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Cardinal Financial 10-Q 2006

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

 

FORM 10-Q

 

 

x Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

 

For the quarterly period ended June 30, 2006

 

 

or

 

 

o 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:  0-24557

 

 

CARDINAL FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

 

Virginia

 

54-1874630

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

 

 

8270 Greensboro Drive, Suite 500

 

 

McLean, Virginia

 

22102

(Address of principal executive offices)

 

(Zip Code)

 

(703) 584-3400

(Registrant’s telephone number, including area code)

 

 

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer         o         Accelerated filer        x        Non-accelerated filer        o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:

24,394,361 shares of common stock, par value $1.00 per share,
outstanding as of July 31, 2006

 




 

CARDINAL FINANCIAL CORPORATION

INDEX TO FORM 10-Q

PART I — FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements:

 

 

 

 

 

Consolidated Statements of Condition

 

 

At June 30, 2006 (unaudited) and December 31, 2005

3

 

 

 

 

Consolidated Statements of Income

 

 

For the three and six months ended June 30, 2006 and 2005 (unaudited)

4

 

 

 

 

Consolidated Statements of Comprehensive Income (Loss)

 

 

For the three and six months ended June 30, 2006 and 2005 (unaudited)

5

 

 

 

 

Consolidated Statements of Changes In Shareholders’ Equity

 

 

For the six months ended June 30, 2006 and 2005 (unaudited)

6

 

 

 

 

Consolidated Statements of Cash Flows

 

 

For the six months ended June 30, 2006 and 2005 (unaudited)

7

 

 

 

 

Notes to Consolidated Financial Statements (unaudited)

8

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and

 

 

Results of Operations

18

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

40

 

 

 

Item 4.

Controls and Procedures

41

 

 

 

PART II — OTHER INFORMATION

42

 

 

Item 1.

Legal Proceedings

42

 

 

 

Item 1A.

Risk Factors

42

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

42

 

 

 

Item 3.

Defaults Upon Senior Securities

42

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

42

 

 

 

Item 5.

Other Information

43

 

 

 

Item 6.

Exhibits

43

 

 

 

SIGNATURES

44

 

2




PART I. FINANCIAL INFORMATION

Item 1.  Financial Statements

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CONDITION
June 30, 2006 and December 31, 2005
(In thousands, except share data)

Assets

 

 

 

 

 

June 30,
2006

 

December 31,
2005

 

 

 

 

 

 

 

(Unaudited)

 

 

 

Cash and due from banks

 

 

 

 

 

$

20,499

 

$

16,514

 

Federal funds sold

 

 

 

 

 

3,379

 

20,075

 

Total cash and cash equivalents

 

 

 

 

 

23,878

 

36,589

 

Investment securities available-for-sale

 

 

 

 

 

236,417

 

178,955

 

Investment securities held-to-maturity (market value of $101,877 and $112,025 at June 30, 2006 and December 31, 2005, respectively)

 

 

 

 

 

106,480

 

115,269

 

Total investment securities

 

 

 

 

 

342,897

 

294,224

 

Other investments

 

 

 

 

 

7,201

 

7,092

 

Loans held for sale, net

 

 

 

 

 

376,475

 

361,668

 

Loans receivable, net of deferred fees and costs

 

 

 

 

 

779,628

 

705,644

 

Allowance for loan losses

 

 

 

 

 

(8,964

)

(8,301

)

Loans receivable, net

 

 

 

 

 

770,664

 

697,343

 

Premises and equipment, net

 

 

 

 

 

20,558

 

18,201

 

Deferred tax asset

 

 

 

 

 

6,684

 

4,399

 

Goodwill and intangibles, net

 

 

 

 

 

20,548

 

20,502

 

Accrued interest receivable and other assets

 

 

 

 

 

15,683

 

12,269

 

Total assets

 

 

 

 

 

$

1,584,588

 

$

1,452,287

 

 

 

 

 

 

 

 

 

 

 

Liabilities and Shareholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-interest bearing deposits

 

 

 

 

 

$

122,185

 

$

114,915

 

Interest bearing deposits

 

 

 

 

 

1,013,307

 

954,957

 

Other borrowed funds

 

 

 

 

 

224,725

 

155,421

 

Mortgage funding checks

 

 

 

 

 

51,008

 

41,635

 

Escrow liabilities

 

 

 

 

 

2,997

 

11,013

 

Accrued interest payable and other liabilities

 

 

 

 

 

20,787

 

26,467

 

Total liabilities

 

 

 

 

 

1,435,009

 

1,304,408

 

 

 

 

 

 

 

 

 

 

 

Common stock, $1 par value

 

2006

 

2005

 

 

 

 

 

Shares authorized

 

50,000,000

 

50,000,000

 

 

 

 

 

Shares issued and outstanding

 

24,394,361

 

24,362,685

 

24,394

 

24,363

 

Additional paid-in capital

 

 

 

 

 

132,342

 

132,150

 

Accumulated deficit

 

 

 

 

 

(771

)

(5,269

)

Accumulated other comprehensive loss

 

 

 

 

 

(6,386

)

(3,365

)

Total shareholders’ equity

 

 

 

 

 

149,579

 

147,879

 

Total liabilities and shareholders’ equity

 

 

 

 

 

$

1,584,588

 

$

1,452,287

 

 

See accompanying notes to consolidated financial statements.

3




 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
Three and six months ended June 30, 2006 and 2005
 (In thousands, except share and per share data)
 (Unaudited)

 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Interest income:

 

 

 

 

 

 

 

 

 

Loans receivable

 

$

12,522

 

$

8,334

 

$

24,027

 

$

15,614

 

Loans held for sale

 

5,276

 

4,657

 

9,553

 

8,015

 

Federal funds sold

 

85

 

77

 

735

 

138

 

Investment securities available-for-sale

 

2,627

 

1,532

 

4,691

 

2,962

 

Investment securities held-to-maturity

 

1,102

 

1,253

 

2,227

 

2,561

 

Other investments

 

88

 

73

 

177

 

127

 

Total interest income

 

21,700

 

15,926

 

41,410

 

29,417

 

Interest expense:

 

 

 

 

 

 

 

 

 

Deposits

 

9,136

 

5,530

 

16,927

 

10,207

 

Other borrowed funds

 

1,853

 

1,272

 

3,377

 

2,264

 

Total interest expense

 

10,989

 

6,802

 

20,304

 

12,471

 

Net interest income

 

10,711

 

9,124

 

21,106

 

16,946

 

Provision for loan losses

 

390

 

820

 

640

 

1,369

 

Net interest income after provision for loan losses

 

10,321

 

8,304

 

20,466

 

15,577

 

Non-interest income:

 

 

 

 

 

 

 

 

 

Service charges on deposit accounts

 

389

 

330

 

758

 

610

 

Loan service charges

 

558

 

618

 

1,181

 

1,244

 

Investment fee income

 

991

 

291

 

1,672

 

450

 

Net gain on sales of loans

 

2,521

 

4,035

 

5,297

 

7,615

 

Net realized gain on investment securities available-for-sale

 

 

33

 

 

33

 

Management fee income

 

664

 

974

 

1,082

 

1,498

 

Other income (loss)

 

458

 

(6

)

795

 

7

 

Total non-interest income

 

5,581

 

6,275

 

10,785

 

11,457

 

Non-interest expense:

 

 

 

 

 

 

 

 

 

Salary and benefits

 

6,099

 

5,566

 

12,030

 

10,435

 

Occupancy

 

1,295

 

1,025

 

2,503

 

2,071

 

Professional fees

 

714

 

475

 

1,221

 

949

 

Depreciation

 

789

 

708

 

1,538

 

1,389

 

Data processing

 

315

 

486

 

640

 

994

 

Telecommunications

 

311

 

277

 

621

 

610

 

Amortization of intangibles

 

145

 

72

 

293

 

122

 

Other operating expenses

 

2,780

 

2,512

 

5,034

 

4,646

 

Total non-interest expense

 

12,448

 

11,121

 

23,880

 

21,216

 

Net income before income taxes

 

3,454

 

3,458

 

7,371

 

5,818

 

Provision for income taxes

 

1,063

 

1,166

 

2,386

 

1,915

 

Net income

 

$

2,391

 

$

2,292

 

$

4,985

 

$

3,903

 

Earnings per common share - basic

 

$

0.10

 

$

0.11

 

$

0.20

 

$

0.20

 

Earnings per common share - diluted

 

$

0.10

 

$

0.11

 

$

0.20

 

$

0.19

 

Weighted-average common shares outstanding - basic

 

24,415,545

 

21,096,617

 

24,401,460

 

19,817,872

 

Weighted-average common shares outstanding - diluted

 

24,995,818

 

21,321,508

 

24,993,471

 

20,101,026

 

 

See accompanying notes to consolidated financial statements.

 

4




 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME  (LOSS)
Three and six months ended June 30, 2006 and 2005
(In thousands)
(Unaudited)

 

 

Three Months
Ended June 30,

 

Six Months
Ended June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Net income

 

$

2,391

 

$

2,292

 

$

4,985

 

$

3,903

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Unrealized gain (loss) on available-for-sale investment securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized holding gain (loss) arising during the period, net of tax of $1.1 million and $1.5 million for the three and six months ended June 30, 2006 and $579 and $150 for the three and six months ended June 30, 2005

 

(2,031

)

1,175

 

(2,754

)

(271

)

 

 

 

 

 

 

 

 

 

 

Less: reclassification adjustment for gains included in net income, net of tax of $11 in 2005

 

 

22

 

 

22

 

 

 

 

 

 

 

 

 

 

 

Unrealized loss on derivative instruments designated as cash flow hedges, net of tax of $312 and $168 for the three and six months ended June 30, 2006.

 

(552

)

 

(268

)

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

(192

)

$

3,445

 

$

1,963

 

$

3,610

 

 

See accompanying notes to consolidated financial statements.

5




 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Six months ended June 30, 2006 and 2005
(In thousands)
(Unaudited)

 

 

Common
Shares

 

Common
Stock

 

Additional
Paid-in
Capital

 

Accumulated
Deficit

 

Accumulated
Other
Comprehensive
Loss

 

Total

 

Balance, December 31, 2004

 

18,463

 

$

18,463

 

$

92,868

 

$

(15,145

)

$

(1,081

)

$

95,105

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock options exercised

 

78

 

78

 

435

 

 

 

513

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Public offering shares issued

 

5,175

 

5,175

 

34,615

 

 

 

39,790

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares issued in acquisition of Wilson/Bennett

 

611

 

611

 

4,273

 

 

 

4,884

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in accumulated other comprehensive loss

 

 

 

 

 

(293

)

(293

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

3,903

 

 

3,903

 

Balance, June 30, 2005

 

24,327

 

$

24,327

 

$

132,191

 

$

(11,242

)

$

(1,374

)

$

143,902

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2005

 

24,363

 

$

24,363

 

$

132,150

 

$

(5,269

)

$

(3,365

)

$

147,879

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock options exercised

 

31

 

31

 

196

 

 

 

227

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Payment of deferred compensation shares

 

 

 

(4

)

 

 

(4

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends on common stock

 

 

 

 

(487

)

 

(487

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Change in accumulated other comprehensive loss

 

 

 

 

 

(3,021

)

(3,021

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

4,985

 

 

4,985

 

Balance, June 30, 2006

 

24,394

 

$

24,394

 

$

132,342

 

$

(771

)

$

(6,386

)

$

149,579

 

 

See accompanying notes to consolidated financial statements.

 

6




 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six Months Ended June 30, 2006 and 2005
(In thousands)
(Unaudited)

 

 

 

2006

 

2005

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

4,985

 

$

3,903

 

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

 

 

 

 

 

Depreciation

 

1,538

 

1,389

 

Amortization of premiums, discounts and intangibles

 

686

 

881

 

Provision for loan losses

 

640

 

1,369

 

Loans held for sale originated and acquired

 

(1,557,215

)

(2,187,040

)

Proceeds from the sale of loans held for sale

 

1,547,705

 

2,085,011

 

Gain on sale of loans held for sale

 

(5,297

)

(7,615

)

Gain on sale of investment securities available-for-sale

 

 

(33

)

Loss on sale of other assets

 

2

 

13

 

Increase in accrued interest receivable, other assets, and deferred tax asset

 

(4,429

)

(4,472

)

Increase (decrease) in accrued interest payable, escrow liabilities and other liabilities

 

(5,355

)

11,180

 

Net cash used in operating activities

 

(16,740

)

(95,414

)

Cash flows from investing activities:

 

 

 

 

 

Purchase of premises and equipment

 

(3,859

)

(3,130

)

Proceeds from sale, maturity and call of investment securities available-for-sale

 

 

1,000

 

Proceeds from sale, maturity and call of mortgage-backed securities available-for-sale

 

 

4,896

 

Proceeds from sale of other investments

 

1,982

 

8,119

 

Purchase of investment securities available-for-sale

 

(23,154

)

(12,964

)

Purchase of mortgage-backed securities available-for-sale

 

(58,555

)

(8,432

)

Purchase of other investments

 

(2,091

)

(7,607

)

Redemptions of investment securities available-for-sale

 

11,393

 

14,511

 

Redemptions of investment securities held-to-maturity

 

8,580

 

10,199

 

Net cash paid in acquisition

 

(339

)

(1,379

)

Net increase in loans receivable, net of deferred fees and costs

 

(73,961

)

(113,063

)

Net cash used in investing activities

 

(140,004

)

(107,850

)

Cash flows from financing activities:

 

 

 

 

 

Net increase in deposits

 

65,620

 

178,276

 

Net increase (decrease) in other borrowed funds

 

98,554

 

(52,610

)

Net increase in mortgage funding checks

 

9,373

 

47,268

 

Proceeds from FHLB advances - long term

 

5,000

 

25,000

 

Repayments of FHLB advances - long term

 

(34,250

)

(2,250

)

Proceeds from public offering of common stock

 

 

39,790

 

Stock options exercised

 

227

 

513

 

Deferred compensation payments

 

(4

)

 

Dividends on common stock

 

(487

)

 

Net cash provided by financing activities

 

144,033

 

235,987

 

Net increase (decrease) in cash and cash equivalents

 

(12,711

)

32,723

 

Cash and cash equivalents at beginning of period

 

36,589

 

23,408

 

Cash and cash equivalents at end of period

 

$

23,878

 

$

56,131

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Cash paid during the period for interest

 

$

20,341

 

$

12,003

 

Cash paid for income taxes

 

4,963

 

150

 

 

 

 

 

 

 

Supplemental schedule of noncash investing and financing activities:

 

 

 

 

 

Unsettled purchased investment securities available-for-sale

 

$

4,200

 

 

 

 

 

 

 

 

On June 9, 2005, the Company acquired all of the issued and outstanding common stock of Wilson/Bennett Capital Management, Inc. In conjunction with the acquisition, the following noncash changes to our financial condition occurred:

 

 

 

 

 

Fair value of non-cash assets acquired, primarily goodwill and intangibles

 

 

 

$

6,296

 

Fair value of liabilities assumed

 

 

 

33

 

Common shares issued in acquisition

 

 

 

4,884

 

 

 

 

 

 

 

On February 9, 2006, the Company acquired certain fiduciary and other assets and assumed the liabilities of FBR National Trust Company. In conjunction with the acquisition, the following noncash changes to our financial condition occurred:

 

 

 

 

 

Fair value of non-cash assets acquired

 

$

507

 

 

 

Fair value of liabilities assumed

 

127

 

 

 

 

See accompanying notes to consolidated financial statements.

7




 

CARDINAL FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2006
(Unaudited)

Note 1

Organization

Cardinal Financial Corporation (the ”Company”) is incorporated under the laws of the Commonwealth of Virginia as a financial holding company whose activities consist of investment in its wholly-owned subsidiaries. The principal operating subsidiary of the Company is Cardinal Bank (the “Bank”), a state-chartered institution. On July 7, 2004, the Bank acquired George Mason Mortgage, LLC (“George Mason”), a mortgage banking company based in Fairfax, Virginia. On June 9, 2005, the Company acquired Wilson/Bennett Capital Management, Inc. (“Wilson/Bennett”), an asset management firm. The Company also owns Cardinal Wealth Services, Inc. (“CWS”), an investment services subsidiary. As described in Note 4, on February 9, 2006, the Bank acquired certain fiduciary and other assets and assumed certain liabilities of FBR National Trust Company, formerly a subsidiary of Friedman, Billings, Ramsey Group, Inc.

Basis of Presentation

In the opinion of management, the accompanying consolidated financial statements have been prepared in accordance with the requirements of Regulation S-X, Article 10. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. However, all adjustments that are, in the opinion of management, necessary for a fair presentation have been included. The results of operations for the three and six months ended June 30, 2006 are not necessarily indicative of the results to be expected for the full year ending December 31, 2006. The unaudited interim financial statements should be read in conjunction with the audited financial statements and notes to financial statements that are included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005 (the “2005 Form 10-K”).

Note 2

Summary of Significant Accounting Policies

As a result of the acquisition of certain fiduciary and other assets and the assumption of certain liabilities of FBR National Trust Company as described in Note 4, the Company adopted an accounting policy for recognition of trust services revenue as follows:

Trust services revenue is recognized in the period earned in accordance with contractual percentage of assets under management or custody and is recognized in the consolidated statements of income as a component of investment fee income. Revenue is generally determined based upon the fair value of assets under management or custody at the end of the period.

8




Note 3

Stock-Based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment. This statement requires that companies recognize in the income statement the grant-date fair value of stock options and other equity-based compensation. The statement also requires stock awards to be classified as either an equity award or a liability award. Equity classified awards are valued as of the grant date using either an observable market price or a valuation methodology. Liability classified awards are valued at fair value at each reporting date. All of the Company’s stock options are classified as equity awards.

The Company has adopted SFAS No. 123R using the modified prospective application method, which requires, among other things, recognition of compensation costs for all awards outstanding at January 1, 2006 for which the requisite service had not been rendered. Total compensation cost charged against income as a result of the adoption of SFAS No. 123R for the three and six months ended June 30, 2006 was $85,000 and $147,000, respectively. The total income tax benefit recognized in the income statement for share-based compensation arrangements was $30,000 and $51,000 for the three and six months ended June 30, 2006, respectively.

The Company estimates that this new standard will result in an increase in pretax expense of approximately $334,000 in 2006 compared to 2005 based on the current number of unvested stock options outstanding. Additional expense would be recorded for any future stock option grants and expense would be reduced by estimated option forfeitures.

At June 30, 2006, the Company had two stock-based employee compensation plans, the 1999 Stock Option Plan (the “Option Plan”) and the 2002 Equity Compensation Plan (the “Equity Plan”).

In 1998, the Company adopted the Option Plan pursuant to which the Company may grant stock options for up to 625,000 shares of the Company’s common stock to employees and members of the Company’s and its subsidiaries’ boards of directors.

In 2002, the Company adopted the Equity Plan. The Equity Plan authorizes the granting of options, which may be incentive stock options, non-qualified stock options, stock appreciation rights, restricted stock awards, phantom stock awards or performance share awards to directors, eligible officers and key employees of the Company. During 2006, the shareholders approved an amendment to the Equity Plan to increase the number of shares of common stock reserved for issuance under it from 1,970,000 to 2,420,000.

Stock options are granted with an exercise price equal to the common stock’s fair market value at the date of grant. Director stock options have ten year terms and vest and become fully exercisable at the grant date. Certain employee stock options have ten year terms and vest and become fully exercisable after three years. Other employee stock options have ten year terms and vest and become fully exercisable in 20% increments beginning as of the grant date. In addition, the Company has granted stock options to employees of the Company that have ten year terms and vest and become fully exercisable in 20% increments beginning after their first year of service. During 2005, certain stock options granted to employees had ten year terms and vested and became fully exercisable immediately.

9




The following table illustrates the effect on net income and earnings per share of common stock as if the Company had applied the fair value recognition provisions of SFAS No. 123R to stock-based employee compensation for the periods indicated:

(In thousands, except per share data)

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30, 2005

 

June 30, 2005

 

Net income

 

$

2,292

 

$

3,903

 

Deduct: Total stock-based employee compensation expense determined under fair value- based method for all awards, net of tax

 

(1,561

)

(3,772

)

Pro forma net income

 

$

731

 

$

131

 

 

 

 

 

 

 

Earnings per share:

 

 

 

 

 

Basic - as reported

 

$

0.11

 

$

0.20

 

Basic - pro forma

 

0.03

 

0.01

 

Diluted - as reported

 

0.11

 

0.19

 

Diluted - pro forma

 

0.03

 

0.01

 

 

Options to purchase 425,176 and 919,911 shares of common stock were granted during the three and six months ended June 30, 2005, respectively. These option grants were immediately fully vested and the pro forma stock-based employee compensation expense during the three and six months ended June 30, 2005 reflects the immediate vesting attributes of these stock option grants.

The weighted average per share fair values of stock option grants made during the three months ended June 30, 2006 and 2005 were $5.86 and $5.37, respectively. The weighted average per share fair values of option grants made during the six months ended June 30, 2006 and 2005 were $5.82 and $5.97, respectively. The fair values of the options granted for these periods were estimated as of the grant date using the Black-Scholes option-pricing model based on the following weighted average assumptions:

 

Three Months Ended

 

Six Months Ended

 

 

 

June 30,

 

June 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Estimated option life

 

6.5 years

 

10 years

 

6.5 years

 

10 years

 

Risk free interest rate

 

4.92 - 5.03%

 

4.15%

 

4.44 - 5.03%

 

4.26%

 

Expected volatility

 

43.20%

 

43.11%

 

43.20%

 

43.11%

 

Expected dividend yield

 

0.50%

 

0.00%

 

0.50%

 

0.00%

 

 

Expected volatility is based upon the average annual historical volatility of the Company’s common stock. The estimated option life is derived from the “simplified method” formula as described in Staff Accounting Bulletin 107 (“SAB 107”). The risk free interest rate is based upon the five-year U.S. Treasury note rate in effect at the time of grant.  The expected dividend yield is based upon implied and historical dividend declarations.

10




Stock option activity during the six months ended June 30, 2006 is presented as follows:

 

 

Number of
Shares

 

Weighted
Average
Exercise
Price

 

Weighted
Average
Remaining
 Contractual
Term

 

Aggregate
Intrinsic
Value
($000)

 

Outstanding at December 31, 2005

 

2,269,221

 

$8.29

 

 

 

 

 

Granted

 

203,000

 

12.11

 

 

 

 

 

Exercised

 

31,436

 

7.17

 

 

 

 

 

Forfeited

 

13,555

 

9.64

 

 

 

 

 

Outstanding at June 30, 2006

 

2,427,230

 

$8.61

 

8.07

 

$7,299

 

Options exercisable at June 30, 2006

 

2,089,739

 

$8.46

 

7.99

 

$6,596

 

 

Total intrinsic value of options exercised during the three and six months ended June 30, 2006 was $128,000 and $140,000, respectively.

A summary of the status of the Company’s non-vested stock options and changes during the six months ended June 30, 2006 is as follows:

 

 

Number of
Shares

 

Weighted
Average
Grant Date
Fair Value

 

Balance at December 31, 2005

 

241,781

 

$

2.10

 

Granted

 

203,000

 

5.82

 

Vested

 

(104,986

)

1.98

 

Forfeited

 

(2,304

)

2.42

 

Balance at June 30, 2006

 

337,491

 

$

4.37

 

 

At June 30, 2006, there were $1.5 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the plans. The cost is expected to be recognized over a weighted average period of 3.8 years. The total fair value of shares that vested during the three and six months ended June 30, 2006 was $105,000 and $335,000, respectively.

On October 19, 2005, the Company’s board of directors authorized that any outstanding, unvested options that were or became “underwater” (i.e., their per share exercise price is greater than the market price) on or before December 31, 2005 be amended to become fully vested. This modification resulted in the immediate vesting of 54,000 stock options that were held by employees of the Company. The options that vested had exercise prices ranging from $9.58 to $11.15. On October 19, 2005, the market value of the Company’s common stock was $9.81. This modification did not result in the recognition of expense in 2005 because the options had no intrinsic value at the grant date or on the date of modification. Vesting of these options was accelerated to eliminate the need to recognize the remaining fair value compensation expense associated with these options following the adoption of SFAS No. 123R. The amount of compensation expense related to these options that would have been recognized in the financial

11




statements after the Company’s implementation of SFAS No. 123R, assuming no forfeitures, was $127,000.

Note 4

Acquisitions

On February 9, 2006, the Bank acquired certain fiduciary and other assets and assumed certain liabilities of FBR National Trust Company, formerly a subsidiary of Friedman, Billings, Ramsey Group, Inc. The Bank acts as trustee or custodian for assets under management in excess of $5 billion as a result of this transaction. This transaction diversifies the Bank’s sources of non-interest income and allows it to provide additional services to its customers.

This transaction was accounted for as a purchase and the acquired assets and assumed liabilities were recorded at their fair values as of the purchase date. This acquisition did not have a significant impact on operating results for the three and six months ended June 30, 2006 and is not expected to have a material impact on the Company’s financial condition or operating results in 2006.

The operating results of the trust division are included in the Company’s consolidated operating results and its Trust and Investment Services segment information since the date of acquisition.

The fair value of the net assets acquired was $380,000. The acquisition resulted in the recognition of an intangible asset for purchased customer relationships of $161,000, which is being amortized on a straight-line basis over nine years, and in the recognition of goodwill of $178,000. The Company used the assistance of an independent valuation consultant to determine the value assigned to identifiable intangible assets. Goodwill will not be amortized but will be reviewed for impairment when evidence of impairment exists or, at a minimum, on an annual basis.

Note 5

Segment Information

The Company operates in three business segments: Commercial Banking, Mortgage Banking, and Trust and Investment Services.

The Commercial Banking segment includes both commercial and consumer lending and provides customers with such products as commercial loans, real estate loans, business financing and consumer loans. In addition, this segment also provides customers with several choices of deposit products including demand deposit accounts, savings accounts and certificates of deposit. The Mortgage Banking segment engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis. The Trust and Investment Services segment provides investment and financial advisory services to businesses and individuals, including financial planning, retirement/estate planning, trust, estates, custody, investment management, escrows, and retirement plans.

Wilson/Bennett is included in the Trust and Investment Services segment since the date of acquisition, June 9, 2005. Results related to the assets acquired, and liabilities assumed, from

12




FBR National Trust Company are reflected in the Trust and Investment Services segment since the date of their acquisition and assumption, February 9, 2006.

Information about the reportable segments and reconciliation of this information to the consolidated financial statements at and for the three and six months ended June 30, 2006 and 2005, is as follows:

(In thousands)

At and for the Three Months Ended June 30, 2006:

 

 

Commercial
Banking

 

Mortgage
Banking

 

Trust and
Investment
Services

 

Other

 

Intersegment
Elimination

 

Consolidated

 

Net interest income

 

$

9,827

 

$

1,142

 

$

 

$

(258

)

$

 

$

10,711

 

Provision for loan losses

 

390

 

 

 

 

 

390

 

Non-interest income

 

888

 

3,690

 

991

 

12

 

 

5,581

 

Non-interest expense

 

6,906

 

3,912

 

977

 

653

 

 

12,448

 

Provision for income taxes

 

1,058

 

320

 

5

 

(320

)

 

1,063

 

Net income (loss)

 

$

2,361

 

$

600

 

$

9

 

$

(579

)

$

 

$

2,391

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,511,410

 

$

394,233

 

$

6,826

 

$

157,453

 

$

(485,334

)

$

1,584,588

 

 

At and for the Three Months Ended June 30, 2005:

 

 

Commercial
Banking

 

Mortgage
Banking

 

Trust and
Investment
Services

 

Other

 

Intersegment
Elimination

 

Consolidated

 

Net interest income

 

$

7,697

 

$

1,632

 

$

 

$

(205

)

$

 

$

9,124

 

Provision for loan losses

 

820

 

 

 

 

 

820

 

Non-interest income

 

470

 

5,505

 

291

 

9

 

 

6,275

 

Non-interest expense

 

5,872

 

4,426

 

324

 

499

 

 

11,121

 

Provision for income taxes

 

453

 

960

 

(17

)

(230

)

 

1,166

 

Net income (loss)

 

$

1,022

 

$

1,751

 

$

(16

)

$

(465

)

$

 

$

2,292

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,310,707

 

$

495,017

 

$

7,228

 

$

165,331

 

$

(511,046

)

$

1,467,237

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

At and for the Six Months Ended June 30, 2006:

 

 

Commercial
Banking

 

Mortgage
Banking

 

Trust and
Investment
Services

 

Other

 

Intersegment
Elimination

 

Consolidated

 

Net interest income

 

19,355

 

$

2,279

 

$

 

$

(528

)

$

 

$

21,106

 

Provision for loan losses

 

640

 

 

 

 

 

640

 

Non-interest income

 

1,813

 

7,277

 

1,672

 

23

 

 

10,785

 

Non-interest expense

 

13,105

 

7,989

 

1,631

 

1,155

 

 

23,880

 

Provision for income taxes

 

2,414

 

548

 

14

 

(590

)

 

2,386

 

Net income (loss)

 

5,009

 

$

1,019

 

27

 

$

(1,070

)

$

 

$

4,985

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,511,410

 

$

394,233

 

$

6,826

 

$

157,453

 

$

(485,334

)

$

1,584,588

 

 

At and for the Six Months Ended June 30, 2005:

 

 

Commercial
Banking

 

Mortgage
Banking

 

Trust and
Investment
Services

 

Other

 

Intersegment
Elimination

 

Consolidated

 

Net interest income

 

$

14,437

 

$

2,943

 

$

 

$

(434

)

$

 

$

16,946

 

Provision for loan losses

 

1,369

 

 

 

 

 

1,369

 

Non-interest income

 

845

 

10,145

 

450

 

17

 

 

11,457

 

Non-interest expense

 

11,465

 

8,376

 

545

 

830

 

 

21,216

 

Provision for income taxes

 

831

 

1,539

 

(38

)

(417

)

 

1,915

 

Net income (loss)

 

$

1,617

 

$

3,173

 

$

(57

)

$

(830

)

$

 

$

3,903

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

1,310,707

 

$

495,017

 

$

7,228

 

$

165,331

 

$

(511,046

)

$

1,467,237

 

 

At June 30, 2006, the Company did not have any operating segments other than those reported. Parent company financial information is included in the “Other” category and represents an

13




overhead function rather than an operating segment. The parent company’s most significant assets are its net investments in its subsidiaries. The parent company’s net interest income is comprised of interest income from short-term investments and interest expense on trust preferred securities. The parent company’s non-interest expense is primarily non-allocable executive salaries and professional services related to the Company’s regulatory requirements.

Note 6

Earnings Per Share

The following is the calculation of basic and diluted earnings per share for the three and six months ended June 30, 2006 and 2005. Stock options outstanding at June 30, 2006 and 2005 were 2,427,230 and 2,076,413, respectively. Stock options issued that were not included in the calculation of diluted earnings per share because the exercise prices were greater than the average market price were 402,108 and 224,891 for the three months ended June 30, 2006 and 2005, respectively. Stock options issued that were not included in the calculation of diluted earnings per share because the exercise prices were greater than the average market price were 414,710 and 283,154 for the six months ended June 30, 2006 and 2005, respectively.

(In thousands, 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

except share and per share data)

 

2006

 

2005

 

2006

 

2005

 

Net income available to common shareholders

 

$

2,391

 

$

2,292

 

$

4,985

 

$

3,903

 

Weighted average common shares - basic

 

24,415,545

 

21,096,617

 

24,401,460

 

19,817,872

 

Weighted average common shares - diluted

 

24,995,818

 

21,321,508

 

24,993,471

 

20,101,026

 

Earnings per common share - basic

 

$

0.10

 

$

0.11

 

$

0.20

 

$

0.20

 

Earnings per common share - diluted

 

$

0.10

 

$

0.11

 

$

0.20

 

$

0.19

 

 

 

 

 

 

 

 

 

 

 

 

Note 7

Derivatives and Hedging Activities

The Company is a party to forward loan sales contracts, which are utilized to mitigate exposure to fluctuations in interest rates related to loan commitments and closed mortgage loans that are held for sale.

Beginning on October 1, 2005, the Company designated these derivatives as cash flow hedges in accordance with SFAS No. 133, Accounting for Derivatives Instruments and Hedging Activities, as amended. These hedges are recorded at fair value in the statement of condition as an other asset or other liability with a corresponding offset to accumulated other comprehensive income in shareholders’ equity. Amounts are reclassified from accumulated other comprehensive income to the income statement in the period or periods that the loan sale is reflected in income.

At June 30, 2006, accumulated other comprehensive income included an after-tax unrealized loss of $556,000 related to forward loan sale contracts. Loans held for sale are generally sold within sixty days of closing and, therefore, substantially all of the amount recorded in accumulated other

14




comprehensive income at June 30, 2006 which is related to the Company’s cash flow hedges will be recognized in earnings during the third quarter of 2006. For the three and six months ended June 30, 2006, the hedge ineffectiveness recorded through earnings was not significant.

At June 30, 2006, the derivative asset was $3.1 million and the derivative liability was $3.6 million. The Company had $169.3 million in loan commitments and $169.3 million in associated forward loan sales. The Company also had $311.9 million in forward loan sales contracts hedging the majority of its loans held for sale.

Note 8

Goodwill and Other Intangibles

Information concerning total amortizable other intangible assets at June 30, 2006 is as follows:

 

 

 

Mortgage Banking

 

Trust and
Investment Services

 

Total

 

(In thousands)

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Balance at December 31, 2005

 

$

1,781

 

$

247

 

$

2,602

 

$

211

 

$

4,383

 

$

458

 

2006 activity:

 

 

 

 

 

 

 

 

 

 

 

 

 

Customer relationship intangibles

 

 

99

 

161

 

99

 

161

 

198

 

Employment/non-compete agreement

 

 

 

 

87

 

 

87

 

Trade name

 

 

 

 

8

 

 

8

 

Balance at June 30, 2006

 

$

1,781

 

$

346

 

$

2,763

 

$

405

 

$

4,544

 

$

751

 

 

The aggregate amortization expense for the three months ended June 30, 2006 and 2005 was $145,000 and $72,000, respectively. The aggregate amortization expense for the six months ended June 30, 2006 and 2005 was $293,000 and $122,000, respectively.

The estimated amortization expense, as amended for the change in estimate described in Note 10, for the next five years is as follows:

 

(In thousands)

 

2006 (July – December)

 

414

 

2007

 

725

 

2008

 

408

 

2009

 

402

 

2010

 

402

 

2011

 

402

 

 

15




 

The changes in the carrying amount of goodwill for year to date June 30, 2006 are as follows:

(In thousands)

 

Commercial
Banking

 

Mortgage
Banking

 

Trust and
Investment
Services

 

Total

 

Balance at December 31, 2005

 

$

22

 

$

12,941

 

$

3,614

 

$

16,577

 

2006 activity:

 

 

 

 

 

 

 

 

 

Trust division acquisition

 

$

 

$

 

$

178

 

$

178

 

Balance at June 30, 2006

 

$

22

 

$

12,941

 

$

3,792

 

$

16,755

 

 

Note 9

Commitments and Contingencies

In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the balance sheet.

The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.

At June 30, 2006, commitments to extend credit were $413 million and standby letters of credit were $6.7 million.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the agreement. Commitments generally have expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future funding requirements. The Bank evaluates each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.

Unfunded commitments under lines of credit are commitments for possible future extensions of credit to existing customers. Those lines of credit may or may not be drawn upon to the total extent of funding to which the Bank has committed.

Standby letters of credit are conditional commitments the Bank issues to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. The credit risk involved in issuing standby letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank holds certificates of deposit, deposit accounts, and real estate as collateral supporting those commitments when collateral is deemed necessary.

16




Note 10

Amendment to Employment Agreement

On June 29, 2006, the Company entered into an Amendment to the Employment Agreement (the “Amendment”) with John W. Fisher, president and chief executive officer of Wilson/Bennett. The Amendment amends the Employment Agreement dated as of June 8, 2005 between the Company and Mr. Fisher.  As provided in the Amendment, Mr. Fisher will retire from the business on September 30, 2006, work with the business in a consulting and business development function through April 30, 2007, and honor his non-compete agreement with the Company which will end on September 30, 2007. As Mr. Fisher transitions out of his involvement with Wilson/Bennett over the next fifteen months, we will continue to monitor the operations, customer base and assets under management and the associated impact on the fair value of goodwill and other intangible assets.

As a result of the Amendment, the Company has changed its estimated useful life for the intangible asset related to the employment/non-compete agreement acquired as part of the Wilson/Bennett acquisition. The useful life was changed from an aggregate of four years from the acquisition date to 15 months from the date of the Amendment.  As a result of this change, amortization expense will increase by $118,000 during the remainder of 2006.

We completed our analysis of the fair value of the goodwill associated with our acquisition of Wilson/Bennett during the second quarter of 2006, which indicated there was no impairment to this asset. 

17




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

The following presents management’s discussion and analysis of our consolidated financial condition at June 30, 2006 and December 31, 2005 and the unaudited results of our operations for the three and six months ended June 30, 2006 and 2005. This discussion should be read in conjunction with our unaudited consolidated financial statements and the notes thereto appearing elsewhere in this report, the audited consolidated financial statements and the notes to consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2005.

Caution About Forward-Looking Statements

We make forward-looking statements in this Form 10-Q that are subject to risks and uncertainties.  These forward looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals.  The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or other similar words or terms are intended to identify forward-looking statements.

These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:

·                  the ability to successfully manage our growth or implement our growth strategies if we are unable to identify attractive markets, locations or opportunities to expand in the future;

·                  changes in interest rates and the successful management of interest rate risk;

·                  risks inherent in making loans such as repayment risks and fluctuating collateral values;

·                  maintaining cost controls and asset quality as we open or acquire new branches;

·                  maintaining capital levels adequate to support our growth;

·                  reliance on our management team, including the ability to attract and retain key personnel;

·                  competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;

·                  changes in general economic and business conditions in our market area;

·                  demand, development and acceptance of new products and services;

·                  problems with technology utilized by us;

·                  changing trends in customer profiles and behavior; and

·                  changes in banking and other laws and regulations applicable to us.

Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements.  In addition, our past results of operations do not necessarily indicate our future results.

18




In addition, this section should be read in conjunction with the description of our “Risk Factors” in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2005.

Overview

We are a locally managed financial holding company headquartered in Tysons Corner, Virginia, committed to providing superior customer service, a diversified mix of financial products and services, and convenient banking to our retail and business customers. We own Cardinal Bank (the “Bank”), a Virginia state-chartered community bank, Cardinal Wealth Services, Inc. (“CWS”), an investment services subsidiary, and Wilson/Bennett Capital Management, Inc. (“Wilson/Bennett”), an asset management firm acquired in June 2005. Through these three subsidiaries and George Mason Mortgage, LLC (“George Mason”), a mortgage banking subsidiary of the Bank, we offer a wide range of traditional banking products and services to both our commercial and retail customers. Our commercial relationship managers focus on attracting small and medium-sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys. We have 23 branch office locations and seven mortgage banking office locations and provide competitive products and services. We complement our core banking operations by offering a full range of investment products and services to our customers through our third-party brokerage relationship with Raymond James Financial Services, Inc. and asset management services through Wilson/Bennett.

On February 9, 2006, we acquired certain fiduciary and other assets and assumed certain liabilities of FBR National Trust Company, formerly a subsidiary of Friedman, Billings, Ramsey Group, Inc. Our new trust division acts as trustee or custodian for assets in excess of $5 billion. Services provided by this division include trust, estates, custody, investment management, escrows, and retirement plans. This acquisition did not have a significant impact on operating results for the three and six months ended June 30, 2006 and is not expected to have a material impact on our financial condition or operating results in 2006. The trust division is included, along with CWS and Wilson/Bennett, in the Trust and Investment Services segment. In prior periods, this segment was called Investment Services.

On June 9, 2005, we acquired Wilson/Bennett for a total consideration of $6.5 million, which consisted of a payment of $1.6 million in cash and the issuance of 611,111 shares of our common stock, which we valued at $4.9 million. Wilson/Bennett’s assets and liabilities were recorded at fair value as of the purchase date. This transaction resulted in the recognition of $3.6 million of goodwill and $2.6 million of other intangible assets. Wilson/Bennett uses a value-oriented approach that focuses on large capitalization stocks. Wilson/Bennett’s primary source of revenue is management fees earned on the assets it manages for its customers. These management fees are generally based upon the market value of assets under management and, accordingly, revenues from Wilson/Bennett will be, assuming a consistent customer base, more when appropriate indices, such as the S&P 500, are higher and lower when such indices are depressed.

When we acquired Wilson/Bennett, it had approximately $225.0 million of assets under management. At June 30, 2006, assets under management by Wilson/Bennett were approximately $203.8 million. At March 31, 2006, assets under management were $159.7 million.  In our Quarterly Report on Form 10-Q for the period ended March 31, 2006, we reported that we were concerned about continued significant declines in assets under management by this subsidiary.  During the second quarter of 2006, Wilson/Bennett opened a significant customer relationship

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that increased assets under management.  We completed our analysis of the fair value of the goodwill associated with our acquisition of Wilson/Bennett during the second quarter of 2006, which indicated there was no impairment to this asset.  Subsequent to this evaluation, John W. Fisher, president and chief executive officer of Wilson/Bennett, announced that he will retire from the business on September 30, 2006, work with the business in a consulting and business development function through April 30, 2007, and honor a non-compete agreement through September 30, 2007. As Mr. Fisher transitions out of his involvement with Wilson/Bennett over the next fifteen months, we will continue to monitor the operations, customer base and assets under management and the associated impact on the fair value of goodwill and other intangible assets.

Net interest income is our primary source of revenue. We define revenue as net interest income plus non-interest income. As discussed further in the interest rate sensitivity section, we manage our balance sheet and interest rate risk exposure to maximize, and concurrently stabilize, net interest income. We do this by monitoring our liquidity position and the spread between the interest rates earned on interest-earning assets and the interest rates paid on interest-bearing liabilities. We attempt to minimize our exposure to interest rate risk, but are unable to eliminate it entirely.  In addition to management of interest rate risk, we also analyze our loan portfolio for exposure to credit risk. Loan defaults and foreclosures are inherent risks in the banking industry and we attempt to limit our exposure to these risks by carefully underwriting and then monitoring our extensions of credit. In addition to net interest income, non-interest income is an important source of revenue for us and includes, among other things, service charges on deposits and loans, investment fee income, which includes trust revenues, net gains on sales of investment securities available-for-sale, gains on sales of mortgage loans, and management fee income

Our business strategy is to grow through geographic expansion while maintaining strong asset quality and achieving increasing profitability. We completed a secondary common stock offering that raised $39.8 million in equity capital during the second quarter of 2005. This capital is being used to support the continuing expansion of our branch office network and balance sheet growth. As a result of this increased capital and retained earnings, our legal lending limit increased to $20.3 million as of June 30, 2006.

Critical Accounting Policies

General

U.S. generally accepted accounting principles are complex and require management to apply significant judgment to various accounting, reporting, and disclosure matters.  Management must use assumptions, judgments and estimates when applying these principles where precise measurements are not possible or practical.  These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates.  Changes in such judgments, assumptions and estimates may have a significant impact on the consolidated financial statements.  Actual results, in fact, could differ from initial estimates.

The accounting policies we view as critical are those relating to judgments, assumptions and estimates regarding the determination of the allowance for loan losses, accounting for economic hedging activities, accounting for business combinations and impairment testing of goodwill, and the valuation of deferred tax assets.

Allowance for Loan Losses

We maintain the allowance for loan losses at a level that represents management’s best estimate of known and inherent losses in our loan portfolio.  Both the amount of the provision expense and the level of the allowance for loan losses are impacted by many factors, including

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general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of individual borrowers.  Unusual and infrequently occurring events, such as hurricanes and other weather-related disasters, may impact our assessment of possible credit losses.  As a part of our analysis, we use comparative peer group data and qualitative factors such as levels of and trends in delinquencies and nonaccrual loans, national and local economic trends and conditions and concentrations of loans exhibiting similar risk profiles to support our estimates.

For purposes of our analysis, we categorize loans into one of five categories:  commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer loans. In the absence of meaningful historical loss factors, peer group loss factors are applied and are adjusted by the qualitative factors mentioned above. The indicated loss factors resulting from this analysis are applied for each of the five categories of loans. In addition, we individually assign loss factors to all loans that have been identified as having loss attributes, as indicated by deterioration in the financial condition of the borrower or a decline in underlying collateral value if the loan is collateral dependent. Since we have limited historical data on which to base loss factors for classified loans, we apply, in accordance with regulatory guidelines, a 5% loss factor to all loans classified as special mention, a 15% loss factor to all loans classified as substandard and a 50% loss factor to all loans classified as doubtful. Loans classified as loss loans are fully reserved or charged off.

Credit losses are an inherent part of our business and, although we believe the methodologies for determining the allowance for loan losses and the current level of the allowance are adequate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment. Additional provisions for such losses, if necessary, would be recorded in the Commercial Banking or Mortgage Banking segments, as appropriate, and would negatively impact earnings.

Derivative Instruments and Hedging Activities

We account for our derivatives and hedging activities in accordance SFAS No. 133, as amended, which requires that all derivative instruments be recorded on the statement of condition at their fair values. We evaluate the effectiveness of these transactions at inception and on an ongoing basis. Ineffectiveness is recorded through earnings. We do not enter into derivative transactions for speculative purposes.

In the normal course of business, we enter into contractual commitments, including rate lock commitments, to finance residential mortgage loans. These commitments, which contain fixed expiration dates, offer the borrower an interest rate guarantee provided the loan meets underwriting guidelines and closes within the time frame established by us. Interest rate risk arises on these commitments and subsequently closed loans if interest rates change between the time of the interest rate lock and the delivery of the loan to the investor. Loan commitments related to residential mortgage loans intended to be sold are considered derivatives.

To mitigate the effect of the interest rate risk inherent in providing rate lock commitments, we economically hedge our commitments by entering into a best efforts delivery forward loan sales contracts. During the rate lock commitment period, these forward loan sales contracts are marked to market through earnings and are not designated as accounting hedges under SFAS No. 133, as amended. Changes in the fair values of loan commitments and changes in the fair values of forward loan sales contracts generally move in opposite directions, and the net impact of changes of these valuations on net income during the loan commitment period is generally inconsequential. At the closing of the loan, the loan commitment derivative expires and

21




we record a loan held for sale and continue to be obligated under the same forward loan sales contract. Loans held for sale are accounted for at the lower of cost or market in accordance with SFAS No. 65, Accounting for Certain Mortgage Banking Activities. Prior to October 1, 2005, the changes in value of the forward loan sales contracts from the date the loan closed to the date it was sold to an investor were marked to market through earnings.

On October 1, 2005, we began designating our forward loan sales contracts as hedges to mitigate the variability in cash flow to be received from the sale of mortgage loans. We contemporaneously document the hedging relationship, including the risk management objective and strategy for undertaking the hedge, how effectiveness will be assessed at inception and at each reporting period and the method for measuring ineffectiveness. We designate each forward loan sales agreement as a cash flow hedge of a specific loan held for sale. For derivatives designated as cash flow hedges, the fair value adjustments are recorded as a component of other comprehensive income, except for the ineffective portion, which is recorded through the income statement.

We discontinue hedge accounting prospectively when it is determined that the derivative is no longer highly effective in offsetting changes in anticipated cash flows of the loans held for sale.

In situations in which hedge accounting is discontinued, we continue to carry the derivative at its fair value on the balance sheet and recognize any subsequent changes in fair value in earnings. When hedge accounting is discontinued because it is probable an anticipated loan sale will not occur, we recognize immediately in earnings any gains and losses that were accumulated in other comprehensive income.

Accounting for Business Combinations/Impairment Testing of Goodwill

We account for acquisitions of other businesses in accordance with SFAS No. 141, Business Combinations. This statement mandates the use of purchase accounting and, accordingly, assets and liabilities, including previously unrecorded assets and liabilities, are recorded at fair values as of the acquisition date. We utilize a variety of valuation methods to estimate fair value of acquired assets and liabilities. These methodologies are often based upon assumptions and estimates which may change at a future date and require that the carrying amount of assets and liabilities acquired be adjusted. To support our purchase allocations, we have utilized independent consultants to identify and value identifiable purchased intangibles. The difference between the fair value of assets acquired and the liabilities assumed is recorded as goodwill. Goodwill and any other intangible assets are accounted for in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. In accordance with this statement, goodwill will not be amortized but will be tested on at least an annual basis for impairment.

To test goodwill for impairment, we perform an analysis to compare the fair value of the reporting unit to which the goodwill is assigned to the carrying value of the reporting unit. We make estimates of the discontinued cash flows from the expected future operations of the reporting unit. If the analysis indicates that the fair value of the reporting unit is less than its carrying value, we do an analysis to compare the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. The implied fair value of the goodwill is determined by allocating the fair value of the reporting unit to all its assets and liabilities. If the implied fair value of the goodwill is less than the carrying value, an impairment loss is recognized.

 

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Valuation of Deferred Tax Assets

We record a provision for income tax expense based on the amounts of current taxes payable or refundable and the change in net deferred tax assets or liabilities during the year. Deferred tax assets and liabilities are recognized for the tax effects of differing carrying values of assets and liabilities for tax and financial statement purposes that will reverse in future periods. When substantial uncertainty exists concerning the recoverability of a deferred tax asset, the carrying value of the asset is reduced by a valuation allowance. The amount of any valuation allowance established is based upon an estimate of the deferred tax asset that is more likely than not to be recovered. Increases or decreases in the valuation allowance result in increases or decreases to the provision for income taxes.

New Financial Accounting Standards

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R, Share-Based Payment. This statement requires that companies recognize in the income statement the grant-date fair value of stock options and other equity-based compensation. We applied this standard beginning January 1, 2006. This statement requires that stock awards be classified as either an equity award or a liability award. Equity classified awards are valued as of the grant date using either an observable market price or a valuation methodology. Liability classified awards are valued at fair value as of each reporting date. We adopted SFAS No. 123R using the modified prospective application method which requires, among other things, that we recognize compensation cost for all awards outstanding at January 1, 2006 for which the requisite service has not been rendered. All of our unvested stock options are classified as equity awards.

On July 13, 2006, the FASB issued Interpretation No. 48 (“FIN No. 48”), Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN No. 48 prescribes a recognition threshold and measurement principles for financial statement disclosure of tax positions taken or expected to be taken on a tax return. This interpretation is effective for fiscal years beginning after December 15, 2006. We are assessing the impact the adoption of FIN No. 48 will have on our consolidated financial position and results of operations.

Statements of Income

Net income for the three months ended June 30, 2006 and 2005 was $2.4 million and $2.3 million, respectively, an increase of $100,000, or 4%.  The increase in net income for the three months ended June 30, 2006 compared to the same period of 2005 is primarily a result of an increase in net interest income after provision for loan losses of $2.0 million, offset by an increase in non-interest expense of $1.3 million, and a $694,000 decrease in non-interest income.  Included in non-interest income for the three months ended June 30, 2006 is a $420,000 gain from the extinguishment of a borrowing.  Net income for the six months ended June 30, 2006 and 2005 was $5.0 million and $3.9 million, respectively, an increase of $1.1 million, or 28%. The increase in net income for the six months ended June 30, 2006 compared to same period of 2005 is primarily a result of an increase in net interest income after provision for loan losses of $4.9 million, offset by an increase in non-interest expense of $2.7 million and a decrease in non-interest income of $672,000. Included in non-interest income for the six months ended June 30, 2006 are gains of $769,000 related to the extinquishment of two borrowings.

Net income attributable to the Commercial Banking segment for the three months ended June 30, 2006 and 2005 was $2.4 million and $1.0 million, respectively.  Net income attributable to the Commercial Banking segment for the six months ended June 30, 2006 and 2005 was $5.0 million and $1.6 million, respectively.  The increase in net income for the three and six months

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periods ended June 30, 2006 compared to the same periods of 2005 in the Commercial Banking segment is attributable to an increase in the volume of average earning assets and the increased yields on those assets.

Net income attributable to the Mortgage Banking segment for the three months ended June 30, 2006 and 2005 was $600,000 and $1.8 million, respectively.  Net income attributable to the Mortgage Banking segment for the six months ended June 30, 2006 and 2005 was $1.0 million and $3.2 million, respectively. The decreases in the Mortgage Banking segment’s net income for the three and six months periods ended June 30, 2006 compared to the same periods of 2005 were due to a slowdown in the regional housing market caused in part by rising interest rates.

The Trust and Investment Services segment, which includes CWS, Wilson/Bennett and the new trust division of the Bank, recorded net income of $9,000 for the three months ended June 30, 2006, as compared to a net loss of ($16,000) for the same period 2005. The trust division of the Bank is included in the results of operations since the date of acquisition, February 9, 2006. This business segment reported net income of $27,000 and a net loss of ($57,000) for the six months ended June 30, 2006 and 2005, respectively.  The increase in net income for this segment is due to the addition of the newly acquired trust division, which occurred during the first quarter of 2006.

Basic earnings per share were $0.10 and $0.11 for the three months ended June 30, 2006 and 2005, respectively. For the three months ended June 30, 2006 and 2005, diluted earnings per share were $0.10 and $0.11, respectively. Weighted average fully diluted shares outstanding for the three months ended June 30, 2006 and 2005 were 24,995,818 and 21,321,508, respectively.

 Basic earnings per share were $0.20 for each of the six months ended June 30, 2006 and 2005, respectively. For the six months ended June 30, 2006 and 2005, diluted earnings per share were $0.20 and $0.19, respectively. Weighted average fully diluted shares outstanding for the six months ended June 30, 2006 and 2005 were 24,993,471 and 20,101,026, respectively.

Return on average assets for the three months ended June 30, 2006 and 2005 was 0.66% and 0.70%, respectively. Return on average equity for the three months ended June 30, 2006 and 2005 was 6.33% and 7.61%, respectively. Return on average assets for the six months ended June 30, 2006 and 2005 was 0.71% and 0.64%, respectively. Return on average equity for the six months ended June 30, 2006 and 2005 was 6.63% and 7.16%, respectively.

Net interest income represents the difference between interest and fees earned on interest earning assets and the interest paid on deposits and other interest bearing liabilities. The level of net interest income is impacted primarily by variations in the volume and mix of these assets and liabilities, as well as changes in interest rates. Net interest income for the three months ended June 30, 2006 and 2005 was $10.7 million and $9.1 million, respectively, a period-to-period increase of $1.6 million, or 18%. The increase in net interest income is primarily the result of an increase in the average volume of loans receivable and investment securities compared with the same period of 2005. These increases were funded through increases in total deposits and other borrowed funds. Net interest income for the three months ended June 30, 2006 and 2005 represented 66% and 59% of our total revenues, respectively.

Net interest income for the six months ended June 30, 2006 and 2005 was $21.1 million and $16.9 million, respectively, a period-to-period increase of $4.2 million, or 25%. The increase in net interest income is primarily the result of an increase in the average volume of loans

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receivable and investment securities compared with the same period of 2005. These increases were funded through increases in total deposits and other borrowed funds. Net interest income for the six months ended June 30, 2006 and 2005 represented 66% and 60% of our total revenues, respectively.

Our net interest margin, or net interest income divided by average earning assets, for the three months ended June 30, 2006 and 2005 was 3.10% and 2.91%, respectively. Our net interest margin for the six months ended June 30, 2006 and 2005 was 3.13% and 2.88%, respectively. The increase in the net interest margin for the three and six months ended June 30, 2006 compared to the same periods of 2005 is a result of a higher volume of loans receivable and investment securities and an increased rate of interest earned on those earning assets compared with the interest rate paid on the increased volume of deposits and other borrowed funds. Tables 1 through 4 present an analysis of average earning assets and interest bearing liabilities with related components of interest income and interest expense.

 

Table 1.

Average Balance Sheets and Interest Rates on Earning Assets and Interest - Bearing Liabilities
Three Months Ended June 30, 2006, 2005 and 2004
(In thousands)

 

 

2006

 

2005

 

2004

 

 

 

Average
Balance

 

Interest
Income/
Expense

 

Rate

 

Average
Balance

 

Interest
Income/
Expense

 

Rate

 

Average
Balance

 

Interest
Income/
Expense

 

Rate

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-earning assets: