsidiaries).
The United States Congress and the North Carolina General Assembly have
periodically considered and adopted legislation that has resulted in, and could
result in further, deregulation of both banks and other financial institutions.
Such legislation could modify or eliminate geographic restrictions on banks and
bank holding companies and current restrictions on the ability of banks to
engage in certain nonbanking activities. For example, the Riegle-Neal Interstate
Banking Act, which was enacted several years ago, allows expansion of interstate
acquisitions by bank holding companies and banks. This and other legislative and
regulatory changes have increased the ability of financial institutions to
expand the scope of their operations, both in terms of services offered and
geographic coverage. Such legislative changes have placed the Company in more
direct competition with other financial institutions, including mutual funds,
securities brokerage firms, insurance companies, investment banking firms, and
internet banks. The Company cannot predict what other legislation might be
enacted or what other regulations might be adopted or, if enacted or adopted,
the effect thereof on the Company's business.
Supervision and Regulation of the Bank
Federal banking regulations applicable to all depository financial
institutions, among other things, (i) provide federal bank regulatory agencies
with powers to prevent unsafe and unsound banking practices; (ii) restrict
preferential loans by banks to "insiders" of banks; (iii) require banks to keep
information on loans to major shareholders and executive officers; and (iv) bar
certain director and officer interlocks between financial institutions.
As a state chartered bank, the Bank is subject to the provisions of the
North Carolina banking statutes and to regulation by the Commissioner. The
Commissioner has a wide range of regulatory authority over the activities and
operations of the Bank, and the Commissioner's staff conducts periodic
examinations of the Bank and its affiliates to ensure compliance with state
banking regulations. Among other things, the Commissioner regulates
10
the merger and consolidation of state chartered banks, the payment of dividends,
loans to officers and directors, recordkeeping, types and amounts of loans and
investments, and the establishment of branches. The Commissioner also has cease
and desist powers over state chartered banks for violations of state banking
laws or regulations and for unsafe or unsound conduct that is likely to
jeopardize the interest of depositors.
The dividends that may be paid by the Bank to the Company are subject to
legal limitations under North Carolina law. In addition, regulatory authorities
may restrict dividends that may be paid by the Bank or the Company's other
subsidiaries. The ability of the Company to pay dividends to its shareholders is
largely dependent on the dividends paid to the Company by its subsidiaries.
The Bank is a member of the Federal Deposit Insurance Corporation (the
"FDIC"), which currently insures the deposits of member banks. For this
protection, each bank pays a quarterly statutory assessment, based on its level
of deposits, and is subject to the rules and regulations of the FDIC. The FDIC
also is authorized to approve conversions, mergers, consolidations and
assumptions of deposit liability transactions between insured banks and
uninsured banks or institutions, and to prevent capital or surplus diminution in
such transactions where the resulting, continuing, or assumed bank is an insured
nonmember bank. In addition, the FDIC monitors the Bank's compliance with
several banking statutes, such as the Depository Institution Management
Interlocks Act and the Community Reinvestment Act of 1977. The FDIC also
conducts periodic examinations of the Bank to assess its compliance with banking
laws and regulations, and it has the power to implement changes in or
restrictions on a bank's operations if it finds that a violation is occurring or
is threatened.
Neither the Company nor the Bank can predict what other legislation might
be enacted or what other regulations might be adopted, or if enacted or adopted,
the effect thereof on the Bank's operations.
See "Capital Resources and Shareholders' Equity" under Item 7 below for a
discussion of regulatory capital requirements.
Available Information
The Company maintains a corporate Internet site at www.firstbancorp.com
which contains a link within the "Investor Relations" section of the site to
each of its filings with the Securities and Exchange Commission. These filings
can also be accessed at the Securities and Exchange Commission's website located
at www.sec.gov. Information included on our Internet site is not incorporated by
reference into this annual report.
Item 2. Properties
The main offices of the Company, the Bank and First Bancorp Financial are
located in a three-story building in the central business district of Troy,
North Carolina. The building houses administrative, training and bank teller
facilities. The Bank's Operations Division, including customer accounting
functions, offices and operations of Montgomery Data, and offices for loan
operations, are housed in a one-story steel frame building approximately
one-half mile west of the main office. The Company operates 58 bank branches and
facilities. The Company owns all its bank branch premises except twelve branch
offices for which the land and buildings are leased and four branch offices for
which the land is leased but the building is owned. There are no other options
to purchase or lease additional properties. The Company considers its facilities
adequate to meet current needs.
Item 3. Legal Proceedings
Various legal proceedings may arise in the ordinary course of business and
may be pending or threatened against the Company and/or its subsidiaries. The
Company is not involved in any pending legal proceedings that management
believes could have a material effect on the consolidated financial position of
the Company.
11
Item 4. Submission of Matters to a Vote of Shareholders
No matters were submitted to a vote of shareholders during the fourth
quarter of 2003.
PART II
Item 5. Market for the Registrant's Common Stock and Related Shareholder Matters
The Company's common stock trades on the NASDAQ National Market System of
the NASDAQ Stock Market under the symbol FBNC. Tables 1 and 22, included in
"Management's Discussion and Analysis" below, set forth the high and low market
prices of the Company's common stock as traded by the brokerage firms that
maintain a market in the Company's common stock and the dividends declared for
the periods indicated. All amounts prior to the Company's September 2000
acquisition of First Savings, except for the Company's stock price, have been
restated to include the combined results of First Bancorp and First Savings. See
"Business - Supervision and Regulation" and Note 15 to the consolidated
financial statements for a discussion of regulatory restrictions on the payment
of dividends. As of December 31, 2003, there were approximately 2,500
shareholders of record and another 2,700 shareholders whose stock is held in
"street name."
Item 6. Selected Financial Data
Table 1 sets forth selected consolidated financial data for the Company.
Item 7. Management's Discussion and Analysis of Results of Operations and
Financial Condition
Management's discussion and analysis is intended to assist readers in
understanding the Company's results of operations and changes in financial
position for the past three years. This review should be read in conjunction
with the consolidated financial statements and accompanying notes beginning on
page 55 of this report and the supplemental financial data contained in Tables 1
through 22 included with this discussion and analysis.
CRITICAL ACCOUNTING POLICIES
The accounting principles followed by the Company and the methods of
applying these principles conform with accounting principles generally accepted
in the United States of America and with general practices followed by the
banking industry. Certain of these principles involve a significant amount of
judgment and/or use of estimates based on the Company's best assumptions at the
time of the estimation. The Company has identified two policies as being more
sensitive in terms of judgments and estimates, taking into account their overall
potential impact to the Company's consolidated financial statements - 1) the
allowance for loan losses, and 2) intangible assets.
Allowance for Loan Losses
Due to the estimation process and the potential materiality of the amounts
involved, the Company has identified the accounting for the allowance for loan
losses and the related provision for loan losses as an accounting policy
critical to the Company's consolidated financial statements. The provision for
loan losses charged to operations is an amount sufficient to bring the allowance
for loan losses to an estimated balance considered adequate to absorb losses
inherent in the portfolio.
Management's determination of the adequacy of the allowance is based
primarily on a mathematical model that estimates the appropriate allowance for
loan losses. This model has two components. The first component involves the
estimation of losses on loans defined as "impaired loans." A loan is considered
to be impaired when, based on current information and events, it is probable the
Company will be unable to collect all amounts due according to the contractual
terms of the loan agreement. The estimated valuation allowance is the
difference, if
12
any, between the loan balance outstanding and the value of the impaired loan as
determined by either 1) an estimate of the cash flows that the Company expects
to receive from the borrower discounted at the loan's effective rate, or 2) in
the case of a collateral-dependent loan, the fair value of the collateral.
The second component of the allowance model is to estimate losses for all
loans not considered to be impaired loans. First, loans that have been risk
graded by the Company as having more than "standard" risk but are not considered
to be impaired are assigned estimated loss percentages generally accepted in the
banking industry. Loans that are classified by the Company as having normal
credit risk are segregated by loan type, and estimated loss percentages are
assigned to each loan type, based on the historical losses, current economic
conditions, and operational conditions specific to each loan type.
The reserve estimated for impaired loans is then added to the reserve
estimated for all other loans. This becomes the Company's "allocated allowance."
In addition to the allocated allowance derived from the model, management also
evaluates other data such as the ratio of the allowance for loan losses to total
loans, net loan growth information, nonperforming asset levels and trends in
such data. Based on this additional analysis, the Company may determine that an
additional amount of allowance for loan losses is necessary to reserve for
probable losses. This additional amount, if any, is the Company's "unallocated
allowance." The sum of the allocated allowance and the unallocated allowance is
compared to the actual allowance for loan losses recorded on the books of the
Company and any adjustment necessary for the recorded allowance to equal the
computed allowance is recorded as a provision for loan losses. The provision for
loan losses is a direct charge to earnings in the period recorded.
Although management uses the best information available to make
evaluations, future adjustments may be necessary if economic, operational, or
other conditions change. In addition, various regulatory agencies, as an
integral part of their examination process, periodically review the Company's
allowance for loan losses. Such agencies may require the Company to recognize
additions to the allowance based on the examiners' judgment about information
available to them at the time of their examinations.
For further discussion including a review of the range of provisions for
loan losses and its impact on reported results in recent periods, see
"Nonperforming Assets" and "Allowance for Loan Losses and Loan Loss Experience"
under "Analysis of Financial Condition and Changes in Financial Condition."
Intangible Assets
Due to the estimation process and the potential materiality of the amounts
involved, the Company has also identified the accounting for intangible assets
as an accounting policy critical to the Company's consolidated financial
statements.
When the Company completes an acquisition transaction, the excess of the
purchase price over the amount by which the fair market value of assets acquired
exceeds the fair market value of liabilities assumed represents an intangible
asset. The Company must then determine the identifiable portions of the
intangible asset, with any remaining amount classified as goodwill. Identifiable
intangible assets associated with these acquisitions are generally amortized
over the estimated life of the related asset, whereas goodwill is tested
annually for impairment, but not systematically amortized. Assuming no goodwill
impairment, it is beneficial to the Company's future earnings to have a lower
amount assigned to identifiable intangible assets and higher amount of goodwill
as opposed to having a higher amount considered to be identifiable intangible
asset and a lower amount classified as goodwill.
For the Company, the only identifiable intangible asset typically recorded
in connection with a whole-bank or bank branch acquisition is the value of the
core deposit intangible, whereas when the Company acquires an insurance agency,
the primary identifiable intangible asset is the value of the acquired customer
list. Determining the amount of identifiable intangible assets and their average
lives involves multiple assumptions and estimates and is typically determined by
performing a discounted cash flow analysis, which involves a combination of any
or all of the following assumptions: customer attrition/runoff, alternative
funding costs, deposit servicing costs, and discount rates. The Company
typically engages a third party consultant to assist in each analysis. For the
whole-bank and bank branch transactions recorded to date, the core deposit
intangible in each case has been estimated to have a ten year life, with an
accelerated rate of amortization. For the 2003 insurance agency acquisition, the
identifiable intangible asset related to the customer list was determined to
have a ten year life, with amortization occurring on a straight-line basis.
Subsequent to the initial recording of the identifiable intangible assets
and goodwill, the Company amortizes the identifiable intangible assets over
their estimated average lives, as discussed above. In addition, on an at least
an annual basis, goodwill is evaluated for impairment by comparing the fair
value of the Company's reporting units to their related carrying value,
including goodwill (the Company's community banking operations is its only
material reporting unit). At its last evaluation, the fair value of the
Company's community banking operations exceeded its carrying value, including
goodwill. If the carrying value of a reporting unit were ever to exceed its fair
value, the Company would determine whether the implied fair value of the
goodwill, using a discounted cash flow analysis, exceeded the carrying value of
the goodwill. If the carrying value of the goodwill exceeded the implied fair
value of the goodwill, an impairment loss would be recorded in an amount equal
to that excess. Performing such a discounted cash flow analysis would involve
the significant use of estimates and assumptions.
The Company reviews identifiable intangible assets for impairment whenever
events or changes in circumstances indicate that the carrying value may not be
recoverable. The Company's policy is that an impairment loss is recognized,
equal to the difference between the asset's carrying amount and its fair value,
if the sum of the expected undiscounted future cash flows is less than the
carrying amount of the asset. Estimating future cash flows involves the use of
multiple estimates and assumptions, such as those listed above.
The foregoing accounting policy was adopted by the Company effective on
January 1, 2002 in accordance with newly issued accounting standards for
goodwill and other intangible assets. For acquisitions occurring prior to
January 1, 2002, the Company generally did not separately identify its
identifiable intangible assets from its goodwill, as all intangible assets were
amortized under accounting standards then in effect. According to the transition
provisions of the accounting standards that changed the Company's accounting
policy to that described above, the entire amount of those combined intangible
assets was accounted for entirely as non-amortizable goodwill. See the section
entitled "Current Accounting Matters" below for further discussion.
MERGER AND ACQUISITION ACTIVITY
Over the past three fiscal years, the Company has completed several
acquisitions, which has resulted in significant amounts of intangible assets
being recorded by the Company, as detailed below. As noted above, the accounting
for intangible assets changed significantly in 2002 with the Company being
required under new accounting standards to cease the amortization of goodwill.
See the section entitled "Current Accounting Matters" below and Note 2 and Note
6 to the consolidated financial statements for additional information regarding
intangible assets and their amortization under previous and current accounting
standards.
The Company completed the following acquisitions during 2003:
(a) Uwharrie Insurance Group - On January 2, 2003, the Company completed
the acquisition of Uwharrie Insurance Group, a Montgomery County based property
and casualty insurance agency. With eight employees, Uwharrie Insurance Group,
Inc. serves approximately 5,000 customers, primarily from its Troy-based
headquarters, and had annual commissions of approximately $500,000. The primary
reason for the acquisition was to gain efficiencies of scale with the Company's
existing property and casualty insurance business. The acquisition resulted in
the Company recording an intangible asset of approximately $544,000. Based on an
14
independent appraisal, $50,000 of the intangible asset recorded was determined
to be attributable to the value of the noncompete agreement signed as part of
the transaction and is being amortized over its two year life, $151,000 was
determined to be attributable to the value of the customer list and is being
amortized on a straight-line basis over ten years, and the remaining $343,000
was determined to be goodwill and thus will not be systematically amortized, but
rather will be subject to an annual impairment test.
(b) On January 15, 2003, the Company completed the acquisition of Carolina
Community Bancshares, Inc. (CCB), the parent company of Carolina Community Bank,
a South Carolina community bank with three branches in Dillon County, South
Carolina. This represented the Company's first entry into South Carolina. Dillon
County, South Carolina is contiguous to Robeson County, North Carolina, a county
where the Company already operated four branches. The Company's primary reason
for the acquisition was to expand into a contiguous market with facilities,
operations and experienced staff in place. In this transaction, the shareholders
of CCB received 0.8 shares of the Company's stock and $20.00 in cash for each
share of CCB stock they owned at the time of closing. The transaction was
completed on January 15, 2003, with the Company paying cash of $8.3 million,
issuing 332,888 shares of common stock that were valued at approximately $8.4
million, and assuming employee stock options with an intrinsic value of
approximately $0.9 million. As of the date of the acquisition, CCB had
approximately $48 million in loans, $59 million in deposits and $70 million in
total assets. In connection with the acquisition of CCB, the Company recorded
total intangible assets of $11.2 million, of which $771,000 was determined to be
the value of the core deposit base and is being amortized on an accelerated
basis over ten years, and $10.4 million was determined to be goodwill and thus
will not be systematically amortized, but rather will be subject to an annual
impairment test.
(c) On October 24, 2003, the Company completed the acquisition of four
branches of RBC Centura Bank located in Fairmont, Harmony, Kenansville, and
Wallace, all in North Carolina. As of the date of the acquisition, the branches
had a total of approximately $102 million in deposits and $25 million in loans.
The primary reason for the acquisition was to expand into new markets and
increase the Company's customer base. Subject to certain limitations, the
Company paid a deposit premium of 14.1% for the branches, which resulted in the
Company recording intangible assets relating to this purchase of $14.2 million.
The identifiable intangible asset associated with the fair value of the core
deposit base, as determined by an independent consulting firm, was valued at
approximately $1.3 million and is being amortized as expense on an accelerated
basis over a ten year period. The remaining intangible asset of $12.9 million
has been classified as goodwill, and thus will not be systematically amortized,
but rather will be subject to an annual impairment test.
15
The following table contains a condensed balance sheet that indicates the
amount assigned to each major asset and liability as of the respective
acquisition dates for the 2003 acquisitions described above.
Uwharrie Carolina RBC
Insurance Community Centura
Assets acquired Group Bank Branches Total
--------------------------------- --------- --------- -------- -----
(in millions)
Cash $ -- 7.0 62.4 69.4
Securities -- 13.1 -- 13.1
Loans, gross -- 47.7 24.8 72.5
Allowance for loan losses -- (0.8) (0.3) (1.1)
Premises and equipment -- 0.8 1.0 1.8
Other -- 1.5 0.2 1.7
----- ---- ---- ----
Total assets acquired -- 69.3 88.1 157.4
----- ---- ---- ----
Liabilities assumed
Deposits -- 58.9 102.0 160.9
Borrowings -- 2.1 -- 2.1
Other -- 0.6 0.3 0.9
----- ---- ---- ----
Total liabilities assumed -- 61.6 102.3 163.9
----- ---- ---- ----
Value of cash paid and/or stock
issued to stock-holders of
acquiree 0.5 18.9 n/a 19.4
----- ---- ---- ----
Intangible assets recorded $ 0.5 11.2 14.2 25.9
===== ==== ==== ====
The Company completed one acquisition in 2002 as follows:
(a) Broadway branch purchase - On October 4, 2002, the Company completed
the purchase of a branch of RBC Centura located in Broadway, North Carolina. The
Company assumed the branch's $8 million in deposits and $3 million in loans. The
primary reason for this acquisition was to increase the Company's presence in
Lee County, a market where the Company already had two branches with a large
customer base. An intangible asset of $0.7 million, all of which was allocated
to goodwill, was recorded in connection with this acquisition.
The Company's acquisitions completed during 2001 were as follows:
(a) Salisbury branch purchase - On December 17, 2001, the Company
completed the purchase of a branch of First Union National Bank located in
Salisbury, North Carolina. The Company assumed the branch's $30 million in
deposits and $9 million in loans. The primary reason for this acquisition was to
increase the Company's presence in Salisbury, a market that the Company entered
in 2000 with the opening of a de novo branch. An intangible asset of $3.2
million was recorded in connection with this acquisition, all of which is
classified as nonamortized goodwill by the Company.
(b) Insurance agency acquisitions - On May 30, 2001, the Company completed
the purchase of two insurance agencies - Aberdeen Insurance & Realty Company and
Hobbs Insurance and Realty Company. Both agencies were located in Moore County
and specialized in placing property and casualty insurance coverage for
individuals and businesses in the Moore County area. The primary reason for this
acquisition was to give the Company the platform to offer property and casualty
insurance to its entire customer base. In completing the acquisition, the
agencies were merged into First Bank Insurance Services, Inc. Approximately
16,000 shares of Company stock were issued in connection with the acquisition of
the two agencies. An intangible asset of $243,000 was recorded in connection
with the acquisition, which is being amortized on a straight-line basis over ten
years.
(c) Century Bancorp, Inc. - On May 17, 2001, the Company completed the
purchase of Century Bancorp, Inc. ("Century"). Century was the holding Company
for Home Savings, Inc., SSB, a one branch savings institution
16
located in Thomasville, NC. Century had total assets of $107 million, total
loans of $90 million, and total deposits of $72 million. The primary reason for
the acquisition was to expand into a contiguous market. In accordance with the
terms of the merger agreement, the Company issued approximately 586,000 shares
of common stock and paid cash of approximately $13.2 million to Century
shareholders in exchange for all shares of Century outstanding. An intangible
asset of $3.2 million was recorded in connection with this acquisition, all of
which is classified as nonamortized goodwill by the Company
(d) Robeson and Scotland counties branch purchase - On March 26, 2001, the
Company completed the purchase of four branches from First Union National Bank
with aggregate deposits of approximately $103 million and aggregate loans of
approximately $17 million. The four branches acquired were in Lumberton,
Pembroke, St. Pauls (all located in Robeson County, NC), and Laurinburg
(Scotland County, NC). The primary reason for the acquisition was to leverage
the Company's capital by expanding into three contiguous markets (Lumberton,
Pembroke and St. Pauls) and increase market share in one market (Laurinburg).
Total intangible assets of $14.6 million were recorded in connection with the
purchase, all of which is classified as nonamortized goodwill by the Company
As discussed above, each of the above transactions was accounted for using
the purchase method of accounting. The following table presents a summary of the
fair market value of assets acquired and liabilities assumed in the purchases
described above:
Salisbury Insurance Robeson and Scotland
Assets acquired branch agencies Century counties branches Total
------------------------------ --------- --------- ------- --------------------- -------
(in millions)
Cash $17.7 -- 5.9 70.2 93.8
Securities -- -- 9.0 -- 9.0
Loans, gross 9.3 -- 90.2 16.7 116.2
Allowance for loan losses (0.2) -- (0.6) (0.3) (1.1)
Premises and equipment 0.5 0.1 0.6 1.9 3.1
Other -- -- 1.4 -- 1.4
----- ----- ------ ------ -------
Total assets acquired 27.3 0.1 106.5 88.5 222.4
----- ----- ------ ------ -------
Liabilities assumed
Deposits 30.3 -- 71.7 102.6 204.6
Borrowings -- -- 13.5 -- 13.5
Other 0.2 -- 2.5 0.5 3.2
----- ----- ------ ------ -------
Total liabilities assumed 30.5 -- 87.7 103.1 221.3
----- ----- ------ ------ -------
Value of cash paid and/or stock
issued to stock-holders of
acquiree n/a 0.3 22.0 n/a 22.3
----- ----- ------ ------ -------
Intangible assets recorded $ 3.2 0.2 3.2 14.6 21.2
===== ===== ====== ====== =======
There are many factors that the Company considers when evaluating how much
to offer for potential acquisition candidates - in the form of a purchase price
comprised of cash and/or stock for a whole company purchase or a deposit premium
in a branch purchase. Most significantly, the Company compares expectations of
future earnings per share on a stand-alone basis with projected future earnings
per share assuming completion of the acquisition under various pricing
scenarios. Significant assumptions that affect this analysis include the
estimated future earnings stream of the acquisition candidate, the amount of
cost efficiencies that can be realized, and the interest rate earned/lost on the
cash received/paid. In addition to the earnings per share comparison, the
Company also considers other factors including (but not limited to): marketplace
acquisition statistics, location of the candidate in relation to the Company's
expansion strategy, market growth potential, management of the candidate,
potential integration issues (including corporate culture), and the size of the
acquisition candidate.
ANALYSIS OF RESULTS OF OPERATIONS
Net interest income, the "spread" between earnings on interest-earning
assets and the interest paid on
17
interest-bearing liabilities, constitutes the largest source of the Company's
earnings. Other factors that significantly affect operating results are the
provision for loan losses, noninterest income such as service fees and
noninterest expenses such as salaries, occupancy expense, equipment expense and
other overhead costs, as well as the effects of income taxes.
Overview - 2003 Compared to 2002
Net income for the year ended December 31, 2003 amounted to $19,417,000,
or $2.03 per diluted share, a 12.7% increase in net income and a 9.7% increase
in diluted earnings per share over the net income of $17,230,000, or $1.85 per
diluted share, reported for the twelve months ended December 31, 2002.
The increase in net income in 2003 was primarily attributable to an
increase in net interest income. Net interest income for the year ended December
31, 2003 amounted to $55.8 million, an increase of $6.4 million, or 12.9%, over
the $49.4 million recorded in 2002. The increase in net interest income was
caused primarily by growth in the Company's loans and deposits. Average loans
outstanding during 2003 were $1.11 billion, or 16.6% higher than in 2002, while
average deposits outstanding increased by 14.1% in 2003 to $1.15 billion.
The positive impact on net interest income from the increases in loans and
deposits more than offset a slightly lower net interest margin realized in 2003
compared to 2002. The Company's net interest margin (tax-equivalent net interest
income divided by average earning assets) for the year ended December 31, 2003
was 4.52% compared to the 4.58% net interest margin realized for 2002. The
slight decrease in net interest margin was caused primarily by the negative
impact of the interest rate cuts initiated by the Federal Reserve in the fourth
quarter of 2002 and the second quarter of 2003. The acquisition of the four RBC
Centura Bank branches in October 2003 also negatively impacted the Company's net
interest margin as a result of the high mix of cash assumed in the acquisition.
Partially offsetting the increases in net interest income realized in 2003
was a higher provision for loan losses recorded by the Company. The provision
for loan losses for 2003 was $2,680,000 compared to $2,545,000 in 2002. The
higher provision for loan losses was due to high loan growth realized by the
Company in 2003 and not because of credit quality concerns. Internally generated
net loan growth in 2003 totaled $148 million compared to $105 million in 2002.
Most components of noninterest income and noninterest expense also
increased in 2003 as a result of the Company's overall growth. Noninterest
income for 2003 was also positively impacted by 1) high refinancing activity
driven by the low interest rate environment that increased the amount of fees
from presold mortgages, 2) the acquisition of Uwharrie Insurance Group, which
increased commissions from financial product sales, and 3) securities gains.
The Company's income taxes increased 14.4% from $9,282,000 in 2002 to
$10,617,000 in 2003. The increase in income tax expense was a result of higher
income before income taxes. The effective income tax rate for both years was
approximately 35%.
Overview - 2002 Compared to 2001
Net income for the year ended December 31, 2002 amounted to $17,230,000,
or $1.85 per diluted share, a 25.9% increase in diluted earnings per share over
the $1.47 per diluted share for the year ended December 31, 2001. In accordance
with the adoption of two new accounting standards, the Company discontinued the
amortization of most of its intangible assets in 2002. If the newly adopted
accounting standards related to intangible assets had been applicable in 2001,
the Company would have recorded additional net income of $1,160,000, or
approximately $0.12 per diluted share, for the twelve months ended December 31,
2001.
The most significant factor in the Company's increase in net income from
2001 to 2002 was an $8.3 million,
18
or 20.3%, increase in net interest income. The increase in net interest income
was a result of a higher level of average earning assets and a higher net
interest margin. Average earning assets increased 10.9% in 2002, while the
Company's net interest margin (tax-equivalent net interest income divided by
average earning assets) increased from 4.23% in 2001 to 4.58% in 2002.
Partially offsetting the increase in net interest income was a higher
provision for loan losses. Although asset quality ratios generally improved in
2002, the Company's provision for loan losses more than doubled due to high loan
growth, amounting to $2,545,000 in 2002 compared to $1,151,000 in 2001. In 2002,
the Company experienced $105 million in internal loan growth compared to $28
million in 2001.
Noninterest income increased 24.0% and noninterest expense increased 12.8%
in 2002 compared to 2001, primarily as a result of the Company's growth,
including a full year's impact of the acquisitions completed in 2001.
Noninterest income was also positively affected in 2002 by increased mortgage
loan refinancing activity that increased mortgage origination fees, as well as
the offering of a check overdraft product beginning in August 2001 that
increased fees earned on deposit accounts for a full 12 months in 2002.
The increase in noninterest expenses was partially offset by the near
elimination of amortization expense related to intangible assets. As noted
above, in 2002 the Company adopted two new accounting standards that required
the Company to cease amortization of virtually all of its intangible assets.
Excluding amortization expense in 2001 related to intangible assets that ceased
to be amortized in 2002, the Company's noninterest expenses increased 19.1% in
2002.
The Company's income taxes increased 27.0% from $7,307,000 in 2001 to
$9,282,000 in 2002. The increase in income tax expense was a result of higher
income before income taxes. The effective income tax rate for both years was
approximately 35%.
Net Interest Income
Net interest income on a reported basis amounted to $55,760,000 in 2003,
$49,390,000 in 2002, and $41,053,000 in 2001. For internal purposes and in the
discussion that follows, the Company evaluates its net interest income on a
tax-equivalent basis by adding the tax benefit realized from tax-exempt
securities to reported interest income. Net interest income on a
taxable-equivalent basis amounted to $56,278,000 in 2003, $49,925,000 in 2002,
and $41,645,000 in 2001.
Table 2 analyzes net interest income on a taxable-equivalent basis. The
Company's net interest income on a taxable-equivalent basis increased by 12.7%
in 2003 and 19.9% in 2002. There are two primary factors that cause changes in
the amount of net interest income recorded by the Company - 1) growth in loans
and deposits, and 2) the Company's net interest margin (tax-equivalent net
interest income divided by average interest-earning assets).
As illustrated in Table 3, in both 2003 and 2002, net interest
income was positively impacted by higher amounts of average loans and deposits
outstanding. In 2003, the average amount of loans outstanding increased 16.6%
and the average amount of deposits outstanding increased 14.1%. In 2002, the
average amount of loans outstanding grew by 14.8%, while the average amount of
deposits increased by 12.3%. The higher amounts of loans and deposits
outstanding in 2002 and 2003 were a result of both internal growth, as well as
growth achieved in corporate acquisitions. In 2003, most of the loan growth was
generated internally while most of the deposit growth was assumed in
acquisitions. The Company internally generated $148 million in net loan growth
in 2003, while $73 million was assumed in acquisitions. Internally generated
deposit growth in 2003 amounted to $33 million, while the Company assumed $161
million in deposits through acquisitions during the year. In 2002, the increase
in the average amount of loans and deposits outstanding was partially a result
of a full year's effect of high 2001 growth as well as growth realized in 2002,
most all of which was internally generated. In 2002, loans grew by $108 million,
with all but $3 million of the growth internally generated, while deposits grew
by $56 million, with all but $8 million internally generated.
19
In 2003, the positive impact on net interest income from the increases in
loans and deposits more than offset slightly lower net interest margins realized
in 2003 compared to 2002, while in 2002 a higher net interest margin enhanced
net interest income. The Company's net interest margin (tax-equivalent net
interest income divided by average earning assets) was 4.52% in 2003 compared to
4.58% in 2002 and 4.23% in 2001. The variations in net interest margin over the
past two years have largely been a result of the Federal Reserve's interest rate
policies during that time, as discussed below.
In 2001, the Company's interest rate spreads were negatively impacted by
the Federal Reserve Board cutting interest rates 11 times totaling 475 basis
points, which resulted in a decrease in the Company's net interest margin to
4.23% (from 4.53% in 2000). Although at January 1, 2001 the Company has had more
interest-sensitive liabilities than interest-sensitive assets subject to
repricing within twelve months, the Company's interest-sensitive assets repriced
sooner (generally the day following the interest rate cut) and by a larger
percentage (generally by the same number of basis points that the Federal
Reserve discount rate was decreased) than did the Company's interest-sensitive
liabilities that were subject to repricing. The Company's primary
interest-sensitive assets are its interest-bearing cash, maturing investments,
and adjustable rate loans (which are typically 45%-55% of the Company's total
loan portfolio), while its primary interest-sensitive liabilities consist of the
following 1) savings, NOW, and money market deposits, and 2) time deposits.
Interest rates paid on savings, NOW and money market deposits are set by
management of the Company, and although the interest rates on these accounts
were decreased by the Company within days of each of the Federal Reserve rate
cuts that have occurred in recent years, it has not been possible to reduce the
interest rates by the full amount of the Federal Reserve cuts due to competitive
considerations and the already relatively low rates paid on these types of
accounts. Interest rates paid on time deposits are generally fixed and not
subject to automatic adjustment. When time deposits mature, the Company has the
opportunity, at the customers' discretion, to renew the time deposit at a rate
set by the Company. Because time deposits that are interest-sensitive in a
twelve month horizon mature throughout the twelve month period, any change in
the renewal rate will affect only a portion of the twelve month period. Also,
although changes in interest rates on renewing time deposits generally track
rate changes in the interest rate environment, the Company has not been able in
recent years to decrease rates on renewing time deposits by the corresponding
decreases in the Federal Reserve discount rate because of competitive pressures
in the Company's market.
In 2002, there were no changes to interest rates initiated by the Federal
Reserve for the first ten months of the year. This allowed a significant portion
of the Company's time deposit portfolio that had been originated when rates were
higher to mature and reprice at lower rates - as noted above, much of the
Company's interest-sensitive assets had repriced immediately in 2001 when the
rate cuts were made and did not experience further declines. Largely due to
these factors, the Company's net interest margin increased in each of the first
three quarters of 2002, peaking at 4.78% in the third quarter of 2002. The 50
basis point rate cut announced by the Federal Reserve on November 6, 2002
negatively impacted the Company's net interest margin in the fourth quarter of
2002 and into 2003 in much the same way as the 2001 rate cuts did. The Company's
fourth quarter of 2002 net interest margin decreased to 4.53% from the 4.78%
margin realized in the third quarter of 2002.
In 2003, although the Company's deposits continued to reprice downward,
the 50 basis rate cut in November 2002 and the subsequent June 27, 2003 rate cut
of 25 basis points had a more pronounced and a longer lasting negative impact on
the Company's net interest margin than previous rate cuts because of the
inability of the Company to reset deposit rates by an amount (because of their
already near-zero rates) that would offset the negative impact of the rate cut
on the yields earned on the Company's interest earning assets. Despite the
relatively stable interest rate environment in 2003, with just the one rate cut
in June, this factor was largely responsible for preventing a rebound in net
interest margin similar to that realized in 2002. For the first three quarters
of 2003, the Company's net interest margin was within six basis points of the
4.53% margin realized in the fourth quarter of 2002.
The Company's net interest margin of 4.44% in the fourth quarter of 2003
was negatively impacted by the
20
acquisition of four RBC Centura Bank branches in October 2003 as a result of the
high mix of cash assumed in the acquisition. In connection with this
acquisition, the Company received approximately $62 million in cash that was not
able to immediately be deployed into a mix of assets with higher yields
consistent with the Company's typical mix.
Another negative factor on the Company's net interest margin over the past
two years, which has had a heightened impact from the declining interest rate
environment, has been a significant change in the Company's loan mix from fixed
rate loans to adjustable rate loans. Since December 31, 2001, the Company has
experienced a shift in its loan portfolio from having 57% fixed rate loans and
43% adjustable rate loans to a mix of 57% adjustable rate and 43% fixed rate.
The primary reason for this shift has been that with interest rates at a
historically low level, the Company has more attractively priced adjustable rate
loans in order to avoid locking in fixed rate loans at a time when most
economists believe that rates will rise. Although the Company will benefit from
having a higher percentage of adjustable rate loans upon a rise in rates, the
shift has negatively impacted the Company in the declining rate environment
experienced over the past two years.
Another factor that positively impacted the Company's net interest margin
when comparing 2002 to 2001 was the reinvestment of funds received in the
Company's 2001 acquisitions and the mix of loans and deposits assumed in the
acquisitions. The March 2001 acquisition of four branches from First Union
National Bank resulted in the Company receiving $70.2 million in cash. The
Company was not able to immediately redeploy the cash received into a mix of
higher yielding investments and loans consistent with the Company's historic
asset mix, and therefore the Company's net interest margin was negatively
impacted. In 2002, due to the high loan growth experienced by the Company, a
significant portion of this cash was redeployed into loans with higher interest
rates than the short-term investments in which the cash had been invested.
Additionally, in connection with the acquisition of Century Bancorp in May 2001,
the Company assumed a high mix of residential mortgage loans and time deposits
(which are generally the lowest yielding type of loan and highest rate type of
deposit). This mix of loans and deposits negatively impacted net interest
margins in 2001. In 2002, many of Century's loans were refinanced by the
borrowers and then resold in the secondary market by the Company, with the
resulting funds used to fund the Company's commercial loan growth (which
generally has higher interest rates than residential mortgages). In addition,
many of Century's time deposits also had the opportunity to reprice at lower
rates in 2002, thus positively impacting the net interest margin.
See additional information regarding net interest income in the section
entitled "Interest Rate Risk."
Provision for Loan Losses
The provision for loan losses charged to operations is an amount
sufficient to bring the allowance for loan losses to an estimated balance
considered appropriate to absorb probable losses inherent in the portfolio.
Management's determination of the adequacy of the allowance is based on the
level of loan growth, an evaluation of the portfolio, current economic
conditions, historical loan loss experience and other risk factors.
The Company recorded provisions for loan losses of $2,680,000 in 2003
compared to $2,545,000 in 2002 and $1,151,000 in 2001.
The increase in the provisions for loan losses in each of the past two
years has been primarily related to increases in the Company's net internal loan
growth, as asset quality ratios have remained fairly stable. Net internal loan
growth in 2003 was $147.8 million compared to $105.2 million in 2002 and $28.1
million in 2001. The remaining loan growth of $72.5 million in 2003, $3.1
million in 2002, and $116.2 million in 2001 came by way of acquisitions with a
preexisting allocation for loan losses already in place. A specific reserve of
$250,000 that was established in 2002 related to the Company's largest
nonaccrual loan relationship also impacted the Company's 2002 provision for loan
losses.
See the section entitled "Allowance for Loan Losses and Loan Loss
Experience" below for a more detailed
21
discussion of the allowance for loan losses. The allowance is monitored and
analyzed regularly in conjunction with the Company's loan analysis and grading
program, and adjustments are made to maintain an adequate allowance for loan
losses.
Noninterest Income
Noninterest income recorded by the Company amounted to $14,918,000 in
2003, $11,968,000 in 2002, and $9,655,000 in 2001.
As shown in Table 4, core noninterest income, which excludes gains and
losses from sales of securities, loans, and other assets, amounted to
$14,612,000 in 2003, a 22.3% increase from the $11,946,000 in 2002. The 2002
core noninterest income of $11,946,000 was 25.7% higher than the $9,506,000
recorded in 2001.
See Table 4 and the following discussion for an understanding of the
components of noninterest income.
Service charges on deposit accounts in 2003 amounted to $7,938,000, a
15.8% increase compared to the $6,856,000 recorded in 2002. The 2002 amount of
$6,856,000 was 30.2% higher than the 2001 amount of $5,265,000. The primary
factors that have increased the amount of service charges on deposits have been
1) periodic rate increases, 2) service charges earned from internally generated
deposit growth, and 3) services charges earned from acquired deposits. Deposit
service charge rates are generally increased 2%-4% per year, while internal
growth among deposit transaction accounts was 4.2% in 2003 and 10.1% in 2002.
The acquisition of CCB on January 15, 2003 contributed approximately $650,000 in
deposit service charges during 2003, while the acquisition of the four RBC
Centura branches on October 24, 2003 contributed approximately $125,000 in
deposit service charges in 2003 - the $775,000 in deposit service charges from
these two acquisitions accounted for approximately 11.3% of the 15.8% increase
in service charges on deposit accounts in 2003. The increase in service charges
on deposit accounts from 2001 to 2002 was also impacted by the acquisition of
five First Union branches during 2001 and the introduction of a product in
August 2001 that charges a fee for allowing customers to overdraw their deposit
account. Realizing a full twelve months of income in 2002 from the 2001 branch
acquisitions impacted deposit service charge income by approximately $550,000,
while having the overdraft product for a full twelve months increased deposit
service charges realized in 2002 by approximately $875,000 over 2001.
Other service charges, commissions and fees amounted to $2,710,000 in
2003, a 16.0% increase from the $2,336,000 earned in 2002. The 2002 amount of
$2,336,000 was 14.2% higher than the $2,046,000 recorded in 2001. This category
of noninterest income includes items such as safety deposit box rentals, fees
from sales of personalized checks, check cashing fees, credit card and merchant
income, debit card income, and ATM charges. This category of income grew
primarily because of increases in these activity-related fee services as a
result of overall growth in the Company's total customer base, including growth
achieved from corporate acquisitions.
Fees from presold mortgages amounted to $2,327,000 in 2003, a 35.8%
increase from the 2002 amount of $1,713,000. The 2002 amount was a 36.1%
increase from the $1,259,000 recorded in 2001. The increases in the past two
years have been primarily attributable to a higher level of mortgage loan
refinancings caused by the progressively lower interest rate environment. In the
last 3-4 months of 2003 and continuing into 2004, a rise in mortgage interest
rates has significantly slowed mortgage refinancing activity and thus negatively
impacted the amount of these fees realized by the Company.
Commissions from sales of insurance and financial products amounted to
$1,304,000 in 2003, $738,000 in 2002, and $731,000 in 2001. This line item
includes commissions the Company receives from three sources - 1) sales of
credit insurance associated with new loans, 2) commissions from the sales of
investment, annuity, and long-term care insurance products, and 3) commissions
from the sale of property and casualty insurance. The following table presents
the contribution of each of the three sources to the total amount recognized in
this line item:
22
($ in thousands) 2003 2002 2001
------ ---- ----
Commissions earned from:
Sales of credit insurance $ 300 326 389
Sales of investments, annuities, and long
term care insurance 299 210 227
Sales of property and casualty insurance 705 202 115
------ --- ---
Total $1,304 738 731
====== === ===
The variance in the commissions from sales of credit insurance has been
primarily due to fluctuations in the annual profit sharing bonus that the
Company received from the insurance carriers for which the Company acts as a
broker. The increase in commissions from sales of investments, annuities, and
long term care insurance is primarily due to the hiring of additional staff in
this area during 2003. As it relates to commissions earned from the sale of
property and casualty insurance, the Company began realizing these commissions
upon the May 2001 completion of the purchase of two insurance companies that
specialize in such insurance. The increase in these commissions from 2001 to
2002 was the result of realizing a full year of commissions, whereas the
increase in 2003 was a result of the acquisition of Uwharrie Insurance Group,
which was completed on January 2, 2003. See the section above entitled "Merger
and Acquisition Activity" for additional discussion.
Data processing fees amounted to $333,000 in 2003, $303,000 in 2002, and
$205,000 in 2001. As noted earlier, Montgomery Data makes its excess data
processing capabilities available to area financial institutions for a fee.
These fees have increased as a result of an increase in data processing clients
from two clients to four clients in the past three years, as well as an increase
in the size and number of transactions generated by those clients.
Noninterest income not considered to be "core" amounted to net gains of
$306,000 in 2003, $22,000 in 2002, and $149,000 in 2001. The 2003 net gain of
$306,000 primarily related to securities gains of $218,000 and an $82,000 gain
from a sale of vacant land located beside one of the Company's existing
branches. The $218,000 in securities gains related to sales initiated in the
third and fourth quarters of 2003. In the third quarter of 2003, the Company
sold a corporate bond at a gain of $82,000 in order to realize current income,
as well as to lock-in a gain on the security, which had an approaching call
date. In the fourth quarter of 2003, the Company sold a pool of mortgage-backed
securities at a total gain of $136,000 in order to realize current income, as
well as to dispose of the securities before their low, amortizing, principal
balance significantly affected their liquidity - the securities sold had an
average principal balance of $400,000 and were paying down by approximately
$25,000 per month. The 2002 net gain of $22,000 primarily related to
miscellaneous securities gains of $25,000. The 2001 net gain of $149,000
primarily related to a $79,000 gain from the sale of two buildings that the
Company previously operated as branches that were consolidated with other
branches in the same towns, and securities that were sold at a $61,000 gain.
Noninterest Expenses
Noninterest expenses for 2003 were $37,964,000, compared to $32,301,000 in
2002 and $28,634,000 in 2001. Table 5 presents the components of the Company's
noninterest expense during the past three years.
Based on the recorded amounts noted above, noninterest expenses increased
17.5% in 2003 and 12.8% in 2002. The growth rate from 2001 to 2002 was impacted
by a change in accounting for intangible assets, which served to reduce the year
to year increase. As of January 1, 2002 the Company ceased to record
amortization expense related to its goodwill, which eliminated almost all of the
Company's amortization expense. Adjusting the reported amount in 2001 to exclude
amortization expense related to intangible assets that ceased to be amortized
beginning on January 1, 2002, the increase in noninterest expenses from 2001 to
2002 was 19.1%.
The increases in noninterest expenses over the past two years have
occurred in nearly every line item of
23
expense and have been primarily as a result of the significant growth
experienced by the Company, both internally and by acquisition. Over the past
two years, the number of the Company's branches has increased from 45 to 57, and
the number of full time/part time employees has increased from 358/69 at
December 31, 2001 to 505/89 at December 31, 2003. Additionally, from December
31, 2001 to December 31, 2003, the amount of loans outstanding increased 37% and
deposits increased 25%.
Income Taxes
The provision for income taxes was $10,617,000 in 2003, $9,282,000 in
2002, and $7,307,000 in 2001.
The increase in income tax expense over the past two years has been
directly correlated with the increase in the Company's income before income
taxes, as the effective tax rate for each of the years ended December 31, 2003,
2002 and 2001 was approximately 35%.
Table 6 presents the components of tax expense and the related effective
tax rates.
ANALYSIS OF FINANCIAL CONDITION AND CHANGES IN FINANCIAL CONDITION
Overview
Over the past two years the Company has achieved high increases in its
levels of loans and deposits through a combination of internal growth and growth
from acquisitions. The following table presents information regarding the nature
of the Company's growth in 2003 and 2002:
Percentage
Balance at Balance at Total growth,
(in thousands) beginning of Internal Growth from end of percentage excluding
period growth acquisitions period growth acquisitions
------------ -------- ------------ ---------- ------- ------------
2003
Loans $ 998,547 147,821 72,527 1,218,895 22.1% 14.8%
========== ======== ======== ========== ======= =======
Deposits - Noninterest bearing 112,380 (3,714) 37,833 146,499 30.4% -3.3%
Deposits - Savings, NOW, and Money
Market 387,691 24,583 50,602 462,876 19.4% 6.3%
Deposits - Time>$100,000 199,794 21,525 17,216 238,535 19.4% 10.8%
Deposits - Time<$100,000 356,092 (9,814) 55,176 401,454 12.7% -2.8%
---------- -------- -------- ---------- ------- -------
Total deposits $1,055,957 32,580 160,827 1,249,364 18.3% 3.1%
========== ======== ======== ========== ======= =======
2002
Loans $ 890,310 105,154 3,083 998,547 12.2% 11.8%
========== ======== ======== ========== ======= =======
Deposits - Noninterest bearing 96,065 14,665 1,650 112,380 17.0% 15.3%
Deposits - Savings, NOW, and Money
Market 353,439 30,930 3,322 387,691 9.7% 8.8%
Deposits - Time>$100,000 189,948 9,846 -- 199,794 5.2% 5.2%
Deposits - Time<$100,000 360,829 (8,206) 3,469 356,092 -1.3% -2.3%
---------- -------- -------- ---------- ------- -------
Total deposits $1,000,281 47,235 8,441 1,055,957 5.6% 4.7%
========== ======== ======== ========== ======= =======
As can be seen in the table above, the Company experienced high increases
in loans in each of the years 2003 and 2002 with total growth of 22.1% and
12.2%, respectively. Internal loan growth was strong both years, amounting to
14.8% in 2003 and 11.8% in 2002. Loans assumed in acquisitions boosted the 2003
loan growth rate from 14.8% to 22.1%, while acquired loan growth in 2002 was
insignificant.
Deposits increased 18.3% in 2003 and 5.6% in 2002. Internally generated
deposit growth was modest in both
24
years, amounting to 3.1% in 2003 and 4.7% in 2002. Deposits assumed in the CCB
acquisition and the purchase of the four RBC Centura branches totaling $161
million boosted total deposit growth from 3.1% to 18.3%, while acquired deposits
in 2002 (branch acquisition in Broadway, NC) added $8.4 million in deposits,
increasing the total deposit growth from 4.7% to 5.6%.
The Company believes the significantly higher internal growth rates for
loans compared to deposits over the past two years is largely attributable to
the type of customers the Company has been able to attract. Most of the
Company's loan growth has come from small-business customers that need loans in
order to expand their business, and have few deposits. Additionally, the Company
has found it difficult to compete for retail deposits in recent years. The
Company frequently competes against banks in the marketplace that either 1) are
so large that they enjoy better economies of scale over the Company and can thus
offer higher rates, or 2) are recently started banks that are focused on
building market share, and not necessarily positive earnings, by offering high
deposit rates. The Company enjoys advantages in the loan marketplace by having
seasoned lenders in place that have the experience necessary to oversee the
completion of a loan and the autonomy to be able to make timely decisions.
With loan growth exceeding deposit growth over each of the past two years,
the Company's liquidity has been reduced. In 2001, the Company's liquidity had
improved significantly as a result of receiving $81 million in net cash in
connection with acquisitions. These funds served as the primary source of
funding needs in 2002. In 2003, although the Company's acquired deposits
exceeded its acquired loans by $88 million, internal loan growth exceeded
internal deposit growth by $115 million, which resulted in a reduction in the
Company's liquidity. The Company increased its borrowings from $30 million to
$76 million in 2003 in order to fund the excess loan growth.
The Company's significant acquisition activity over the past three years
has required the Company to raise capital in order to maintain its
"well-capitalized" capital ratio status. Accordingly, the Company raised capital
in each of the fourth quarters of 2002 and 2003 by issuing $20 million each year
(for a total of $40 million) in trust preferred debt securities, which qualify
as regulatory capital for the Company. All of the Company's capital ratios have
significantly exceeded the minimum regulatory thresholds for all periods covered
by this report.
Although the Company's market area, the central Piedmont region of North
Carolina, has experienced recessionary times over the past several years
consistent with the national economy, the Company's asset quality ratios have
remained fairly stable over the past three years with net-charges offs to
average loans ranging from 9 basis points to 11 basis points and nonperforming
assets to total assets ranging from 36 basis points to 45 basis points.
The Company does not participate in large syndicated credits that have
resulted in large credit losses at several other North Carolina-based banks.
Distribution of Assets and Liabilities
Table 7 sets forth the percentage relationships of significant components
of the Company's balance sheets at December 31, 2003, 2002, and 2001.
The most significant variance in the percentages over the past two years
has been the increase in the percentage of loans to total assets, which
increased from 77% at December 31, 2001 to 82% at December 31, 2003, and the
declining percentage of deposits to total assets which declined from 88% to 84%
over that same two year period. These changes are a result of the high loan
growth and lower deposit growth experienced over that same time period that was
discussed in the section above. On the asset side, the increasing loan
percentage has been offset by a lower amount of securities and short term
investments held by the company, while on the liability side, an increase in
borrowings has offset the lower deposit percentage. Although a higher reliance
on borrowings negatively impacts the Company's net interest margin because of
their higher cost compared to deposits, the Company has used the proceeds from
the borrowings to fund loans, which carry a higher interest
25
rate than the borrowings, and thus the net effect is a positive impact on net
interest income.
Securities
Information regarding the Company's securities portfolio as of December
31, 2003, 2002, and 2001 is presented in Tables 8 and 9.
The composition of the investment securities portfolio reflects the
Company's investment strategy of maintaining an appropriate level of liquidity
while providing a relatively stable source of income. The investment portfolio
also provides a balance to interest rate risk and credit risk in other
categories of the balance sheet while providing a vehicle for the investment of
available funds, furnishing liquidity, and supplying securities to pledge as
required collateral for certain deposits.
Total securities available for sale and held to maturity amounted to
$117.7 million, $80.8 million, and $112.8 million at December 31, 2003, 2002,
and 2001, respectively. The increase in securities available for sale from
December 31, 2002 to December 31, 2003 was primarily attributable to security
purchases with funds obtained from the October 2003 RBC Centura branch purchase.
The decrease in securities from December 31, 2001 to December 31, 2002 was
primarily attributable to called and maturing bonds, as well as a high level of
principal repayments on mortgage-backed securities due to the low interest rate
environment. Instead of reinvesting the maturities/paydowns back into
securities, the proceeds were used to fund the high loan growth experienced.
The mix of the types of the Company's securities was similar at December
31, 2003 as it was two years earlier. In the intervening year of 2002, the mix
of securities changed due to the above noted variances in the receipt of
maturities/paydowns of the various categories of investments, as the Company
purchased very few securities as a result of the proceeds of the
maturities/paydowns being used to fund loan growth. Upon the Company's purchase
of the four branches of RBC Centura on October 24, 2003, the Company received
approximately $62 million cash, a significant portion of which was invested in
securities. The Company purchased primarily U.S. Government agency securities
with these funds in order to assure a portfolio mix consistent with the
Company's investment policy, which limits the amount of mortgage-backed
securities and corporate bonds in which the Company can invest.
The majority of the Company's U.S. Government agency debt securities are
issued by the Federal Home Loan Bank and carry one maturity date, often with an
issuer call feature, while the mortgage-backed securities have been primarily
issued by Freddie Mac and Fannie Mae and vary in their repayment in correlation
with the underlying pools of home mortgage loans. The Company's investment in
corporate bonds is primarily comprised of trust preferred securities issued by
other North Carolina bank holding companies.
Included in mortgage-backed securities at December 31, 2003 were
collateralized mortgage obligations (CMOs) with an amortized cost of $21,648,000
and a fair value of $21,458,000. Included in mortgage-backed securities at
December 31, 2002 were CMOs with an amortized cost of $12,590,000 and a fair
value of $12,720,000. Included in mortgage-backed securities at December 31,
2001 were CMOs with an amortized cost of $21,703,000 and a fair value of
$21,866,000. The CMOs that the Company has invested in are substantially all
"early tranche" pieces of the CMO, which minimizes long-term interest rate risk
to the Company.
At December 31, 2003, net unrealized gains of $1,868,000 were included in
the carrying value of securities classified as available for sale, compared to a
net unrealized gain of $1,399,000 at December 31, 2002 and a net unrealized gain
of $1,024,000 at December 31, 2001. The increase in the unrealized gain position
at each of the past two year ends are a result of the progressively lower
interest rate environment in effect at each period end. Management evaluated any
unrealized losses on individual securities at each year end and determined them
to be of a temporary nature and caused by fluctuations in market interest rates,
not by concerns about the ability of the issuers to meet their obligations. Net
unrealized gains, net of applicable deferred income taxes, of $1,140,000,
$853,000, and $677,000 have been reported as part of a separate component of
shareholders' equity (accumulated other comprehensive income) as of December 31,
2003, 2002, and 2001, respectively.
26
The fair value of securities held to maturity, which the Company carries
at amortized cost, was more than the carrying value at December 31, 2003 and
2002 by $700,000 and $767,000, respectively. Management evaluated any unrealized
losses on individual securities at each year end and determined them to be of a
temporary nature and caused by fluctuations in market interest rates, not by
concerns about the ability of the issuers to meet their obligations.
Table 9 provides detail as to scheduled contractual maturities and book
yields on securities available for sale and securities held to maturity at
December 31, 2003. Mortgage-backed and other amortizing securities are shown
maturing in the time periods consistent with their estimated lives based on
expected prepayment speeds.
The weighted average taxable-equivalent yield for the securities available
for sale portfolio was 4.85% at December 31, 2003. The expected weighted average
life of the available for sale portfolio using the call date for above-market
callable bonds, the maturity date for all other non-mortgage-backed securities,
and the expected life for mortgage-backed securities, was 5.0 years.
The weighted average taxable-equivalent yield for the securities held to
maturity portfolio was 6.19% at December 31, 2003. The expected weighted average
life of the held to maturity portfolio using the call date for above-market
callable bonds and the maturity date for all other securities, was 2.5 years.
As of December 31, 2003 and 2002, the Company held no investment
securities of any one issuer, other than U.S. Treasury and U.S. Government
agencies or corporations, in which aggregate book values and market values
exceeded 10% of shareholders' equity.
Loans
Table 10 provides a summary of the loan portfolio composition at each of
the past five year ends.
The loan portfolio is the largest category of the Company's earning assets
and is comprised of commercial loans, real estate mortgage loans, real estate
construction loans, and consumer loans. The Company restricts virtually all of
its lending to its 21 county market area, which is located in the central
Piedmont region of North Carolina, and one county each in Virginia and South
Carolina. The diversity of the region's economic base has historically provided
a stable lending environment.
Loans outstanding increased $220.3 million, or 22.1%, to $1.22 billion
during 2003. Approximately $148 million of the 2003 growth was from net internal
loan growth, while $73 million was assumed in acquisitions. Loans outstanding
increased $108.2 million, or 12.2%, to $998.5 million during 2002. Approximately
$105 million of the 2002 growth was from net internal loan growth, while $3
million was assumed in acquisitions. The majority of the 2003 and 2002 loan
growth occurred in loans secured by real estate, with approximately $174.5
million, or 79.2% in 2003, and $99.5 million, or 91.9%, in 2002 of the net loan
growth occurring in real estate mortgage or real estate construction loans.
Over the years, the Company's loan mix has remained fairly consistent,
with real estate loans (mortgage and construction) comprising approximately 85%
of the loan portfolio, commercial, financial, and agricultural loans comprising
10%, and consumer installment loans comprising approximately 5% of the
portfolio.
At December 31, 2003, $1.038 billion, or 85.1%, of the Company's loan
portfolio was secured by liens on real property. Included in this total are
$549.9 million, or 45.1% of total loans, in loans secured by liens on 1-4 family
residential properties and $487.9 million, or 40.0% of total loans, in loans
secured by liens on other types of real estate. At December 31, 2002, $863.3
billion, or 86.4%, of the Company's loan portfolio was secured by liens on real
property. Included in this total were $466.5 million, or 46.7% of total loans,
in loans secured by liens on 1-4 family residential properties and $396.8
million, or 39.7% of total loans, in loans secured by liens on
27
other types of real estate. The Company's $1.038 billion in real estate mortgage
loans at December 31, 2003 can be further classified as follows - for comparison
purposes, the classification of the Company's $863.3 million real estate loan
portfolio at December 31, 2002 is shown in parenthesis:
o $361.2 million, or 29.6% of total loans (vs. $305.0 million,
or 30.5% of total loans), are primarily dependent on cash flow
from a commercial business for repayment.
o $360.8 million, or 29.6% of total loans (vs. $306.5 million,
or 30.7% of total loans), are traditional residential mortgage
loans in which the borrower's personal income is the primary
repayment source.
o $98.2 million, or 8.1% of total loans (vs. $68.1 million, or
6.8% of total loans), are real estate construction loans.
o $95.8 million, or 7.9% of total loans (vs. $72.7 million or
7.3% of total loans), are home equity loans.
o $93.3 million, or 7.7% of total loans (vs. $87.3 million, or
8.7% of total loans), are personal consumer installment loans
in which the borrower has provided residential real estate as
collateral.
o $28.5 million, or 2.3% of total loans (vs. $23.7 million or
2.4% of total loans), are primarily dependent on cash flow
from agricultural crop sales.
Table 11 provides a summary of scheduled loan maturities over certain time
periods, with fixed rate loans and adjustable rate loans shown separately.
Approximately 22% of the Company's loans outstanding at December 31, 2003 mature
within one year and 71% of total loans mature within five years. The percentages
of variable rate loans and fixed rate loans as compared to total performing
loans were 57.0% and 43.0%, respectively, as of December 31, 2003. The Company
intentionally makes a blend of fixed and variable rate loans so as to reduce
interest rate risk. As noted in the section above entitled "Net Interest
Income," the Company has experienced a significant shift in its fixed/variable
loan mix over the past two years.
Nonperforming Assets
Nonperforming assets include nonaccrual loans, loans past due 90 or more
days and still accruing interest, restructured loans and other real estate. As a
matter of policy the Company places all loans that are past due 90 or more days
on nonaccrual basis, and thus there were no loans at any of the past five year
ends that were 90 days past due and still accruing interest. Table 12 summarizes
the Company's nonperforming assets at the dates indicated.
Nonaccrual loans are loans on which interest income is no longer being
recognized or accrued because management has determined that the collection of
interest is doubtful