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EX-32 - EXHIBIT 32 - SHORE BANCSHARES INCv423318_ex32.htm
EX-31.1 - EXHIBIT 31.1 - SHORE BANCSHARES INCv423318_ex31-1.htm
EX-31.2 - EXHIBIT 31.2 - SHORE BANCSHARES INCv423318_ex31-2.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-Q

 

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2015

 

OR

 

£TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from ________ to ________

 

Commission file number 0-22345

 

SHORE BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

 

Maryland   52-1974638
(State or Other Jurisdiction of   (I.R.S. Employer
Incorporation or Organization)   Identification No.)
     
28969 Information Lane, Easton, Maryland   21601
(Address of Principal Executive Offices)   (Zip Code)

 

(410) 763-7800

Registrant’s Telephone Number, Including Area Code

 

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

  Large accelerated filer ¨   Accelerated filer þ
  Non-accelerated filer ¨   Smaller reporting company ¨
  (Do not check if a smaller reporting company)    

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No þ

 

APPLICABLE ONLY TO CORPORATE ISSUERS

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 12,631,160 shares of common stock outstanding as of October 31, 2015.

 

 

 

 

INDEX

 

  Page
     
Part I. Financial Information 2  
     
Item 1.  Financial Statements 2  
     
Consolidated Balance Sheets -    
September 30, 2015 (unaudited) and December 31, 2014 2  
     
Consolidated Statements of Operations -    
For the three and nine months ended September 30, 2015 and 2014 (unaudited) 3  
     
Consolidated Statements of Comprehensive Income -    
For the three and nine months ended September 30, 2015 and 2014 (unaudited) 4  
     
Consolidated Statements of Changes in Stockholders’ Equity -    
For the nine months ended September 30, 2015 and 2014 (unaudited) 5  
     
Consolidated Statements of Cash Flows -    
For the nine months ended September 30, 2015 and 2014 (unaudited) 6  
     
Notes to Consolidated Financial Statements (unaudited) 7  
     
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations 28  
     
Item 3.  Quantitative and Qualitative Disclosures about Market Risk 39  
     
Item 4.  Controls and Procedures 39  
     
Part II.  Other Information 40  
     
Item 1.  Legal Proceedings 40  
     
Item 1A.  Risk Factors 40  
     
Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds 40  
     
Item 3.  Defaults Upon Senior Securities 40  
     
Item 4.  Mine Safety Disclosures 40  
     
Item 5.  Other Information 40  
     
Item 6.  Exhibits 40  
     
Signatures 40  
     
Exhibit Index 41  

 

 1 

 

 

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.

SHORE BANCSHARES, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share amounts)

 

   September 30,   December 31, 
   2015   2014 
   (Unaudited)     
ASSETS          
Cash and due from banks  $17,401   $24,211 
Interest-bearing deposits with other banks   41,345    68,460 
Federal funds sold   7,430    3,552 
Investment securities:          
Available for sale, at fair value   220,434    236,108 
Held to maturity, at amortized cost – fair value of $4,280 (2015) and $4,694 (2014)   4,192    4,630 
           
Loans   777,062    710,746 
Less:  allowance for credit losses   (8,098)   (7,695)
Loans, net   768,964    703,051 
           
Premises and equipment, net   16,958    16,275 
Goodwill   11,931    11,931 
Other intangible assets, net   1,231    1,331 
Other real estate owned, net   2,884    3,691 
Other assets   25,043    27,162 
TOTAL ASSETS  $1,117,813   $1,100,402 
           
LIABILITIES          
Deposits:          
Noninterest-bearing  $220,945   $193,814 
Interest-bearing   738,489    755,190 
Total deposits   959,434    949,004 
           
Short-term borrowings   6,480    4,808 
Other liabilities   6,012    6,121 
TOTAL LIABILITIES   971,926    959,933 
           
STOCKHOLDERS’ EQUITY          
Common stock, par value $.01 per share; shares authorized – 35,000,000; shares issued and outstanding – 12,630,428 (2015) and  12,618,513 (2014)   126    126 
Additional paid in capital   63,767    63,532 
Retained earnings   81,187    76,495 
Accumulated other comprehensive income   807    316 
TOTAL STOCKHOLDERS’ EQUITY   145,887    140,469 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  $1,117,813   $1,100,402 

 

See accompanying notes to Consolidated Financial Statements.

 

 2 

 

 

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

(Dollars in thousands, except per share amounts)

 

   For the Three Months
Ended
   For the Nine Months
Ended
 
   September 30,   September 30, 
   2015   2014   2015   2014 
                 
INTEREST INCOME                    
Interest and fees on loans  $8,912   $8,788   $25,984   $26,475 
Interest and dividends on investment securities:                    
Taxable   892    850    2,748    2,040 
Tax-exempt   2    3    8    9 
Interest on federal funds sold   1    1    2    1 
Interest on deposits with other banks   30    44    82    139 
Total interest income   9,837    9,686    28,824    28,664 
                     
INTEREST EXPENSE                    
Interest on deposits   824    1,046    2,581    3,244 
Interest on short-term borrowings   3    4    11    14 
Total interest expense   827    1,050    2,592    3,258 
                     
NET INTEREST INCOME   9,010    8,636    26,232    25,406 
Provision for credit losses   410    775    1,600    2,700 
                     
NET INTEREST INCOME AFTER PROVISION FOR CREDIT LOSSES   8,600    7,861    24,632    22,706 
                     
NONINTEREST INCOME                    
Service charges on deposit accounts   769    618    2,061    1,778 
Trust and investment fee income   360    496    1,279    1,382 
Insurance agency commissions   2,107    2,176    6,514    7,789 
Other noninterest income   669    704    1,924    2,361 
Total noninterest income   3,905    3,994    11,778    13,310 
                     
NONINTEREST EXPENSE                    
Salaries and wages   4,468    4,689    13,174    13,295 
Employee benefits   935    934    3,015    3,136 
Occupancy expense   600    565    1,837    1,769 
Furniture and equipment expense   223    225    711    741 
Data processing   800    741    2,451    2,240 
Directors’ fees   117    131    356    375 
Amortization of other intangible assets   34    34    100    168 
Insurance agency commissions expense   -    -    -    906 
FDIC insurance premium expense   243    399    933    1,234 
Write-downs of other real estate owned   7    290    88    466 
Other noninterest expenses   1,969    1,811    5,735    5,521 
Total noninterest expense   9,396    9,819    28,400    29,851 
                     
INCOME BEFORE INCOME TAXES   3,109    2,036    8,010    6,165 
Income tax expense   1,200    774    3,065    2,340 
                     
NET INCOME  $1,909   $1,262   $4,945   $3,825 
                     
Basic net income per common share  $0.15   $0.10   $0.39   $0.37 
Diluted net income per common share   0.15    0.10    0.39    0.37 
Dividends paid per common share   0.02    -    0.02    - 

 

See accompanying notes to Consolidated Financial Statements.

 

 3 

 

 

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(Dollars in thousands)

 

   For the Three Months Ended
September 30,
   For the Nine Months Ended
September 30,
 
   2015   2014   2015   2014 
                 
Net income  $1,909   $1,262   $4,945   $3,825 
                     
Other comprehensive income                    
Securities available for sale:                    
Unrealized holding gains (losses) on available-for-sale securities   1,319    (181)   824    322 
Tax effect   (532)   73    (333)   (130)
Net of tax amount   787    (108)   491    192 
                     
Total other comprehensive income (loss)   787    (108)   491    192 
Comprehensive income  $2,696   $1,154   $5,436   $4,017 

 

See accompanying notes to Consolidated Financial Statements.

 

 4 

 

 

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

For the Nine Months Ended September 30, 2015 and 2014

(Dollars in thousands, except per share amounts)

 

               Accumulated     
       Additional       Other   Total 
   Common   Paid in   Retained   Comprehensive   Stockholders’ 
   Stock   Capital   Earnings   Income (Loss)   Equity 
Balances, January 1, 2015  $126   $63,532   $76,495   $316   $140,469 
                          
Net income   -    -    4,945    -    4,945 
                          
Unrealized gains on available-for-sale securities, net of taxes   -    -    -    491    491 
                          
Stock-based compensation   -    235    -    -    235 
                          
Cash dividends declared   -    -    (253)   -    (253)
                          
Balances, September 30, 2015  $126   $63,767   $81,187   $807   $145,887 
                          
Balances, January 1, 2014  $85   $32,207   $71,444   $(437)  $103,299 
                          
Net income   -    -    3,825    -    3,825 
                          
Unrealized gains on available-for-sale securities, net of taxes   -    -    -    192    192 
                          
Issuance of common stock through public offering, net   41    31,238    -    -    31,279 
                          
Stock-based compensation   -    79    -    -    79 
                          
Balances, September 30, 2014  $126   $63,524   $75,269   $(245)  $138,674 

 

See accompanying notes to Consolidated Financial Statements.

 

 5 

 

 

SHORE BANCSHARES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(Dollars in thousands)

 

   For the Nine Months Ended 
   September 30, 
   2015   2014 
CASH FLOWS FROM OPERATING ACTIVITIES:          
Net income  $4,945   $3,825 
Adjustments to reconcile net income to net cash provided by operating activities:          
Provision for credit losses   1,600    2,700 
Depreciation and amortization   1,845    1,725 
Discount accretion on debt securities   (83)   (41)
Stock-based compensation expense   235    79 
Deferred income tax expense   2,640    1,923 
Losses on sales of other real estate owned   47    3 
Write-downs of other real estate owned   88    466 
Gain on sale of wholesale insurance subsidiary   -    (114)
Net changes in:          
Accrued interest receivable   46    (79)
Other assets   (1,120)   (204)
Accrued interest payable   (38)   (26)
Other liabilities   (71)   (985)
Net cash provided by operating activities   10,134    9,272 
           
CASH FLOWS FROM INVESTING ACTIVITIES:          
Proceeds from maturities and principal payments of investment securities available for sale   40,573    35,473 
Purchases of investment securities available for sale   (24,830)   (111,949)
Proceeds from maturities and principal payments of investment securities held to maturity   432    443 
Net change in loans   (68,448)   3,354 
Purchases of premises and equipment   (1,362)   (736)
Proceeds from sales of other real estate owned   1,605    734 
Proceeds from sale of wholesale insurance subsidiary   -    2,878 
Net cash used in investing activities   (52,030)   (69,803)
           
CASH FLOWS FROM FINANCING ACTIVITIES:          
Net changes in:          
Noninterest-bearing deposits   27,131    17,402 
Interest-bearing deposits   (16,701)   (10,216)
Short-term borrowings   1,672    615 
Common stock dividends paid   (253)   - 
Proceeds from issuance of common stock through public offering, net   -    31,279 
Net cash provided by financing activities   11,849    39,080 
Net decrease in cash and cash equivalents   (30,047)   (21,451)
Cash and cash equivalents at beginning of period   96,223    131,090 
Cash and cash equivalents at end of period  $66,176   $109,639 
           
Supplemental cash flows information:          
Interest paid  $2,630   $3,284 
Income taxes paid  $368   $85 
Transfers from loans to other real estate owned  $934   $2,224 
Transfers from loans held for sale to loans  $-   $3,521 

 

See accompanying notes to Consolidated Financial Statements.

 

 6 

 

 

Shore Bancshares, Inc.

Notes to Consolidated Financial Statements

For the Three and Nine Months Ended September 30, 2015 and 2014

(Unaudited)

 

Note 1 - Basis of Presentation

 

The consolidated financial statements include the accounts of Shore Bancshares, Inc. and its subsidiaries with all significant intercompany transactions eliminated. The consolidated financial statements conform to accounting principles generally accepted in the United States of America (“GAAP”) and to prevailing practices within the banking industry. The accompanying interim financial statements are unaudited; however, in the opinion of management all adjustments necessary to present fairly the consolidated financial position at September 30, 2015, the consolidated results of operations and comprehensive income for the three and nine months ended September 30, 2015 and 2014, and changes in stockholders’ equity and cash flows for the nine months ended September 30, 2015 and 2014, have been included. All such adjustments are of a normal recurring nature. The amounts as of December 31, 2014 were derived from the 2014 audited financial statements. The results of operations for the three and nine months ended September 30, 2015 are not necessarily indicative of the results to be expected for any other interim period or for the full year. This Quarterly Report on Form 10-Q should be read in conjunction with the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2014. For purposes of comparability, certain reclassifications have been made to amounts previously reported to conform with the current period presentation.

 

When used in these notes, the term “the Company” refers to Shore Bancshares, Inc. and, unless the context requires otherwise, its consolidated subsidiaries.

 

Recent Accounting Standards

 

ASU 2014-04, “Receivables (ASC Topic 310) – Troubled Debt Restructurings by Creditors, Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure.” ASU 2014-04 clarifies when an in substance repossession or foreclosure occurs which is defined as when a creditor should be considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan such that the loan receivable should be derecognized and the real estate property recognized. The ASU requires that the real property be recognized upon obtaining legal title to the real estate collateral, or the borrower voluntarily conveying all interest in the real estate property to the lender to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement. The Company adopted ASU No. 2014-04 effective January 1, 2015. The adoption of ASU No. 2014-04 did not have a material impact on the Company's Consolidated Financial Statements.

 

ASU No. 2014-14, “Classification of Certain Government-Guaranteed Mortgage Loans upon Foreclosure.” ASU 2014-14, The FASB issued an amendment to clarify how creditors are to classify certain government-guaranteed mortgage loans upon foreclosure. This amendment requires that a mortgage loan be derecognized and a separate other receivable be recognized upon foreclosure if the following conditions are met: (1) The loan has a government guarantee that is not separate from the loan before foreclosure and (2) at the time of foreclosure, the creditor has the intent to convey the real estate property to the guarantor and make a claim on the guarantee, and the creditor has the ability to recover under the claim and (3) at the time of foreclosure, any amount of the claim that is determined on the basis of the fair value of the real estate is fixed. Upon foreclosure, the separate other receivable should be measured based on the amount of the loan balance (principal and interest) expected to be recovered from the guarantor. This amendment is effective for annual reporting periods, including interim periods within those annual periods, beginning after December 15, 2014. Entities may apply the amendments in this Update either (a) prospectively to foreclosures that occur after the date of adoption or (b) modified retrospective transition using a cumulative-effect adjustment (through a reclassification to a separate other receivable) as of the beginning of the annual period of adoption. Prior periods should not be adjusted. The Company adopted ASU No. 2014-14 effective January 1, 2015. The adoption of ASU No. 2014-14 did not have a material impact on the Company's Consolidated Financial Statements.

 

 7 

 

 

ASU No. 2015-02, “Amendments to the Consolidation Analysis.” This ASU affects reporting entities that are required to evaluate whether they should consolidate certain legal entities. Specifically, the amendments: (1) Modify the evaluation of whether limited partnerships and similar legal entities are variable interest entities (“VIEs”) or voting interest entities; (2) Eliminate the presumption that a general partner should consolidate a limited partnership; (3) Affect the consolidation analysis of reporting entities that are involved with VIEs, particularly those that have fee arrangements and related party relationships; and (4) Provide a scope exception from consolidation guidance for reporting entities with interests in legal entities that are required to comply with or operate in accordance with requirements that are similar to those in Rule 2a-7 of the Investment Company Act of 1940 for registered money market funds. ASU No. 2015-02 is effective for interim and annual reporting periods beginning after December 15, 2015. The Company is currently evaluating the provisions of ASU No. 2015-02 to determine the potential impact the new standard will have on the Company's Consolidated Financial Statements.

 

ASU No. 2015-05, “Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement.” This ASU provides guidance to customers about whether a cloud computing arrangement includes a software license. If a cloud computing arrangement includes a software license, the customer should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract. The new guidance does not change the accounting for a customer’s accounting for service contracts. ASU No. 2015-05 is effective for interim and annual reporting periods beginning after December 15, 2015. The Company is currently evaluating the provisions of ASU No. 2015-05 to determine the potential impact the new standard will have on the Company's Consolidated Financial Statements.

 

FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers." The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies generally will be required to use more judgment and make more estimates than under current guidance. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. The standard was initially effective for public entities for interim and annual reporting periods beginning after December 15, 2016; early adoption is not permitted. However, in August 2015, the FASB issued ASU No. 2015-14, "Revenue from Contracts with Customers - Deferral of the Effective Date" which defers the effective date by one year (i.e., interim and annual reporting periods beginning after December 15, 2017). Early adoption is permitted, but not before the original effective date (i.e., interim and annual reporting periods beginning after December 15, 2016). For financial reporting purposes, the standard allows for either full retrospective adoption, meaning the standard is applied to all of the periods presented, or modified retrospective adoption, meaning the standard is applied only to the most current period presented in the financial statements with the cumulative effect of initially applying the standard recognized at the date of initial application. The Company is currently evaluating the provisions of ASU No. 2014-09 and will be closely monitoring developments and additional guidance to determine the potential impact the new standard will have on the Company's Consolidated Financial Statements.

 

Note 2 – Earnings Per Share

 

Basic earnings per common share is calculated by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period, adjusted for the dilutive effect of common stock equivalents (stock-based awards). The following table provides information relating to the calculation of earnings per common share:

 

   For the Three Months Ended   For the Nine Months Ended 
   September 30,   September 30, 
(In thousands, except per share data)  2015   2014   2015   2014 
Net income  $1,909   $1,262   $4,945   $3,825 
Weighted average shares outstanding - Basic   12,630    12,615    12,627    10,381 
Dilutive effect of common stock equivalents   10    10    10    12 
Weighted average shares outstanding - Diluted   12,640    12,625    12,637    10,393 
Earnings per common share - Basic  $0.15   $0.10   $0.39   $0.37 
Earnings per common share - Diluted  $0.15   $0.10   $0.39   $0.37 

 

There were no weighted average common stock equivalents excluded from the calculation of diluted earnings per share for the three and nine months ended September 30, 2015 and 2014.

 

 8 

 

 

Note 3 – Investment Securities

 

The following table provides information on the amortized cost and estimated fair values of investment securities.

 

       Gross   Gross   Estimated 
   Amortized   Unrealized   Unrealized   Fair 
(Dollars in thousands)  Cost   Gains   Losses   Value 
Available-for-sale securities:                    
September 30, 2015                    
U.S. Treasury  $5,111   $12   $-   $5,123 
U.S. Government agencies   65,707    207    160    65,754 
Mortgage-backed   147,629    1,647    363    148,913 
Equity   634    10    -    644 
Total  $219,081   $1,876   $523   $220,434 
                     
December 31, 2014                    
U.S. Treasury  $5,210   $5   $-   $5,215 
U.S. Government agencies   75,220    87    347    74,960 
Mortgage-backed   154,525    1,230    452    155,303 
Equity   624    6    -    630 
Total  $235,579   $1,328   $799   $236,108 
                     
Held-to-maturity securities:                    
September 30, 2015                    
U.S. Government agencies  $2,575   $-   $43   $2,532 
States and political subdivisions   1,617    131    -    1,748 
     Total  $4,192   $131   $43   $4,280 
                     
December 31, 2014                    
U.S. Government agencies  $2,791   $-   $83   $2,708 
States and political subdivisions   1,839    147    -    1,986 
    Total  $4,630   $147   $83   $4,694 

 

The following tables provide information about gross unrealized losses and fair value by length of time that the individual securities have been in a continuous unrealized loss position at September 30, 2015 and December 31, 2014.

 

  

Less than

12 Months

  

More than

12 Months

   Total 
(Dollars in thousands)  Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
 
September 30, 2015                              
Available-for-sale securities:                              
U.S. Government agencies  $14,989   $19   $-   $141   $14,989   $160 
Mortgage-backed   14,067    43    22,488    320    36,555    363 
Total  $29,056   $62   $22,488   $461   $51,544   $523 
                               
Held-to-maturity securities:                              
U.S. Government agencies  $-   $-   $2,532   $43   $2,532   $43 

  

 9 

 

  

  

Less than

12 Months

  

More than

12 Months

   Total 
(Dollars in thousands)  Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
   Fair
Value
   Unrealized
Losses
 
December 31, 2014                              
Available-for-sale securities:                              
U.S. Government agencies  $41,574   $138   $6,954   $209   $48,528   $347 
Mortgage-backed   12,933    44    26,828    408    39,761    452 
Total  $54,507   $182   $33,782   $617   $88,289   $799 
                               
Held-to-maturity securities:                              
U.S. Government agencies  $-   $-   $2,708   $83   $2,708   $83 

 

All of the securities with unrealized losses in the portfolio have modest duration risk, low credit risk, and minimal losses when compared to total amortized cost. The unrealized losses on debt securities that exist are the result of market changes in interest rates since original purchase. Because the Company does not intend to sell these securities and it is not more likely than not that the Company will be required to sell these securities before recovery of their amortized cost bases, which may be at maturity for debt securities, the Company considers the unrealized losses to be temporary.

 

The following table provides information on the amortized cost and estimated fair values of investment securities by maturity date at September 30, 2015.

 

   Available for sale   Held to maturity 
   Amortized   Estimated   Amortized   Estimated 
(Dollars in thousands)  Cost   Fair Value   Cost   Fair Value 
Due in one year or less  $10,149   $10,168   $-   $- 
Due after one year through five years   57,710    57,839    711    761 
Due after five years through ten years   12,084    12,134    403    454 
Due after ten years   138,504    139,649    3,078    3,065 
    218,447    219,790    4,192    4,280 
Equity securities   634    644    -    - 
Total  $219,081   $220,434   $4,192   $4,280 

 

The maturity dates for debt securities are determined using contractual maturity dates.

 

Note 4 – Loans and Allowance for Credit Losses

 

The Company makes residential mortgage, commercial and consumer loans to customers primarily in Talbot County, Queen Anne’s County, Kent County, Caroline County and Dorchester County in Maryland and in Kent County, Delaware. The following table provides information about the principal classes of the loan portfolio at September 30, 2015 and December 31, 2014.

 

(Dollars in thousands) 

September 30,

2015

   December 31,
2014
 
Construction  $86,548   $69,157 
Residential real estate   303,137    273,336 
Commercial real estate   323,160    305,788 
Commercial   57,129    52,671 
Consumer   7,088    9,794 
Total loans   777,062    710,746 
Allowance for credit losses   (8,098)   (7,695)
Total loans, net  $768,964   $703,051 

  

 10 

 

 

Loans are stated at their principal amount outstanding net of any purchase premiums, deferred fees and costs. Interest income on loans is accrued at the contractual rate based on the principal amount outstanding. Fees charged and costs capitalized for originating loans are being amortized substantially on the interest method over the term of the loan. A loan is placed on nonaccrual (i.e., interest income is no longer accrued) when it is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more, unless the loan is well secured and in the process of collection. Any unpaid interest previously accrued on those loans is reversed from income.

 

Interest payments received on nonaccrual loans are applied as a reduction of the loan principal balance unless collectability of the principal amount is reasonably assured, in which case interest is recognized on a cash basis. Loans are returned to accrual status when all principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

A loan is considered impaired if it is probable that the Company will not collect all principal and interest payments according to the loan’s contractual terms. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The impairment of a loan is measured at the present value of expected future cash flows using the loan’s effective interest rate, or at the loan’s observable market price or the fair value of the collateral if the loan is collateral dependent. Generally, the Company measures impairment on such loans by reference to the fair value of the collateral. Once the amount of impairment has been determined, the uncollectible portion is charged off. Income on impaired loans is recognized on a cash basis, and payments are first applied against the principal balance outstanding (i.e., placing impaired loans on nonaccrual status). Generally, interest income is not recognized on impaired loans unless the likelihood of further loss is remote. The allowance for credit losses may include specific reserves related to impaired loans. Specific reserves remain until charge offs are made. Impaired loans do not include groups of smaller balance homogenous loans such as residential mortgage and consumer installment loans that are evaluated collectively for impairment. Reserves for probable credit losses related to these loans are based on historical loss ratios and are included in the formula portion of the allowance for credit losses. See additional discussion under the caption “Critical Accounting Policies” in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

A loan is considered a troubled debt restructuring (“TDR”) if a borrower is experiencing financial difficulties and a creditor has granted a concession. Concessions may include interest rate reductions or below market interest rates, principal forgiveness, restructuring amortization schedules and other actions intended to minimize potential losses. Loans are identified to be restructured when signs of impairment arise such as borrower interest rate reduction request, slowness to pay, or when an inability to repay becomes evident. The terms being offered are evaluated to determine if they are more liberal than those that would be indicated by policy or industry standards for similar, untroubled credits. In those situations where the terms or the interest rates are considered to be more favorable than industry standards or the current underwriting guidelines of the Company’s banking subsidiaries, the loan is classified as a TDR. All loans designated as TDRs are considered impaired loans and may be on either accrual or nonaccrual status. In instances where the loan has been placed on nonaccrual status, six consecutive months of timely payments are required prior to returning the loan to accrual status.

 

All loans classified as TDRs which are restructured and accrue interest under revised terms require a full and comprehensive review of the borrower’s financial condition, capacity for repayment, realistic assessment of collateral values, and the assessment of risk entered into any workout agreement. Current financial information on the borrower, guarantor, and underlying collateral is analyzed to determine if it supports the ultimate collection of principal and interest. For commercial loans, the cash flows are analyzed, both for the underlying project and globally. For consumer loans, updated salary, credit history and cash flow information is obtained. Current market conditions are also considered. Following a full analysis, the determination of the appropriate loan structure is made.

 

 11 

 

 

The following tables include impairment information relating to loans and the allowance for credit losses as of September 30, 2015 and December 31, 2014.

 

(Dollars in thousands)  Construction   Residential
real estate
   Commercial
real estate
   Commercial   Consumer   Unallocated   Total 
September 30, 2015                                   
Loans individually evaluated for impairment  $11,766   $10,753   $6,768   $165   $122   $-   $29,574 
Loans collectively evaluated for impairment   74,782    292,384    316,392    56,964    6,966    -    747,488 
Total loans  $86,548   $303,137   $323,160   $57,129   $7,088   $-   $777,062 
                                    
Allowance for credit losses allocated to:                                   
Loans individually evaluated for impairment  $676   $363   $189   $-   $-   $-   $1,228 
Loans collectively evaluated for impairment   1,166    1,928    2,622    499    156    499    6,870 
Total allowance for credit losses  $1,842   $2,291   $2,811   $499   $156   $499   $8,098 

 

(Dollars in thousands)  Construction   Residential
real estate
   Commercial
real estate
   Commercial   Consumer   Unallocated   Total 
December 31, 2014                                   
Loans individually evaluated for impairment  $10,067   $10,403   $9,359   $188   $124   $-   $30,141 
Loans collectively evaluated for impairment   59,090    262,933    296,429    52,483    9,670    -    680,605 
Total loans  $69,157   $273,336   $305,788   $52,671   $9,794   $-   $710,746 
                                    
Allowance for credit losses allocated to:                                   
Loans individually evaluated for impairment  $41   $1,099   $129   $1   $3   $-   $1,273 
Loans collectively evaluated for impairment   1,262    1,735    2,250    447    226    502    6,422 
Total allowance for credit losses  $1,303   $2,834   $2,379   $448   $229   $502   $7,695 

 

 

 12 

 

 

The following tables provide information on impaired loans and any related allowance by loan class as of September 30, 2015 and December 31, 2014. The difference between the unpaid principal balance and the recorded investment is the amount of partial charge-offs that have been taken.

 

(Dollars in thousands)  Unpaid
principal
balance
   Recorded
investment
with no
allowance
   Recorded
investment
with an
allowance
   Related
allowance
   Quarter-to-
date average
recorded
investment
   Year-to-date
average
recorded
investment
 
September 30, 2015                              
Impaired nonaccrual loans:                              
Construction  $11,999   $4,796   $2,889   $643   $8,025   $8,121 
Residential real estate   4,399    3,591    487    156    3,812    2,710 
Commercial real estate   1,451    884    209    9    2,137    2,511 
Commercial   177    165    -    -    170    105 
Consumer   128    122    -    -    123    123 
Total   18,154    9,558    3,585    808    14,267    13,570 
                               
Impaired accruing TDRs:                              
Construction   4,081    3,273    808    33    4,099    4,076 
Residential real estate   6,675    3,350    3,325    207    7,520    7,084 
Commercial real estate   5,675    4,300    1,375    180    5,687    6,065 
Commercial   -    -    -    -    27    38 
Consumer   -    -    -    -    -    - 
Total   16,431    10,923    5,508    420    17,333    17,263 
                               
Total impaired loans:                              
Construction   16,080    8,069    3,697    676    12,124    12,197 
Residential real estate   11,074    6,941    3,812    363    11,332    9,794 
Commercial real estate   7,126    5,184    1,584    189    7,824    8,576 
Commercial   177    165    -    -    197    143 
Consumer   128    122    -    -    123    123 
Total  $34,585   $20,481   $9,093   $1,228   $31,600   $30,833 

  

 13 

 

 

                   September 30, 2014 
(Dollars in thousands)  Unpaid
principal
balance
   Recorded
investment
with no
allowance
   Recorded
investment
with an
allowance
   Related
allowance
   Quarter-to-
date average
recorded
investment
   Year-to-date
average
recorded
investment
 
December 31, 2014                              
Impaired nonaccrual loans:                              
Construction  $9,277   $6,045   $-   $-   $7,492   $7,918 
Residential real estate   4,664    1,053    2,982    799    2,604    4,014 
Commercial real estate   4,703    2,842    280    100    3,132    4,443 
Commercial   1,372    136    5    1    389    558 
Consumer   129    99    25    3    124    55 
Total   20,145    10,175    3,292    903    13,741    16,988 
                               
Impaired accruing TDRs:                              
Construction   4,022    3,196    826    41    3,404    2,301 
Residential real estate   6,368    668    5,700    300    16,190    16,131 
Commercial real estate   6,237    4,774    1,463    29    5,459    6,826 
Commercial   47    47    -    -    54    62 
Consumer   -    -    -    -    -    - 
Total   16,674    8,685    7,989    370    25,107    25,320 
                               
Total impaired loans:                              
Construction   13,299    9,241    826    41    10,896    10,219 
Residential real estate   11,032    1,721    8,682    1,099    18,794    20,145 
Commercial real estate   10,940    7,616    1,743    129    8,591    11,269 
Commercial   1,419    183    5    1    443    620 
Consumer   129    99    25    3    124    55 
Total  $36,819   $18,860   $11,281   $1,273   $38,848   $42,308 

  

 14 

 

 

The following tables provide a roll-forward for troubled debt restructurings as of September 30, 2015 and September 30, 2014.

 

(Dollars in thousands)  1/1/15
TDR
Balance
   New
TDRs
   Disbursements
(Payments)
   Charge
offs
   Reclassification/
Transfers
In/(Out)
   Payoffs   9/30/15
TDR
Balance
   Related
Allowance
 
For the nine months ended 9/30/2015                                        
Accruing TDRs                                        
Construction  $4,022   $-   $(83)  $-   $142   $-   $4,081   $33 
Residential Real Estate   6,368    1,837    (206)   -    (1,324)   -    6,675    207 
Commercial Real Estate   6,237    -    (562)   -    -    -    5,675    180 
Commercial   47    -    (6)   -    (41)   -    -    - 
Consumer   -    -    -    -    -    -    -    - 
Total  $16,674   $1,837   $(857)  $-   $(1,223)  $-   $16,431   $420 
                                         
Nonaccrual TDRs                                        
Construction  $3,321   $-   $(207)  $(1,058)  $2,911   $-   $4,967   $643 
Residential Real Estate   3,382    -    (21)   -    (2,911)   -    450    89 
Commercial Real Estate   346    -    (4)   (40)   (302)   -    -    - 
Commercial   -    -    -    -    -    -    -    - 
Consumer   25    -    (2)   -    -    -    23    - 
Total  $7,074   $-   $(234)  $(1,098)  $(302)  $-   $5,440   $732 
                                         
Total TDRs  $23,748   $1,837   $(1,091)  $(1,098)  $*(1,525)  $-   $21,871   $1,152 

 

(Dollars in thousands)  1/1/14
TDR
Balance
   New
TDRs
   Disbursements
(Payments)
   Charge offs   Reclassification/
Transfers
In/(Out)
   Payoffs   9/30/14
TDR
Balance
   Related
Allowance
 
For the nine months ended 9/30/2014                                        
Accruing TDRs                                        
Construction  $1,620   $-   $(52)  $(538)  $2,643   $(270)  $3,403   $1 
Residential Real Estate   14,582    -    1,324    -    478    (158)   16,226    168 
Commercial Real Estate   9,791    -    (71)   (549)   (2,508)   (1,097)   5,566    6 
Commercial   95    -    (19)   -    -    (24)   52    - 
Consumer   -    -    -    -    -    -    -    - 
Total  $26,088   $-   $1,182   $(1,087)  $613   $(1,549)  $25,247   $175 
                                         
Nonaccrual TDRs                                        
Construction  $3,561   $-   $(12)  $(235)  $760   $-   $4,074   $- 
Residential Real Estate   1,884    -    (40)   (203)   (1,037)   (123)   481    - 
Commercial Real Estate   842    -    (91)   (65)   (336)   -    350    - 
Commercial   -    -    -    -    -    -    -    - 
Consumer   26    -    (1)   -    -    -    25    25 
Total  $6,313   $-   $(144)  $(503)  $(613)  $(123)  $4,930   $25 
                                         
Total TDRs  $32,401   $-   $1,038   $(1,590)  $-   $(1,672)  $30,177   $200 

 

* $1.3 million in subsequently modified TDRs were transferred from accruing TDR classification to accrual status during the period, thus removing the TDR designation. In accordance with ASC 310-40-50-2 “Creditor Disclosure of Troubled Debt Restructurings,” an impaired loan that has been subsequently restructured in a troubled debt restructuring involving modification of terms need not be included in the disclosures in years after the restructuring if both of the following conditions exist: a) the subsequent restructuring agreement specifies an interest rate equal to or greater than the rate that the creditor was willing to accept at the time of the restructuring for a new loan with comparable risk; and b) the loan is not impaired based on the terms specified by the restructuring agreement. During the period ended September 30, 2015, three loans totaling $1.3 million met the conditions stipulated in ASC 310-40-50-2, and after a careful evaluation of well supported documentation by management, these loans were upgraded to accrual status.

 

 15 

 

 

The following tables provide information on loans that were modified and considered TDRs during the nine months ended September 30, 2015 and September 30, 2014.

 

(Dollars in thousands)  Number of
contracts
   Premodification
outstanding
recorded
investment
   Postmodification
outstanding
recorded
investment
   Related
allowance
 
TDRs:                    
For the nine months ended September 30, 2015                    
Construction   -   $-   $-   $- 
Residential real estate   10    1,835    1,837    19 
Commercial real estate   -    -    -    - 
Commercial   -    -    -    - 
Consumer   -    -    -    - 
Total   10   $1,835   $1,837   $19 
                     
For the nine months ended September 30, 2014                    
Construction   -   $-   $-   $- 
Residential real estate   -    -    -    - 
Commercial real estate   -    -    -    - 
Commercial   -    -    -    - 
Consumer   -    -    -    - 
Total   -   $-   $-   $- 

 

The following tables provide information on TDRs that defaulted during the nine months ended September 30, 2015 and September 30, 2014. Generally, a loan is considered in default when principal or interest is past due 90 days or more.

 

(Dollars in thousands)  Number of
contracts
   Recorded
investment
   Related
allowance
 
TDRs that subsequently defaulted:               
For the nine months ended September 30, 2015               
Construction   -   $-   $- 
Residential real estate   -    -    - 
Commercial real estate   2    279    - 
Commercial   -    -    - 
Consumer   -    -    - 
Total   2   $279   $- 
                
TDRs that subsequently defaulted:               
For the nine months ended September 30, 2014               
Construction   -   $-   $- 
Residential real estate   -    -    - 
Commercial real estate   -    -    - 
Commercial   -    -    - 
Consumer   -    -    - 
Total   -   $-   $- 

  

 16 

 

 

Management uses risk ratings as part of its monitoring of the credit quality in the Company’s loan portfolio. Loans that are identified as special mention, substandard or doubtful are adversely rated. They are assigned higher risk ratings than favorably rated loans in the calculation of the formula portion of the allowance for credit losses.

 

The following tables provide information on loan risk ratings as of September 30, 2015 and December 31, 2014.

 

(Dollars in thousands)  Pass/Performing   Special
mention
   Substandard   Doubtful   Total 
September 30, 2015                         
Construction  $69,344   $5,525   $11,679   $-   $86,548 
Residential real estate   283,551    7,823    11,763    -    303,137 
Commercial real estate   294,148    20,261    8,542    209    323,160 
Commercial   55,282    1,632    215    -    57,129 
Consumer   6,930    35    123    -    7,088 
Total  $709,255   $35,276   $32,322   $209   $777,062 

 

(Dollars in thousands)  Pass/Performing   Special
mention
   Substandard   Doubtful   Total 
December 31, 2014                         
Construction  $52,241   $5,643   $11,273   $-   $69,157 
Residential real estate   252,643    6,675    14,018    -    273,336 
Commercial real estate   275,573    20,040    10,175    -    305,788 
Commercial   50,583    1,885    114    89    52,671 
Consumer   9,658    13    123    -    9,794 
Total  $640,698   $34,256   $35,703   $89   $710,746 

 

The following tables provide information on the aging of the loan portfolio as of September 30, 2015 and December 31, 2014.

 

   Accruing         
(Dollars in thousands)  Current   30-59
days
past due
   60-89
days past
due
   90 days
or more
past due
   Total past
due
   Nonaccrual   Total 
September 30, 2015                                   
Construction  $78,863   $-   $-   $-   $-   $7,685   $86,548 
Residential real estate   296,151    2,274    634    -    2,908    4,078    303,137 
Commercial real estate   320,934    1,133    -    -    1,133    1,093    323,160 
Commercial   56,901    21    42    -    63    165    57,129 
Consumer   6,874    79    9    4    92    122    7,088 
Total  $759,723   $3,507   $685   $4   $4,196   $13,143   $777,062 
Percent of total loans   97.7%   0.5%   0.1%   -%    0.6%   1.7%     

 

   Accruing         
(Dollars in thousands)  Current   30-59
days
past due
   60-89
days past
due
   90 days or
more past
due
   Total past
due
   Nonaccrual   Total 
December 31, 2014                                   
Construction  $61,325   $1,786   $-   $-   $1,786   $6,046   $69,157 
Residential real estate   263,165    3,351    2,702    83    6,136    4,035    273,336 
Commercial real estate   301,695    459    513    -    972    3,121    305,788 
Commercial   52,352    47    131    -    178    141    52,671 
Consumer   9,619    11    37    4    52    123    9,794 
Total  $688,156   $5,654   $3,383   $87   $9,124   $13,466   $710,746 
Percent of total loans   96.8%   0.8%   0.5%   -%    1.3%   1.9%     

  

 17 

 

 

Management evaluates the adequacy of the allowance for credit losses at least quarterly and adjusts the provision for credit losses based on this analysis. The following tables provide a summary of the activity in the allowance for credit losses allocated by loan class for the three months and nine months ended September 30, 2015 and 2014. Allocation of a portion of the allowance to one loan class does not preclude its availability to absorb losses in other loan classes.

 

(Dollars in thousands)  Construction   Residential
real estate
   Commercial
real estate
   Commercial   Consumer   Unallocated   Total 
For the three months ended September 30, 2015                                   
Allowance for credit losses:                                   
Beginning balance  $1,852   $2,318   $2,616   $505   $168   $458   $7,917 
                                    
Charge-offs   (479)   (26)   -    (136)   -    -    (641)
Recoveries   9    102    233    60    8    -    412 
Net charge-offs   (470)   76    233    (76)   8    -    (229)
                                    
Provision   460    (103)   (38)   70    (20)   41    410 
Ending balance  $1,842   $2,291   $2,811   $499   $156   $499   $8,098 

 

(Dollars in thousands)  Construction   Residential
real estate
   Commercial
real estate
   Commercial   Consumer   Unallocated   Total 
For the three months ended September 30, 2014                                   
Allowance for credit losses:                                   
Beginning balance  $2,248   $2,354   $2,652   $858   $306   $658   $9,076 
                                    
Charge-offs   (213)   (242)   (35)   (1,019)   (6)   -    (1,515)
Recoveries   1    229    9    24    7    -    270 
Net charge-offs   (212)   (13)   (26)   (995)   1    -    (1,245)
                                    
Provision   (206)   47    115    935    (39)   (77)   775 
Ending balance  $1,830   $2,388   $2,741   $798   $268   $581   $8,606 

  

 18 

 

 

(Dollars in thousands)  Construction   Residential
real estate
   Commercial
real estate
   Commercial   Consumer   Unallocated   Total 
For the nine months ended September 30, 2015                                   
Allowance for credit losses:                                   
Beginning balance  $1,303   $2,834   $2,379   $448   $229   $502   $7,695 
                                    
Charge-offs   (1,058)   (283)   (320)   (285)   (45)   -    (1,991)
Recoveries   116    247    248    142    41    -    794 
Net charge-offs   (942)   (36)   (72)   (143)   (4)   -    (1,197)
                                    
Provision   1,481    (507)   504    194    (69)   (3)   1,600 
Ending balance  $1,842   $2,291   $2,811   $499   $156   $499   $8,098 

 

(Dollars in thousands)  Construction   Residential
real estate
   Commercial
real estate
   Commercial   Consumer   Unallocated   Total 
For the nine months ended September 30, 2014                                   
Allowance for credit losses:                                   
Beginning balance  $1,960   $3,854   $3,029   $1,266   $243   $373   $10,725 
                                    
Charge-offs   (454)   (1,229)   (1,648)   (1,956)   (153)   -    (5,440)
Recoveries   12    335    22    231    21    -    621 
Net charge-offs   (442)   (894)   (1,626)   (1,725)   (132)   -    (4,819)
                                    
Provision   312    (572)   1,338    1,257    157    208    2,700 
Ending balance  $1,830   $2,388   $2,741   $798   $268   $581   $8,606 

 

Foreclosure Proceedings

Consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure totaled $581 thousand as of September 30, 2015.

 

Note 5 – Other Assets

 

The Company had the following other assets at September 30, 2015 and December 31, 2014.

 

(Dollars in thousands)  September 30, 2015   December 31, 2014 
Nonmarketable investment securities  $1,621   $1,586 
Accrued interest receivable   2,617    2,663 
Deferred income taxes   12,772    15,744 
Prepaid expenses   1,334    750 
Other assets   6,699    6,419 
Total  $25,043   $27,162 

  

 19 

 

 

The following table provides information on significant components of the Company’s deferred tax assets and liabilities as of September 30, 2015 and December 31, 2014.

 

(Dollars in thousands) 

September 30,

2015

   December 31,
2014
 
Deferred tax assets:          
Allowance for credit losses  $3,230   $3,072 
Reserve for off-balance sheet commitments   121    121 
Net operating loss carry forward   10,426    13,265 
Write-downs of other real estate owned   320    355 
Deferred income   1,164    1,132 
Accrued expenses   926    918 
Other   198    80 
Total deferred tax assets   16,385    18,943 
Deferred tax liabilities:          
Depreciation   293    372 
Purchase accounting adjustments   2,069    1,751 
Deferred capital gain on branch sale   415    425 
Unrealized gains on available-for-sale securities   546    214 
Other   290    437 
Total deferred tax liabilities   3,613    3,199 
Net deferred tax assets  $12,772   $15,744 
           

 

The Company’s deferred tax assets primarily consist of net operating loss carryovers that will be used to offset taxable income in future periods through their statutory period of 20 years for federal tax purposes. No valuation allowance on these deferred tax assets was recorded at September 30, 2015 and December 31, 2014 as management believes it is more likely than not that all deferred tax assets will be realized based on the following positive material factors: 1) The Company was profitable for all four quarters of 2014 and the first three quarters of 2015 on a GAAP basis. The net operating loss was originally created in the third quarter of 2013 and was solely attributable to Talbot Bank’s sale of loans and other real estate owned (the “Asset Sale”), which is considered non-recurring. 2) The Company had pre-tax income of $8.1 million for the year ended December 31, 2014, providing further evidence that the Asset Sale was producing positive results and confirming the expectation of utilizing the deferred tax assets. 3) As a contingent opportunity, the Company has had discussions with certain investors about entering into a sales leaseback transaction for some of its branch locations which would generate a material taxable gain. The decision to act on this has been deferred; however, it would become a very viable option as a tax planning strategy if there was a risk that the net operating loss carryovers would expire before they were fully utilized. Alternatively, the Company has reviewed negative factors which would influence the conclusion of realizing the deferred tax assets. These factors include the following: 1) The Company could be subject to Section 382 of the Internal Revenue Code (“IRC”), which could further limit the realization of the net operating loss-related deferred tax asset (“NOL-DTA”). 2) Although the local economy of the market in which the Company operates has been showing continued signs of improvement over the past three years, if this trend flattens or reverses, there is a potential that this potential negative evidence could outweigh the prevailing positive factors.

 

Based on the aforementioned considerations, the Company has concluded that the predominance of observable positive evidence outweighs the future potential of negative evidence and therefore it is more likely than not that the Company will be able to realize in the future all of the net deferred tax assets.

 

Note 6 – Other Liabilities

 

The Company had the following other liabilities at September 30, 2015 and December 31, 2014.

 

(Dollars in thousands)  September 30, 2015   December 31, 2014 
Accrued interest payable  $134   $172 
Other accounts payable   2,762    2,435 
Deferred compensation liability   1,447    1,503 
Other liabilities   1,669    2,011 
Total  $6,012   $6,121 

 

 20 

 

 

Note 7 - Stock-Based Compensation

 

As of September 30, 2015, the Company maintained the Shore Bancshares, Inc. 2006 Stock and Incentive Compensation Plan (“2006 Equity Plan”) under which it may issue shares of common stock or grant other equity-based awards. Stock-based awards granted to date generally are time-based, vest in equal installments on each anniversary of the grant date over a three- to five-year period of time, and, in the case of stock options, expire 7 years from the grant date. On July 1, 2015, the Company's board of directors (the "Board") also adopted a form of performance share/restricted stock unit award agreement that will be used to grant performance equity incentive awards pursuant to and subject to the provisions of the 2006 Equity Plan. Stock-based compensation expense is recognized ratably over the requisite service period for all awards, is based on the grant-date fair value and reflects forfeitures as they occur.

 

The following tables provide information on stock-based compensation expense for the three and nine months ended September 30, 2015 and 2014.

 

   For the Three Months Ended   For the Nine Months Ended 
   September 30,   September 30, 
(Dollars in thousands)  2015   2014   2015   2014 
Stock-based compensation expense  $41   $30   $232   $79 
Excess tax expense related to stock-based compensation   3    -    3    - 

 

   September 30, 
(Dollars in thousands)  2015   2014 
Unrecognized stock-based compensation expense  $55   $92 
Weighted average period unrecognized expense is expected to be recognized   0.4 years    1.0 years 

 

The following table summarizes restricted stock award activity for the Company under the 2006 Equity Plan for the nine months ended September 30, 2015 and 2014.

 

   Number   Weighted Average Grant 
September 30, 2015  of Shares   Date Fair Value 
Nonvested at beginning of period   14,251   $8.33 
Granted   11,915    9.19 
Vested   (13,678)   8.90 
Cancelled   -    - 
Nonvested at end of period   12,488   $8.74 

 

   Number   Weighted Average Grant 
September 30, 2014  of Shares   Date Fair Value 
Nonvested at beginning of period   13,930   $8.33 
Granted   3,654    9.57 
Vested   (3,333)   8.93 
Cancelled   -    - 
Nonvested at end of period   14,251   $8.51 

 

The fair value of restricted stock awards that vested during the first nine months of 2015 and 2014 was $122 thousand and $30 thousand, respectively.

 

 21 

 

 

The following table summarizes stock option activity for the Company under the 2006 Equity Plan for the nine months ended September 30, 2015 and 2014.

 

       Weighted 
   Number   Average 
September 30, 2015  of Shares   Exercise Price 
Outstanding at beginning of period   27,108   $6.64 
Granted   34,219    9.18 
Exercised   -    - 
Expired/Cancelled   -    - 
Outstanding at end of period   61,327   $8.05 
           
Exercisable at end of period   27,108   $6.64 

 

       Weighted 
   Number   Average 
September 30, 2014  of Shares   Exercise Price 
Outstanding at beginning of period   40,662   $6.64 
Granted   -    - 
Exercised   -    - 
Expired/Cancelled   -    - 
Outstanding at end of period   40,662   $6.64 
           
Exercisable at end of period   20,331   $6.64 

 

The weighted average fair value of stock options granted during 2015 was $3.44. The Company estimates the fair value of options using the Black-Scholes valuation model with weighted average assumptions for dividend yield, expected volatility, risk-free interest rate and expected lives (in years). The expected dividend yield is calculated by dividing the total expected annual dividend payout by the average stock price. The expected volatility is based on historical volatility of the underlying securities. The risk-free interest rate is based on the Federal Reserve Bank’s constant maturities daily interest rate in effect at grant date. The expected contract life of the options represents the period of time that the Company expects the awards to be outstanding based on historical experience with similar awards. The following weighted average assumptions were used as inputs to the Black-Scholes valuation model for options granted in 2015.

 

Dividend yield 0%
Expected volatility 32%
Risk-free interest rate 1.97%
Expected contract life (in years) 7 years

 

At the end of the third quarter of 2015, the aggregate intrinsic value of the options outstanding under the 2006 Equity Plan was $102 thousand based on the $9.72 market value per share of the Company’s common stock at September 30, 2015. Similarly, the aggregate intrinsic value of the options exercisable was $83 thousand at September 30, 2015. Since there were no options exercised during the first nine months of 2015 or 2014, there was no intrinsic value associated with stock options exercised and no cash received on exercise of options. At September 30, 2015, the weighted average remaining contract life of options outstanding was 6.5 years.

 

 22 

 

 

Note 8 – Accumulated Other Comprehensive Income

 

The Company records unrealized holding gains (losses), net of tax, on investment securities available for sale as accumulated other comprehensive income (loss), a separate component of stockholders’ equity. The following table provides information on the changes in the components of accumulated other comprehensive income (loss) for the nine months ended September 30, 2015 and 2014.

 

(Dollars in thousands)  Accumulated net
unrealized holding
gains (losses) on
available for sale
securities
   Total accumulated
other
comprehensive
income (loss)
 
Balance, December 31, 2014  $316   $316 
Other comprehensive income   491    491 
Balance, September 30, 2015  $807   $807 
           
Balance, December 31, 2013  $(437)  $(437)
Other comprehensive income   192    192 
Balance, September 30, 2014  $(245)  $(245)

 

Note 9 – Fair Value Measurements

 

Accounting guidance under GAAP defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. This accounting guidance also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.

 

The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, the Company may be required to record at fair value other assets on a nonrecurring basis, such as impaired loans, loans held for sale and other real estate owned (foreclosed assets). These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

 

Under fair value accounting guidance, assets and liabilities are grouped at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine their fair values. These hierarchy levels are:

 

Level 1 inputs – Unadjusted quoted prices in active markets for identical assets or liabilities that the entity has the ability to access at the measurement date.

 

Level 2 inputs – Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. These might include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

 

Level 3 inputs – Unobservable inputs for determining the fair values of assets or liabilities that reflect an entity’s own assumptions about the assumptions that market participants would use in pricing the assets or liabilities.

 

Below is a discussion on the Company’s assets measured at fair value on a recurring basis.

 

Investment Securities Available for Sale

Fair value measurement for investment securities available for sale is based on quoted prices from an independent pricing service. The fair value measurements consider observable data that may include present value of future cash flows, prepayment assumptions, credit loss assumptions and other factors. The Company classifies its investments in U.S. Treasury securities as Level 1 in the fair value hierarchy, and it classifies its investments in U.S. Government agencies securities, mortgage-backed securities issued or guaranteed by U.S. Government sponsored entities, and equity securities as Level 2.

 

 23 

 

 

The tables below present the recorded amount of assets measured at fair value on a recurring basis at September 30, 2015 and December 31, 2014. No assets were transferred from one hierarchy level to another during the first nine months of 2015 or 2014.

 

           Significant     
           Other   Significant 
       Quoted   Observable   Unobservable 
       Prices   Inputs   Inputs 
(Dollars in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3) 
September 30, 2015                    
Securities available for sale:                    
 U.S. Treasury  $5,123   $5,123   $-   $- 
 U.S. Government agencies   65,754    -    65,754    - 
 Mortgage-backed   148,913    -    148,913    - 
 Equity   644    -    644    - 
Total  $220,434   $5,123   $215,311   $- 

 

           Significant     
           Other   Significant 
       Quoted   Observable   Unobservable 
       Prices   Inputs   Inputs 
(Dollars in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3) 
December 31, 2014                    
Securities available for sale:                    
 U.S. Treasury  $5,215   $5,215   $-   $- 
 U.S. Government agencies   74,960    -    74,960    - 
 Mortgage-backed   155,303    -    155,303    - 
 Equity   630    -    630    - 
Total  $236,108   $5,215   $230,893   $- 

 

Below is a discussion on the Company’s assets measured at fair value on a nonrecurring basis.

 

Loans

The Company does not record loans at fair value on a recurring basis; however, from time to time, a loan is considered impaired and a valuation allowance may be established if there are losses associated with the loan. Loans are considered impaired if it is probable that payment of interest and principal will not be made in accordance with contractual terms. The fair value of impaired loans can be estimated using one of several methods, including the collateral value, market value of similar debt, liquidation value and discounted cash flows. At September 30, 2015 and December 31, 2014, substantially all impaired loans were evaluated based on the fair value of the collateral and were classified as Level 2 in the fair value hierarchy.

 

Other Real Estate and Other Assets Owned (Foreclosed Assets)

Foreclosed assets are adjusted for fair value upon transfer of loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is based on independent market prices, appraised value of the collateral or management’s estimation of the value of the collateral. At September 30, 2015 and December 31, 2014, foreclosed assets were classified as Level 2 in the fair value hierarchy.

 

 24 

 

 

The tables below present the recorded amount of assets measured at fair value on a nonrecurring basis at September 30, 2015 and December 31, 2014. No assets were transferred from one hierarchy level to another during the first nine months of 2015 or 2014.

 

           Significant     
           Other   Significant 
       Quoted   Observable   Unobservable 
       Prices   Inputs   Inputs 
(Dollars in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3) 
September 30, 2015                    
Impaired loans                    
 Construction  $11,090   $-   $11,090   $- 
 Residential real estate   10,390    -    10,390    - 
 Commercial real estate   6,579    -    6,579    - 
 Commercial   165    -    165    - 
 Consumer   122    -    122    - 
Total impaired loans   28,346    -    28,346    - 
Other real estate owned   2,884    -    2,884    - 
Total assets measured at  fair value on a nonrecurring basis  $31,230   $-   $31,230   $- 

 

           Significant     
           Other   Significant 
       Quoted   Observable   Unobservable 
       Prices   Inputs   Inputs 
(Dollars in thousands)  Fair Value   (Level 1)   (Level 2)   (Level 3) 
December 31, 2014                    
Impaired loans                    
 Construction  $10,026   $-   $10,026   $- 
 Residential real estate   9,304    -    9,304    - 
 Commercial real estate   9,230    -    9,230    - 
 Commercial   187    -    187    - 
 Consumer   121    -    121    - 
Total impaired loans   28,868    -    28,868    - 
Other real estate owned   3,691    -    3,691    - 
Total assets measured at  fair value on a nonrecurring basis  $32,559   $-   $32,559   $- 

 

The following information relates to the estimated fair values of financial assets and liabilities that are reported in the Company’s consolidated balance sheets at their carrying amounts. The discussion below describes the methods and assumptions used to estimate the fair value of each class of financial asset and liability for which it is practicable to estimate that value.

 

Cash and Cash Equivalents

Cash equivalents include interest-bearing deposits with other banks and federal funds sold. For these short-term instruments, the carrying amount is a reasonable estimate of fair value.

 

Investment Securities Held to Maturity

For all investments in debt securities, fair values are based on quoted prices. If a quoted price is not available, then fair value is estimated using quoted prices for similar securities.

 

Loans

The fair values of categories of fixed rate loans, such as commercial loans, residential real estate, and other consumer loans, are estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Other loans, including variable rate loans, are adjusted for differences in loan characteristics.

 

 25 

 

 

Financial Liabilities

The fair values of demand deposits, savings accounts, and certain money market deposits are the amounts payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities. These estimates do not take into consideration the value of core deposit intangibles. Generally, the carrying amount of short-term borrowings is a reasonable estimate of fair value. The fair values of securities sold under agreements to repurchase (included in short-term borrowings) and long-term debt are estimated using the rates offered for similar borrowings.

 

Commitments to Extend Credit and Standby Letters of Credit

The majority of the Company’s commitments to grant loans and standby letters of credit are written to carry current market interest rates if converted to loans. In general, commitments to extend credit and letters of credit are not assignable by the Company or the borrower, so they generally have value only to the Company and the borrower. Therefore, it is impractical to assign any value to these commitments.

 

The following table provides information on the estimated fair values of the Company’s financial assets and liabilities that are reported in the balance sheets at their carrying amounts. The financial assets and liabilities have been segregated by their classification level in the fair value hierarchy.

 

   September 30, 2015   December 31, 2014 
       Estimated       Estimated 
   Carrying   Fair   Carrying   Fair 
(Dollars in thousands)  Amount   Value   Amount   Value 
Financial assets                    
Level 1 inputs                    
Cash and cash equivalents  $66,176   $66,176   $96,223   $96,223 
                     
Level 2 inputs                    
Investment securities held to maturity  $4,192   $4,280   $4,630   $4,694 
Loans, net   768,964    788,590    703,051    724,771 
                     
Financial liabilities                    
Level 2 inputs                    
Deposits  $959,434   $959,193   $949,004   $948,605 
Short-term borrowings   6,480    6,480    4,808    4,808 

 

Note 10 – Financial Instruments with Off-Balance Sheet Risk

In the normal course of business, to meet the financial needs of its customers, the Company’s bank subsidiaries are parties to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Letters of credit are conditional commitments issued by the Company’s bank subsidiaries to guarantee the performance of a customer to a third party. Letters of credit and other commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Because many of the letters of credit and commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements.

 

The following table provides information on commitments outstanding at September 30, 2015 and December 31, 2014.

 

(Dollars in thousands)  September 30, 2015   December 31, 2014 
Commitments to extend credit  $140,986   $127,080 
Letters of credit   7,004    7,347 
Total  $147,990   $134,427 

 

Note 11 – Segment Reporting

The Company operates two primary business segments: Community Banking and Insurance Products and Services. Through the Community Banking business, the Company provides services to consumers and small businesses on the Eastern Shore of Maryland and Delaware through its 18-branch network. Community banking activities include small business services, retail brokerage, trust services and consumer banking products and services. Loan products available to consumers include mortgage, home equity, automobile, marine, and installment loans, credit cards and other secured and unsecured personal lines of credit. Small business lending includes commercial mortgages, real estate development loans, equipment and operating loans, as well as secured and unsecured lines of credit, credit cards, accounts receivable financing arrangements, and merchant card services.

 

 26 

 

 

Through the Insurance Products and Services business, the Company provides a full range of insurance products and services to businesses and consumers in the Company’s market areas. Products include property and casualty, life, marine, individual health and long-term care insurance. Pension and profit sharing plans and retirement plans for executives and employees are available to suit the needs of individual businesses.

 

The following table includes selected financial information by business segments for the first nine months of 2015 and 2014.

 

   Community   Insurance Products   Parent   Consolidated 
(Dollars in thousands)  Banking   and Services   Company   Total 
2015                    
Interest income  $28,670   $-   $154   $28,824 
Interest expense   (2,592)   -    -    (2,592)
Provision for credit losses   (1,600)   -    -    (1,600)
Noninterest income   5,237    6,541    -    11,778 
Noninterest expense   (16,133)   (5,287)   (6,980)   (28,400)
Net intersegment (expense) income   (5,897)   (624)   6,521    - 
Income (loss) before taxes   7,685    630    (305)   8,010 
Income tax (expense) benefit   (2,941)   (241)   117    (3,065)
Net income (loss)  $4,744   $389   $(188)  $4,945 
                     
Total assets  $1,090,022   $9,222   $18,569   $1,117,813 
                     
2014                    
Interest income  $28,664   $-   $-   $28,664 
Interest expense   (3,258)   -    -    (3,258)
Provision for credit losses   (2,700)   -    -    (2,700)
Noninterest income   4,894    8,416    -    13,310 
Noninterest expense   (17,235)   (6,789)   (5,827)   (29,851)
Net intersegment (expense) income   (4,919)   (534)   5,453    - 
Income (loss) before taxes   5,446    1,093    (374)   6,165 
Income tax (expense) benefit   (2,067)   (415)   142    (2,340)
Net income (loss)  $3,379   $678   $(232)  $3,825 
                     
Total assets  $1,070,991   $10,292   $15,002   $1,096,285 

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Unless the context clearly suggests otherwise, references to “the Company”, “we”, “our”, and “us” in the remainder of this report are to Shore Bancshares, Inc. and its consolidated subsidiaries.

 

Forward-Looking Information

Portions of this Quarterly Report on Form 10-Q contain forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature, including statements that include the words “anticipate”, “estimate”, “should”, “expect”, “believe”, “intend”, and similar expressions, are expressions about our confidence, policies, and strategies, the adequacy of capital levels, and liquidity and are not guarantees of future performance. Such forward-looking statements involve certain risks and uncertainties, including economic conditions, competition in the geographic and business areas in which we operate, inflation, fluctuations in interest rates, legislation, and governmental regulation. These risks and uncertainties are described in detail in the section of the periodic reports that Shore Bancshares, Inc. files with the Securities and Exchange Commission (the “SEC”) entitled “Risk Factors” (see Item 1A of Part II of this report and Item 1A of Part I of the Annual Report of Shore Bancshares, Inc. on Form 10-K for the year ended December 31, 2014 (the “2014 Annual Report”)). Actual results may differ materially from such forward-looking statements, and we assume no obligation to update forward-looking statements at any time except as required by law.

 

Introduction

The following discussion and analysis is intended as a review of significant factors affecting the Company’s financial condition and results of operations for the periods indicated. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes presented elsewhere in this report, as well as the audited consolidated financial statements and related notes included in the 2014 Annual Report.

 

Shore Bancshares, Inc. is the largest independent financial holding company headquartered on the Eastern Shore of Maryland. It is the parent company of The Talbot Bank of Easton, Maryland located in Easton, Maryland (“Talbot Bank”) and CNB located in Centreville, Maryland (together with Talbot Bank, the “Banks”). The Banks operate 18 full service branches in Kent County, Queen Anne’s County, Talbot County, Caroline County and Dorchester County in Maryland and Kent County, Delaware. The Company engages in the insurance business through an insurance producer firm, The Avon-Dixon Agency, LLC, (“Avon-Dixon”) with two specialty lines, Elliott Wilson Insurance (Trucking) and Jack Martin Associates (Marine); and an insurance premium finance company, Mubell Finance, LLC (“Mubell”) (Avon-Dixon and Mubell are collectively referred to as the “Insurance Subsidiaries”). Avon-Dixon and Mubell are wholly-owned subsidiaries of Shore Bancshares, Inc. The Company engages in the trust services business through the trust department at CNB under the trade name Wye Financial & Trust.

 

The shares of common stock of Shore Bancshares, Inc. are listed on the NASDAQ Global Select Market under the symbol “SHBI”.

 

Shore Bancshares, Inc. maintains an Internet site at www.shorebancshares.com on which it makes available free of charge its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and all amendments to the foregoing as soon as reasonably practicable after these reports are electronically filed with, or furnished to, the SEC.

 

Regulatory Enforcement Actions

Talbot Bank entered into a Stipulation and Consent to the Issuance of a Consent Order (the “Consent Agreement”) with the Federal Deposit Insurance Corporation (the “FDIC”), a Stipulation and Consent to the Issuance of a Consent Order (the “Maryland Consent Agreement” and together with the Consent Agreement, the “Consent Agreements”) with the Maryland Commissioner of Financial Regulation (the “Commissioner”) and an Acknowledgement of Adoption of the Order by the Commissioner (the “Acknowledgement”). The FDIC and the Commissioner issued the related Consent Order (the “Order”), effective May 24, 2013. On May 11, 2015 the FDIC and the Commissioner terminated the Order.

 

While the Order has been terminated, Talbot Bank will be required to continue to adhere to certain requirements and restrictions based on commitments made to the FDIC and the Commissioner in connection with the termination of the Order, which include, among other things, continued reduction of classified assets and maintenance of capital in excess of regulatory minimums.

 

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Critical Accounting Policies

Our financial statements are prepared in accordance with GAAP. The financial information contained within the financial statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has determined that the accounting policies with respect to the allowance for credit losses, goodwill and other intangible assets, deferred tax assets, and fair value are critical accounting policies. These policies are considered critical because they relate to accounting areas that require the most subjective or complex judgments, and, as such, could be most subject to revision as new information becomes available.

 

Allowance for Credit Losses

The allowance for credit losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Topic 450, “Contingencies”, of the Financial Accounting Standards Board’s Accounting Standards Codification (“ASC”), which requires that losses be accrued when they are probable of occurring and estimable; and (ii) ASC Topic 310, “Receivables”, which requires that losses be accrued based on the differences between the loan balance and the value of collateral, present value of future cash flows or values that are observable in the secondary market. Management uses many factors to estimate the inherent loss that may be present in our loan portfolio, including economic conditions and trends, the value and adequacy of collateral, the volume and mix of the loan portfolio, and our internal loan processes. Actual losses could differ significantly from management’s estimates. In addition, GAAP itself may change from one previously acceptable method to another. Although the economics of transactions would be the same, the timing of events that would impact the transactions could change.

 

Three basic components comprise our allowance for credit losses: (i) the specific allowance; (ii) the formula allowance; and (iii) the unallocated allowance. Each component is determined based on estimates that can and do change when the actual events occur. The specific allowance is established against impaired loans (i.e., nonaccrual loans and troubled debt restructurings (“TDRs”)) based on our assessment of the losses that may be associated with the individual loans. The specific allowance remains until charge-offs are made. An impaired loan may show deficiencies in the borrower’s overall financial condition, payment history, support available from financial guarantors and/or the fair market value of collateral. The formula allowance is used to estimate the loss on internally risk-rated loans, exclusive of those identified as impaired. Loans are grouped by type (construction, residential real estate, commercial real estate, commercial or consumer). Each loan type is assigned allowance factors based on management’s estimate of the risk, complexity and size of individual loans within a particular category. Loans identified as special mention, substandard, and doubtful are adversely rated. These loans are assigned higher allowance factors than favorably rated loans due to management’s concerns regarding collectability or management’s knowledge of particular elements regarding the borrower. The unallocated allowance captures losses that have impacted the portfolio but have yet to be recognized in either the specific or formula allowance.

 

Management has significant discretion in making the adjustments inherent in the determination of the provision and allowance for credit losses, including in connection with the valuation of collateral, the estimation of a borrower’s prospects of repayment, and the establishment of the allowance factors in the formula allowance and unallocated allowance components of the allowance. The establishment of allowance factors is a continuing exercise, based on management’s ongoing assessment of the totality of all factors, including, but not limited to, delinquencies, loss history, trends in volume and terms of loans, effects of changes in lending policy, the experience and depth of management, national and local economic trends, concentrations of credit, the quality of the loan review system and the effect of external factors such as competition and regulatory requirements, and their impact on the portfolio. Allowance factors may change from period to period, resulting in an increase or decrease in the amount of the provision or allowance, based on the same volume and classification of loans. Changes in allowance factors will have a direct impact on the amount of the provision, and a corresponding effect on net income. Errors in management’s perception and assessment of these factors and their impact on the portfolio could result in the allowance not being adequate to cover losses in the portfolio, and may result in additional provisions or charge-offs.

 

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Goodwill and Other Intangible Assets

Goodwill represents the excess of the cost of an acquisition over the fair value of the net assets acquired. Other intangible assets represent purchased assets that also lack physical substance but can be distinguished from goodwill because of contractual or other legal rights or because the asset is capable of being sold or exchanged either on its own or in combination with a related contract, asset or liability. Goodwill and other intangible assets are required to be recorded at fair value. Determining fair value is subjective, requiring the use of estimates, assumptions and management judgment. Goodwill and other intangible assets with indefinite lives are tested at least annually for impairment, usually during the third quarter, or on an interim basis if circumstances dictate. Intangible assets that have finite lives are amortized over their estimated useful lives and also are subject to impairment testing. Impairment testing requires that the fair value of each of the Company’s reporting units be compared to the carrying amount of its net assets, including goodwill. The Company’s reporting units were identified based on an analysis of each of its individual operating segments (i.e., the Banks and Insurance Subsidiaries). If the fair value of a reporting unit is less than book value, an expense may be required to write down the related goodwill or purchased intangibles to record an impairment loss.

 

Deferred Tax Assets

Deferred tax assets and liabilities are determined by applying the applicable federal and state income tax rates to cumulative temporary differences. These temporary differences represent differences between financial statement carrying amounts and the corresponding tax bases of certain assets and liabilities. Deferred taxes result from such temporary differences. A valuation allowance, if needed, reduces deferred tax assets to the amount most likely to be realized, which is based on estimates of future taxable income, recoverable taxes paid in prior years and expected results of tax planning strategies. The Company evaluates all positive and negative evidence before determining if a valuation allowance is deemed necessary regarding the realization of deferred tax assets.

 

Fair Value

The Company measures certain financial assets and liabilities at fair value. Investment securities are significant financial assets measured at fair value on a recurring basis. Impaired loans and other real estate owned are significant financial assets measured at fair value on a nonrecurring basis. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. In determining fair value, the Company is required to maximize the use of observable inputs and minimize the use of unobservable inputs, reducing subjectivity.

 

OVERVIEW

 

The Company reported net income of $1.9 million for the third quarter of 2015, or diluted income per common share of $0.15, compared to net income of $1.3 million, or diluted income per common share of $0.10, for the third quarter of 2014. For the second quarter of 2015, the Company reported net income of $1.6 million, or diluted income per common share of $0.13. When comparing the third quarter of 2015 to the third quarter of 2014, the primary reasons for improved net income were increases in net interest income of $374 thousand, a decline in the provision for credit losses of $365 thousand and a decline in noninterest expenses of $423 thousand. When comparing the third quarter of 2015 to the second quarter of 2015, the primary reasons for the improved results were increases in net interest income and noninterest income of $327 thousand and $117 thousand, respectively, coupled with decreases in the provision for credit losses of $130 thousand.

 

For the first nine months of 2015, the Company reported net income of $4.9 million, or diluted income per common share of $0.39, compared to net income of $3.8 million, or diluted income per common share of $0.37, for the first nine months of 2014. Earnings improved due to an increase in net interest income of $826 thousand and a decline in the provision for credit losses of $1.1 million. Noninterest expense decreased $1.5 million, which was entirely offset by a decline in noninterest income of $1.5 million with both variances primarily due to the sale of Tri-State General Insurance Agency, LTD (“Tri-State”) late in the second quarter of 2014.

 

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RESULTS OF OPERATIONS

 

Net Interest Income

Tax-equivalent net interest income is net interest income adjusted for the tax-favored status of income from certain loans and investments. As shown in the table below, tax-equivalent net interest income was $9.0 million for the third quarter of 2015 and $8.6 million for the third quarter of 2014. Tax-equivalent net interest income was $8.7 million for the second quarter of 2015. The increase in net interest income for the third quarter of 2015 when compared to the third quarter of 2014 was primarily due to higher volumes in earning assets, specifically loans and investment securities, which were partially offset by lower rates received on loans. Total average interest-bearing deposits exhibited a decrease resulting in a lower cost due to favorable rates.

 

The increase in net interest income for the third quarter of 2015 when compared to the second quarter of 2015 was primarily due to a change in asset mix from investment securities to loans which provided more favorable rates, as well as lower volumes and rates paid on average interest-bearing deposits. The yields on average loans slightly declined due to downward re-pricing on loan renewals, which was offset by the increased loan volume and lower volumes of and rates paid on average time and demand deposits. Net interest margin is tax-equivalent net interest income (annualized) divided by average earning assets. Our net interest margin remained at 3.43% for the third and second quarter of 2015, as compared to 3.38% for the third quarter of 2014, respectively. The higher net interest margin for the third quarter of 2015 when compared to the third quarter of 2014 was mainly due to higher volumes on average loans and average investment securities and lower rates paid on average time deposits.

 

On a tax-equivalent basis, interest income increased $146 thousand, or 1.5%, for the third quarter of 2015 when compared to the third quarter of 2014. The increase in interest income was due to a 2.8% increase in average balances of earning assets (i.e., loans, investment securities, and federal funds sold) partially offset by a 5 basis point decrease in yields earned on average earning assets. Loans had the largest impact on the increase in interest income, due to an increase in the average balance of $57.7 million, or 8.2%, resulting in an increase in interest income of $120 thousand, or 1.4%. The balance on taxable investment securities increased $8.9 million, or 4.0%, and corresponding interest income increased $42 thousand, or 4.9%, compared to the third quarter of 2014. The decline in the yield on average loans was due to downward re-pricing on renewal loans as well as yields on newly originated loans. Tax-equivalent interest income increased $295 thousand, or 3.1%, when compared to the second quarter of 2015, mainly due to higher volume on average loans.

 

Interest expense decreased $223 thousand, or 21.2%, when comparing the third quarter of 2015 to the third quarter of 2014. The decrease in interest expense was due to an 11 basis point decline in rates paid on interest-bearing liabilities (i.e., deposits and borrowings) and a 2.3% decline in average balances of interest-bearing liabilities. Changes in the rates and balances related to time deposits (i.e., certificates of deposit $100,000 or more and other time deposits) had the largest impact on interest expense. For the three months ended September 30, 2015, the rates paid on time deposits decreased 18 basis points and the average balances of these deposits decreased $34.5 million, or 10.0%, when compared to the same period last year, which reduced interest expense $232 thousand. A portion of this decline was offset primarily by increases in the balance of money market and savings deposits. Noninterest-bearing deposits increased $29.5 million when compared to the same period last year contributing to a lower cost of funding. When comparing the third quarter of 2015 to the second quarter of 2015, interest expense decreased $31 thousand, or 3.6%. The decline was primarily due to lower interest rates paid on and average balances of time deposits.

 

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The following table presents the distribution of the average consolidated balance sheets, interest income/expense, and annualized yields earned and rates paid for the three months ended September 30, 2015 and 2014.

 

   For the Three Months Ended   For the Three Months Ended 
   September 30, 2015   September 30, 2014 
   Average   Income(1)/   Yield/   Average   Income(1)/   Yield/ 
(Dollars in thousands)  Balance   Expense   Rate   Balance   Expense   Rate 
Earning assets                              
Loans (2), (3)  $763,306   $8,929    4.64%  $705,637   $8,809    4.95%
Investment securities:                              
Taxable   229,979    892    1.55    221,105    850    1.53 
Tax-exempt   243    3    5.01    432    5    4.16 
Federal funds sold   2,341    1    0.10    1,378    1    0.06 
Interest-bearing deposits   48,361    30    0.25    87,215    44    0.20 
Total earning assets   1,044,230    9,855    3.74%   1,015,767    9,709    3.79%
Cash and due from banks   17,434              24,445           
Other assets   57,891              61,989           
Allowance for credit losses   (8,194)             (9,098)          
Total assets  $1,111,361             $1,093,103           
                               
Interest-bearing liabilities                              
Demand deposits  $184,471    60    0.13%  $183,094    65    0.14%
Money market and savings deposits   242,830    85    0.14    225,670    69    0.12 
Certificates of deposit $100,000 or more   148,617    343    0.92    166,806    467    1.11 
Other time deposits   163,224    336    0.82    179,533    445    0.98 
Interest-bearing deposits   739,142    824    0.44    755,103    1,046    0.55 
Short-term borrowings   6,501    3    0.24    7,946    4    0.21 
Total interest-bearing liabilities   745,643    827    0.44%   763,049    1,050    0.55%
Noninterest-bearing deposits   214,684              185,209           
Other liabilities   6,137              6,230           
Stockholders’ equity   144,897              138,615           
Total liabilities and stockholders’ equity  $1,111,361             $1,093,103           
                               
Net interest spread       $9,027    3.30%       $8,659    3.24%
Net interest margin             3.43%             3.38%
                               
Tax-equivalent adjustment                              
Loans       $17             $22      
Investment securities        -              2      
Total       $17             $24      

 

(1)All amounts are reported on a tax-equivalent basis computed using the statutory federal income tax rate of 34.0%, exclusive of the alternative minimum tax rate and nondeductible interest expense.
(2)Average loan balances include nonaccrual loans and loans held for sale.
(3)Interest income on loans includes amortized loan fees, net of costs, and all are included in the yield calculations.

 

Tax-equivalent net interest income for the nine months ended September 30, 2015 was $26.3 million, as seen in the table below. This represented an increase of $814 thousand, or 3.2%, when compared to the same period last year. The increase was mainly due to higher volumes of and yields paid on taxable investment securities, coupled with lower volume and rates paid on time deposits. Although the volume on average loans increased $28.1 million, the yield declined 29 basis points reducing interest income $502 thousand. The net interest margin declined 3 basis points to 3.43% for the first nine months of 2015 from the 3.46% for the first nine months of 2014.

 

On a tax-equivalent basis, interest income was $28.9 million for the first nine months of 2015, an increase of $148 thousand, or less than 1.0%, when compared to the first nine months of 2014, mainly due to income from investment securities slightly outpacing the decrease in income generated from loans. For the first nine months of 2015, average loans increased 4.0% and the related yield declined 29 basis points, while average taxable securities increased 27.7% and the related yield increased 8 basis points when compared to the same period in 2014.

 

Interest expense was $2.6 million for the nine months ended September 30, 2015, a decrease of $666 thousand, or 20.4%, when compared to the same period last year. Average interest-bearing liabilities decreased $21.1 million, or 2.8%, while rates paid declined 10 basis points to 0.47% primarily due to a decline in time deposit activity.

 

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For the first nine months of 2015, the average balance of time deposits decreased $37.0 million, or 10.4%, when compared to the same period last year, and the average rate paid on these deposits declined 17 basis points, which toget