First Community Bancshares 10-K 2006
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
For the fiscal year ended December 31, 2005
Commission file number 000-19297
FIRST COMMUNITY BANCSHARES, INC.
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.00 par value
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. o Yes þ No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. o Yes þ No
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. þ Yes o No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated, an accelerated filer or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes þ No
State the aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2005.
$384,602,389 based on the closing sales price at that date
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
Class Common Stock, $1.00 Par Value; 11,229,852 shares outstanding as of March 7, 2006
Portions of the Proxy Statement for the annual meeting of shareholders to be held April 25, 2006, are incorporated by reference in Part III of this Form 10-K.
First Community Bancshares, Inc. (the Company) is a one-bank holding company incorporated in the State of Nevada and serves as the holding company for First Community Bank, N. A. (the Bank), a national association that conducts commercial banking operations within the states of Virginia, West Virginia, North Carolina and Tennessee. United First Mortgage, Inc., acquired in the latter part of 1999, was a wholly-owned subsidiary of the Bank and served as a wholesale and retail distribution channel for the Banks mortgage banking business segment. In August 2004, the Company sold 100% of its interest in the mortgage banking subsidiary. Accordingly, the Companys financial statements have been reformatted to segregate the assets, liabilities, operations and cash flows of this discontinued operating segment. The required information concerning discontinued operations is set forth in Note 16 of the Consolidated Financial Statements included herein. The Bank also owns Stone Capital Management (Stone Capital), an investment advisory firm purchased in January 2003. The Company had total consolidated assets of approximately $1.9 billion at December 31, 2005 and conducts commercial and mortgage banking business through fifty-one full-service banking locations, ten loan production offices, and six trust and investment management offices.
Currently, the Company is a bank holding company, and the banking operations are expected to remain the principal business and major source of revenue. The Company provides a mechanism for ownership of the subsidiary banking operations, provides capital funds as required, and serves as a conduit for distribution of dividends to stockholders. The Company also considers and evaluates options for growth and expansion of the existing subsidiary banking operations. The Company currently derives substantially all of its revenues from dividends paid by its subsidiary bank. Dividend payments by the Bank are determined in relation to earnings, asset growth and capital position and are subject to certain restrictions by regulatory agencies as described more fully under Regulation and Supervision of this item.
The Company and its subsidiaries employed 716 full-time equivalent employees at December 31, 2005. Management considers employee relations to be excellent.
The Company is a bank holding company and, as such, is subject to regulation under the Bank Holding Company Act of 1956, as amended (the BHC Act). The BHC Act requires the prior approval of the Federal Reserve Board for a bank holding company to acquire or hold more than a 5% voting interest in any bank, and restricts interstate banking activities. The BHC Act allows interstate bank acquisitions anywhere in the country and interstate branching by acquisition and consolidation in those states that had not opted out by January 1, 1997.
The BHC Act restricts the Companys nonbanking activities to those which are determined by the Federal Reserve Board to be closely related to banking. The BHC Act does not place territorial restrictions on the activities of nonbank subsidiaries of bank holding companies. The Companys banking subsidiary is subject to limitations with respect to transactions with affiliates.
The Federal Reserve Board has adopted capital adequacy guidelines pursuant to which it assesses the adequacy of capital in examining and supervising a bank holding company and in analyzing applications to it under the BHC Act. The Federal Reserve Board capital adequacy guidelines generally require bank holding companies to maintain total capital equal to 8% of total risk-adjusted assets, with at least one-half of that amount consisting of Tier I or core capital and up to one-half of that amount consisting of Tier II or supplementary capital. Tier I capital for bank holding companies generally consists of the sum of common stockholders equity and perpetual preferred stock (subject in the case of the latter to limitations on the kind and amount of such stocks which may be included as Tier I capital), less goodwill and, with certain exceptions, intangibles. Tier II capital generally consists of hybrid capital instruments; perpetual preferred stock which is not eligible to be included as Tier I capital; term subordinated debt
and intermediate-term preferred stock; and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no additional capital) for assets such as cash to 100% for the bulk of assets which are typically held by a bank holding company, including multi-family residential and commercial real estate loans, commercial business loans and consumer loans. Single-family residential first mortgage loans which are not past-due (90 days or more) or non-performing and which have been made in accordance with prudent underwriting standards are assigned a 50% level in the risk-weighting system, as are certain privately-issued mortgage-backed securities representing indirect ownership of such loans. Off-balance sheet items also are adjusted to take into account certain risk characteristics. At December 31, 2005, the Companys Tier I capital and total capital ratios were 10.54% and 11.65%, respectively.
In addition to the risk-based capital requirements, the Federal Reserve Board requires bank holding companies to maintain a minimum leverage capital ratio of Tier I capital to total assets of 3.0%. Total assets for this purpose does not include goodwill and any other intangible assets and investments that the Federal Reserve Board determines should be deducted from Tier I capital. The Federal Reserve Board has announced that the 3.0% Tier I leverage capital ratio requirement is the minimum for the top-rated bank holding companies without any supervisory, financial or operational weaknesses or deficiencies or those which are not experiencing or anticipating significant growth. Other bank holding companies are expected to maintain Tier I leverage capital ratios of at least 4.0% to 5.0% or more, depending on their overall condition. The Companys leverage ratio, at December 31, 2005, was 7.77%.
The enactment of the Graham-Leach-Bliley Act of 1999 (the GLB Act) represented a pivotal point in the history of the financial services industry. The GLB Act removed large parts of a regulatory framework that had its origins in the 1930s. Since March 2000, banks, other depository institutions, insurance companies, and securities firms have been permitted to enter into combinations that allow a single financial services organization to offer customers a more complete array of financial products and services. The GLB Act provides a new regulatory framework for financial holding companies, which have as their primary regulator the Federal Reserve Board. Functional regulation of a financial holding companys separately regulated subsidiaries is conducted by their primary functional regulator. The GLB Act requires satisfactory or higher Community Reinvestment Act compliance for insured depository institutions and their financial holding companies in order for them to engage in new financial activities. The GLB Act also provides a federal right to privacy of non-public personal information of individual customers. The Company and its subsidiaries are also subject to certain state laws that deal with the use and distribution of non-public personal information.
The Bank is subject to the provisions of the National Bank Act, is under the supervision of and is subject to periodic examination by the Comptroller of the Currency (the OCC), and is subject to the rules and regulations of the OCC, Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC).
The Bank is also subject to certain laws of each state in which such bank is located. Such state laws may restrict branching of banks within the state and acquisition or merger involving banks located in other states. Virginia, West Virginia, North Carolina, and Tennessee have all adopted nationwide reciprocal interstate banking.
The Federal Deposit Insurance Corporation Act, as amended (FDICIA), among other things, requires the federal banking agencies to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. An FDIC-insured bank will be well capitalized if it has a total capital ratio of 10% or greater, a Tier 1 capital ratio of 6% or greater and a leverage ratio of 5% or greater and is not subject to any order or written directive by any such regulatory authority to meet and maintain a specific capital level for any capital measure. A depository institutions capital tier will depend upon where its capital levels compare to various relevant capital measures and certain other factors, as established by regulation. As of December 31, 2005, the Bank had capital levels that qualify it as being well capitalized under such regulations.
The Bank is subject to capital requirements adopted by the OCC similar to the capital requirements for the Company. The capital ratios of the Bank are set forth in Note 13 to the Consolidated Financial Statements included herewith.
The monetary policies of regulatory authorities, including the Federal Reserve Board and the FDIC, have a significant effect on the operating results of banks and holding companies. The nature of future monetary policies and the effect of such policies on the future business and earnings of the Company cannot be predicted.
The USA Patriot Act of 2001 (the Patriot Act) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions. The Patriot Act requires such financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism and grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions operations. In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institutions anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions. Compliance with the Patriot Act by the Company has not had a material impact on the Companys results of operations or financial condition.
The Sarbanes-Oxley Act of 2002 comprehensively revised the laws affecting corporate governance, accounting obligations and corporate reporting for companies with equity or debt securities registered under the Securities Exchange Act of 1934, as amended. In particular, the Sarbanes-Oxley Act established: (i) new requirements for audit committees, including independence, expertise, and responsibilities; (ii) additional responsibilities regarding financial statements for the Chief Executive Officer and Chief Financial Officer of the reporting company; (iii) new standards for auditors and regulation of audits; (iv) increased disclosure and reporting obligations for reporting companies and their directors and executive officers; and (v) new and increased civil and criminal penalties for violation of the securities laws.
In response to the Sarbanes-Oxley legislation, the Board of Directors of the Company approved a series of actions to strengthen and improve its already strong corporate governance practices. Included in those actions was the adoption of a new Code of Ethics, Corporate Governance Guidelines and new charters for its Audit, Compensation, and Nominating Committees.
The Company makes available free of charge on its website at www.fcbinc.com its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and all amendments thereto, as soon as reasonably practicable after the Company files such reports with, or furnishes them to, the Securities and Exchange Commission. Investors are encouraged to access these reports and the other information about the Companys business on its website. Information found on the Companys website is not part of this Annual Report on Form 10-K. The Company will also provide copies of its Annual Report on Form 10-K, free of charge, upon written request of its Investor Relations department at the Companys main address, P.O. Box 989, Bluefield, VA 24605.
This Annual Report on Form 10-K may include forward-looking statements, which are made in good faith by the Company pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, among others, statements with respect to the Companys beliefs, plans, objectives, goals, guidelines, expectations, anticipations, estimates and intentions that are subject to significant risks and uncertainties and are subject to change based on various factors, many of which are beyond the Companys control. The words may, could, should, would, believe, anticipate, estimate, expect, intend, plan and similar expressions are intended to identify forward-looking statements. The following factors, among others, could cause the Companys financial performance to differ materially from that expressed in such forward-looking statements: the strength of the United States economy in general and the strength of the local economies in which the Company conducts operations; the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System; inflation, interest rate, market and monetary fluctuations; the timely development of competitive new products and services of the
Company and the acceptance of these products and services by new and existing customers; the willingness of customers to substitute competitors products and services for the Companys products and services and vice versa; the impact of changes in financial services laws and regulations (including laws concerning taxes, banking, securities and insurance); technological changes; the effect of acquisitions, including, without limitation, the failure to achieve the expected revenue growth and/or expense savings from such acquisitions; the growth and profitability of the Companys non-interest or fee income being less than expected; unanticipated regulatory or judicial proceedings; changes in consumer spending and saving habits; and the success of the Company at managing the risks involved in the foregoing.
The Company cautions that the foregoing list of important factors is not exclusive. The Company does not undertake to update any forward-looking statement.
We are unable to predict actual fluctuations of market interest rates with complete accuracy. Rate fluctuations are affected by many factors, including inflation, recession, a rise in unemployment, a tightening of the money supply and domestic and international disorder and instability in domestic and foreign financial markets.
Changes in the interest rate environment may reduce profits. We expect that the Company and the Bank will continue to realize income from the differential or spread between the interest earned on loans, securities and other interest-earning assets, and interest paid on deposits, borrowings and other interest-bearing liabilities. Net interest spreads are affected by the difference between the maturities and repricing characteristics of interest-earning assets and interest-bearing liabilities. Changes in levels of market interest rates could materially and adversely affect the Companys net interest spread, levels of prepayments and cash flows, the market value of its securities portfolio, and overall profitability.
The Company is a separate legal entity from the Bank and its subsidiaries and does not have significant operations of its own. The Company currently depends on the Banks cash and liquidity as well as dividends to pay the Companys operating expenses and dividends to shareholders. No assurance can be made that in the future the Bank will have the capacity to pay the necessary dividends and that the Company will not require dividends from the Bank to satisfy the Companys obligations. The availability of dividends from the Bank is limited by various statutes and regulations. It is possible, depending upon the financial condition of the Company and other factors that the OCC, the Banks primary regulator, could assert that payment of dividends or other payments by the Bank are an unsafe or unsound practice. In the event the Bank is unable to pay dividends sufficient to satisfy the Companys obligations and the Bank is unable to pay dividends to the Company, the Company may not be able to service its obligations as they become due, including payments required to be made to the FCBI Capital Trust, a business trust subsidiary of the Company, or pay dividends on the Companys common stock. Consequently, the inability to receive dividends from the Bank could adversely affect the Companys financial condition, results of operations, cash flows and prospects.
Like all financial institutions, the Bank maintains an allowance for loan losses to provide for probable loan defaults and non-performance. The Banks allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect the Banks operating results. The Banks allowance for loan losses is determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, plans for problem loan resolution, the opinions of our regulators, changes in the size and composition of the loan portfolio and industry information. Also included in managements estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. The
amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates that may be beyond the Banks control, and these losses may exceed current estimates. Federal regulatory agencies, as an integral part of their examination process, review the Banks loans and allowance for loan losses. While we believe that the Banks allowance for loan losses is adequate to provide for probable losses, we cannot assure you that we will not need to increase the Banks allowance for loan losses or that regulators will not require us to increase this allowance. Either of these occurrences could materially and adversely affect the Banks earnings and profitability.
Changes in economic conditions, particularly an economic slowdown, could hurt the Companys business. The Companys business is directly affected by political and market conditions, broad trends in industry and finance, legislative and regulatory changes, and changes in governmental monetary and fiscal policies and inflation, all of which are beyond the Companys control. A deterioration in economic conditions, in particular an economic slowdown within the Companys geographic region, could result in the following consequences, any of which could hurt the Companys business materially:
The Companys business activities and credit exposure are concentrated in Virginia, West Virginia, North Carolina, Tennessee and the surrounding southeast region. A downturn in this regional real estate market could hurt the Companys business because of the geographic concentration within this regional area. If there is a significant decline in real estate values, the collateral for the Companys loans will provide less security. As a result, the Companys ability to recover on defaulted loans by selling the underlying real estate would be diminished, and we would be more likely to suffer losses on defaulted loans.
Commercial business and commercial real estate loans generally are considered riskier than single-family residential loans because they have larger balances to a single borrower or group of related borrowers. Commercial business and commercial real estate loans involve risks because the borrowers ability to repay the loan typically depends primarily on the successful operation of the business or the property securing the loan. Most of the commercial business loans are made to small business or middle market customers who may have a heightened vulnerability to economic conditions. Moreover, a portion of these loans have been made or acquired by the Company in the last several years and the borrowers may not have experienced a complete business or economic cycle.
The Bank seeks to mitigate the risks inherent in the Banks loan portfolio by adhering to specific underwriting practices. These practices include analysis of a borrowers prior credit history, financial statements, tax returns and cash flow projections, valuation of collateral based on reports of independent appraisers and verification of liquid assets. Although the Bank believes that its underwriting criteria are appropriate for the various kinds of loans it makes, the Bank may incur losses on loans that meet its underwriting criteria, and these losses may exceed the amounts set aside as reserves in the Banks allowance for loan losses.
The Company and its subsidiaries operations are subject to extensive regulation by federal, state and local governmental authorities and are subject to various laws and judicial and administrative decisions imposing requirements and restrictions on part or all of the Companys operations. The Company believes that it is in substantial compliance in all material respects with applicable federal, state and local laws, rules and regulations. Because the Companys business is highly regulated, the laws, rules and regulations applicable to it are subject to regular modification and change. There are various laws, rules and regulations that impact the Companys operations, including, among other things, matters pertaining to corporate governance, requirements for listing and maintenance on national securities exchanges and over the counter markets, Securities and Exchange Commission (SEC) rules pertaining to public reporting disclosures and banking regulations governing the amount of loans that a financial institution, such as the Bank, can acquire for investment from an affiliate. In addition, the Financial Accounting Standards Board (FASB), made changes which require, among other things, the expensing of the costs relating to the issuance of stock options. These laws, rules and regulations, or any other laws, rules or regulations, that may be adopted in the future, could make compliance more difficult or expensive, restrict the Companys ability to originate, broker or sell loans, further limit or restrict the amount of commissions, interest or other charges earned on loans originated or sold by the Bank and otherwise adversely affect the Companys business, financial condition or prospects.
The Companys business operations are centered primarily in Virginia, West Virginia, North Carolina, Tennessee and the surrounding southeast region. Increased competition within this region may result in reduced loan originations and deposits. Ultimately, we may not be able to compete successfully against current and future competitors. Many competitors offer the types of loans and banking services that we offer. These competitors include other savings associations, national banks, regional banks and other community banks. The Company also faces competition from many other types of financial institutions, including finance companies, brokerage firms, insurance companies, credit unions, mortgage banks and other financial intermediaries. In particular, the Banks competitors include other state and national banks and major financial companies whose greater resources may afford them a marketplace advantage by enabling them to maintain numerous banking locations and mount extensive promotional and advertising campaigns.
Additionally, banks and other financial institutions with larger capitalization and financial intermediaries not subject to bank regulatory restrictions have larger lending limits and are thereby able to serve the credit needs of larger clients. These institutions, particularly to the extent they are more diversified than the Company, may be able to offer the same loan products and services that the Company offers at more competitive rates and prices. If the Company is unable to attract and retain banking clients, the Company may be unable to continue the Banks loan and deposit growth and the Companys business, financial condition and prospects may be negatively affected.
The Company has no unresolved staff comments as of the filing date of this 2005 Annual Report on Form 10-K.
The Company generally owns its offices, related facilities, and unimproved real property. The principal offices of the Company are located at One Community Place, Bluefield, Virginia, where the Company owns and occupies approximately 36,000 square feet of office space. The Bank operates fifty-one full-service branches and ten loan production offices throughout the four-state region of Virginia, West Virginia, North Carolina and Tennessee. The Bank also provides wealth management services through two trust and investment management offices, as well as Stone Capital, an investment advisory firm, which has four offices. The Companys banking subsidiary owns 42 of its banking offices while others are leased or are located on leased land. There are no mortgages or liens against any property of the Bank or the Company. The Bank operates 50 Automated Teller Machines (ATMs).
In Virginia, the Bank operates offices in Blacksburg, Bluefield, Clintwood, Drakes Branch, Emporia, Max Meadows, Norfolk, Pound, Richlands, Richmond, Tazewell, and Wytheville. In West Virginia, the Bank operates offices in Athens, Beckley, Bluefield, Bridgeport, Buckhannon, Cowen, Craigsville, Grafton, Hinton, Linside, Man, Mullens, Oceana, Pineville, Princeton, Richwood, Rowlesburg, Summersville, and Teays Valley. In North Carolina, the Bank operates offices in Charlotte, Elkin, Hays, Mount Airy, Sparta, Taylorsville, and Winston-Salem. In Tennessee, the Bank operates offices in Fall Branch, Johnson City, Kingsport, and Piney Flats. A complete listing of all branches and ATM sites can be found on the Internet at www.fcbresource.com. Information on such website is not part of this Annual Report on Form 10-K.
The Company is currently a defendant in various legal actions and asserted claims involving lending and collection activities and other matters in the normal course of business. While the Company and legal counsel are unable to assess the ultimate outcome of each of these matters with certainty, they are of the belief that the resolution of these actions should not have a material adverse affect on the financial position of the Company.
No matters were submitted to a vote of security holders during the fourth quarter of 2005.
The number of common stockholders of record on December 31, 2005 was 3,613 and outstanding shares totaled 11,251,803. The number of common stockholders is measured by the number of recordholders.
The Companys common stock trades on the NASDAQ National Market under the symbol FCBC. On December 31, 2005, the Companys year-end common stock price was $31.16, a 13.60% decrease from the $36.08 closing price on December 31, 2004.
Book value per common share was $17.29 at December 31, 2005, compared with $16.29 at December 31, 2004, and $15.57 at the close of 2003. The year-end market price for the Companys common stock of $31.16 represents 180.2% of the Companys book value as of the close of the year and reflects total market capitalization of $350.6 million. Utilizing the year-end market price and 2005 diluted earnings per share, First Community common stock closed the year trading at a price/earnings multiple of 13.4 times diluted earnings per share.
Cash dividends for 2005 totaled $1.02 per share, up $0.02 or 2.0% from the $1.00 paid in 2004. The 2005 dividends resulted in a cash yield on the year-end market value of 3.27%. Total dividends paid for the current and prior year totaled $11.5 million and $11.2 million, respectively.
The following table sets forth the high and low stock prices, book value per share, and dividends paid per share on the Companys common stock during the periods indicated.
The Companys stock repurchase plan, as amended, allows the purchase and retention of up to 550,000 shares. The plan has no expiration date, remains open and no plans have expired during the reporting period. No determination has been made to terminate the plan or to stop making purchases. The following table sets forth open market purchases by the Company of its equity securities during 2005. The repurchase of Company stock has the effect of increasing earnings per share. During 2005, the weighted-average increase in the number treasury shares had an insignificant impact on earnings per share.
This discussion should be read in conjunction with the consolidated financial statements, notes and tables included throughout this report. All statements other than statements of historical fact included in this report, including statements in this Managements Discussion and Analysis of Financial Condition and Results of Operations are, or may be deemed to be, forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act. As discussed below, the financial statements, footnotes, schedules and discussion within this report have been reformatted to conform to the presentation required for discontinued operations pursuant to the Companys sale of its mortgage banking subsidiary.
First Community Bancshares, Inc. is a bank holding company which provides commercial banking services and has positioned itself as a regional community bank and a financial services alternative to larger banks which often provide less emphasis on personal relationships, and smaller community banks which lack the capital and resources to efficiently serve customer needs. The Company has focused its growth efforts on building financial partnerships and more enduring and complete relationships with businesses and individuals through a very personal approach to banking and financial services. The Company and its operations are guided by a strategic plan which includes growth through acquisitions and through office expansion in new market areas including strategically identified metro markets in Virginia, West Virginia, North Carolina and Tennessee. While the Companys mission remains that of a community bank, management believes that entry into new markets will accelerate the Companys growth rate by diversifying the demographics of its customer base and customer prospects and by generally increasing its sales and service network.
Despite strong competition, the Company has succeeded in establishing new offices in seven new market areas including four new loan production offices in the last year and three new full service offices since the second quarter of 2003. The Company has also completed two bank acquisitions and one wealth management acquisition since January 2003 and has grown total assets by 17% over the last two years and 32% over the last four years. The Company continues its pursuit of community banking partners and is progressing with plans for new offices within its established target markets. Additional details regarding recent acquisitions and expansion are included under the heading Recent Acquisitions and Branching Activity.
Throughout 2005, short-term market interest rates increased significantly, while long-term market rates remained largely unchanged. Those changes have resulted in a flat interest rate curve, an environment that has led to compression of net interest margins.
The local economies in which the Company operates are diverse and cover the majority portion of a four state region. West Virginia and Southwest Virginia continue to benefit from increasing crude oil prices. These economies have significant exposure to extractive industries, such as coal and natural gas, which become more active and lucrative when oil prices rise. The local economies in the central portion of North Carolina have suffered in recent years due to foreign competition in both furniture and textiles as well as consolidation in the financial services industry. Despite these detractions, the economies in this region continue to benefit from strong real estate development, good commercial occupancy rates and national companies relocating and expanding in the Triad and Central Piedmont areas. The Eastern Virginia local economies are experiencing strong growth in residential and commercial development as those areas continue to benefit from a wide array of corporate activities and relocations.
As the Company competes for increased market share and growth in both loans and deposits it continues to encounter strong competition from many sources. Bank expansion through de novo branches and Loan Production Offices has grown in popularity as a means of reaching out to new markets. Many of the markets targeted by the Company are also being entered by other banks in nearby markets and, in some cases, from more distant markets. Despite strong competition from other banks, credit unions and mortgage companies, the Company has seen success in newly established offices in Winston-Salem as well as other markets in both Virginia and North Carolina. The Company attributes this measure of success to its recruitment of local, established bankers and loan personnel in those targeted markets. Competitive forces do impact the Company through pressure on interest yields, product fees and loan structure and terms; however, the Company has countered these pressures with its relationship style and pricing and a disciplined approach to loan underwriting.
The Companys consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP) and conform to general practices within the banking industry. The Companys financial position and results of operations are affected by managements application of accounting policies, including judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in the Companys consolidated financial position and consolidated results of operations.
Estimates, assumptions, and judgments are necessary principally when assets and liabilities are required to be recorded at estimated fair value, when a decline in the value of an asset carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded based upon the probability of occurrence of a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by third party sources, when available. When third party information is not available, valuation adjustments are estimated by management primarily through the use of internal modeling techniques and appraisal estimates.
The Companys accounting policies are fundamental to understanding Managements Discussion and Analysis of Financial Condition and Results of Operation. The following is a summary of the Companys more subjective and complex critical accounting policies. In addition, the disclosures presented in the Notes to the Consolidated Financial Statements and in Managements Discussion and Analysis provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified i.) the determination of the allowance for loan losses, ii.) accounting for acquisitions and intangible assets, and iii.) accounting for income taxes as the accounting areas
that require the most subjective or complex judgments. Derivatives hedging practices were previously included, but were eliminated in August 2004 in connection with the disposition of the Companys mortgage banking subsidiary.
The allowance for loan losses is established and maintained at levels management deems adequate to cover losses inherent in the portfolio and is based on managements evaluation of the risks in the loan portfolio and changes in the nature and volume of loan activity. In June 2005, the Company reclassified $392 thousand of its allowance for loan losses to a separate allowance for lending-related commitments, which is included in other liabilities. Estimates for loan losses are determined by analyzing historical loan losses, current trends in delinquencies and charge-offs, plans for problem loan resolution, the opinions of the Companys regulators, changes in the size and composition of the loan portfolio and industry information. Also included in managements estimates for loan losses are considerations with respect to the impact of economic events, the outcome of which are uncertain. These events may include, but are not limited to, a general slowdown in the economy, fluctuations in overall lending rates, political conditions, legislation that may directly or indirectly affect the banking industry, and economic conditions affecting specific geographic areas in which the Company conducts business.
The Company determines the allowance for loan losses by making specific allocations to impaired loans and loan pools that exhibit inherent weaknesses and various credit risk factors. Allocations to loan pools are developed giving weight to risk ratings, historical loss trends and managements judgment concerning those trends and other relevant factors. These factors may include, among others, actual versus estimated losses, regional and national economic conditions, business segment and portfolio concentrations, industry competition and consolidation, and the impact of government regulations. The foregoing analysis is performed by management to evaluate the portfolio and calculate an estimated valuation allowance through a quantitative and qualitative analysis that applies risk factors to those identified risk areas.
This risk management evaluation is applied at both the portfolio level and the individual loan level for commercial loans and credit relationships while the level of consumer and residential mortgage loan allowance is determined primarily on a total portfolio level based on a review of historical loss percentages and other qualitative factors including concentrations, industry specific factors and economic conditions. The commercial portfolio requires more specific analysis of individually significant loans and the borrowers underlying cash flow, business conditions, capacity for debt repayment and the valuation of secondary sources of payment, such as collateral. This analysis may result in specifically identified weaknesses and corresponding specific impairment allowances.
The use of various estimates and judgments in the Companys ongoing evaluation of the required level of allowance can significantly impact the Companys results of operations and financial condition and may result in either greater provisions against earnings to increase the allowance or reduced provisions based upon managements current view of portfolio and economic conditions and the application of revised estimates and assumptions.
The Company may, from time to time, engage in business combinations with other companies. The acquisition of a business is generally accounted for under purchase accounting rules promulgated by the FASB. Purchase accounting requires the recording of underlying assets and liabilities of the entity acquired at their fair market value. Any excess of the purchase price of the business over the net assets acquired and any identified intangibles is recorded as goodwill. Fair values are assigned based on quoted prices for similar assets, if readily available, or appraisal by qualified independent parties for relevant asset and liability categories. Financial assets and liabilities are typically valued using discount models which apply current discount rates to streams of cash flow. All of these valuation methods require the use of assumptions which can result in alternate valuations and varying levels of goodwill and, in some cases, amortization expense or accretion income.
Management must also make estimates of useful or economic lives of certain acquired assets and liabilities. These lives are used in establishing amortization and accretion of some intangible assets and liabilities, such as the intangible associated with core deposits acquired in the acquisition of a commercial bank.
Goodwill is recorded as the excess of the purchase price, if any, over the fair value of the revalued net assets. Goodwill is tested at least annually in the month of November for possible impairment. This testing again uses a discounted cash flow model applied to the anticipated stream of cash flows from operations of the business or segment being tested. Impairment testing necessarily uses estimates in the form of growth and attrition rates, anticipated rates of return, and discount rates. These estimates have a direct bearing on the results of the impairment testing and serve as the basis for managements conclusions as to impairment.
The establishment of provisions for federal and state income taxes is a complex area of accounting which also involves the use of judgments and estimates in applying relevant tax statutes. The Company operates in multiple state tax jurisdictions and this requires the appropriate allocation of income and expense to each state based on a variety of apportionment or allocation bases. Management strives to keep abreast of changes in tax law and the issuance of regulations which may impact tax reporting and provisions for income tax expense. The Company is also subject to audit by federal and state tax authorities. Results of these audits may produce indicated liabilities which differ from Company estimates and provisions. The Company continually evaluates its exposure to possible tax assessments arising from audits and records its estimate of possible exposure based on current facts and circumstances. The Company recently completed a state tax audit. The results of that audit are discussed under the heading Results of Operations Income Tax Expense.
On December 2, 2005, the Company completed the sale of its Clifton Forge, Virginia, branch location to Sonabank, N. A. The sale included deposits and repurchase agreements totaling approximately $45 million and loans of approximately $7 million. The transaction resulted in an approximate $4.4 million pre-tax gain on sale.
The Company has plans to open five de novo branches, convert three loan production offices to full service locations, and open two new loan production offices in 2006 and 2007. Most of these locations will be in the Richmond, Virginia and Winston-Salem, North Carolina metropolitan areas.
The following schedule details branch and loan production office openings since January 1, 2004.
After the close of business on March 31, 2004, PCB Bancorp, Inc., a Tennessee-chartered bank holding company (PCB) headquartered in Johnson City, Tennessee, was acquired by the Company. PCB had five full service branch offices located in Johnson City, Kingsport and surrounding areas in Washington and Sullivan Counties in East Tennessee. At acquisition, PCB had total assets of $171.0 million, total net loans of $128.0 million and total deposits of $150.0 million. These resources were included in the Companys financial statements beginning with the second quarter of 2004.
Under the terms of the merger agreement, shares of PCB common stock were purchased for $40.00 per share in cash. The total deal value, including the cash-out of outstanding stock options, was approximately $36.0 million. Concurrent with the PCB acquisition, Peoples Community Bank, the wholly-owned subsidiary of PCB, was merged into the Bank. As a result of the acquisition and preliminary purchase price allocation, approximately $21.3 million
in goodwill was recorded which represents the excess of the purchase price over the fair market value of the net assets acquired and identified intangibles.
Net income for 2005 was $26.3 million, up $3.9 million from $22.4 million in 2004. Basic and diluted earnings per share for 2005 were $2.33 and $2.32, respectively, compared to basic and diluted earnings per share of $1.99 and $1.97, respectively, in 2004.
The Companys key profitability ratios are return on average assets (net income as a percentage of average assets) and return on average equity (net income as a percentage of average common shareholders equity). Returns on average assets for the last two years were 1.37% and 1.24%. The returns on average equity for the last two years were 13.79% and 12.53%. The Company continues to compare favorably to national peer returns of 1.16% and 13.51%, respectively, based on the September 2005 Bank Holding Company Performance Report.
The primary source of the Companys earnings is net interest income, the difference between income on earning assets and the cost of funds supporting those assets. Significant categories of earning assets are loans and securities while deposits and borrowings represent the major portion of interest-bearing liabilities. For purposes of the following discussion, comparison of net interest income is done on a tax equivalent basis, which provides a common basis for comparing yields on earning assets exempt from federal income taxes to those which are fully taxable (see the table titled Average Balance Sheets and Net Interest Income Analysis).
Net interest income was $73.6 million for 2005, compared to $69.2 million for 2004. Tax-equivalent net interest income totaled $77.7 million for 2005, an increase of $4.8 million from the $72.9 million reported for 2004. The increase reflects a $6.3 million increase due to increased volume, which was partially offset by a $1.5 million decrease due to rate changes on the underlying assets and liabilities.
During 2005, average earning assets increased $118.3 million while average interest-bearing liabilities increased $100.5 million over the comparable period. The yield on average earning assets increased 37 basis points to 6.42% from 6.05% for 2004. The rate earned on assets was positively impacted by the continued increases in short-term market interest rates throughout 2005.
Total cost of average interest-bearing liabilities increased 47 basis points during 2005, as such liabilities were also affected by increases in short-term market interest rates. The net result was a decrease of 10 basis points to net interest rate spread, or the difference between interest income on earning assets and expense on interest-bearing liabilities. 2005 spread was 4.01% compared to 4.11% for the same period last year. The Companys tax-equivalent net interest margin of 4.39% for 2005 was essentially unchanged with a small decrease of 2 basis points from 4.41% in 2004.
The largest contributor to the increase in the yield on average earning assets in 2005, on a volume-weighted basis, was the $142.9 million increase in loans held for investment. The loan portfolio contributed approximately $13.1 million to the change in interest income, while the portfolios average yield increased 28 basis points from the prior year to 6.91%. The yield on variable-rate loans tied to prime and other indices increased in response to the recent increases in short-term interest rates.
During 2005, the tax-equivalent yield on securities available for sale increased 36 basis points to 4.98% while the average balance decreased by $17.0 million. Although the total portfolio decreased through the period, the average tax-equivalent yield increased due to the addition of higher-rate securities and the sale of lower-rate securities. Funds received from the paydowns, maturities, calls, and sales of investment securities helped fund loan growth.
Average interest-bearing balances with banks remained steady during 2005, while the yield increased 154 basis points to 3.36%. The yield on those balances is directly correlated to the increases in the target federal funds rate which occurred throughout the year.
The Company attempts to control the cost of deposited funds in relation to the prevailing economic climate and competitive forces. The Company achieves its balance sheet management goals through its Asset/Liability Management Committee. Throughout 2005, the pressures of increasing short-term interest rates resulted in an increase of 40 basis points in the average cost of interest-bearing deposits. The average rate paid on interest-bearing demand deposits remained consistent, while the average rate paid on savings, which includes money market and passbook accounts, increased 32 basis points. The Company was successful in keeping rates paid on interest-bearing checking accounts relatively stable and increased money market account rates to remain competitive. Average time deposits increased $46.2 million while the average rate paid increased 48 basis points to 2.92%. During the first quarter, the Company ran a successful certificate of deposit campaign, which generated market-rate deposits centered mostly in the Richmond and Winston-Salem markets. The level of average non-interest-bearing demand deposits increased $16.0 million to $228.8 million compared to the prior year.
Average federal funds purchased and repurchase agreements increased $19.3 million due mostly to increases in the balances of customer repurchase agreements. The average rate paid on those funds also increased, as they are closely tied to the target federal funds rate. Average Federal Home Loan Bank (FHLB) advances increased $29.5 million as the Company borrowed $75 million through the year. Interest paid on those borrowings increased 19 basis points as interest rates were increasing on adjustable-rate borrowings. Other borrowings remained steady, but the rate paid increased 198 points because the majority of such borrowings consist of the Companys trust preferred borrowings, which are tied to LIBOR.
Average Balance Sheets and Net Interest Income Analysis
The following table recaps the adjustments incorporated when converting net interest earnings to a tax-equivalent basis:
Rate and Volume Analysis of Interest
The following table summarizes the changes in interest earned and paid resulting from changes in volume of earning assets and paying liabilities and changes in their interest rates. In this analysis, the change in interest due to both rate and volume has been allocated to the volume and rate columns in proportion to absolute dollar amounts. This table will assist you in understanding the changes in the Companys principal source of revenue, net interest income. The principal themes or trends which are evident in this table include:
The provision for loan losses for the year ended December 31, 2005 was $3.7 million, an increase of $1.0 million when compared to the year ended December 31, 2004. The increase in loan loss provision between the periods is primarily attributable to new or increased specific allocations, increased commercial and residential real estate loan volume, and changes in various qualitative risk factors. Net charge-offs for 2005 and 2004 were $4.9 million and $2.7 million, respectively. Expressed as a percentage of average loans, net charge-offs increased from 0.24% for 2004, to 0.38% for 2005. The Company experienced a loss from a previously disclosed credit to a hospitality concern, which accounted for a large portion of the increase in net charge-offs in 2005. During 2005, the $4.4 million loan was charged down to its net realizable value of $2.2 million. The note was sold to a third party and the final net loss to the Company was $1.5 million.
Details of non-interest income are summarized in the following table:
Non-interest income consists of all revenues which are not included in interest and fee income related to earning assets. Non-interest income from continuing operations for 2005 was $22.3 million compared to $17.3 million in the same period of 2004. Wealth management income, which includes fees for trust services and commission and fee income generated by Stone Capital, increased $467 thousand in 2005, or 18.8%, compared to 2004 as a result of the Companys continued focus on growth. Stone Capital has expanded its retail asset management services through the addition of two investment advisors and the licensing of a number of investment associates within the bank branches.
Service charges on deposit accounts increased $973 thousand, or 10.7%, while other service charges, commissions and fees reflected gains of $546 thousand, or 24.4%. Other service charges, commissions and fees increased largely because of ATM usage fees on foreign cards of $1.4 million and official check commissions of $256 thousand.
Other operating income includes $4.4 million in gain from the sale of the Clifton Forge, Virginia, branch location. The remaining components of other operating income decreased $525 thousand compared to 2004. 2005 included securities gains of $753 thousand, which were $851 thousand less than those recognized in 2004.
Total non-interest expense from continuing operations was $55.6 million, an increase of $7.6 million for 2005 over 2004. The single largest item contributing to the increase was the $3.8 million prepayment penalty incurred in connection with the early termination of $77.0 million of FHLB advances in late December. Salaries and benefits increased approximately $2.8 million due to increases in staffing to support added corporate services, continued branch and loan production office growth, and increased health benefits costs.
Occupancy and furniture and equipment expenses increased $344 thousand and $447 thousand, respectively, compared to 2004. The general level of occupancy and furniture and equipment costs in 2005 grew largely as a result of increases in depreciation and insurance costs associated with de novo branches and depreciation associated with continued investment in operating equipment and technology infrastructure.
All other operating expense accounts increased $100 thousand in 2005 compared to 2004. The most significant item within the increase in other operating expense was the increase in audit fees, which increased over $335 thousand year-over-year.
The Company uses a traditional efficiency ratio that is a non-GAAP financial measure of operating expense control and efficiency of operations. Management believes this traditional ratio better focuses attention on the core operating performance of the Company over time than does a GAAP-based ratio, and is highly useful in comparing period-to-period operating performance of the Companys core business operations. It is used by management as part of its assessment of its performance in managing non-interest expenses. However, this measure is supplemental and is not a substitute for an analysis of performance based on GAAP measures. The reader is cautioned that the traditional efficiency ratio used by the Company may not be comparable to GAAP or non-GAAP efficiency ratios reported by other financial institutions.
In general, the efficiency ratio is non-interest expenses as a percentage of net interest income plus non-interest income. Non-interest expenses used in the calculation of the traditional, non-GAAP efficiency ratio exclude amortization of goodwill and intangibles and non-recurring expenses. Income for the traditional ratio is increased for the favorable effect of tax-exempt income (see Table I), and excludes securities gains and losses, which vary widely from period to period without appreciably affecting operating expenses, and non-recurring gains. The measure is different from the GAAP based efficiency ratio, which also is presented in this report. The GAAP based measure is calculated using non-interest expense and income amounts as shown on the face of the Consolidated Statements of Income. The GAAP and traditional based efficiency ratios are reconciled in the table below.
The traditional, non-GAAP efficiency ratios for continuing operations for 2005, 2004, and 2003 were 53.9%, 53.2%, and 45.2%, respectively. Increases in the current year is reflective of the higher direct costs associated with the new offices in 2005 and 2004 and added corporate overhead required to support Company expansion. The following table details the components used in calculation of the efficiency ratios.
GAAP based and Traditional Efficiency Ratios
On January 1, 2006, the Company adopted the equity-based compensation accounting provisions of Statement of Financial Accounting Standards (SFAS) 123R. Through December 31, 2005, the Company accounted for equity-based compensation under APB Opinion No. 25, using the intrinsic-value model. Under Opinion No. 25, the Company recognized no compensation expense related to stock options granted, and provided pro-forma disclosures of the effects of accounting for stock options under the fair value model. The Company has selected the modified prospective method of transition. Management expects the adoption of the new equity-based compensation accounting standard to result in increased compensation expense. The total compensation cost related to nonvested stock option awards that management expects to recognize is approximately $721 thousand. The weighted average period over which that compensation cost is expected to be recognized is 1.9 years. Future awards of stock options will increase the amount of compensation expense to be recognized under SFAS 123R.
Income tax expense is comprised of federal and state current and deferred income taxes on pre-tax earnings of the Company. Income taxes as a percentage of pre-tax income may vary significantly from statutory rates due to items of income and expense which are excluded, by law, from the calculation of taxable income. These items are commonly referred to as permanent differences. The most significant permanent differences for the Company include i) income on state and municipal securities which are exempt from federal income tax, ii) certain dividend payments which are deductible by the Company, iii) tax credits generated by investments in low income housing and iv) for 2004, goodwill impairment expense which is not deductible.
Consolidated income taxes for 2005 were $10.1 million, a 27.7% effective tax rate, compared to $7.7 million, an effective tax rate of 25.6%, for 2004. The effective tax rate for the 2004 was less than 2005 due to the tax benefits realized from the divestiture of the mortgage banking subsidiary. Specifically, the non-deductible impairment charges recognized in 2003 and the first two quarters of 2004 reduced the book carrying basis of the investment in the mortgage subsidiary and resulted in a permanent difference during the third quarter of 2004 upon sale of the entity. This difference reduced the 2004 effective tax rate to 25.6% and is the primary cause of the increase in the effective tax rate when comparing 2004 to 2005.
The previously disclosed state tax audit of state income, franchise, and sales tax in one of the Companys tax jurisdictions was concluded during the fourth quarter of 2005. The outcome of this audit was favorable to the Company and resulted in total state income and franchise tax refunds of approximately $473 thousand. During the fourth quarter the company submitted the required claims of refund to the state. The Company anticipates receiving these refunds during the first quarter of 2006.
Net income for 2004 was $22.4 million, down $2.8 million from $25.2 million in 2003. Basic and diluted earnings per share for 2004 were $1.99 and $1.97, respectively, compared to basic and diluted earnings per share of $2.27 and $2.25, respectively, in 2003.
The Companys key profitability ratios are return on average assets (net income as a percentage of average assets) and return on average equity (net income as a percentage of average common shareholders equity). Return on average assets for 2004 and 2003 were 1.24% and 1.56%, respectively. The return on average equity for those years were 12.53% and 15.13%, respectively. The returns compare with national peer returns of 1.20% and 14.00%, respectively, based on the September 2004 Bank Holding Company Performance Report.
Net interest income from continuing operations was $69.2 million for the year ended December 31, 2004 compared to $64.2 million for the corresponding period in 2003. Tax equivalent net interest income totaled $72.9 million for 2004, an increase of $5.0 million from the $67.9 million reported in 2003. This $5.0 million increase includes a $9.5 million increase due to an increase in earning assets, which were added to the portfolio at declining replacement rates. This increase was partially offset by a net $4.4 million reduction due to rate changes on the underlying assets and liabilities as asset yields fell in the declining rate environment. Average earning assets increased $187.7 million while average interest-bearing liabilities increased $175.4 million. The yield on average earning assets decreased 39 basis points from 6.44% for the year ended December 31, 2003 to 6.05% for the year ended December 31, 2004. This decrease was accompanied by a 24 basis point decline in the cost of funds during the same periods. As a result, the net interest rate spread at December 31, 2004 was lower at 4.11% compared to 4.26% for the same period last year. The Companys tax equivalent net interest margin of 4.41% for the year ended December 31, 2004 decreased 23 basis points from 4.64% in 2003.
The largest contributor to the decrease in the yield on average earning assets in 2004, on a volume-weighted basis, was the decrease in the overall tax equivalent yield on loans held for investment of 60 basis points from the prior year to 6.63%, as loans repriced downward in response to the declining rate environment of the preceding year and continued low rates in the first half of 2004. The average balance of loans increased $182.5 million, largely due to the PCB acquisition in Tennessee and expansion offices in North Carolina. The decline in asset yield is
attributable to the recent interest rate environment which created refinancing or repricing incentives for fixed-rate borrowers to lower their borrowing costs. Strong competition for commercial loans also held loan yields lower in 2004.
During 2004, the taxable equivalent yield on securities available for sale decreased 24 basis points to 4.62% while the average balance increased by $16.2 million. Consistent with the current rate environment, the Company and the securities industry as a whole have experienced rapid turnover in securities as higher yielding securities are either called or prepaid as refinancing opportunities arise. The increasing average security balance is the result of continued reinvestment of available funds. The average balance of investment securities held to maturity decreased $3.7 million, while the average yield decreased 23 basis points to 8.00%. Securities held to maturity are largely comprised of tax-free municipal securities. Compared to 2003, average interest-bearing balances with banks decreased $6.6 million between 2003 and 2004, while the yield increased 30 basis points to 1.82%.
The average cost of interest-bearing liabilities decreased by 24 basis points from 2.18% in 2003 to 1.94% in 2004 while the average volume of interest-bearing liabilities increased $175.4 million.
Compared to 2003, the average balance of FHLB and other short-term convertible and callable borrowings increased in 2004 by $58.6 million to $240.6 million while the average rate decreased 3 basis points to 3.15%, the result of the addition of balances acquired with the CommonWealth and PCB acquisitions, the addition of new advances at lower rates partially offset by the maturity of a $25 million FHLB advance in December 2004. The average balance of all other borrowings increased $5.1 million in 2004 compared to 2003; the result of the issuance of $15 million in subordinated debentures late in the third quarter of 2003, while the rate paid decreased 30 basis points.
In addition, the average balances of interest-bearing demand and savings deposits increased $20.4 million and $86.1 million, respectively. The average rate paid on demand deposits decreased by 5 basis points while the average rate paid on savings increased by 7 basis points (the result of higher rates paid by PCB on certain money market accounts). Average time deposits increased $5.1 million while the average rate paid decreased 41 basis points from 2.85% in 2003 to 2.44% in 2004. The level of average non-interest-bearing demand deposits increased $33.8 million to $212.8 million at December 31, 2004 compared to 2003. Average interest-bearing deposits and non-interest bearing demand deposits for CommonWealth Bank, which was acquired in June 2003, totaled $66.1 million and $25.1 million, respectively in 2004 and $35.9 million and $18.1 million, respectively in 2003. Included in the 2004 average balances related to the PCB acquisition were interest-bearing and non-interest bearing deposits of $97.7 million and $14.2 million at December 31, 2004.
The provision for loan losses for the year ended December 31, 2004 decreased $748 thousand compared to the year ended December 31, 2003. The provision for loan losses was $2.7 million in 2004 and $3.4 million in 2003. Net charge-offs for 2004 and 2003 were $2.7 million and $4.8 million, respectively. Expressed as a percentage of average loans held for investment, net charge-offs decreased from 0.49% for 2003, to 0.24% for 2004.
Total non-interest income increased approximately $2.8 million, or 19.2%, from $14.5 million for the year ended December 31, 2003 to $17.3 million for the corresponding period in 2004. Service charges on deposit accounts increased $1.1 million or 13.0% while other service charges, commissions and fees reflected gains of $226 thousand or 11.2%. Other operating income improved 70.3%, or $774 thousand, in 2004.
During 2004, the Company realized a gain on sale of securities of approximately $1.6 million due largely to the sale of $25.0 million of corporate bonds held in the Companys available for sale investment portfolio, the market value of which had declined in step with the flattening of the Treasury yield curve. The proceeds from the sale of these securities in the second quarter of 2004 provided sufficient liquidity to pay-off overnight borrowings and assisted the Company in funding increased loan demand. These gains, along with smaller gains on securities called, compared to those of the same period of 2003 reflect a year over year increase of $406 thousand.
Wealth management revenues, which include fees for trust services, increased $330 thousand in 2004 versus 2003. The increase in fiduciary revenues in 2004 relates to both account and asset growth within the trust division which came under new management in early 2004. The increase in revenues includes an increase of $106 thousand in mutual fund shareholder service fees which were previously retained by an outsourced investment advisor and increased estate fees of $52 thousand. Stone Capital asset management fees grew from $371 thousand in 2003 to $531 thousand in 2004. This growth reflects the initial stages of expansion of the retail asset management services under Stone Capital and its addition of investment advisors and the licensing of a number of investment associates within the bank branches.
Total non-interest expense from continuing operations was $48.0 million, an increase of 27.8% or $10.4 million for 2004 over 2003. A $6.0 million or 29.1% increase in salaries and benefits and a $2.8 million increase in other operating expenses account for 85% of this increase, resulting from the Companys expansion into Blacksburg, Virginia, Eastern Virginia, East Tennessee, and Charlotte, Winston-Salem and Mount Airy, North Carolina. This expansion brings with it the associated costs of additional branch personnel, corporate services and support, added technology and infrastructure as further detailed below.
The $6.0 million increase in salaries and benefits includes the addition of CommonWealth Bank in June 2003 ($1.0 million), the acquisition of PCB in the second quarter of 2004 ($1.9 million), the salaries and benefits associated with three North Carolina de novo branches opened in late 2003 and the opening of two new North Carolina loan production offices in the first quarter of 2004 ($1.2 million), and three new loan production offices in Virginia and West Virginia ($230 thousand), as well as a general increase in salaries and benefits as staffing needs at several locations were satisfied in order to support added corporate services and continued branch growth.
Occupancy and furniture and equipment expenses increased $647 thousand and $878 thousand, respectively, compared to 2003 for a total of $1.5 million. The general level of occupancy and furniture and equipment costs grew largely as a result of the CommonWealth acquisition ($156 thousand), the PCB Bancorp acquisition ($477 thousand), increases in depreciation and insurance costs associated with new de novo branches ($210 thousand) and depreciation associated with continued investment in operating equipment and technology infrastructure.
All other operating expense accounts increased $2.8 million in 2004 compared to 2003. Significant increases were related to the additional costs associated with the opening of three new branches in Winston-Salem and two loan production offices in Charlotte and Mount Airy, North Carolina ($119 thousand), the opening of three loan production offices in Virginia and West Virginia ($68 thousand), the acquisition of CommonWealth in Richmond, Virginia ($263 thousand) and the Tennessee acquisition of PCB Bancorp ($616 thousand). Other operational and data processing expenses also increased as a result of the acquisition and branching activity, such as correspondent bank fees, insurance, courier and OCC assessments.
The efficiency ratios for continuing operations for 2004 and 2003 were 53.2% and 45.2%, respectively. Increases in the current year is reflective of the higher direct costs associated with the acquisitions and new offices in 2003 and 2004 and added corporate overhead required to support Company expansion.
Consolidated income taxes were $7.7 million for 2004, a 25.6% effective tax rate, compared with $10.3 million, an effective tax rate of 29.1% in 2003. During 2004, the Company sold its mortgage subsidiary. Prior to the disposition of the mortgage subsidiary the Company recognized goodwill impairment expense in 2003 and the first two quarters of 2004. Because the goodwill impairment charges were not deductible, they increased the effective tax rate for 2003 and for the first two quarters of 2004. The impairment charges did, however, reduce the book carrying basis of the mortgage subsidiary which resulted in a tax benefit of $950 thousand at the time of sale. This difference reduced the combined effective tax rate for 2004 to 25.6% from 29.1% in 2003.
Securities available for sale were $404.4 million at December 31, 2005, compared to $376.0 million at December 31, 2004, an increase of $28.4 million.
The Company attempts to maintain an acceptable level of interest rate risk within its securities portfolio. At December 31, 2005, the average life and duration of the portfolio were 7.0 years and 5.4, respectively. Average life and duration were somewhat higher than December 31, 2004, at 4.0 years and 3.5, respectively. However, the Company has been shifting towards more floating-rate securities. At December 31, 2005, 22% of the portfolio was floating-rate, compared to 16% at December 31, 2004.
Available for sale and held to maturity securities are reviewed quarterly for possible other-than-temporary impairment. This review includes an analysis of the facts and circumstances of each individual investment such as the length of time the fair value has been below cost, the expectation for that securitys performance, the creditworthiness of the issuer and the Companys intent and ability to hold the security to recovery or maturity. A decline in value that is considered to be other-than-temporary would be recorded as a loss within non-interest income in the Consolidated Statements of Income. At December 31, 2005, the combined depreciation in value of the individual securities in an unrealized loss position for more than 12 months was less than 1% of the combined reported value of the aggregate securities portfolio. Management does not believe any unrealized loss, individually or in the aggregate, as of December 31, 2005, represents other-than-temporary impairment. The Company has the intent and ability to hold these securities until such time as the value recovers or the securities mature. Furthermore, the Company believes the decline in value is attributable to changes in market interest rates and not the credit quality of the issuer.
The following table details amortized cost and fair value of securities available for sale December 31, 2005, 2004, and 2003.
Investment securities held to maturity are comprised primarily of high-grade state and municipal bonds. These securities generally carry AAA bond ratings, most of which also carry credit enhancement insurance by major insurers of investment obligations. The portfolio totaled $24.2 million at December 31, 2005 compared to $34.2 million at December 31, 2004. This decrease is reflective of continuing paydowns, maturities and calls within the portfolio. The market value of investment securities held to maturity was 102.9% and 104.1% of book value at December 31, 2005 and 2004, respectively. Recent trends in interest rates have had little effect on the portfolio market value since December 31, 2004, due to its larger percentage of municipal securities which display less price sensitivity to rate changes.
The average final maturity of the held to maturity investment portfolio decreased from 7.4 years in 2004 to 5.3 years in 2005 with the tax-equivalent yield decreasing from 8.00% at year-end 2004 to 7.95% at the close of 2005. The average maturity of the investment portfolio, based on market assumptions for prepayment, is 1.6 years and 1.91 years at December 2005 and 2004, respectively. The average maturity data differs from final maturity data because of the use of assumptions as to anticipated prepayments.
The following table details amortized cost and fair value of securities held to maturity at December 31, 2003.
To mitigate interest rate risk, the Company sells most of the long-term, fixed-rate mortgage loans it originates in the secondary market. At December 31, 2005, the Company held $1.3 million of loans for sale to the secondary market. The gross notional amount of outstanding commitments to originate mortgage loans for customers at December 31, 2005, was $9.2 million on 53 loans.
Total loans held for investment increased $92.3 million to $1.33 billion at December 31, 2005, from $1.24 billion at December 31, 2004 as a result of increased loan production and contributions by new loan production offices. Average loan to deposit ratio increased to 92.3% at December 31, 2005, compared with 86.3% at December 31, 2004. 2005 average loans held for investment of $1.30 billion increased $142.9 million when compared to the average for 2004 of $1.16 billion. The increase in average loans reflects the impact of the acquisition of PCB on March 31, 2004 and growth through the Companys de novo and loan production office expansion efforts, along with the existing branches.
The held for investment loan portfolio continues to be diversified among loan types and industry segments. The following table presents the various loan categories and changes in composition at year-end 2001 through 2005.
Loan Portfolio Summary
The Company maintained no foreign loans in the periods presented.
The following table details the maturities and rate sensitivity of the Companys loan portfolio at December 31, 2005.
Maturities and Rate Sensitivity of Loan Portfolio at December 31, 2005
The allowance is increased by charges to earnings in the form of provisions and by recoveries of prior charge-offs, and decreased by charge-offs. The provisions are calculated to bring the allowance to a level, which, according to a systematic process of measurement, is reflective of the required amount needed to absorb probable losses.
Management performs monthly assessments to determine the appropriate level of the allowance. Differences between actual loss experience and estimates are reflected through adjustments that are made by either increasing or decreasing the loss provision based upon current measurement criteria. Commercial, consumer and mortgage loan portfolios are evaluated separately for purposes of determining the loan loss portion of the allowance. The specific components of the loan allowance include allocations to individual commercial credits and allocations to the remaining non-homogeneous and homogeneous pools of loans. Managements allocations are based on judgment of qualitative and quantitative factors about both the macro and micro economic conditions reflected within the portfolio of loans and commitments and the economy as a whole. Factors considered in this evaluation include, but are not necessarily limited to, probable losses from loan and other credit arrangements, general economic conditions, changes in credit concentrations or pledged collateral, historical loan loss experience, and trends in portfolio volume, maturity, composition, delinquencies, and non-accruals. While management has attributed the allowance for loan losses to various portfolio segments, the allowance is available for the entire portfolio.
The allowance for loan losses was $14.7 million at December 31, 2005, compared to $16.3 million at December 31, 2004. The decrease in the allowance since December 2004 is primarily attributable to changes in various qualitative risk factors specific to the portfolio and increased charge-offs for 2005. Management considers the allowance adequate based upon its analysis of the portfolio as of December 31, 2005. However, no assurance can be made that additions to the allowance for loan losses will not be required in future periods.
The following table details loan charge-offs and recoveries by loan type for the five years ended December 31, 2001 through 2005.
Summary of Loan Loss Experience
The following table details the allocation of the allowance for loan losses for the five years ended December 31, 2005.
Non-performing assets include loans on non-accrual status, loans contractually past due 90 days or more and still accruing interest, other real estate owned, and repossessions. The levels of non-performing assets for the last five years are presented in the following table.
Summary of Non-Performing Assets
Total non-performing assets were $4.8 million at December 31, 2005 compared to $6.6 million at December 31, 2004, a decrease of $1.7 million. Non-accrual loans decreased by $1.8 million to $3.4 million at December 31, 2005. Ongoing activity within the classification and categories of non-performing loans continues to include collections on delinquencies, foreclosures and movements into or out of the non-performing classification as a result of changing customer business conditions. Loans 90 days past due and still accruing at December 31, 2005 and 2004, were $11 thousand and $0, respectively. Other real estate owned decreased $19 thousand to $1.4 million in 2005 and is carried at the lesser of estimated net realizable value or cost.
Certain loans included in the non-accrual category have been written down to the estimated realizable value or have been assigned specific reserves within the allowance for loan losses based upon managements estimate of loss upon ultimate resolution.
During 2005, 2004 and 2003, $1.3 million, $2.1 million, and $1.6 million, respectively, of assets were acquired through foreclosure and transferred to other real estate owned.
In addition to non-performing loans reflected in the foregoing table, the Company has identified certain performing loans as impaired based upon managements evaluation of credit strength, projected ability to repay in accordance with the contractual terms of the loans and varying degrees of dependence on the sale of related collateral for liquidation of the loans.
The following table presents the Companys investment in loans considered to be impaired and related information on those impaired loans.
The Company has considered all impaired loans in the evaluation of the adequacy of the allowance for loan losses at December 31, 2005. The following table presents detail of non-performing loans for the five years ended December 31, 2005. Additional information regarding nonperforming loans can be found in Note 5, Allowance for Loan Losses, included in the Financial Statements under Item 8 of this report.
There are no outstanding commitments to lend additional funds to borrowers related to restructured loans.
Potential Problems Loans In addition to loans which are classified as non-performing, the Company closely monitors certain loans which could develop into problem loans. These potential problem loans present characteristics of weakness or concentrations of credit to one borrower. At December 31, 2005, there were no significant potential problem loans.
Although the Companys loans are made primarily in the four-state region in which it operates, the Company had no concentrations of loans to one borrower or industry representing 10% or more of outstanding loans at December 31, 2005.
Total deposits grew by $46.9 million, or 3.4%, during 2005. Noninterest-bearing demand deposits increased by $9.0 million, or 4.1%, while interest-bearing demand deposits decreased $5.8 million, or 3.9%. Savings deposits, which are made of up money market accounts and passbook savings, decreased $30.0 million, or 7.8%, while time deposits increased $73.6 million, or 12.2%. The attrition from savings and the increase in time deposits reflects the continued migration of new and current customer funds in response to the upward movement in time deposit interest rates. Adding to the increase in time deposits were the results of the Companys successful first quarter certificate of deposit marketing campaign.
Average total deposits increased to $1.41 billion for 2005 versus $1.34 billion in 2004, an increase of 5.0%. Average savings deposits increased by $2.3 million while average time deposits increased by $46.2 million. Average interest-bearing demand and non-interest bearing demand deposits increased by $3.3 million and $16.0 million, respectively. In 2005, the average rate paid on interest bearing deposits was 2.03%, up from 1.63% in 2004.
Average Deposits and Average Rates
Scheduled Maturities of Certificates of Deposit Greater than $100,000 As of December 31, 2005
The Companys borrowings consist primarily of overnight federal funds purchased from the FHLB and other sources, securities sold under agreements to repurchase, and FHLB borrowings. This category of liabilities represents wholesale sources of funding and liquidity for the Company.
Federal funds purchased were $82.5 million and $32.5 million, at year-end 2005 and 2004, respectively. Securities sold under repurchase agreements were $124.2 million and $109.9 million at December 31, 2005 and 2004, respectively. These agreements are sold to customers as an alternative to available deposit products. The underlying securities included in repurchase agreements remain under the Companys control during the effective period of the agreements.
Short-term borrowings include overnight federal funds, and securities sold under agreements to repurchase. Balances and rates paid on short-term borrowings for continuing operations are summarized as follows:
Short-term borrowings increased on average approximately $19.3 million compared to the prior year as a result of continued loan demand and increases in portfolio assets. Funding cost is managed by the Companys Asset/Liability Management Committee, which monitors, among other things, product and pricing, overall cost of funds, and maintenance of an acceptable net interest margin.
In December 2005, the Company prepaid certain of its highest interest rate FHLB advances. The retired obligations had a weighted-average interest rate and maturity of 5.96% and 4.3 years, respectively. In connection with the early termination, the Company incurred prepayment penalties of approximately $3.8 million. In January 2006, the Company borrowed $75 million in new adjustable-rate advances from the FHLB. $50 million of the advances were hedged by an interest rate swap to approximate a fixed rate of 4.34%. The remaining $25 million floats at an interest rate equal to 3-month LIBOR less 45 basis points.
At December 31, 2005, FHLB borrowings included $106.1 million in convertible and callable advances and $7.7 million of noncallable advances for a total of $113.8 million. The weighted-average interest rates of all advances were 4.17% and 5.54% at December 31, 2005 and 2004, respectively. At December 31, 2005, the FHLB advances had maturities between twelve months and 8 years. The scheduled maturities of the advances are as follows:
Also included in other indebtedness is $15.5 million of junior subordinated debentures issued by the Company in October 2003 to an unconsolidated trust subsidiary.
Liquidity represents the Companys ability to respond to demands for funds and is primarily derived from maturing investment securities, overnight investments, periodic repayment of loan principal, and the Companys ability to generate new deposits. The Company also has the ability to attract short-term sources of funds and draw on credit lines that have been established at financial institutions to meet cash needs.
Total liquidity of $681.0 million at December 31, 2005, is comprised of the following: cash on hand and deposits with other financial institutions of $57.5 million; securities available for sale of $404.4 million; securities held to maturity due within one year of $1.8 million; and FHLB credit availability of $217.3 million.
Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally used to pay down short-term borrowings. On a longer-term basis, the Company maintains a strategy of investing in securities, mortgage-backed obligations and loans with varying maturities. The Company uses sources of funds primarily to meet ongoing commitments, to pay maturing savings certificates and savings withdrawals, fund loan commitments and maintain a portfolio of securities. At December 31, 2005, approved loan commitments
outstanding amounted to $198.1 million. Certificates of deposit scheduled to mature in one year or less totaled $422.4 million. Management believes that the Company has adequate resources to fund outstanding commitments and could either adjust rates on certificates of deposit in order to retain or attract deposits in changing interest rate environments or replace such deposits with advances from the FHLB or other funds providers if it proved to be cost effective to do so.
The following table presents contractual cash obligations as of December 31, 2005.
The following table presents detailed information regarding the Companys off-balance sheet arrangements at December 31, 2005.
Lines of credit with no stated maturity date are included in commitments for less than one year.
In January 2006, the Company entered into a pay fixed and receive variable interest rate swap. The swap effectively fixes $50 million of FHLB borrowings at 4.34% for a period of five years. Management does not anticipate this derivative transaction will have a significant impact on reported earnings or cash flows.
Total stockholders equity increased $11.3 million to $194.5 million at December 31, 2005, as the Company continued to balance capital adequacy and returns to stockholders. The increase in equity was due mainly to net earnings of $26.3 million after dividends paid to stockholders of $11.5 million.
Risk-based capital guidelines and leverage ratio measure capital adequacy of banking institutions. At December 31, 2005, the Companys Tier I capital ratio was 10.54% compared with 10.80% in 2004. The Companys total risk-based capital-to-asset ratio was 11.65% at the close of 2005 compared with 12.09% in 2004. Both of these ratios are well above the current minimum level of 8% prescribed for bank holding companies. The leverage ratio is the measurement of total tangible equity to total assets. The Companys leverage ratio at December 31, 2005 was 7.77% versus 7.62% at December 31, 2004, both of which are well above the minimum levels prescribed by the Federal Reserve. See Note 12 of the Notes to Consolidated Financial Statements.
As part of its community banking services, the Company offers trust management and estate administration services through its Trust and Financial Services Division (Trust Division). The Trust Division reported market value of assets under management of $487 million and $506 million at December 31, 2005 and 2004, respectively. The Trust Division manages inter vivos trusts and trusts under will, develops and administers employee benefit plans and individual retirement plans and manages and settles estates. Fiduciary fees for these services are charged on a schedule related to the size, nature and complexity of the account.
The Trust Division employs 18 professionals and full time equivalent support staff with a wide variety of estate and financial planning, investing and plan administration skills. The Trust Division is located within the Companys banking offices in Bluefield, West Virginia. Services and trust development activities are offered to other branch locations and primary markets through the Bluefield-based division.
The Companys profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest-earning assets, such as loans and securities, and its interest expense on interest-bearing liabilities, such as deposits and borrowings. The Company, like other financial institutions, is subject to interest rate risk to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities. The Company manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds while maintaining an acceptable level of net interest income given the current interest rate environment.
The Companys primary component of operational revenue, net interest income, is subject to variation as a result of changes in interest rate environments in conjunction with unbalanced repricing opportunities on earning assets and interest-bearing liabilities. Interest rate risk has four primary components including repricing risk, basis risk, yield curve risk and option risk. Repricing risk occurs when earning assets and paying liabilities reprice at differing times as interest rates change. Basis risk occurs when the underlying rates on the assets and liabilities the institution holds change at different levels or in varying degrees. Yield curve risk is the risk of adverse consequences as a result of unequal changes in the spread between two or more rates for different maturities for the same instrument. Lastly, option risk is due to embedded options, often called put or call options, given or sold to holders of financial instruments.
In order to mitigate the effect of changes in the general level of interest rates, the Company manages repricing opportunities and thus, its interest rate sensitivity. The Company seeks to control its interest rate risk (IRR) exposure to insulate net interest income and net earnings from fluctuations in the general level of interest rates. To measure its exposure to IRR, quarterly simulations of net interest income are performed using financial models that
project net interest income through a range of possible interest rate environments including rising, declining, most likely and flat rate scenarios. The results of these simulations indicate the existence and severity of IRR in each of those rate environments based upon the current balance sheet position, assumptions as to changes in the volume and mix of interest-earning assets and interest-paying liabilities and managements estimate of yields to be attained in those future rate environments and rates that will be paid on various deposit instruments and borrowings. Specific strategies for management of IRR have included shortening the amortized maturity of new fixed-rate loans, increasing the volume of adjustable-rate loans to reduce the average maturity of the Banks interest-earning assets, and monitoring the term structure of liabilities to maintain a balanced mix of maturity and repricing to mitigate the potential exposure. The simulation model used by the Company captures all earning assets, interest-bearing liabilities and all off-balance sheet financial instruments and combines the various factors affecting rate sensitivity into an earnings outlook. Based upon the latest simulation, the Company believes that it is biased slightly toward liability sensitive position. Absent adequate management, liability sensitive positions can negatively impact net interest income in a rising rate environment or, alternatively, positively impact net interest income in a falling rate environment.
The Company has established policy limits for tolerance of interest rate risk that allow for no more than a 10% reduction in projected net interest income based on quarterly income simulations compared to forecasted results. In addition, the policy addresses exposure limits to changes in the Economic Value of Equity according to predefined policy guidelines. The most recent simulation indicates that current exposure to interest rate risk is within the Companys defined policy limits as short-term rates are anticipated to remain relatively stable throughout 2006.
The following table summarizes the impact of immediate and sustained rate shocks in the interest rate environment on net interest income and the economic value of equity as of December 31, 2005 and 2004. The model simulates plus and minus 200 basis points from the flat rate simulation at December 31, 2005. This table, which illustrates the prospective effects of hypothetical interest rate changes, is based upon numerous assumptions including relative and estimated levels of key interest rates over a twelve-month time period. This type of modeling technique, although useful, does not take into account all strategies that management might undertake in response to a sudden and sustained rate shock as depicted. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables.
Rate Sensitivity Analysis
FIRST COMMUNITY BANCSHARES, INC.
See Notes to Consolidated Financial Statements.
FIRST COMMUNITY BANCSHARES, INC.
See Notes to Consolidated Financial Statements.
FIRST COMMUNITY BANCSHARES, INC.
(See Note 1 for detail of income taxes and interest paid and Note 2 for supplemental information regarding detail of cash paid in acquisitions.)
See Notes to Consolidated Financial Statements
FIRST COMMUNITY BANCSHARES, INC.