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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, 2004
Commission File Number 0-15572
FIRST BANCORP
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(Exact Name of Registrant as Specified in its Charter)
North Carolina 56-1421916
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(State of Incorporation) (I.R.S. Employer Identification Number)
341 North Main Street, Troy, North Carolina 27371-0508
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (910) 576-6171
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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 or information
statements incorporated by reference in Part III of the Form 10-K or any
amendment to the Form 10-K. |X|
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 closing price of
the Common Stock as of June 30, 2004 as reported on the NASDAQ National Market
System, was approximately $251,936,000. 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
March 11, 2005 was 14,118,859.
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
Begins on
Page (s)
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PART I
Item 1 Business 4
Item 2 Properties 12
Item 3 Legal Proceedings 12
Item 4 Submission of Matters to a Vote of Shareholders 12
PART II
Item 5 Market for the Registrant's Common Stock, Related Shareholder
Matters, and Issuer Purchases of Equity Securities 12
Item 6 Selected Consolidated Financial Data 13,42
Item 7 Management's Discussion and Analysis of Financial Condition
and Results of Operations 14
Critical Accounting Policies 14
Merger and Acquisition Activity 16
Statistical Information
Net Interest Income 20,43
Provision for Loan Losses 21,49
Noninterest Income 22,44
Noninterest Expenses 24,44
Income Taxes 24,45
Stock-Based Compensation 24
Distribution of Assets and Liabilities 26,45
Securities 27,45
Loans 28,47
Nonperforming Assets 29,48
Allowance for Loan Losses and Loan Loss Experience 30,48
Deposits 32,50
Borrowings 33
Liquidity, Commitments, and Contingencies 34,51
Off-Balance Sheet Arrangements and Derivative Financial Instruments 35
Interest Rate Risk (Including Quantitative
and Qualitative Disclosures About Market Risk) 35,51
Return on Assets and Equity 37,52
Capital Resources and Shareholders' Equity 37,52
Inflation 39
Current Accounting and Regulatory Matters 39
Item 7A Quantitative and Qualitative Disclosures About Market Risk 41
Forward-Looking Statements 41
Item 8 Financial Statements and Supplementary Data:
Consolidated Balance Sheets as of December 31, 2004 and 2003 54
Consolidated Statements of Income for each of the years in the
three-year period ended December 31, 2004 55
Consolidated Statements of Comprehensive Income for each of the
years in the three-year period ended December 31, 2004 56
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, 2004 57
Consolidated Statements of Cash Flows for each of the years
in the three-year period ended December 31, 2004 58
Notes to Consolidated Financial Statements 59
Independent Auditors' Report 89
Selected Consolidated Financial Data 42
Quarterly Financial Summary 53
Item 9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosures 90
Item 9A Controls and Procedures 90
Item 9B Other Information 90
PART III
Item 10 Directors and Executive Officers of the Registrant; Compliance
with Section 16 (a) of the Exchange Act 91*
Item 11 Executive Compensation 91*
Item 12 Security Ownership of Certain Beneficial Owners and Management 91*
Item 13 Certain Relationships and Related Transactions 92*
Item 14 Principal Accountant Fees and Services 92*
Part IV
Item 15 Exhibits and Financial Statement Schedules 92
SIGNATURES 95
* 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 2005 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. Each of these subsidiaries are fully consolidated for
financial reporting purposes. 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 $41.2 million in trust preferred debt securities. Under
current accounting requirements, these three statutory business trusts are not
consolidated for financial reporting purposes - see discussion of FIN 46 in
"Current Accounting and Regulatory Matters" under Item 7 below.
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, 2004, the Bank operated in a 23 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 59 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 Radford, Virginia to the north, to Wytheville, Virginia to the northwest, and
Harmony, North Carolina to the west. Of the Bank's 59 branches, 53 are in North
Carolina, with three branches each in South Carolina and 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, 2004.
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.
As discussed in the last paragraph of "General Business" below, the Company
intends to dissolve First Montgomery and First Troy in 2005.
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
consolidated subsidiaries.
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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. In December 2004, the Bank also began
offering its internet banking product, with on-line bill-pay and cash management
features. 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 "investment division" of First Bank Insurance became a part the Bank.
The primary 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. At
December 31, 2004, Montgomery Data had five outside customers that provided
gross revenues of $416,000, $333,000, and $303,000 for the years ended December
31, 2004, 2003, and 2002, respectively. However, three of the five customers
have notified Montgomery Data that they intend to terminate their services with
Montgomery Data and switch to a lower cost provider during the first half of
2005. These three customers provided $328,000 in gross revenue to Montgomery
Data in 2004.
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 periodically purchases parcels of real estate from the Bank
that were acquired through foreclosure or from branch closings. 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 $20.6 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 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 $20.6 million in debt
securities ($10.3 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
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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. In 2005, in response to evolving taxing
authority developments (discussed in more detail in "Liquidity, Commitments, and
Contingencies" under Item 7 below), the Company intends to dissolve and
liquidate First Montgomery and First Troy by transferring the assets and
liabilities of each of these subsidiaries up-stream to the Bank.
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, 2004, the Company's approximate market share, and the number of
bank competitors located in the county. The following table does not include the
Company's approximately $50 million in wholesale brokered deposits.
No. of Deposits Market Number of
County Branches (in millions) Share Competitors
--------------- ---------- --------------- -------- -----------
Anson, NC 1 $ 10 4.4% 4
Cabarrus, NC 2 25 1.3% 8
Chatham, NC 2 49 9.3% 9
Davidson, NC 2 106 6.6% 8
Dillon, SC 3 61 26.3% 2
Duplin, NC 2 40 10.2% 7
Guilford, NC 1 34 0.5% 22
Harnett, NC 3 87 10.3% 7
Iredell, NC 1 20 1.3% 14
Lee, NC 4 117 16.5% 6
Montgomery, NC 5 89 39.1% 4
Montgomery, VA 1 3 0.1% 9
Moore, NC 10 305 24.3% 10
Randolph, NC 4 50 3.6% 14
Richmond, NC 1 20 4.9% 5
Robeson, NC 5 123 14.1% 9
Rockingham, NC 1 8 0.6% 9
Rowan, NC 2 35 2.9% 10
Scotland, NC 2 41 15.8% 5
Stanly, NC 4 73 10.5% 5
Wake, NC 1 11 0.1% 21
Washington, VA 1 10 1.4% 12
Wythe, VA 1 22 5.4% 8
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Total 59 $ 1,339
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The Company's 59 branches and facilities are primarily located in small
communities whose economies are 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
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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, Raleigh and Greensboro in addition
to smaller cities such as Albemarle, Asheboro, High Point, Pinehurst and
Sanford.
Approximately 23% of the Company's non-brokered 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 its 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 serves. Individual lending officers are responsible for
pursuing collection of past-due amounts and monitoring any changes in the
financial status of borrowers.
The Bank's internal audit department evaluates specific loans and overall
loan quality at individual branches
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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, and 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.
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. The Company 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 it can enhance its earnings by pursuing these
types of acquisition opportunities through 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 more locations for the
convenience of customers, and 4) leveraging the Company's customer base by
offering new products and services.
In the last four years, the Company has made acquisitions in all three of
the aforementioned categories of
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acquisitions. In 2001, acquisitions resulted in the Company adding $116.2
million in loans and $204.6 million in deposits, expanding into four contiguous
markets (Lumberton, Pembroke, St. Pauls, and Thomasville), providing another
branch for customers in one of the Company's newer markets (Salisbury), and
giving 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 provided
efficiencies of scale when combined with the agency purchased in 2001. The
Company did not complete any acquisitions during 2004.
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, 2004, the Company had 526 full-time and 74 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 (the "Federal Reserve Board") and the North Carolina Office of the
Commissioner of Banks (the "Commissioner"). The Bank is subject to supervision
and examination by the Federal Deposit Insurance Corporation (the "FDIC") and
the Commissioner. 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 Federal Reserve Board. The Company is also regulated by 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.
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,
9
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. The 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 Bank 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.
After the September 11, 2001 terrorist attacks in New York and Washington,
D.C., the United States government acted in several ways to tighten control on
activities perceived to be connected to money laundering and terrorist funding.
A series of orders were issued that identify terrorists and terrorist
organizations and require the blocking of property and assets of, as well as
prohibiting all transactions or dealings with, such terrorists, terrorist
organizations and those that assist or sponsor them. The USA Patriot Act
substantially broadened existing anti-money laundering legislation and the
extraterritorial jurisdiction of the United States, imposed new compliance and
due diligence obligations, created new crimes and penalties, compelled the
production of documents located both inside and outside the United States,
including those of foreign institutions that have a correspondent relationship
in the United States, and clarified the safe harbor from civil liability to
customers. In addition, the United States Treasury Department issued regulations
in cooperation with the federal banking agencies, the Securities and Exchange
Commission, the Commodity Futures Trading Commission and the Department of
Justice to require customer identification and verification, expand the
money-laundering program requirement to the major financial services sectors,
including insurance and unregistered investment companies, such as hedge funds,
and facilitate and permit the sharing of information between law enforcement and
financial institutions, as well as among financial institutions themselves. The
United States Treasury Department also has created the Treasury USA Patriot Act
Task Force to work with other financial regulators, the regulated
10
community, law enforcement and consumers to continually improve the regulations.
The Company has established policies and procedures to ensure compliance with
the USA Patriot Act.
In 2002, the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act") was
signed into law. The Sarbanes-Oxley Act represents a comprehensive revision of
laws affecting corporate governance, accounting obligations and corporate
reporting. The Sarbanes-Oxley Act is applicable to all companies with equity or
debt securities registered under the Securities Exchange Act of 1934, as
amended. In particular, the Sarbanes-Oxley Act establishes: (i) new requirements
for audit committees, including independence, expertise, and responsibilities;
(ii) additional responsibilities regarding financial statements for the Chief
Executive Officer and Chief Financial Officer of the reporting company; (iii)
new standards for auditors and regulation of audits; (iv) increased disclosure
and reporting obligations for the reporting company and their directors and
executive officers; and (v) new and increased civil and criminal penalties for
violation of the securities laws. The most significant expense associated with
compliance with the Sarbanes-Oxley Act has been the internal control
documentation and attestation requirements of Section 404 of the Act. In 2004,
the Company's incremental external costs associated with complying with Section
404 of the Sarbanes-Oxley Act amounted to approximately $190,000. The Company
expects to incur an additional $350,000-$400,000 in external costs related to
Section 404 in the first quarter of 2005 and an additional $150,000-$200,000 in
the second quarter of 2005. The incremental costs relate to higher external
audit fees and outside consultant fees. These amounts do not include the value
of the significant internal resources devoted to compliance. As permitted by the
Securities and Exchange Commission Release No. 34-50754, the registrant has not
filed in this report the internal control reports required by Section 404 of the
Sarbanes-Oxley Act. The Company expects to file these reports by May 2, 2005, as
permitted by the aforementioned release.
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 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 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
11
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, including its
annual reports on Form 10-K, its quarterly reports on Form 10-Q, its current
reports on Form 8-K, and amendments to those reports filed or furnished pursuant
to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. These filings
are available, free of charge, as soon as reasonably practicable after the
Company electronically files such material with, or furnishes it to, 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 the Company's 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
owned by the Bank and 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 two one-story steel frame buildings
approximately one-half mile west of the main office. Both of these buildings are
owned by the Bank. The Company operates 59 bank branches. The Company owns all
its bank branch premises except eleven 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. In addition, the Company leases one loan production
office. 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.
However, neither the Company nor any of its subsidiaries is involved in any
pending legal proceedings that management believes could have a material effect
on the consolidated financial position of the Company.
Item 4. Submission of Matters to a Vote of Shareholders
No matters were submitted to a vote of shareholders during the fourth
quarter of 2004.
PART II
Item 5. Market for the Registrant's Common Stock, Related Shareholder Matters,
and Issuer Purchases of Equity Securities
The Company's common stock trades on the NASDAQ National Market System of
the NASDAQ Stock Market under the symbol FBNC. Table 22, included in
"Management's Discussion and Analysis" below, set
12
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. See "Business - Supervision and
Regulation" above and Note 15 to the consolidated financial statements for a
discussion of regulatory restrictions on the payment of dividends. As of
December 31, 2004, there were approximately 2,600 shareholders of record and
another 3,000 shareholders whose stock is held in "street name." There were no
sales of unregistered securities during the year ended December 31, 2004.
Issuer Purchases of Equity Securities
Pursuant to authorizations by the Company's board of directors, the
Company has repurchased shares of common stock in private transactions and in
open-market purchases. The most recent board of director authorization was
announced on July 30, 2004 and authorized the repurchase of 375,000 shares of
the Company's stock. During 2004, the Company repurchased a total of 300,816
shares of its common stock at an average price of $21.65. The following table
sets forth information about the Company's stock repurchases for the three
months ended December 31, 2004.
Issuer Purchases of Equity Securities
- ---------------------------------------------------------------------------------------------------------------------------
Total Number of Shares Maximum Number of
Purchased as Part of Shares that May Yet Be
Total Number of Average Price Paid Publicly Announced Purchased Under the
Period Shares Purchased (2) per Share Plans or Programs (1) Plans or Programs (3)
- ----------------------------- --------------------- ------------------ ---------------------- -----------------------
Month #1 (October 1, 2004 to
October 31, 2004) 12,251 $ 24.47 12,251 315,165
Month #2 (November 1, 2004
to November 30, 2004) 150 25.55 150 315,015
Month #3 (December 1, 2004
to December 31, 2004) -- -- -- 315,015
------- ------- ------- --------
Total 12,401 $ 24.49 12,401 315,015
======= ======= ======= ========
Footnotes to the Above Table
(1) All amounts prior to November 15, 2004 have been adjusted to reflect the
3-for-2 stock split paid by the Company on November 15, 2004.
(2) All shares were repurchased pursuant to publicly announced share
repurchase authorizations. On July 30, 2004, the Company announced that
its Board of Directors had approved the repurchase of 375,000 shares of
the Company's common stock. The repurchase authorization does not have an
expiration date. There are no plans or programs the issuer has determined
to terminate prior to expiration, or under which the issuer does not
intend to make further purchases.
(3) The shares included in the table above do not include shares that were
used by option holders to satisfy the exercise price of the Company's call
options issued by the Company to its employees and directors pursuant to
the 1994 First Bancorp Stock Option Plan. In October 2004, 3,200 shares of
the Company's common stock with a weighted average price of $25.57 were
used to satisfy the exercise price of employee option exercises. In
November 2004, 477 shares of the Company's common stock, with a weighted
average market price of $25.20 were used to satisfy such exercises. In
December 2004, 842 shares of the Company's common stock, with a weighted
average market price of $29.30 were used to satisfy such exercises.
Item 6. Selected Consolidated Financial Data
Table 1 sets forth selected consolidated financial data for the Company.
13
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
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 54 of this report and the supplemental financial data contained in Tables 1
through 22 included with this discussion and analysis. All share data has been
adjusted to reflect the 3-for-2 stock split paid on November 15, 2004.
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 three 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, 2) tax uncertainties, and 3) 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 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.
14
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."
Tax Uncertainties
The Company reserves for tax uncertainties in instances when it has taken
a position on a tax return that may differ from the opinion of the applicable
taxing authority. In accounting for tax contingencies, the Company assesses the
relative merits and risks of certain tax transactions, taking into account
statutory, judicial and regulatory guidance in the context of the Company's tax
position. For those matters where it is probable that the Company will have to
pay additional taxes, interest or penalties and a loss or range of losses can be
reasonably estimated, the Company records reserves in the consolidated financial
statements. For those matters where it is reasonably possible but not probable
that the Company will have to pay additional taxes, interest or penalties and
the loss or range of losses can be reasonably estimated, the Company only makes
disclosures in the notes and does not record reserves in the consolidated
financial statements. The process of concluding that a loss is reasonably
possible or probable and estimating the amount of loss or range of losses and
related tax reserves is inherently subjective and future changes to the reserve
may be necessary based on changes in management's intent, tax law or related
interpretations, or other functions.
The section below entitled "Liquidity, Commitments, and Contingencies" and
Note 12 to the consolidated financial statements includes the disclosure of a
tax uncertainty that the Company has concluded requires disclosure, but not loss
accrual.
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
assets and a lower amount classified as goodwill.
For the Company, the primary 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,
15
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 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 operation is its only material
reporting unit). At its last evaluation, the fair value of the Company's
community banking operation 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.
MERGER AND ACQUISITION ACTIVITY
Over the past three fiscal years, the Company has completed several
acquisitions, which have 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 Note 2 and Note 6 to the consolidated financial statements for additional
information regarding intangible assets.
The Company did not announce or complete any acquisitions in 2004. The
Company completed the following acquisitions during 2003:
(a) On January 2, 2003, the Company completed the acquisition of Uwharrie
Insurance Group, Inc. ("Uwharrie"), a Montgomery County based property and
casualty insurance agency. Uwharrie was subsequently merged into First Bank
Insurance. With eight employees, Uwharrie served 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 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
16
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 is not being
systematically amortized, but rather is 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 1.2 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 499,332 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 $10.2 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 $9.4 million was determined to be goodwill
and thus is not being systematically amortized, but rather is 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 is not being systematically amortized,
but rather is subject to an annual impairment test.
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 -- 2.5 0.2 2.7
------- ----- ------ ------
Total assets acquired -- 70.3 88.1 158.4
------- ----- ------ ------
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 10.2 14.2 24.9
======= ===== ====== ======
17
The Company completed one acquisition in 2002 as follows:
(a) On October 4, 2002, the Company completed the purchase of a branch of
RBC Centura Bank 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.
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 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 - 2004 Compared to 2003
Net income for the year ended December 31, 2004 amounted to $20,114,000,
or $1.40 per diluted share, a 3.6% increase in net income and a 3.7% increase in
diluted earnings per share over the net income of $19,417,000, or $1.35 per
diluted share, reported for 2003. All per share amounts have been adjusted to
reflect the 3-for-2 stock split paid on November 15, 2004.
Total assets at December 31, 2004 amounted to $1.64 billion, 11.1% higher
than a year earlier. Total loans at December 31, 2004 amounted to $1.37 billion,
a 12.2% increase from a year earlier, and total deposits amounted to $1.39
billion at December 31, 2004, an 11.2% increase from a year earlier.
Approximately $50 million of the total 2004 deposit increase of $139 million
related to wholesale brokered deposits that the Company gathered in order to
help fund the high loan growth experienced during 2004.
The increase in loans and deposits over the past twelve months resulted in
an increase in the Company's net interest income from 2003 to 2004. Net interest
income for the year ended December 31, 2004 amounted to $61.3 million, a 9.9%
increase over the $55.8 million recorded in 2003. The positive impact on net
interest income from the increases in loans and deposits more than offset a
lower net interest margin realized in 2004 compared to 2003. The Company's net
interest margin (tax-equivalent net interest income divided by average earning
assets) for 2004 was 4.31% compared to the 4.52% in 2003. The Company's net
interest margin was negatively impacted by the thirteen interest rate cuts
initiated by the Federal Reserve from 2001 to 2003 and the Company's shift
toward originating more adjustable rate loans compared to fixed rate loans to
protect the Company from anticipated increases in interest rates. The Federal
Reserve increased interest rates by 125 basis points in the second half of 2004
which was responsible for the Company's net interest margin increasing during
the third and fourth quarters of 2004 after having decreased for the immediately
preceding five consecutive quarters.
18
The Company's provision for loan losses did not vary significantly in 2004
compared to 2003, amounting to $2,905,000 in 2004 compared to $2,680,000 in
2003. The Company's asset quality ratios remained sound in 2004, with a
net-charge off ratio (net charge-offs divided by average loans) of 0.14% in 2004
compared to 0.10% in 2003, and a December 31, 2004 nonperforming asset to total
asset ratio of 0.32%, compared to 0.39% at the prior year end.
For the year ended 2004, noninterest income amounted to $15.9 million, a
6.3% increase from $14.9 million in 2003. Except for fees from presold
mortgages, most components of noninterest income increased for the year ended
2004 compared to 2003 as a result of the Company's overall growth, particularly
the Company's October 2003 acquisition of four bank branches with $102 million
in deposits, which impacted the Company's noninterest income for all twelve
months of 2004 compared to only three months in 2003. Fees from presold
mortgages decreased significantly in 2004 as a result of a decline in mortgage
refinancing activity caused by higher mortgage interest rates. Fees from presold
mortgages decreased from $2.3 million in 2003 to $1.0 million in 2004. The
Company realized securities gains and other gains of $648,000 in 2004 compared
to $306,000 in 2003.
Noninterest expenses for the year ended December 31, 2004 amounted to
$43.7 million, a 15.2% increase from the $38.0 million recorded in 2003. The
increase in noninterest expenses is primarily attributable to growth in the
Company's branch network, which increased by eight branches since October 2003.
The Company's effective tax rates were slightly lower for 2004 compared to
2003, amounting to 34.1% in 2004 compared to 35.3% for 2003. The lower effective
tax rate in 2004 was caused by several factors including higher amounts of state
tax exempt income, higher amounts of low income housing investment tax credits,
and the reversal of an $89,000 tax liability that was recorded in connection
with a previous corporate acquisition.
Overview - 2003 Compared to 2002
Net income for the year ended December 31, 2003 amounted to $19,417,000,
or $1.35 per diluted share, a 12.7% increase in net income and a 9.8% increase
in diluted earnings per share over the net income of $17,230,000, or $1.23 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 provision for loan losses did not vary significantly in 2003 compared
to 2002, amounting to $2,680,000 and $2,545,000, respectively. The Company's
asset quality ratios were sound in both years, with a net-charge off ratio (net
charge-offs divided by average loans) of 0.10% in 2003 compared to 0.11% in
2002, and a December 31, 2003 nonperforming asset to total asset ratio of 0.39%,
compared to 0.36% at the prior year end.
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 a low interest rate environment that increased the amount of fees from
presold mortgages, 2)
19
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%.
Net Interest Income
Net interest income on a reported basis amounted to $61,290,000 in 2004,
$55,760,000 in 2003, and $49,390,000 in 2002. 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 tax-equivalent
basis amounted to $61,765,000 in 2004, $56,278,000 in 2003, and $49,925,000 in
2002.
Table 2 analyzes net interest income on a tax-equivalent basis. The
Company's net interest income on a taxable-equivalent basis increased by 9.7% in
2004 and 12.7% in 2003. 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 2004 and 2003, net interest income was
positively impacted by higher amounts of average loans and deposits outstanding.
In 2004, the average amount of loans outstanding increased 16.4%, and the
average amount of deposits outstanding increased 13.3%. In 2003, the average
amount of loans outstanding increased 16.6%, and the average amount of deposits
outstanding increased 14.1%. The higher amounts of average loans and deposits
outstanding in 2004 and 2003 were a result of both internal growth, as well as
growth achieved in corporate acquisitions. Although the Company did not complete
any acquisitions in 2004, the increases in the Company's average loan and
deposit amounts in 2004 compared to 2003 were impacted by acquisitions completed
in 2003, as the loans and deposits assumed in the 2003 acquisitions were
outstanding for the full year in 2004 compared to only a partial year in 2003
(from the date of the respective acquisitions). For additional analysis
regarding the nature of the Company's loan and deposit growth see "Analysis of
Financial Condition and Changes in Financial Condition - Overview" below.
Table 3 also illustrates that changes in interest rates resulted in
reductions in interest income and interest expense in 2003 and 2004. In 2003,
interest rates earned/paid were both lower due to a lower interest rate
environment. In 2004, although the average prime rate was slightly higher than
in 2003, the average yields realized on earning assets and the average rates
paid on interest-bearing liabilities for the year were both lower than in 2003.
The average yield on earning assets was lower in 2004 than in 2003 due to a
growing percentage of adjustable rate loans, which carry lower initial rates
than fixed rate loans (see below for additional discussion), and lower
renewal/reinvestment rates earned on fixed rate earning assets that matured
during 2004 that had been originated during periods of higher interest rates.
The average rate paid on interest-bearing liabilities was lower in 2004 than in
2003 due to the interest rates on deposits that are set by management not being
increased at the same time, or by the full amount, as increases in the prime
rate of interest that occurred in 2004. Also, interest expense on time deposits
was otherwise lower as a result of time deposits that were originated prior to
the increases in interest rates, with maturities subsequent to the dates of the
rate changes. The reduction in interest income for both years was more than the
reduction in interest expense, and thus changes in interest rates negatively
impacted the Company's net interest income in both years. However, the positive
impact of having higher amounts of loans and deposits more than offset the
negative impact that rates had on the Company, resulting in the increases in net
interest income experienced in 2003 and 2004.
The Company measures the spread between the yield on its earning assets
and the cost of its funding primarily in terms of the ratio entitled "net
interest margin" which is defined as tax-equivalent net interest income divided
by average earning assets. The Company's net interest margin has declined in
each of the past two years, amounting to 4.31% in 2004, 4.52% in 2003, and 4.58%
in 2002.
20
The Company's net interest margin was negatively impacted by the interest
rate environment and a shift towards originating more adjustable rate loans
compared to fixed rate loans to protect the Company from an expected rise in
interest rates. The mostly declining interest rate environment in effect from
2001 until June 30, 2004, and the level to which it dropped, resulted in the
Company being unable to reset deposit rates by an amount that would offset the
negative impact of the lower yields earned on the Company's interest earning
assets. In the declining rate environment, the Company's interest-sensitive
assets repriced sooner (most on 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. Additionally, as
fixed rate earning assets originated during periods of higher interest rates
matured, they were generally replaced with lower yielding earning assets. The
Company was unable to reset deposit rates by the full amount of the interest
rate cuts because of their already near-zero rates and because of competitive
pricing pressures. Also, interest rates paid on time deposits are generally
fixed and are 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 found
it especially difficult 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 areas.
The shift in the Company's loan mix from fixed rate loans to adjustable
rate loans has occurred primarily over the past three years. At December 31,
2001, the Company's loan portfolio was comprised of 57% fixed rate loans and 43%
adjustable rate loans. Since that time, the ratio gradually shifted as the
Company has originated more adjustable rate loans than fixed rate loans. At
December 31, 2004, the Company's loan portfolio was comprised of 60% adjustable
rate loans and 40% fixed rate loans. The primary reason for this shift was that
with interest rates at historically low levels, the Company more attractively
priced adjustable rate loans in order to avoid locking in fixed rate loans at a
time when most economists believed that rates would inevitably rise. Although
the Company believes that this strategy was prudent given the historically low
interest rate environment, it has had a negative effect on the Company's
recently realized net interest margins because adjustable rate loans carry lower
initial rates than fixed rate loans of similar maturities. Additionally, the
generally declining rate environment experienced from 2001 through June 2004
resulted in the Company's adjustable rate loans repricing to lower levels
following each rate cut.
Another factor affecting the Company's net interest margin over the past
two years has been an increased reliance on time deposit greater than $100,000
and borrowings. Time deposits greater than $100,000 and borrowings are generally
the highest cost sources of funds for the Company and their increased usage has
been necessary to fund high loan growth that has exceeded core retail deposit
growth. The ratio of the average amount of time deposits greater than $100,000
and borrowings to total funding (total deposits plus borrowings) increased from
20.1% in 2002, to 22.7% in 2003, to 25.6% in 2004.
In the second half of 2004, the Federal Reserve increased interest rates
by a total of 125 basis points, which was largely responsible for the Company's
net interest margin increasing for each of last two quarters of 2004, rising
from 4.26% in the second quarter of 2004 to 4.28% in the third quarter of 2004
and to 4.32% in the fourth quarter of 2004.
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.
21
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 provision for loan losses recorded by the Company did not vary
significantly over the past three years, amounting to $2,905,000 in 2004
compared to $2,680,000 in 2003 and $2,545,000 in 2002. Internal loan growth was
strong for each of those years, amounting to $148 million in both 2004 and 2003
and $105 million in 2002. There was no external/acquired loan growth in 2004,
while in 2003 and 2002 there was acquired growth of $72.5 million and $3.1
million, respectively, for which a preexisting allocation for loan losses was
already in place. Asset quality ratios were stable during each of the three
years in the period ended December 31, 2004.
See the section entitled "Allowance for Loan Losses and Loan Loss
Experience" below for a more detailed 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 $15,864,000 in
2004, $14,918,000 in 2003, and $11,968,000 in 2002.
As shown in Table 4, core noninterest income, which excludes gains and
losses from sales of securities, loans, and other assets, amounted to
$15,216,000 in 2004, a 4.1% increase from $14,612,000 in 2003. The 2003 core
noninterest income of $14,612,000 was 22.3% higher than the $11,946,000 recorded
in 2002.
See Table 4 and the following discussion for an understanding of the
components of noninterest income.
Service charges on deposit accounts in 2004 amounted to $9,064,000, a
14.2% increase compared to the $7,938,000 recorded in 2003. The 2003 amount of
$7,938,000 was 15.8% higher than the 2002 amount of $6,856,000. 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) service 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%-5% in both 2004 and 2003. The
deposits assumed in the acquisition of the four RBC Centura branches on October
24, 2003 generated approximately $720,000 in service charges for the full year
of 2004 compared to $125,000 realized during the partial period in 2003
subsequent to the acquisition. This incremental income of $595,000 accounted for
approximately 7.5% of the 14.2% increase in service charges on deposit accounts.
In comparing 2003 to 2002, the $125,000 realized in 2003 from the four RBC
Centura branches along with the $650,000 in deposit service charges realized
from CCB subsequent to its January 15, 2003 acquisition date accounted for
approximately 11.3% of the 15.8% increase in service charges on deposit accounts
in 2003. The Company's income from service charges on deposit accounts in the
fourth quarter of 2004 was essentially flat when compared to the fourth quarter
of 2003, which was a result of a higher customer deposit base, the positive
effects of which were offset by the negative impact that higher short term
interest rates that occurred in the second half of 2004 had on service charges
that the Company earned from its commercial depositors - in the Company's
commercial account service charge rate structure, commercial depositors are
given "earnings credits" (negatively impacting service charges) on their average
deposit balances that are tied to short term interest rates. For this reason,
the Company expects little or no growth in this category of income in 2005.
Other service charges, commissions and fees amounted to $3,361,000 in
2004, a 24.0% increase from the $2,710,000 earned in 2003. The 2003 amount of
$2,710,000 was 16.0% higher than the $2,336,000 recorded in 2002. This category
of noninterest income includes items such as credit card interchange income
related to merchants and customers, debit card interchange income, ATM charges,
safety deposit box rentals, fees from sales of personalized checks, and check
cashing fees. This category of income grew primarily because of
22
increases in these activity-related fee services as a result of credit and debit
card promotions that increased card use and the overall growth in the Company's
total customer base, including growth achieved from corporate acquisitions.
Fees from presold mortgages amounted to $969,000 in 2004, a 58.4% decrease
from the 2003 amount of $2,327,000. The 2003 amount was a 35.8% increase from
the $1,713,000 recorded in 2002. Fees from presold mortgages peaked in 2003 as a
result of a high level of mortgage loan refinancings caused by a very low
residential mortgage interest rate environment. In 2004, the high levels of
mortgage loan refinancings slowed because 1) many homeowners had already
refinanced their mortgages in previous years, and 2) there was a slight rise in
residential mortgage interest rates.
Commissions from sales of insurance and financial products amounted to
$1,406,000 in 2004, $1,304,000 in 2003, and $738,000 in 2002. This line item
includes commissions the Company receives from three sources - 1) sales of
credit insurance associated with new loans, 2) commissions from the sales of
investment, annuity, and long-term care insurance products, and 3) commissions
from the sale of property and casualty insurance. The following table presents
the contribution of each of the three sources to the total amount recognized in
this line item:
2004 2003 2002
($ in thousands) ------ ------ ------
Commissions earned from:
----------------------------------
Sales of credit insurance $ 291 300 326
Sales of investments, annuities,
and long term care insurance 291 299 210
Sales of property and casualty
insurance 824 705 202
------ ------ ------
Total $1,406 1,304 738
====== ====== ======
The increase in commissions from sales of investments, annuities, and long
term care insurance from 2002 to 2003 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 significant increase in
this income in 2003 was a result of the acquisition of Uwharrie Insurance Group,
which was completed on January 2, 2003. See "Merger and Acquisition Activity"
above for additional discussion.
Data processing fees amounted to $416,000 in 2004, $333,000 in 2003, and
$303,000 in 2002. As noted earlier, Montgomery Data makes its excess data
processing capabilities available to area financial institutions for a fee. At
December 31, 2004, the Company processed for five area banks. These fees have
increased as a result of an increase in the size and number of transactions
generated by those clients. The Company has been notified by three of the five
financial institutions that utilize this service that they intend to terminate
their contracts with the Company effective in the first half of 2005 - each
client is switching to a lower cost service provider. Fees from these three
institutions amounted to $328,000 in 2004. Montgomery Data intends to continue
to market this service to area banks, but does not currently have any near-term
prospects for additional business.
Noninterest income not considered to be "core" amounted to net gains of
$648,000 in 2004, $306,000 in 2003, and $22,000 in 2002. The 2004 net gain of
$648,000 included securities gains of $299,000, which were effected primarily in
order to realize current income. Also in 2004, the Company sold a former bank
branch building that resulted in a gain of approximately $350,000. The 2003 net
gain of $306,000 primarily related to securities gains of $218,000 effected
primarily to realize current income and an $82,000 gain from a sale of vacant
land located beside one of the Company's existing branches. The 2002 net gain of
$22,000 primarily related to miscellaneous securities gains of $25,000.
23
Noninterest Expenses
Noninterest expenses for 2004 were $43,717,000, compared to $37,964,000 in
2003 and $32,301,000 in 2002. 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
15.2% in 2004 and 17.5% in 2003. The increases in noninterest expenses over the
past two years have occurred in nearly every line item of 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 48 to 59, and the number of full time
equivalent employees has increased from 447 at December 31, 2002 to 563 at
December 31, 2004. Additionally, from December 31, 2002 to December 31, 2004,
the amount of loans outstanding increased 37% and deposits increased 32%. The
incremental expense associated with the January 2003 acquisition of CCB was
approximately $1.7 million for each of 2003 and 2004. The incremental expense
associated with the acquisition of the four RBC Centura branches in October 2003
was approximately $380,000 in 2003 and $1.9 million in 2004. In 2004, the
Company's incremental external costs associated with complying Section 404 of
the Sarbanes-Oxley Act amounted to approximately $190,000. The Company expects
to incur an additional $350,000-$400,000 in external costs related to Section
404 in the first quarter of 2005 and an additional $150,000-$200,000 in the
second quarter of 2005. The incremental costs relate to higher external audit
fees and outside consultant fees. These amounts do not include the value of the
significant internal resources devoted to compliance.
Income Taxes
The provision for income taxes was $10,418,000 in 2004, $10,617,000 in
2003, and $9,282,000 in 2002.
The effective tax rate for 2004 was approximately 34% in 2004 compared to
approximately 35% in each of 2003 and 2002. The slightly lower effective tax
rate in 2004 was caused by several factors including higher amounts of state tax
exempt income, higher amounts of low income housing investment tax credits, and
the reversal of an $89,000 tax liability that was recorded in connection with a
previous corporate acquisition.
The section below entitled "Liquidity, Commitments, and Contingencies"
contains discussion regarding possible loss exposure related to taxes. As
described in that section, the Company plans to discontinue certain elements of
the Company's operating structure, which is expected to increase the Company's
effective tax rate from approximately the 34%-35% experienced in recent years to
approximately 39%. If the Company's effective tax rate had been 39% in 2004, the
Company's net income would have been lower by approximately $1.3 million.
Table 6 presents the components of tax expense and the related effective
tax rates.
Stock-Based Compensation
For the three years ended December 31, 2004, the Company was not required
to record an expense for the value of stock options granted to employees. As
discussed in more detail below in the next to last paragraph of the section
entitled "Current Accounting and Regulatory Matters," a new accounting standard
("Statement 123(R)", as defined below) will require the Company to record the
value of stock options as an expense in the income statement beginning July 1,
2005. Note 1(k) to the consolidated financial statements contains pro forma net
income and earnings per share information as if the Company applied the fair
value recognition provisions required by the new standard. Note 1(k) indicates
that the Company's stock-based employee compensation expense would have been
$1,291,000, $319,000, and $256,000 for the three years ended December 31, 2004,
2003, and 2002, respectively. The significant increase in expense in 2004
compared to 2003 and 2002 is primarily due to the Company granting 128,000
employee options in April 2004 with immediate vesting (under the new standard,
expense related to the fair market value of options is recognized when the
options vest). Prior to that grant, all previous employee option grants had five
year vesting periods (20% vesting each year), and thus the amount of
24
expense related to options was generally spread over the five year vesting
period. The Compensation Committee of the Board of Directors of the Company
granted the April 2004 options without any vesting requirements for two reasons
- - 1) the options were granted primarily as a reward for past performance and
therefore had already been "earned" in the view of the Committee, and 2) to
potentially minimize the impact that any change in accounting standards for
stock options could have on future years' reported net income. The Company
expects that future employee stock option grants will revert to having five year
vesting periods.
As noted above, beginning on July 1, 2005, the Company will be required to
expense, within its income statement, the value of stock option grants that vest
from that date forward. The Company currently has outstanding stock options with
a fair value of $103,000 that will vest on a pro-rata basis between July 1, 2005
and December 31, 2005, with $52,000 vesting in the third quarter of 2005 and
$51,000 vesting in the fourth quarter of 2005. In 2006 and 2007, the Company's
stock-based compensation expense related to options currently outstanding will
be approximately $123,000 and $43,000, respectively. New stock option grants
that vest after July 1, 2005 will increase the amount of stock-based
compensation expense recorded by the Company. Except for grants to directors
(see below), the Company cannot estimate the amount of future stock option
grants at this time. In the past, stock option grants to employees have been
irregular, generally falling into three categories - 1) to attract and retain
new employees, 2) to recognize changes in responsibilities of existing
employees, and 3) to periodically reward exemplary performance. As it relates to
director stock option grants, the Company expects to continue to grant 2,250
stock options to each of the Company's directors on June 1 of each year until
the 2014 expiration of the current stock option plan. In 2004, the amount of pro
forma expense associated with the director grants was $126,000.
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 2004 and 2003:
Balance at Balance at Total Percentage growth,
(in thousands) beginning Internal Growth from end of percentage excluding
of period growth acquisitions period growth acquisitions
------------- ----------- --------------- ----------- ----------- -------------------
2004
- ------------------------------
Loans $1,218,895 148,158 -- 1,367,053 12.2% 12.2%
========== ========= ========= ========= ========= =========
Deposits - Noninterest bearing 146,499 19,279 -- 165,778 13.2% 13.2%
Deposits - Savings, NOW, and
Money Market 462,876 9,935 -- 472,811 2.1% 2.1%
Deposits - Time>$100,000 238,535 96,221 -- 334,756 40.3% 40.3%
Deposits - Time<$100,000 401,454 13,969 -- 415,423 3.5% 3.5%
---------- --------- --------- --------- --------- ---------
Total deposits $1,249,364 139,404 -- 1,388,768 11.2% 11.2%
========== ========= ========= ========= ========= =========
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%
========== ========= ========= ========= ========= =========
As shown in the table above, the Company experienced high internal growth
in loans in 2004 and 2003 with
25
internal growth of 12.2% and 14.8%, respectively. Growth from acquisitions
increased the loan growth rate in 2003 to 22.1%.
Deposits increased 11.2% in 2004 and 18.3% in 2003. In 2004, of the $96
million in growth in the category "Deposits - Time>$100,000," $50 million
related to brokered deposits that the Company attracted in order to fund the
strong loan growth experienced. Excluding the brokered deposits, the Company's
deposit growth in 2004 was 7.2%. In 2003, internal deposit growth was 3.1%, with
deposits assumed in acquisitions boosting total deposit growth from 3.1% to
18.3%.
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. The Company increased its borrowings
from $30 million at December 31, 2002 to $76 million at December 31, 2003 to $92
million at December 31, 2004 in order to help fund the excess loan growth.
Additionally, the Company entered the brokered deposit market for the first time
in 2004 and gathered $50 million in brokered deposits to help fund loan growth.
In 2004, regulatory capital ratios declined slightly as asset growth
exceeded capital growth. In 2002 and 2003, as a result of the negative impact
that acquisition growth had on the Company's regulatory capital ratios, the
Company raised capital in each of the fourth quarters of 2002 and 2003 by
issuing $20.6 million each year (for a total of $41.2 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 most of the past several
years, the Company's asset quality ratios have remained fairly stable over the
past three years with net charge-offs to average loans ranging from 10 basis
points to 14 basis points and nonperforming assets to total assets ranging from
32 basis points to 36 basis points.
Distribution of Assets and Liabilities
Table 7 sets forth the percentage relationships of significant components
of the Company's balance sheets at December 31, 2004, 2003, and 2002.
The relative size of the components of the balance sheet has not varied
significantly over the past two years with loans comprising 81%-82% of total
assets and deposits comprising 84%-87%. The most significant variance in Table 7
is the increase in 2004 in the percentage of time deposits of $100,000 or more,
which increased from 16% at December 31, 2003 to 21% at December 31, 2004. The
Company aggressively attracted large time deposits in 2004, including gathering
the $50 million in brokered deposits, in order to help fund the strong loan
growth experienced that was not able to be fully funded with core retail
deposits.
26
Securities
Information regarding the Company's securities portfolio as of December
31, 2004, 2003, and 2002 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
$102.6 million, $117.7 million, and $80.8 million at December 31, 2004, 2003,
and 2002, respectively. The decrease in securities from December 31, 2003 to
December 31, 2004 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