Item 1. Business
General
FNB Financial Services Corporation (the "Company") is a North Carolina ("NC") financial holding company with consolidated assets of $865.3 million, deposits of $724.3 million and shareholders' equity of $70.4 million, as of December 31, 2004. The Company was organized in 1984 as a North Carolina bank holding company, although its predecessor and wholly-owned subsidiary, FNB Southeast (the "Bank"), opened as Rockingham Savings Bank and Trust in 1910, and was then chartered as a national bank in 1918 under the name of First National Bank of Reidsville. In May 1997, the Bank changed its name to First National Bank Southeast to reflect its expansion into new markets. Effective March 15, 1999, the Bank changed its charter from a national bank to a NC state bank and changed its name to FNB Southeast. The Company filed an election with the Federal Reserve Board to become a financial holding company on January 23, 2001, and became a financial holding company effective February 12, 2001, under the Gramm-Leach-Bliley Act. A financial holding company is permitted to engage in activities that are financial in nature or incidental to a financial activity. The permitted activities of a financial holding company are broader than for a bank holding company.
Historically, the Company has served the Rockingham County area of NC through three branches in Reidsville and two in Eden, NC. In 1995, the Company initiated a new strategic growth plan. On August 31, 1999, the Company acquired Black Diamond Savings Bank, FSB ("Black Diamond"), a federal savings bank headquartered in Norton, Virginia ("VA"). By the end of 2004, the Bank's branching network included offices in the Rockingham County towns of Eden, Ruffin and Madison and in the new markets of Greensboro, Burgaw and Wilmington and the number of North Carolina branches had grown from five to thirteen. It also completed the acquisition of the Harrisonburg, VA branch of Guaranty Bank. The acquisition of Black Diamond also added branches in Norton, Harrisonburg, Pennington Gap and Richlands, VA. The Bank of Tazewell purchased selected loans and assumed the deposits of the Bank's Richlands, VA branch during April 2004. The Bank transferred $15.0 million in deposit accounts and $7.3 million in loan accounts in the transaction. The Company recognized approximately $700,000 in net gain on the sale. Also during April, an approximate $125,000 gain was realized from the sale of the fixed assets associated with the Bank's Richlands, VA branch. The Company also relocated its headquarters during the second quarter of 2004 to Greensboro, NC.
The Bank is community oriented and focuses primarily on offering commercial, real estate and consumer loans, and deposit and other financial services to individuals, small to medium-sized businesses and other organizations in its market areas. It emphasizes individualized services and community involvement, while at the same time providing its customers with the financial sophistication and array of products typically offered by larger banks. It competes successfully with larger banks located within and outside NC and VA by retaining its personalized approach and community focus.
Under the leadership of Ernest J. Sewell, who became President and Chief Executive Officer in 1995, the Company adopted the following three-part strategy: (1) increase market share and geographic reach through opportunistic acquisitions in markets where the mix of economic, operational, cultural and other factors are favorable; (2) position the Company to manage its planned growth by adding experienced personnel and upgrading its internal systems and procedures; and (3) generate internal growth at its existing banking offices by offering new and complementary services and products. To accomplish these objectives, during the past ten years the Company has: (a) increased the number of its NC banking offices to thirteen; (b) expanded the number of its full-time personnel by adding new employees, including several senior executives; (c) completed the merger with Black Diamond to extend the Company's reach into selected VA markets; (d) completed a systematic review and revision of its loan administration, loan
policy and credit procedures; (e) enhanced its mix of products and services by forming investment services and mortgage banking subsidiaries; (f) relocated its corporate headquarters to Greensboro, NC.; and (g) moved forward with its leadership transition strategy by promoting Pressley A. Ridgill to President of the Bank. Ridgill joined the Company in 2000 as Executive Vice President and Chief Operating Officer of the Bank and during his five years with the Company has directed the operations and planning of numerous areas within the Bank, including Finance, Deposit Operations, Information Technology, Risk Management, and Investor Relations. As President, he will continue to manage the investment portfolio, assist with the strategic direction of the organization, and evaluate and negotiate acquisitions.
The Company plans to continue to pursue its strategy by strengthening its presence in existing markets and opportunistically reaching into new markets in NC and VA. The Company continues to seek qualified personnel to help manage its planned growth and to develop new products that are consistent with the Company's customer service orientation. For example, the Company opened a wholesale mortgage division in the fourth quarter of 2003 and staffed the division with twelve employees. During 2004, and at the outset of 2005, the Company also added several members to its management team in light of its continued growth and to reflect the steps underway to continue its overall strategy.
Paul McCombie, C. Grayson Whitt and Alan D. Pike joined the Bank as senior vice presidents and regional executives. McCombie assumed responsibility for our coastal offices located in Wilmington and Burgaw. Whitt will manage the Bank's full-service offices in Rockingham County, NC, while Pike will oversee the banking offices in Guilford County. Kenneth W. Banner joined the Bank as Executive Vice President of FNB Southeast Mortgage Corporation and will be responsible for all aspects of the mortgage banking operation. Thomas M. Saitta joined the Bank in the newly created position of Director of Marketing to support its expanding sales and marketing efforts.
During 2004, the Company (i) installed a new mainframe computer and related software, (ii) redesigned commercial and retail products, (iii) expanded online banking services, and (iv) announced the renovation of the Company's Operations Center in Reidsville, NC. The Company also plans, where appropriate, to continue to upgrade its systems and procedures and refine its ability to offer customers sophisticated services without sacrificing its personalized approach.
Strategy
Expand Banking Operations. Throughout most of its 95-year history, the Company's banking activities were centered around Reidsville, located in Rockingham County in the north central part of NC. Beginning in 1995, however, the Company initiated a growth strategy to further penetrate markets in which it had an existing market share and expand into and develop new markets, such as Wilmington and Greensboro in NC and into VA. Management selects its target markets based on a number of factors, including market size and growth potential, banking relationships developed by members of management during their careers and the ability to integrate the targeted market into the Company's community oriented culture.
The Company's expansion strategy, both within and outside of its existing markets, involves three key elements: (i) ascertaining which markets may be underserved by financial institutions whose primary focus is to cater to the individualized needs of the customer; (ii) installing high-quality, well-trained management to serve the market; and (iii) locating reasonably priced facilities. Management believes that it has been successful in implementing these strategic elements in its expansion program to date.
The Guilford County deposit market is the largest in the Company's market area and totaled $6.71 billion at June 30, 2004. In April 2004, the Company completed the relocation of its headquarters to 1501 Highwoods Boulevard, Greensboro. The Company is the largest financial holding company headquarted in Greensboro, NC. This move will allow the Company more access to the financial markets and assist
the Company in reaching the larger customer base in Guilford County. We continue to evaluate potential sites for additional branches in Guilford and New Hanover counties in NC and in Rockingham County, VA.
Seize Market Expansion Opportunities. The Company intends to continue to capitalize on opportunities to enter new and contiguous markets which it believes are underserved as a result of banking consolidation and in which the Company's community oriented philosophy and culture might flourish. The Company believes that there is value to be added by providing the opportunity for greater personalized banking relationships that exist with larger commercial banks in its markets, although the Company also recognizes the need to carefully analyze markets that are already well served by numerous institutions. The Company will continue to distinguish itself by emphasizing high quality, sophisticated services in a hometown environment.
Establish a Platform for Future Growth. The Company seeks to position itself to manage its expected growth in two fundamental ways: (1) attract, retain and reward experienced personnel who are committed both to conducting business in a friendly and personable manner and to serving the communities in which they work and live; and (2) continue to upgrade, modify and expand its internal systems, procedures, equipment and software to improve operating efficiencies. The Company will continue to analyze technological developments in the banking industry for opportunities to improve or augment its services and products; however, management will continue to make every effort to maintain the Company's personalized approach.
Maintain a Friendly Environment for Employees and Customers. The Company has instituted various programs to instill high morale among its employees, which the Company believes translate into exceptional customer service. The Company holds weekly sales meetings to elicit ideas about featured products and services and to develop and communicate ideas for expanding banking relationships with existing and potential customers. Management believes that the overall effect of these type programs is to improve morale, customer service and financial performance. During the second half of 2004, the Company initiated a program to develop a team concept at the senior management level. Weekly teleconferences were held to encourage open and direct communication between members of senior management and provide regular updates on significant activities within their respective areas. Periodic off site strategic planning sessions of the senior management team provide an open forum to address concerns and develop initiatives for the continued improvement of the Company.
Market Areas
For operational purposes, the Company groups its markets into four regions: the Triad and Wilmington regions of NC, and the Norton and Harrisonburg regions of VA. The Company's deposit market share in the Rockingham County portion of the Triad Region as of June 30, 2004, the most recent date for which data are available, was 27.1%, which ranked first among banks and thrift institutions. The following table summarizes the banking offices and deposit totals for the Company's offices, categorized by city.
Region and City Deposits at December 31, ------------------------------------- 2004 2003 2002 --------- -------------- --------- (In thousands) Triad Region: Reidsville (1) ........... $ 174,132 $ 196,292 $ 226,819 Eden (2) ................. 52,935 53,322 45,333 Madison .................. 20,984 20,383 22,482 Ruffin ................... 12,256 10,710 10,872 Greensboro (1) ........... 135,964 97,736 77,548 --------- --------- --------- Subtotal .............. 396,271 378,443 383,054 --------- --------- ---------
Wilmington Region: Wilmington (2) ........... 122,330 83,668 55,259 Burgaw ................... 32,094 26,954 25,247 --------- --------- --------- Subtotal .............. 154,424 110,622 80,506 --------- --------- ---------
Norton Region: Norton ................... 60,801 53,970 58,551 Pennington Gap ........... 19,735 17,973 22,933 Richlands (4) ............ -- 18,641 22,174 --------- --------- --------- Subtotal .............. 80,536 90,584 103,658 --------- --------- ---------
Harrisonburg Region: Harrisonburg (3) ......... 93,054 62,258 37,787 --------- --------- --------- Total deposits ........ $ 724,285 $ 641,907 $ 605,005 ========= ========= =========
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(1) Includes three banking offices for all years. (2) Includes two banking offices for all years. (3) Includes two banking office for 2003 and 2004, and one office for 2002. (4) Branch sold April 2004.
The following is a summary description of the Company's market areas.
Triad Region - Rockingham County. Rockingham County is located in the north central area of NC. It has a land area of 565 square miles and a population of approximately 90,000. The Commonwealth of VA borders the County on the north, while Guilford County is the neighboring county to the south. Piedmont Triad International Airport is located twenty miles away, and Norfolk Southern has two rail connection lines in the County. U.S. Highways 29, 158, and 220 serve the area. The County, which consists of several community oriented towns, provides a full range of municipal services and extends financial support to certain boards, agencies, and commissions to assist its effort to serve its citizens. The North Carolina Employment Security Commission reported a December 2004 unemployment rate of 8.3% for Rockingham County. Business and government leaders in the county have made progress in diversifying the area's economy to make up for job losses primarily in the textile and tobacco industries.
Triad Region - Guilford County. Guilford County has a diverse economy attributable to a blend of trade, manufacturing and service businesses. Local industry is characterized by the production of a wide range of products, including textiles, apparel, furniture, tobacco, machinery, pharmaceuticals, microchips, and
electronics equipment. Guilford County, with a population of 420,000, has access to major domestic and international markets from Interstate Highways 40 and 85; U.S. Highways 29, 70, 220 and 421; major rail connections; and the Piedmont Triad International Airport. According to the NC Employment Security Commission, Guilford County reported an unemployment rate of 4.8% for December 2004, compared to a statewide unemployment rate of 5.0%. The planned FedEx hub is on schedule for completion in 2009 and is expected to have a significant positive impact on the Triad Region of NC. During 2004, Dell announced plans to locate a major assembly plant in the Triad, which will bring up to 1,500 jobs to the region. Additionally, Dell suppliers and other complementary businesses are expected to contribute positively to the economy of the Triad Region.
Wilmington Region. Wilmington is the county seat and industrial center of New Hanover County, located on the southeast coast of NC. The total population of the County is approximately 160,000. Interstate Highway 40 and U.S. Highways 17 and 74, as well as major rail connections serve the County. This area is serviced by national and regional airlines through facilities at the New Hanover International Airport located near Wilmington. The New Hanover County area has experienced extensive industrial development and service/trade sector growth over the past twenty years. Industries in the Wilmington region produce fiber optic cables for the communications industry; aircraft engine parts, pharmaceuticals, nuclear fuel components and various textile products. The New Hanover County area economy has become broadly diversified and has developed into a major resort area, a busy sea port (one of North Carolina's two deep water ports), a light manufacturing center, chemical manufacturing center and the distribution hub of southeastern North Carolina. The NC Employment Security Commission reported a December 2004 unemployment rate of 3.5% for New Hanover County.
Norton Region. Norton is located in southwestern VA in the midst of the Appalachian Mountains. The mining, retail and service industries of this region operate from an abundant natural resource base that includes natural gas, coal, timber and mineral deposits. The area is served by several U.S. Highways and by major rail connections. The Bank operates branches in Norton (Wise County) and, Pennington Gap (Lee County). The Company sold the Richlands, VA branch in 2004. For December 2004, the VA Employment Commission reported the unemployment rate in Wise County was 4.0%.
Harrisonburg Region. Rockingham County is centrally located in the Shenandoah Valley in west central VA. Harrisonburg, the county seat with a population of 40,000, is an important educational, industrial, retail, tourism, commercial, agricultural and governmental center. Interstate Highway 81, several primary U.S. highways, the Shenandoah Valley Regional Airport and a major rail connection serve the area. The Bank operates two branches in Harrisonburg, serving the counties of Rockingham and Augusta. According to the VA Employment Commission, the December 2004 unemployment rate for Rockingham County was 2.0% compared to a statewide unemployment rate of 3.0%.
Deposits
The Company offers a variety of deposit products to individuals and to small and medium-sized businesses and other organizations through the Bank at interest rates generally competitive with local market conditions. The accompanying table sets forth the mix of depository accounts at the Company as a percentage of total deposits at the dates indicated.
As of December 31, ---------------------- 2004 2003 2002 ----- ---- ------ Noninterest-bearing demand ..... 10.9% 10.9% 10.2% Savings, NOW, MMI .............. 26.5 18.5 16.5 Certificates of deposit ........ 62.6 70.6 73.3 ----- ----- ------ 100.0% 100.0% 100.0% ===== ===== ======
The Bank accepts deposits at its 17 banking offices, 15 of which have automated teller machines("ATMs"). Its memberships in the "STAR", "CIRRUS" and "PLUS" networks allow customers access to their depository accounts from regional ATM facilities. It charges competitive fees for the use of its ATM facilities by those who are not depositors with the Bank. Deposit flows are controlled primarily through the pricing of such deposits and, to a certain extent, through promotional activities. Such promotional activities include the Company's "Legacy Banking" and "Presidential Banking" accounts for deposit relationships of $25,000 and $75,000, respectively, and the "Freedom 50 Club", which extends special privileges and sponsors group excursions to sites and performances of interest to account holders in certain markets over the age of 55. At December 31, 2004, the Bank had $126.5 million in certificates of deposit of $100,000 or more. The Bank has joined an electronic network that allows it to post interest rates and attract certificates of deposit nationally. The investors are generally credit unions or commercial banks and amounts are typically just under $100,000 to assure FDIC insurance coverage. It also utilizes brokered deposits to supplement in-market deposit growth. The accompanying table presents the scheduled maturities of time deposits of $100,000 or more at December 31, 2004.
Scheduled maturity of time deposits of $100,000 or more ------------------------------------------------------- (In thousands)
Less than three months ................................ $ 43,994 Three through six months .............................. 51,478 Seven through twelve months ........................... 21,437 Over twelve months .................................... 9,563 --------- Total time deposits - $100,000 or more ............. $ 126,472 =========
See also Note 7 in the Notes to Consolidated Financial Statements of this Annual Report on Form 10-K.
Subsidiaries
In April 2000, the Company established FNB Southeast Investment Services, Inc. (the "Investment Subsidiary") as a wholly owned subsidiary of the Bank. The Investment Subsidiary employs three investment advisors who are based in the Company's largest markets of Greensboro and Wilmington, NC and Harrisonburg, VA and allocate their time among the Company's branches and are available to current and potential customers. The advisors offer a complete line of investment products and services. The Company receives commissions based on the advisors'sales and benefits (i) by earning additional fee income and (ii) by attracting potential customers to its branches. The Investment Subsidiary generated revenues of $507,000 in 2004 and $670,000 in 2003. During 2004, the decision was made to upgrade our services and product portfolio through an association with Raymond James. We expect this change to provide better service and more diverse products to our customers while yielding increased fee income to the Company.
In June 2001, the Company established FNB Southeast Mortgage Corporation (the "Mortgage Subsidiary") as a wholly owned subsidiary of the Bank. At inception, the Mortgage Subsidiary purchased selected assets of a successful mortgage brokerage company operating in the coastal area near Wilmington, NC. The Company formed a wholesale division of the Mortgage Subsidiary during the fourth quarter of 2003 as part of a continuing strategy to promote the subsidiary's growth and expand the variety of mortgage services offered. Fee income generated by the Mortgage Subsidiary increased to $2,233,000 in 2004, compared to $2,019,000 in 2003.
Marketing
The Company currently markets its services through advertising campaigns and in printed material, such as newspapers, magazines, billboards, and direct mailings, as well as through promotional items, such as caps, pens, pencils and shirts. The Company's officers are also heavily involved in local civic affairs and
philanthropic organizations in order to focus customers on products and services at a personal level. The Company occasionally sponsors community events and holds grand opening ceremonies for its new branches to which local dignitaries are invited to speak and participate in the festivities. The Company engages a marketing firm to assist with creative design, research, public relations, media placement, etc., as well as assisting with promoting the overall image of the Company to the general public and investment community. During 2004, the Company hired a Director of Marketing to manage this expanding area of the Company and coordinate the marketing efforts on a full-time basis.
o Value. Among other things, the Company offers attractive rates for its financial products, including its certificates of deposit and checking accounts. This pricing structure has been successful in attracting depositors who are motivated by the Company's rates, as well as by the variety of individualized services it promotes and offers.
o Convenience and Service. The Company's personnel focus upon serving the individual needs of the Company's customers. For example, senior management personnel are accessible on very short notice, before, during, and after normal banking hours, by way of mobile phones and other means.
Management intends to continue to market the Company's services through a combination of advertising campaigns, public relations activities and local affiliations. While the key messages of value, convenience, service and reliability will continue to play a major role in the Company's marketing and public relations efforts, management may also focus on targeted groups, such as professionals, in addition to small to medium-sized local businesses.
A vital part of the Company's marketing plan is the execution of a public relations strategy. Many traditional public relations methods are used in promoting its services. Management pursues media coverage, including general press, industry periodicals and other media covering banking and finance, consumer issues and special interests. Press releases, quarterly shareholder reports, media alerts and presentations are used to announce new banking services as they are added.
Competition
Commercial banking in the southeastern United States is extremely competitive, due in large part to interstate branching. Currently, many of the Company's competitors are significantly larger and have greater resources. The Company continues to encounter significant competition from a number of sources, including bank holding companies, financial holding companies, commercial banks, thrift institutions, credit unions, and other financial institutions and financial intermediaries. The Company competes in its market areas with some of the largest banking organizations in the Southeast, several of which have numerous branches in NC and VA. The Company's competition is not limited to financial institutions based in NC and VA. The enactment of federal legislation authorizing nationwide interstate banking has greatly increased the size and financial resources of some of the Company's competitors. Consequently, many of its competitors have substantially higher lending limits due to their greater total capitalization, and many perform functions for their customers, such as trust services, that the Company generally does not offer. The Company primarily relies on providing quality products and services at a competitive price within the market area. As a result of interstate banking legislation, the Company's market is open to future penetration by banks located in other states provided that the other states allow their domestic banking institutions to acquire NC banking institutions, thereby increasing competition.
In its Triad Region, as of June 2004, the Company competed with 15 commercial banks and two savings institutions, as well as numerous credit unions. As of that date, the Company competed with 13 commercial banks, two savings institution and several credit unions in its Wilmington Region. In its
Norton Region, as of June 2004, the Company competed with 8 commercial banks. As of that date, the Company competed with 13 commercial banks in its Harrisonburg Region.
Employees
All employees during 2004 were compensated by the Bank or its subsidiaries. On December 31, 2004, the Company had approximately 255 full-time and 14 part-time employees. None of the Company's employees are represented by a collective bargaining unit, and we have not experienced any type of strike or labor dispute. We consider our relationship with our employees to be very good, as they are extremely important to our long-term success. The Board and management continually seek ways to enhance their benefits and well being.
Available Information
The Company makes its Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports available free of charge on its internet website www.fnbsoutheast.com, as soon as reasonably practicable after the reports are electronically filed or furnished to the SEC. Any materials that the Company files with the SEC may be read and/or copied at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Public information may be obtained by calling the SEC at 1-800-SEC-0330. These filings are also accessible on the SEC's website at www.sec.gov.
Additionally, the Company's corporate governance policies, including the charters of the Audit, Compensation, and Nominating and Corporate Governance committees; and the Code of Business Conduct and Ethics may also be found under the "Investor Information" section of the Company's website. The Company elects to disclose any amendments to or waivers of any provisions of its Code of Business Conduct and Ethics applicable to its principal executive officers and senior financial officers on its website. A written copy of the foregoing corporate governance policies is available upon written request to the Company.
Supervision and Regulation
Bank and financial holding companies and commercial banks are extensively regulated under both federal and state law. The following is a brief summary of certain statutes and rules and regulations that affect or will affect the Company, the Bank, and the Bank's subsidiaries. This summary is qualified in its entirety by reference to the particular statute, and regulatory provisions referred to below, and is not intended to be an exhaustive description of the statutes or regulations applicable to the business of the Company and the Bank. Supervision, regulation and examination of the Company and the Bank by the regulatory agencies are intended primarily for the protection of depositors rather than shareholders of the Company. Statutes and regulations which contain wide-ranging proposals for altering the structures, regulations, and competitive relationship of financial institutions are introduced regularly. The Company cannot predict whether or in what form any proposed statute or regulation will be adopted or the extent to which the business of the Company and the Bank may be affected by such statute or regulation.
General. There are a number of obligations and restrictions imposed on financial holding companies and bank holding companies and their depository institution subsidiaries by law and regulatory policy that are designed to minimize potential loss to the depositors of such depository institutions and the FDIC insurance funds in the event the depository institution becomes in danger of default or in default. For example, to avoid receivership of an insured depository institution subsidiary, a holding company is required to guarantee the compliance of any insured depository institution subsidiary that may become "undercapitalized" with the terms of any capital restoration plan filed by such subsidiary with its appropriate federal banking agency up to the lesser of (i) an amount equal to 5% of the bank's total assets
at the time the bank became undercapitalized or (ii) the amount which is necessary (or would have been necessary) to bring the bank into compliance with all acceptable capital standards as of the time the bank fails to comply with such capital restoration plan. The Company, as a registered financial holding company, is subject to the regulation of the Federal Reserve. Under a policy of the Federal Reserve with respect to holding company operations, a holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. The Federal Reserve under the BHCA also has the authority to require a holding company to terminate any activity or to relinquish control of a nonbank subsidiary (other than a nonbank subsidiary of a bank) upon the Federal Reserve's determination that such activity or control constitutes a serious risk to the financial soundness and stability of any bank subsidiary of the holding company.
In addition, insured depository institutions under common control are required to reimburse the FDIC for any loss suffered by its deposit insurance funds as a result of the default of a commonly controlled insured depository institution or for any assistance provided by the FDIC to a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the deposit insurance funds. The FDIC's claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.
As a result of the Company's ownership of the Bank, the Company is also registered under the bank holding company laws of North Carolina. Accordingly, the Company is also subject to regulation and supervision by the Commissioner.
Capital Adequacy Guidelines for Holding Companies. The Federal Reserve has adopted capital adequacy guidelines for bank holding companies and banks that are members of the Federal Reserve system and have consolidated assets of $150 million or more. Bank and financial holding companies subject to the Federal Reserve's capital adequacy guidelines are required to comply with the Federal Reserve's risk-based capital guidelines. Under these regulations, the minimum ratio of total capital to risk-weighted assets is 8%. At least half of the total capital is required to be "Tier I capital," principally consisting of common stockholders' equity, noncumulative perpetual preferred stock, and a limited amount of cumulative perpetual preferred stock, less certain goodwill items. The remainder ("Tier II capital") may consist of a limited amount of subordinated debt, certain hybrid capital instruments and other debt securities, perpetual preferred stock, and a limited amount of the general loan loss allowance. In addition to the risk-based capital guidelines, the Federal Reserve has adopted a minimum Tier I capital (leverage) ratio, under which a holding company must maintain a minimum level of Tier I capital to average total consolidated assets of at least 3% in the case of a holding company which has the highest regulatory examination rating and is not contemplating significant growth or expansion. All other holding companies are expected to maintain a Tier I capital (leverage) ratio of at least 1% to 2% above the stated minimum.
Capital Requirements for the Bank. The Bank, as a NC commercial bank, is required to maintain a surplus account equal to 50% or more of its paid-in capital stock. As a NC chartered, FDIC-insured commercial bank that is a member of the Federal Reserve System, it is also subject to capital requirements imposed by the Federal Reserve. Under Federal Reserve regulations, member banks must maintain a minimum ratio of qualifying capital to weighted risk assets equal to 8%. At least half of the total capital is required to be Tier I Capital, with the remainder consisting of Tier II Capital. In addition to the foregoing risk based capital guidelines, member banks which receive the highest rating in the examination process and are not anticipating or experiencing any significant growth, must maintain a minimum level of Tier I Capital to total assets of 3%. Member banks, which do not fall within the
foregoing standards, are required to maintain higher capital ratios. The Bank exceeded all applicable minimum capital requirements as of December 31, 2004.
Dividend and Repurchase Limitations. The Company must obtain Federal Reserve approval prior to repurchasing common stock for consideration in excess of 10% of its net worth during any twelve-month period unless the Company (i) both before and after the redemption satisfies capital requirements for "well capitalized" state member banks; (ii) received a one or two rating in its last examination; and (iii) is not the subject of any unresolved supervisory issues.
Although the payment of dividends and repurchase of stock by the Company are subject to certain requirements and limitations of NC corporate law, except as set forth in this paragraph, neither the Commissioner nor the FDIC have promulgated any regulations specifically limiting the right of the Company to pay dividends and repurchase shares. However, the ability of the Company to pay dividends or repurchase shares is dependent upon the Company's receipt of dividends from the Bank.
NC commercial banks, such as the Bank, are subject to legal limitations on the amounts of dividends they are permitted to pay. The Bank may pay dividends from undivided profits, which are determined by deducting and charging certain items against actual profits, including any contributions to surplus required by NC law. Also, an insured depository institution, such as the Bank, is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become "undercapitalized" (as such term is defined in the applicable law and regulations).
Deposit Insurance Assessments. The Bank is subject to insurance assessments imposed by the FDIC. Under current law, the insurance assessment to be paid by members of the Bank Insurance Fund, such as the Bank, shall be as specified in a schedule required to be issued by the FDIC. FDIC assessments for deposit insurance range from 0 to 27 basis points per $100 of insured deposits, depending on the institution's capital position and other supervisory factors.
Federal Home Loan Bank System. The Federal Home Loan Bank ("FHLB") system provides a central credit facility for member institutions. In December 2004, the FHLB of Atlanta implemented a new capital plan. As a member of the FHLB of Atlanta, the Bank is required to own capital stock in the FHLB of Atlanta in an amount at least equal to 0.20% (or 20 basis points) of the Bank's total assets at the end of each calendar year, plus 4.5% of its outstanding advances (borrowings) from the FHLB of Atlanta under the new activity-based stock ownership requirement. On December 31, 2004, the Bank was in compliance with this requirement.
Community Reinvestment. Under the Community Reinvestment Act ("CRA"), as implemented by regulations of the FDIC, an insured institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions, nor does it limit an institution's discretion to develop, consistent with the CRA, the types of products and services that it believes are best suited to its particular community. The CRA requires the federal banking regulators, in connection with their examinations of insured institutions, to assess the institutions' records of meeting the credit needs of their communities, using the ratings of "outstanding," "satisfactory," "needs to improve," or "substantial noncompliance," and to take that record into account in its evaluation of certain applications by those institutions. All institutions are required to make public disclosure of their CRA performance ratings. The Bank received a "satisfactory" rating in its last CRA examination, which was conducted during July 2004.
Prompt Corrective Action. The FDIC has broad powers to take corrective action to resolve the problems of insured depository institutions. The extent of these powers will depend upon whether the institution in question is "well capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized," or "critically undercapitalized." Under the regulations, an institution is considered "well capitalized" if it has (i) a total risk-based capital ratio of 10% or greater, (ii) a Tier I risk-based capital ratio of 6% or greater, (iii) a leverage ratio of 5% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. An "adequately capitalized" institution is defined as one that has (i) a total risk-based capital ratio of 8% or greater, (ii) a Tier I risk-based capital ratio of 4% or greater and (iii) a leverage ratio of 4% or greater (or 3% or greater in the case of an institution with the highest examination rating). An institution is considered (A) "undercapitalized" if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of an institution with the highest examination rating); (B) "significantly undercapitalized" if the institution has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3% and (c) "critically undercapitalized" if the institution has a ratio of tangible equity to total assets equal to or less than 2%. At December 31, 2004, the Bank had the requisite capital levels to qualify as "well capitalized".
Changes in Control. The BHCA prohibits the Company from acquiring direct or indirect control of more than 5% of the outstanding voting stock or substantially all of the assets of any bank or savings bank or merging or consolidating with another bank or financial holding company or savings bank holding company without prior approval of the Federal Reserve. Similarly, Federal Reserve approval (or, in certain cases, non-disapproval) must be obtained prior to any person acquiring control of the Company. Control is conclusively presumed to exist if, among other things, a person acquires more than 25% of any class of voting stock of the Company or controls in any manner the election of a majority of the directors of the Company. Control is presumed to exist if a person acquires more than 10% of any class of voting stock and the stock is registered under Section 12 of the Exchange Act or the acquiror will be the largest shareholder after the acquisition.
Federal Securities Law. The Company has registered its common stock with the SEC pursuant to Section 12(g) of the Exchange Act. As a result of such registration, the proxy and tender offer rules, insider trading reporting requirements, annual and periodic reporting and other requirements of the Exchange Act are applicable to the Company.
Transactions with Affiliates. Under current federal law, depository institutions are subject to the restrictions contained in Section 22(h) of the Federal Reserve Act with respect to loans to directors, executive officers and principal shareholders. Under Section 22(h), loans to directors, executive officers and shareholders who own more than 10% of a depository institution (18% in the case of institutions located in an area with less than 30,000 in population), and certain affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the institution's loans-to-one-borrower limit (as discussed below). Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers and shareholders who own more than 10% of an institution, and their respective affiliates, unless such loans are approved in advance by a majority of the board of directors of the institution. Any "interested" director may not participate in the voting. The FDIC has prescribed the loan amount (which includes all other outstanding loans to such person), as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Further, pursuant to Section 22(h), the Federal Reserve requires that loans to directors, executive officers, and principal shareholders be made on terms substantially the same as offered in comparable transactions with non-executive employees of the Bank. The FDIC has imposed additional limits on the amount a bank can loan to an executive officer.
Loans to One Borrower. The Bank is subject to the loans to one borrower limits imposed by the North Carolina Office of the Commissioner of Banks (the "Commissioner"), which are substantially the same as those applicable to national banks. Under these limits, no loans and extensions of credit to any borrower
outstanding at one time and not fully secured by readily marketable collateral shall exceed 15% of the unimpaired capital and unimpaired surplus of the bank. Loans and extensions of credit fully secured by readily marketable collateral may comprise an additional 10% of unimpaired capital and unimpaired surplus.
Gramm-Leach-Bliley Act. The federal Gramm-Leach-Bliley Act enacted in 1999 (the "GLB Act") dramatically changed various federal laws governing the banking, securities and insurance industries. The GLB Act has expanded opportunities for banks and bank holding companies to provide services and engage in other revenue-generating activities that previously were prohibited to them. However, this expanded authority also may present us with new challenges as our larger competitors are able to expand their services and products into areas that are not feasible for smaller, community oriented financial institutions. The GLB Act likely will have a significant economic impact on the banking industry and on competitive conditions in the financial services industry generally.
USA Patriot Act of 2001. The USA Patriot Act of 2001 was enacted in response to the terrorist attacks that occurred in New York, Pennsylvania and Washington, D.C. on September 11, 2001. The Act is intended to strengthen the ability of U.S. law enforcement and the intelligence community to work cohesively to combat terrorism on a variety of fronts. The potential impact of the Act on financial institutions of all kinds is significant and wide ranging. The Act contains sweeping anti-money laundering and financial transparency laws and requires various regulations, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.
Sarbanes-Oxley Act of 2002. On July 30, 2002, the Sarbanes-Oxley Act of 2002 was signed into law and became some of the most sweeping federal legislation addressing accounting, corporate governance and disclosure issues. The impact of the Sarbanes-Oxley Act is wide-ranging as it applies to all public companies and imposes significant new requirements for public company governance and disclosure requirements. Some of the provisions of the Sarbanes-Oxley Act became effective immediately while others are still in the process of being implemented.
In general, the Sarbanes-Oxley Act mandates important new corporate governance and financial reporting requirements intended to enhance the accuracy and transparency of public companies' reported financial results. It establishes new responsibilities for corporate chief executive officers, chief financial officers and audit committees in the financial reporting process and creates a new regulatory body to oversee auditors of public companies. It backs these requirements with new SEC enforcement tools, increases criminal penalties for federal mail, wire and securities fraud, and creates new criminal penalties for document and record destruction in connection with federal investigations. It also increases the opportunity for more private litigation by lengthening the statute of limitations for securities fraud claims and providing new federal corporate whistleblower protection.
The economic and operational effects of this new legislation on public companies, including us, have been and will continue to be significant in terms of the time, resources and costs associated with complying with the new law.
Other. Additional regulations require annual examinations of all insured depository institutions by the appropriate federal banking agency, with some exceptions for small, well-capitalized institutions and state chartered institutions examined by state regulators, and establish operational and managerial, asset quality, earnings and stock valuation standards for insured depository institutions, as well as compensation standards.
The Bank is subject to examination by the Federal Reserve and the Commissioner. In addition, it is subject to various other state and federal laws and regulations, including state usury laws, laws relating to fiduciaries, consumer credit and equal credit, fair credit reporting laws and laws relating to branch banking. The Bank, as an insured North Carolina commercial bank, is prohibited from engaging as a principal in activities that are not permitted for national banks, unless (i) the FDIC or the Federal Reserve, as it is a member bank, determines that the activity would pose no significant risk to the appropriate deposit insurance fund and (ii) the Bank is, and continues to be, in compliance with all applicable capital standards.
Limits on Rates Paid on Deposits and Brokered Deposits. Regulations promulgated by the FDIC place limitations on the ability of insured depository institutions to accept, renew or roll-over deposits by offering rates of interest which are significantly higher than the prevailing rates of interest on deposits offered by other insured depository institutions having the same type of charter in such depository institution's normal market area. Under these regulations, "well capitalized" depository institutions may accept, renew or roll-over such deposits without restriction, "adequately capitalized" depository institutions may accept, renew or roll-over such deposits with a waiver from the FDIC (subject to certain restrictions on payments of rates) and "undercapitalized" depository institutions may not accept, renew, or roll-over such deposits. The regulations contemplate that the definitions of "well capitalized," "adequately capitalized" and "undercapitalized" will be the same as the definitions adopted by the FDIC to implement the corrective action provisions discussed below.
Only a "well capitalized" (as defined in the statute as significantly exceeding each relevant minimum capital level) depository institution may accept brokered deposits without prior regulatory approval. "Adequately capitalized" banks may accept brokered deposits with a waiver from the FDIC (subject to certain restrictions on payment of rates), while "undercapitalized" banks may not accept brokered deposits. The regulations contemplate that the definitions of "well capitalized," "adequately capitalized" and "undercapitalized" are the same as the definitions adopted by the agencies to implement the prompt corrective action provisions discussed below.
The Company does not believe that these regulations have had or will have a material adverse effect on the Bank's current operations.
Taxation. Federal Income Taxation. Financial institutions such as the Bank are subject to the provisions of the Internal Revenue Code of 1986, as amended (the "Code") in the same general manner as other corporations. However, banks which meet certain definitional tests and other conditions prescribed by the Code may benefit from certain favorable provisions regarding their deductions from taxable income for annual additions to their bad debt reserve. The Bank may compute its addition to the bad debt reserve under the specific charge-off method or the reserve method. Under the reserve method, the addition to bad debts from losses on loans is computed by use of the experience method. Use of the experience method requires minimum additions to the reserve based on the amount allowable under a six-year moving average. The Code also provides annual limits on the amount the Bank can add to its reserves for loan losses.
State Taxation. Under NC law, the Bank is subject to corporate income taxes at a 6.90% rate and an annual franchise tax at a rate of 0.15%.
Future Requirements. Statutes and regulations, which contain wide-ranging proposals for altering the structures, regulations and competitive relationships of financial institutions, are introduced regularly. Neither the Company nor the Bank can predict whether or what form any proposed statute or regulation will be adopted or the extent to which the business of the Company or the Bank may be affected by such statute or regulation.
Item 2.
Item 2. Properties
The Company's executive offices were relocated to 1501 Highwoods Boulevard in Greensboro, NC during April 2004. The Company's principal support and operational functions are located at 202 South Main Street in Reidsville, NC. The Company has 13 banking offices located in NC and four banking offices in VA. The location of these banking offices, their form of occupancy and deposits as of December 31, 2004, information about drive-up ATM facilities, and the year each office was opened is described in the accompanying table:
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(1) Original office opened in a different location in 1910. Current office opened in 1980. Consists of 27,000 square feet in a two story building; former headquarters location; scheduled to undergo extensive renovations in 2005; will continue to serve as a full service branch as well as becoming the Operations Center for the Company. (2) The current headquarters office opened in 2004. (3) Mortgage loan production offices.
Item 3.
Item 3. Legal Proceedings
In the ordinary course of operations, the Company and the Bank are party to various legal proceedings. In the opinion of management, neither the Company nor the Bank is involved in any pending legal proceedings other than routine, non-material proceedings occurring in the ordinary course of business.
Item 4.
Item 4. Submission of Matters To a Vote of Security Holders
There were no matters submitted to a vote of the security holders of the Company during the fourth quarter of the Company's fiscal year ended December 31, 2004.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Prices and Dividend Policies
The Company's common stock is traded on The Nasdaq Stock Market National Market System under the symbol "FNBF." The following table shows the high and low sale price of the Company's common stock on The Nasdaq Stock Market National Market System(1), based on published financial sources, for each of the last two fiscal years. The table also reflects the per share amount of cash dividends paid for each share during the fiscal quarter for each of the last two fiscal years. Only one cash dividend was paid during each of the fiscal quarters listed.(1)
---------- (1) For comparative purposes, the sale prices and dividends paid amounts shown in the accompanying table have been restated to reflect the 5-for-4 stock split effected as a 25% stock dividend, effective December 29, 2003.
As of March 14, 2005, there were approximately 1,652 beneficial owners of the Company's common stock, including 1,248 holders of record of the Company's common stock. For a discussion as to any restrictions on the Company or the Bank's ability to pay dividends, reference Item 1 - Supervision and Regulation of the Company and the Bank.
See also Note 18 in the Notes to Consolidated Financial Statements of this Annual Report on Form 10-K. See also "Supervision and Regulation - Regulation of the Company, Dividend and Repurchase Limitations" and "Regulation of the Bank - Dividends."
The accompanying table details, by month, the information related to the activity related to the share repurchase program approved by the Company's Board of Directors in July 2004 authorizing the repurchase of up to 275,124 shares of the Company's outstanding common stock. The program was publicly announced in the month of approval.
Recent Sales of Unregistered Securities
The Company did not sell any of its securities in the last three fiscal years, which were not registered under the Securities Act of 1933, as amended, except that it granted options to employees or directors to acquire an aggregate of 324,033 shares of its common stock at a weighted average exercise price of $16.14 per share pursuant to the Company's Omnibus Equity Compensation Plan.
Item 6.
Item 6. Selected Financial Data
The annual selected historical financial data presented in the accompanying table are derived from the audited consolidated financial statements for FNB Financial Services Corporation and Subsidiary. As this information is only a summary, you should read it in conjunction with the historical financial statements (and related notes) of the Company and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere herein.
Selected Consolidated Financial Data
- ---------- (1) Loans net of unearned income, before allowance for credit losses. (2) Assumes the exercise of outstanding dilutive options to acquire common stock. See Note 14 to the Company's consolidated financial statements. (3) Computed by dividing noninterest expense by the sum of taxable equivalent net interest income and noninterest income. (4) Nonperforming loans and nonperforming assets include loans past due 90 days or more that are still accruing interest. (5) Per share data has been restated to reflect the 5-for-4 stock split, effected as a 25% stock dividend, effective December 29, 2003.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following presents management's discussion and analysis of our financial condition and results of operations and should be read in conjunction with the financial statements and related notes included elsewhere in this annual report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors. All share data have been adjusted to give retroactive effect to stock splits and stock dividends. The following discussion is intended to assist in understanding the financial condition and results of operations of the Company.
Executive Overview
Significant Accomplishments. In the opinion of the management of FNB Financial Services Corporation, the Company's most significant accomplishments during 2004 were:
o We relocated the Company's headquarters to Greensboro, NC, which enhanced our ability to employ and retain personnel with the skills and experience necessary to continue to execute our strategic plan and to promote our penetration of this significant urban market. o We began the execution of our management succession plan with the promotion of Pressley A. Ridgill to President of the Bank. o We expanded our core management team with the promotion of key personnel and the addition of several members. o We continued to execute upon the Company's strategic plan of expanding our markets, products and services. o Diluted net income per share increased 12.3%. o Net interest income increased 18.4%. o Asset quality continued to improve; all significant credit quality ratios improved year-to-year.
Challenges. The achievement of the Company's strategic initiatives and long-term financial goals is subject to many uncertainties. The challenges, which in the opinion of management are most likely to have a near-term effect on operations, are presented below:
o Volatility of interest rates. o Building revenue momentum. o Improving efficiency. o The economic environment in our core markets. o Costs associated with the current heightened regulatory environment. o Expanding our core management team. o Volatility in the mortgage banking business. o Intense price competition.
General
The Company earned $8.34 million in 2004, an 11.8% increase over the $7.46 million earned in 2003. Diluted net income per share of $1.46 for 2004 represents a 12.3% increase over diluted net income per share of $1.30 in 2003. The Bank of Tazewell purchased selected loans and assumed the deposits of the Bank's Richlands, VA branch during April 2004. The Bank transferred $15.0 million in deposit accounts and $7.3 million in loan accounts in the transaction. We recognized approximately $700,000 in net gain on the sale. Also during April, we realized approximately $125,000 gain from the sale of the fixed assets associated with the Richlands, VA branch. Total assets at December 31, 2004 stood at $865.3 million compared to $780.9 million one year earlier. The increase in assets is primarily attributable to an $82.0
million increase in gross loans. Gross loans at December 31, 2004 totaled $663.4 million, up from $581.4 million at yearend 2003. Investment securities, which is the next largest component of assets, totaled $141.6 million at December 31, 2004, a 1.5% decrease from the balance of $143.7 million a year ago.
During 2004, deposits increased 12.8% to $724.3 million at yearend. Borrowings, comprised of federal funds purchased, retail repurchase agreements, and FHLB advances, totaled $66.5 million at December 31, 2004, compared to $70.9 million at the prior yearend. Shareholders' equity increased 7.1% to $70.4 million at yearend 2004. Book value per share was $12.69 at December 31, 2004.
The Company's subsidiary bank, FNB Southeast, is a NC chartered commercial bank that, as of December 31, 2004, operated thirteen banking offices in NC and four banking offices in VA. The Bank operates two wholly owned subsidiaries. FNB Southeast Investment Services, Inc. was formed in 2000 to provide retail investment products and services. FNB Southeast Mortgage Corporation was formed in 2001 to provide mortgage banking services.
Financial Condition at December 31, 2004 and 2003
The Company's consolidated assets of $865.3 million at yearend 2004 reflect an increase of 10.8% over the previous year, following an increase of 6.4% in 2003. Total average assets increased 7.6% to $815.6 million in 2004, compared to $758.1 million in 2003. During 2004, the Company experienced a 6.3% increase in average earning assets. Average earning assets totaled $764.1 million in 2004, compared to $718.9 million in 2003. The increase in 2004 was primarily attributable to a 7.2% growth in average outstanding loans. The increase in average outstanding loans was funded primarily by an 8.0% rise in average deposits resulting from successful deposit marketing campaigns during 2004.
Gross loan growth during 2004 was $82.0 million, with outstanding loans up 14.1% at yearend, which followed increases of 3.2% in 2003 and 5.3% in 2002. Loans secured by real estate totaled $442.2 million in 2004 and represented 66.7% of total loans, compared with 64.1% at yearend 2003. Within this category, commercial real estate loans increased 4.2% during fiscal 2004 to a level of $166.7 million, while residential real estate loans rose 19.5% to $113.4 million and construction loans increased 37.7% to $162.1 million. Commercial, financial and agricultural loans totaled $86.2 million and represented 13.0% of total loans at the end of 2004, and 15.5% at yearend 2003. Consumer loans increased 15.9% during 2004, led by increased home equity loans. Management believes the Company is not dependent on any single customer or group of customers concentrated in a particular industry, the loss of whose deposits or whose insolvency would have a material adverse effect on operations.
Investment securities (at amortized cost) totaled $142.4 million at yearend 2004, a 1.1% decline from $143.9 million at yearend 2003. U.S. Government agency and mortgage backed securities continue to represent the major share of the total portfolio, and totaled $104.9 million, or 58.2% of the portfolio at yearend 2004, compared to $106.8 million, or 74.2% of the portfolio one year earlier. Management believes that the additional risk of owning agency securities over U.S. Treasury securities is negligible and has capitalized on the favorable spreads available on the former. State and municipal obligations amounted to $31.9 million at yearend, compared to $32.6 million a year earlier. The Company's investment strategy is to achieve acceptable total returns, while investing in securities with relatively short maturity dates as necessary to fund loan growth. To this end, the Company has consistently categorized the entire portfolio as "Available for Sale," which it believes offers the greatest amount of flexibility in managing a total return concept. The table, "Investment Securities," presents the composition of the securities portfolio for the last three years, as well as information about cost, fair value and weighted average yield.
Total deposits increased $82.4 million to $724.3 million at December 31, 2004, resulting in a 12.8% increase over $641.9 million in deposits one year earlier. This increase was driven by an $8.8 million, or
12.6%, increase in demand deposits and a $73.5 million, or 61.9%, increase in savings, NOW and MMI accounts; while time deposit growth was relatively flat.
The market for deposits remains fiercely competitive and the Company relies on appropriate pricing and quality customer service to retain and increase its retail deposit base. During the year, the Company had several featured products to generate new deposits and increase the customer base. For commercial customers, the Company is focused on building a total relationship, which will foster growth in both loans and deposits. In addition to traditional checking accounts, the Company offers a cash management sweep account, with outstanding balances of $7.9 million at yearend.
In order to attract additional deposits when necessary, the Company maintains membership in an electronic network that allows it to post interest rates and attract deposits nationally. As of December 31, 2004, FNB Southeast had three of such certificates of deposit totaling $7.6 million, with an overall rate of 1.74% for this portfolio. This certificate portfolio decreased by $18.4 million during 2004. The Company also held one brokered certificate of deposit totaling $7.4 million at December 31, 2004 maturing during 2005, compared to $25.0 million one year earlier. Brokered certificates typically have an original term of twelve to twenty-four months. The decrease in bulletin board deposits and brokered deposits is attributable to the increase of in-market deposits generated in 2004. Brokered deposits may continue to decrease during 2005; however, these deposits can be utilized for future balance sheet funding as necessary.
The Company also has a credit facility available with the FHLB of Atlanta. Borrowing capacity is established at 17% of the Bank's total assets as submitted on regulatory financial reports. The Company also utilized a portion of its approximately $145 million line with the FHLB to fund earning assets. FHLB borrowings totaled $45.0 million at yearend. Management continues to believe this is a cost effective and prudent alternative to deposit balances, since a particular amount, term and structure may be selected to meet its current needs.
Financial Condition at December 31, 2003 and 2002
The Company's consolidated assets of $780.9 million at December 31, 2003 reflect an increase of 6.4% over the previous year. Total average assets increased 8.1% to $758.1 million in 2003, compared to $701.5 million in 2002. During 2003, the Company experienced a 7.2% increase in average earning assets. Average earning assets totaled $718.9 million in 2003, compared to $670.6 million in 2002. The increase in 2003 was primarily attributable to a 26.1% growth in the average investment securities balance, combined with an increase in average outstanding loans. The increase in the average balance of securities was attributable to a combination of a slightly weaker loan demand and a 9.6% rise in average deposits resulting from successful deposit marketing campaigns during 2003.
Gross loan growth during 2003 was $17.8 million, with outstanding loans up 3.2% at yearend, which followed increases of 5.3% in 2002 and 6.9% in 2001. Loans secured by real estate totaled $372.6 million in 2003 and represented 64.1% of total loans, compared with 67.1% at yearend 2002. Within this category, commercial real estate loans decreased 6.3% during fiscal 2003 to a level of $160.0 million, while residential real estate loans decreased 20.5% to $94.9 million and construction loans increased 34.3% to $117.8 million. Commercial, financial and agricultural loans totaled $90.2 million and represented 15.5% of total loans at the end of 2003 and 2002. Consumer loans increased 20.4% during 2003, led by increased home equity loans. Management believes the Company is not dependent on any single customer or group of customers concentrated in a particular industry, the loss of whose deposits or whose insolvency would have a material adverse effect on operations.
Investment securities (at amortized cost) of $143.9 million at yearend 2003 were up $17.5 million, or 13.9%, from $126.4 million at yearend 2002. U.S. Government agency securities continue to represent
the major share of the total portfolio, and totaled $106.8 million, or 74.2% of the portfolio at yearend 2003, compared to $115.3 million, or 91.2% of the portfolio one year earlier. Management believes that the additional risk of owning agency securities over U.S. Treasury securities is negligible and has capitalized on the favorable spreads available on the former. State and municipal obligations increased $25.6 million and amounted to at $32.6 million at yearend. The increase in municipal securities in 2003 is attributable to the favorable tax effected yield, compared to other available securities. The Company's investment strategy is to achieve acceptable total returns, while investing in securities with relatively short maturity dates as necessary to fund loan growth. To this end, the Company has consistently categorized the entire portfolio as "Available for Sale," which it believes offers the greatest amount of flexibility in managing a total return concept. The table, "Investment Securities," presents the composition of the securities portfolio for the last three years, as well as information about cost, fair value and weighted average yield.
Total deposits increased $36.9 million to $641.9 million at December 31, 2003, resulting in a 6.1% increase over $605.0 million in deposits one year earlier. This increase was driven by an $8.3 million, or 13.5% increase in demand deposits, a $9.7 million, or 2.2% increase in time deposits and an $18.8 million, or 18.8% increase in savings, NOW and MMI accounts.
The market for deposits remains fiercely competitive and the Company relies on appropriate pricing and quality customer service to retain and increase its retail deposit base. During the year, the Company had several featured products to generate new deposits and increase the customer base. For commercial customers, the Company is focused on building a total relationship, which will foster growth in both loans and deposits. In addition to traditional checking accounts, the Company offers a cash management sweep account, with outstanding balances of $6.7 million at 2003 yearend.
In order to attract additional deposits when necessary, the Company maintains membership in an electronic network that allows it to post interest rates and attract deposits nationally. As of December 31, 2003, FNB Southeast had 10 of such certificates of deposit totaling $989,000, with an overall rate of 3.60% for this portfolio. This certificate portfolio decreased by $10.5 million during 2003. The Company also held three brokered certificates of deposit totaling $25.0 million at December 31, 2003, compared to $44.5 million one year earlier. The brokered certificates have an original term of twelve to twenty-four months with maturities of $25.0 million in 2004. The decrease in bulletin board deposits and brokered deposits is attributable to the increase of in market deposits generated in 2003. Brokered deposits may continue to decrease during 2004.
The Company also has a credit facility available with the FHLB of Atlanta. Borrowing capacity is established at 17% of the Bank's total assets as submitted on regulatory financial reports. The Company also utilized a portion of it's approximately $130 million line with the FHLB to fund earning assets. FHLB borrowings totaled $55.5 million at yearend. Management continues to believe this is a cost effective and prudent alternative to deposit balances, since a particular amount, term and structure may be selected to meet its current needs.
Net Interest Income
Like most financial institutions, the primary component of our earnings is net interest income. Net interest income is the difference between interest income, principally from loans and investments, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume and changes in interest rates earned and paid. By volume, we mean the average dollar level of interest-earning assets and interest-bearing liabilities. Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, and margin refers to net interest income divided by average interest-earning assets. Spread and margin are influenced by the levels and relative mix of interest-earning assets and interest-bearing liabilities, as well as by levels of noninterest-bearing liabilities. During the years ended December 31, 2004, 2003 and 2002, our average
interest-earning assets were $764.1 million, $718.9 million, and $670.6 million, respectively. During these same years, our net interest margins were 3.63%, 3.16% and 3.07%, respectively.
Average Balances and Average Rates Earned and Paid. The following table sets forth, for the years 2002 through 2004, information with regard to average balances of assets and liabilities, as well as the total dollar amounts of interest income from interest-earning assets and interest expense on interest-bearing liabilities, resultant yields or costs, net interest income, net interest spread, net interest margin and ratio of average interest-earning assets to average interest-bearing liabilities. Average loans include nonaccruing loans, the effect of which is to lower the average yield.
Average Balance Sheets and Net Interest Income Analysis Fully Taxable Equivalent Basis (Dollars in thousands)
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Average Balance Sheets and Net Interest Income Analysis (cont'd) Fully Taxable Equivalent Basis (Dollars in thousands)
Year Ended December 31, ------------------------------ ------------------------------ Interest Average Average Income/ Yield/ Balance Expense Rate --------- -------- ------- Interest earning assets: Loans, net (1) $ 547,816 $ 37,199 6.79% Taxable investment securities 100,418 5,375 5.35 Tax-exempt investment 5,766 452 7.84 securities (2) Other securities 4,082 232 5.68 Overnight deposits 12,548 205 1.63 --------- -------- Total earning assets 670,630 43,463 6.48
Non-earning assets: Cash and due from banks 14,597 Premises and equipment 11,072 Other assets 12,159 Less: Allowance for credit loss (6,928) --------- Total assets $ 701,530 =========
Interest bearing liabilities: Savings and NOW $ 45,172 231 0.51% MMI 50,531 1,061 2.10 Time deposits 416,226 16,730 4.02 Federal funds purchased, borrowed funds and securities sold under 61,121 1,533 2.51 agreements to repurchase --------- -------- Total interest bearing liabilities 573,050 19,555 3.41
Other liabilities and shareholder's equity Demand deposits 57,708 Other liabilities 6,982 Shareholders' equity 63,790 --------- Total liabilities and shareholders' equity $ 701,530 =========
Net interest income and net yield on earning assets (3) $ 23,908 3.57% ======== =====
Interest rate spread (4) 3.07% =====
- ---------- (1) The average loan balances include nonaccruing loans and only interest income actually collected and recognized. (2) The fully taxable equivalent basis is computed using a federal tax rate of 34%. (3) Net yield on earning assets is computed by dividing net interest income by average earning assets. (4) Earning asset yield minus interest bearing liabilities rate
Rate/Volume Analysis
The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period's rate), (ii) changes attributable to rate (changes in rate multiplied by the prior period's volume), and (iii) net change (the sum of the previous columns). The change attributable to both rate and volume (changes in
rate multiplied by changes in volume) has been allocated equally to both the changes attributable to volume and the changes attributable to rate.
Analysis of Interest Changes Due To Volume and Rates Fully Taxable Equivalent Basis (In thousands)
- ---------- (1) Yields on nontaxable securities are stated on a fully taxable equivalent basis, assuming a 34% Federal tax rate. The adjustments made to convert to a fully taxable equivalent basis were $692,000 for 2004, $562,000 for 2003, and $155,000 for 2002. (2) Changes attributable to both volume and rate have been allocated proportionately.
Results of Operations -- Years Ended December 31, 2004 and 2003
Net Income. Our net income for 2004 was $8.34 million, an increase of $880,000 from net income of $7.46 million earned in 2003. Diluted net income per share was $1.46, compared to $1.30 a year earlier. We have continued to experience strong growth, with total assets averaging $815.6 million during the current year as compared to $758.1 million in 2003, an increase of 7.6%. Our net interest income after provision for credit losses increased $4.72 million over the prior year. During 2004, the Federal Reserve began increasing the federal funds rate at 25 basis point increments at its June meeting and, ultimately, increased the federal funds rate a total of 125 basis points during the year. Paralleling this rise in the federal funds rate was an increase in the prime rate from 4.0% at the beginning of the year to 5.25% at yearend 2004. Our growth in earning assets, combined with a rising interest rate environment led to an increase of $4.56 million in net interest income. Our noninterest expense growth included the completion of a new corporate headquarters building as well as personnel and other infrastructure costs associated with the expansion of our business.
Net Interest Income. Net interest income represents the gross profit from the lending and investment activities of a banking organization and is the most significant factor affecting the earnings of the Company. Net interest income is influenced by changes in interest rates, volume and the mix of these various components. Net interest income on a fully taxable equivalent basis for 2004 was $30.1 million, which represented an 18.5% increase from the previous year level of $25.4 million. Actual net interest income for 2004 was $29.4 million, an 18.4% increase from $24.8 million recorded in 2003. Average total earning assets increased $45.2 million, or 6.3%, during 2004 as compared to 2003, while our average
yield rose 41 points, from 3.53% in 2003 to 3.94% in 2004. The rates earned on a significant portion of our loans adjust when index rates such as prime rate changes. Conversely, most of our interest-bearing liabilities, including certificates of deposit and borrowings, have rates fixed until maturity. As a result interest rate increases generally result in an immediate positive impact to interest income on loans, with a more delayed impact on interest expense because increases in interest costs will occur only upon renewals of certificates of deposit or borrowings. Average loans outstanding during the 2004 fiscal year were $613.5 million, compared to $572.5 million in 2003, an increase of 7.2%. Average investment securities during 2004 were $139.9 million, compared to $139.0 million in 2003.
Trends in interest rates turned upward for the year, as the Federal Reserve increased the federal funds rate by a total of 125 basis points with 25 basis point increases coming in June, August, September, November, and December 2004. As a result, the prime lending rate rose to 5.25% at December 31, 2004 from 4.00% at December 31, 2003. This had the effect of increasing both the earning asset yield and the interest bearing liability rate. During 2004, the rise in the earning asset yield outpaced the increase in the interest bearing liability rate.
The weighted average yield on earning assets increased to 5.91% for 2004, compared to 5.86% for 2003. This increase in the asset yield in 2004 was primarily attributable to the increased yield on loans, combined with a decreased yield on investment securities. During the current year, the yield on loans increased 14 basis points to 6.46% from 6.32% in 2003. This rise is due to variable rate loans that repriced higher during the year in response to increases in the underlying index, and new fixed rate loans originated at higher rates.
The weighted average rate paid on interest bearing liabilities was 2.28%, compared to 2.70% in 2003. Average interest bearing deposits for 2004 totaled $598.7 million, a 7.2% increase from $558.7 million in 2003. The overall rate for interest bearing deposits declined 46 basis points to 2.26% in 2004, compared to 2.72% in the prior year. The overall rate on borrowings was 2.38% in 2004, compared to 2.53% a year earlier. Average borrowings totaled $64.1 million in 2004 and $62.2 million in 2003, an increase of 3.1%.
The table, "Average Balance Sheets and Net Interest Income Analysis," summarizes net interest income and average yields earned and rates paid for the years indicated, on a tax equivalent basis. The table, "Analysis of Interest Changes Due to Volume and Rates," presents the changes in interest income and interest expense attributable to volume and rate changes between the years indicated.
Provision for Credit Losses. We recorded a $1.3 million provision for credit losses for the year ended December 31, 2004, compared to a $1.4 million provision in the prior year. Provisions for credit losses are charged to income to bring our allowance for credit losses to a level deemed appropriate by management. See "Asset Quality" for a discussion of the factors relevant to the provision/allowance for credit losses.
Noninterest Income. Noninterest income of $8.1 million in 2004 was $661,000, or 8.9%, more than the previous year amount of $7.4 million. Net gains on sale of securities for 2004 totaled $109,000, compared to $564,000 in 2003. Service charges on deposit accounts increased to $3.8 million from $3.6 million in 2003. The Company was able to capitalize on increased fees and increased volume of demand deposits and other accounts with service charges. Revenues from our mortgage banking operation increased 10.6%, rising from $2.0 million in 2003 to $2.2 million in 2004 as we began to realize increased revenues from our wholesale mortgage division. Additionally, we realized approximately $700,000 in net gains on the sale of our Richlands, VA banking operation and approximately $125,000 in net gains from the sale of the fixed assets associated with the branch.
Noninterest Expense. Because of our continued strong growth we have experienced increases in every major component of our noninterest expenses. For the year ended December 31, 2004, our noninterest
expense increased $4.2 million, or 21.5%. Personnel expense of $12.4 million in 2004 exceeded the previous year expense of $10.5 million by $1.9 million, or 18.0% and reflects the addition of a wholesale mortgage division, increased staffing costs associated with the relocation of our corporate headquarters, expansion of our commercial lending staff, and the additional costs arising from the normal expansion of business, along with normal increases in salaries and benefits. At December 31, 2004, we had approximately 255 full-time and 14 part-time employees, compared with 225 full-time and 12 part-time employees at December 31, 2003. Occupancy and equipment expenses totaled $4.3 million for 2004, which was up 20.0% from $3.6 million in 2003, reflecting the expenses associated with our corporate headquarter relocation and investments in technology to support our banking operations. Other expenses were $7.1 million, compared to $5.0 million in 2003, reflecting the increased volume of business activity, principally increases in lending and growth in deposit accounts.
Provision for Income Taxes. The Company's provision for income taxes totaled $4.1 million for 2004, an increase of $300,000, or 7.9%, compared to 2003. Our effective tax rates for the years ended 2004 and 2003 were 32.9% and 33.7%, respectively. The decline in the effective rate from 2003 to 2004 reflects the implementation of investment strategies that resulted in a reduction in the consolidated income tax provision. The increase in the provision for 2004, compared to the prior year, results from higher pretax income, offset in part by a lower effective tax rate. Overall, the effective tax rate is attributable to the current expense required to provide an adequate provision for income taxes at the end of 2004 and 2003.
Results of Operations -- Years Ended December 31, 2003 and 2002
Net Income. Our net income for 2003 was $7.46 million, an increase of $678,000 from net income of $6.78 million earned in 2002. Diluted net income per share was $1.30, compared to $1.17 a year earlier. We have continued to experience strong growth, with total assets averaging $758.1 million during the current year as compared to $701.5 million in 2002, an increase of 8.1%. Our net interest income after provision for credit losses increased $938,000 over the prior year.
Net Interest Income. Net interest income represents the gross profit from the lending and investment activities of a banking organization and is the most significant factor affecting the earnings of the Company. Net interest income is influenced by changes in interest rates, volume and the mix of these various components. Net interest income on a fully taxable equivalent basis for 2003 was $25.4 million, which represented a 6.2% increase from $23.9 million in 2002. Actual net interest income for 2004 was $24.8 million, a 4.5% increase from $23.8 million recorded in 2003. The increase in net interest income is primarily attributable to lower overall rates paid on time deposits. The net effect was to increase the interest rate spread, which is the average yield on earning assets minus the average rate paid on interest bearing liabilities. While the average yield on earning assets declined in 2003, that decline was more than offset by the reduction in average rates paid on interest bearing liabilities. Average loans outstanding during the 2003 fiscal year were $572.5 million, compared to $547.8 million in 2002, an increase of 4.5%. Average investment securities during 2003 were $139.0 million compared to $110.3 million in 2002.
Trends in interest rates remained downward for the year, as the Federal Reserve decreased the federal funds rate by 25 basis points in July 2003, which followed a 50 basis point interest rate reduction in November 2002. As a result, the prime lending rate declined to 4.00% at December 31, 2003 from 4.25% at December 31, 2002. This had the effect of decreasing both the earning asset yield and the interest bearing liability rate. During 2003, the decline in the interest bearing liability rate outpaced the decline in the earning asset yield. Additionally, the decline in interest rates resulted in increases in the fair market value of the Company's investment portfolio during 2003. The increased fair value resulted in increased liquidity, due to securities being called and the sale of securities at a gain.
The weighted average yield on earning assets decreased 62 basis points to 5.86% for 2003 compared to 6.48% for 2002. This decrease in the asset yield in 2003 was primarily attributable to the decreased yield on loans and, to a lesser degree, to a decreased yield on investment securities. This was partially offset by an increase of $24.7 million in average loans outstanding, combined with an increase of $20.6 million in tax-exempt investments. During the current year, the yield on loans decreased 47 basis points to 6.32% from 6.79% in 2002. This decline is due to variable rate loans that repriced lower during the year in response to decreases in the underlying index, and new fixed rate loans originated at lower rates.
The weighted average rate paid on interest bearing liabilities was 2.70% in 2003 and 3.41% in 2002. Average interest bearing deposits for 2003 totaled $558.7 million, a 9.1% increase from $511.9 million in 2002. The overall rate for interest bearing deposits declined 80 basis points to 2.72% in 2003, compared to 3.52% in the prior year.
The overall rate on borrowings was 2.53% in 2003, compared to 2.51% a year earlier. Average borrowings totaled $62.2 million in 2003 and $61.1 million in 2002, an increase of 1.8%.
The table, "Average Balance Sheets and Net Interest Income Analysis," summarizes net interest income and average yields earned and rates paid for the years indicated, on a tax equivalent basis. The table, "Analysis of Interest Changes Due to Volume and Rates," presents the changes in interest income and interest expense attributable to volume and rate changes between the years indicated.
Provision for Credit Losses. We recorded a $1.4 million provision for credit losses for the year ended December 31, 2003, compared to a $1.3 million provision in the prior year. Provisions for credit losses are charged to income to bring our allowance for credit losses to a level deemed appropriate by management. See "Asset Quality" for a discussion of the factors relevant to the provision/allowance for credit losses.
Noninterest Income. Noninterest income of $7.4 million in 2003 was $2.1 million, or 40.5%, more than the previous year amount of $5.3 million. Gains on sale of securities for 2003 totaled $564,000, compared to $318,000 in 2002. Service charges on deposit accounts increased to $3.6 million from $2.8 million in 2002. The Company was able to capitalize on increased fees and increased volume of demand deposits and other accounts with service charges.
Noninterest Expense. Personnel expense of $10.5 million in 2003 exceeded the previous year expense of $9.8 million by $725,000, or 7.4%. At December 31, 2003, we had approximately 225 full-time and 12 part-time employees, compared with 188 full-time and 10 part-time employees at December 31, 2002. Occupancy expenses totaled $1.2 million for 2003, which was up 9.2% from $1.1 million in 2002. Furniture and equipment expenses totaled $2.4 million in the current year, a 24.8% increase from $1.9 million recorded in 2002. The efficiency ratio, which measures noninterest expense as a percentage of net interest income plus noninterest income, was 59.7% in 2003 and 2002. Other expenses were $4.2 million compared to $3.7 million in 2002.
Provision for Income Taxes. The Company's provision for income taxes totaled $3.8 million for 2003, an increase of $262,000, or 7.4%, compared to the 2002 provision of $3.5 million in 2002. The Company's effective tax rates for the years ended 2003 and 2002 were 33.7% and 34.2%, respectively. The decline in the effective rate from 2002 to 2003 reflects the implementation of investment strategies that resulted in a reduction in the consolidated income tax provision. The increase in the provision for 2003, compared to the prior year results from higher pretax income, offset in part by lower effective tax rate. Overall, the effective tax rate is attributable to the current expense required to provide an adequate provision for income taxes at the end of 2003 and 2002.
Liquidity and Cash Flow
Liquidity management refers to the ability to meet day-to-day cash flow requirements based primarily on activity in loan and deposit accounts of the Company's customers. Management measures our liquidity position by giving consideration to both on- and off-balance sheet sources of, and demands for, funds on a daily and weekly basis. Deposit withdrawals, loan funding and general corporate activity create a need for liquidity for the Company. Sources of liquidity include cash and cash equivalents, net of federal requirements to maintain reserves against deposit liabilities, investment securities eligible for pledging to secure borrowings from correspondent banks pursuant to securities sold under repurchase agreements, investments available for sale, loan repayments, loan sales, deposits, and borrowings from the Federal Home Loan Bank secured with pledged loans and securities, and from correspondent banks under overnight federal funds credit lines. In addition to interest rate-sensitive deposits, the Company's primary demand for liquidity is anticipated fundings under credit commitments to customers.
The investment portfolio at December 31, 2004, included securities with call features, whereby the issuer of such a security has the option to repay the purchaser of said instrument and cancels the instrument before the contractual maturity date. Due to the interest rate on the original instrument and current market rates on such instruments, the Company anticipates that very few debt instruments in the portfolio may be called in the upcoming year.
During 2004, the Company deployed cash flow from operating and financing activities to fund increases in the loan portfolio. Overall, cash and cash equivalents declined by $5.1 million, to $24.2 million at December 31, 2004.
As presented in the consolidated statement of cash flows, the Company generated $3.0 million in operating cash flow during 2004, a decrease from $7.5 million in 2003. The increase in loans held for sale was a primary contributor to this change, offset somewhat by a net increase in other liabilities, combined with a net decrease in other assets. In 2004, interest received in excess of interest paid was $32.5 million, while in 2003, interest received in excess of interest paid was $26.2 million. This change resulted from the growth in earning assets and continued improvement in net interest margin in 2004.
In 2004, the Company had a net increase of $82.4 million in loans, compared to $19.7 million in 2003. During 2004, the Company received $31.1 million from sales, calls, and maturities of securities, while purchasing $29.6 million. The lower turnover in the security portfolio was attributable to the continuing upward trend in interest rates during the year. In 2003, the Company purchased $130.6 million of securities, while receiving $105.0 million from sales, calls, and maturities.
Net increases in deposits totaling $82.4 million, offset somewhat by a $4.3 million combined net decrease in other borrowings and federal funds purchased and retail repurchase agreements, comprised the Company's major financing sources during 2004, amounting to a net $78.1 million versus a combined total of $47.0 million during 2003 and $40.7 million in 2002. In total, cash flows from growth in deposits were $82.4 million in 2004, versus $36.9 million in 2003 and $18.2 million in 2002. Partially offsetting these cash inflows was the repurchase of $3.5 million of the Company's outstanding common stock in 2004, compared to the repurchase of $2.3 million in 2003; and in 2002 a decrease of $11.4 million in federal funds and repurchase agreements, combined with repurchases of $4.1 million of the Company's common stock.
Liquidity is further enhanced by an approximately $145 million line of credit with the FHLB collateralized by FHLB stock, investment securities, qualifying 1 to 4 family residential mortgage loans, and qualifying commercial real estate loans. The Company provides various reports to the FHLB on a regular basis throughout the year to maintain the availability of the credit line. Each borrowing request to
the FHLB is initiated through an advance application that is subject to approval by the FHLB before funds are advanced under the credit agreement.
The Company also has unsecured overnight borrowing lines totaling $38 million available through five financial institutions. These lines are used to manage the day-to-day, short-term liquidity needs of the Company. Each overnight line has a requirement to repay the line in full on a frequent basis, typically within five to ten business days. The Company also established a $15 million wholesale repurchase agreement with a regional brokerage firm. The Company can access this additional source of liquidity by pledging investment securities with the brokerage firm.
The Company also projects future cash flow requirements based on scheduled loan and deposit maturities, borrowing maturities, capital expenditures and other factors. At December 31, 2004 and for the upcoming twelve-month period, the Company had scheduled loan maturities of $227.0 million, securities maturities of $10.5 million and $324.3 million in maturing time deposits. The Company also has $192.3 million in deposits with no contractual maturity, and $78.8 million in demand deposit accounts that are subject to withdrawal during 2005. The Company has $20.0 million of borrowings that are scheduled for repayment in 2005. Anticipated capital expenditures during 2005 are approximately $1.9 million. Internal analysis indicated the Company is positioned to meet expected liquidity requirements during the upcoming twelve-month period.
Contractual Obligations and Commitments
In the normal course of business there are various outstanding contractual obligations of the Company that will require future cash outflows. In addition, there are commitments and contingent liabilities, such as commitments to extend credit, that may or may not require future cash outflows. Payments for borrowings do not include interest. Payments related to leases are based on actual payments specified in the underlying contracts. The accompanying table reflects contractual obligations of the Company outstanding as of December 31, 2004.
Contractual Obligations (In thousands)
Capital Resources
Banks, bank holding companies, and financial holding companies, as regulated institutions, must meet required levels of capital. The Federal Reserve has adopted minimum capital regulations or guidelines that categorize components and the level of risk associated with various types of assets. Financial institutions are required to maintain a level of capital commensurate with the risk profile assigned to its assets in accordance with the guidelines. As shown in the table, "Regulatory Capital" the Company and the Bank both maintained capital levels exceeding the minimum levels to be "well capitalized" for the three years presented. The Bank will continue to be required to meet certain levels of capital.
Regulatory Capital (Dollars in thousands)
Lending Activities
General. The Company offers a broad array of lending services, including real estate, commercial and consumer loans, to individuals and small to medium-sized business and other organizations that are located in or conduct a substantial portion of their business in the Company's market areas. The Company has also established niche markets such as residential construction lending in local markets. The Company's total loans at December 31, 2004, were $663.4 million, or 76.7% of total assets. It also makes secured construction loans to homebuilders and residential mortgages, which are often secured by first and second real estate mortgages. At December 31, 2004, the Company had no large loan concentrations (exceeding 10% of its portfolio) in any particular industry.
Loan Composition. The accompanying table summarizes, at the dates indicated, the composition of the Company's loan portfolio and the related percentage composition.
Loan Portfolio Composition (Dollars in thousands)
As of December 31, --------------------------------------- 2004 2003 ------------------ ------------------ Real Estate: Commercial $ 166,685 25.1% $ 159,953 27.5% Residential 113,407 17.1 94,864 16.3 Construction 162,143 24.5 117,786 20.3 --------- ------ --------- ------ Total real estate 442,235 66.7 372,603 64.1
Commercial, financial and Agricultural 86,184 13.0 90,224 15.5 --------- ------ --------- ------ Consumer: Direct 40,741 6.1 39,276 6.7 Home equity 75,435 11.4 65,563 11.3 Revolving 18,831 2.8 13,718 2.4 --------- ------ --------- ------ Total consumer 135,007 20.3 118,557 20.4 --------- ------ --------- ------ Total $ 663,426 100.0% $ 581,384 100.0% ========= ====== ========= ======
Loan Portfolio Composition (cont'd) (Dollars in thousands)
Loan Portfolio - Maturities and Interest Rate Sensitivities (In thousands)
Real Estate Loans. Loans secured by real estate for a variety of purposes constituted $442.4 million, or 66.7%, of the Company's total loans at December 31, 2004. At yearend, the Company held real estate loans of various sizes ranging up to $7.9 million, secured by office buildings, retail establishments, warehouses, motels, restaurants and other types of property. Loan terms are typically limited to five years, with payments through the date of maturity generally based on a 15-year amortization schedule. Interest rates may be fixed or adjustable, based on market conditions, and the Company generally charges an origination fee. Management has attempted to reduce credit risk in the real estate portfolio by emphasizing loans on owner-occupied office and retail buildings where the loan to value ratio, established by independent appraisals, does not exceed 80%, and net projected cash flow available for debt service amounts to at least 120% of the debt service requirement. The Company also often requires personal guarantees of the principal owners of the property and obtains personal financial statements of the principal owners in such cases. The Company experienced net chargeoffs on commercial real estate loans of $298,000 in 2004, no net chargeoffs in 2003, and net recoveries of $18,000 in 2002.
The Company originates residential loans for its portfolio on single and multi-family properties, both owner-occupied and non owner-occupied, and at December 31, 2004, it held $113.4 million of such loans. Loan terms are typically limited to five years, with payments through the date of maturity generally based on a 15 or 30 year amortization schedule. Rates may be fixed or variable, and the Company typically charges an origination fee. The Company attempts to minimize credit risk by requiring a loan to value ratio of 80% or less. The Company experienced net recoveries on residential real estate loans of $1,000 in 2004 and net chargeoffs of $20,000 in 2003 and $43,000 in 2002.
The Company also originates residential mortgage loans for sale into the secondary market. Through its mortgage banking activities, the Company originates both fixed and variable rate residential mortgage loans for sale with servicing released. The Company is able to generate loan origination fees, typically ranging from 1.0% to 1.5% of the loan balance, which are recognized as income when the loan is sold. At December 31, 2004, the Company held $10.3 million of such loans for sale, and during 2004 the Company sold an aggregate of $101.8 million of such loans. The Company sells these loans on a non-recourse basis.
The Company's current lending strategy is for the majority of construction and development loans on commercial and residential projects to be in the range of $300,000 to $4.0 million. At December 31, 2004, 2003, and 2002, the Company held $162.1 million, $117.8 million, and $87.7 million, respectively, of such loans. To reduce credit risk associated with such loans, the Company limits its lending to projects involving small commercial centers that have strong anchor tenants and are substantially pre-leased, or residential projects built in strong, proven markets. The leases on commercial projects must generally result in a loan to appraised value of 80% or less and a net cash flow to debt service at no less than 120%. The Company historically has required a personal guarantee from the developer or builder. Loan terms are typically twelve to fifteen months, although the Company occasionally will make a "mini-permanent" loan for purposes of construction and development of up to a five year term. Rates are typically variable, and the Company typically charges an origination fee. The Company experienced no net chargeoffs from construction and development loans during 2004, 2003, or 2002.
Commercial Loans. The Company makes loans for commercial purposes to various types of businesses. At December 31, 2004, the Company held $166.7 million of commercial loans, or 25.1% of its total loan portfolio. Equipment loans are typically made on terms up to five years at fixed or variable rates, with the financed equipment pledged as collateral to the Company. The Company attempts to reduce its credit risk on these loans by limiting the loan to value ratio to 80%. Working capital loans are made on terms typically not exceeding one year. These loans may be secured or unsecured, but the Company attempts to limit its credit risk by requiring the borrower to demonstrate its capacity to produce net cash flow available for debt service equal to 110% to 150% of its debt service requirements. The Company experienced net charge-offs from commercial loans of $248,000 in 2004, $1,035,949 in 2003, and $803,000 in 2002.
Consumer Loans. The Company makes a variety of loans to individuals for personal and household purposes, including (i) secured and unsecured installment and term loans originated directly by the Company; (ii) home equity revolving lines of credit; and (iii) unsecured revolving lines of credit. The home equity loans and certain of the direct loans are secured by the borrowers' residences. At December 31, 2004, the Company held $135.0 million of consumer loans, including home equity lines of credit. During 2004, 2003, and 2002, respectively, the Company experienced net consumer chargeoffs of $501,000, $310,612, and $133,000.
Loan Approval and Review. The Company has adopted various levels of officer lending authority in connection with its loan approval policies. When the aggregate outstanding loans to a single borrower exceed that individual officer's lending authority, the loan request must be considered and approved by an officer with a higher lending limit. Branch loan officers typically have retail lending limits ranging from $75,000 to $250,000. Community executives can generally approve commercial relationships up to $750,000. If the lending request exceeds the community executive's lending limit, the loan must be submitted to and approved by the senior credit officer. The senior credit officer has authority to approve commercial relationships up to $1,000,000. Under joint approval, the senior credit officer and selected regional executives may approve loans up to $1,750,000 million. All loans in excess of $1,750,000 must be approved by the Chief Executive Officer, who may approve loans
up to $2,500,000. Loans exceeding $2,500,000 must be approved by the Credit Management Committee of the Board.
The Company has a loan review procedure involving multiple officers of the Company that is designed to promote early identification of credit quality problems through its credit management committee. All loan officers are charged with the responsibility of reviewing on an annual basis all credit relationships in excess of $250,000 in their respective portfolios. Loan officers also review all criticized and classified assets in their portfolio quarterly with the senior credit officer of the Company. The loan officers are responsible for implementing, where appropriate, approved action plans with respect to such criticized and classified assets which are designed to improve the Company's credit position and lead to a favorable resolution of the problem loan. As part of its overall strategy to improve policies and procedures, the Company also periodically engages a third party consultant to review its loan portfolio. The Company has used the findings of these examinations to further enhance credit quality through improved credit administration policies and procedures.
The Company's credit review system supplements its loan rating system, pursuant to which the Company may place a loan on its criticized asset list or may classify a loan in one of various other classification categories. A specified minimum percentage of loans in each adverse asset classification category, based on the historical loss experience of the Company in each such category, is used to determine the adequacy of the Company's allowance for credit losses quarterly. These loans are also individually reviewed by the senior credit officer of the Company to determine whether a greater allowance allocation is justified due to the facts and circumstances of a particular adversely classified loan.
See also Note 4 in the Notes to Consolidated Financial Statements of this Annual Report on Form 10-K.
Asset Quality
Management places great emphasis on maintaining the Company's asset quality. The allowance for credit losses, which is utilized to absorb actual losses in the loan portfolio, is maintained at a level consistent with management's best estimate of probable credit losses incurred as of the balance sheet date.
Allocation of the Allowance for Credit Losses (Dollars in thousands)
2004 2003 -------------- -------------- $ % (1) $ % (1) ------ ----- ------ ----- Balance at end of period applicable to: Commercial 5,166 13 5,116 16 Real estate-construction 1 24 5 20 Real estate-mortgage 43 42 49 44 Consumer 2,143 21 1,954 20 ------ ---- ------ ---- Total allocation 7,353 100 7,124 100 ====== ==== ====== ====
- ---------- (1) Percent of loans in each category to total loans.
The loan portfolio is analyzed on an ongoing basis to evaluate current risk levels, and risk grades are adjusted accordingly. The Company's allowance for credit losses is also analyzed quarterly by
management. This analysis includes a methodology that separates the total loan portfolio into homogeneous loan classifications for purposes of evaluating risk. The required allowance is calculated by applying a risk adjusted reserve requirement to the dollar volume of loans within a homogenous group. Major loan portfolio subgroups include: risk graded commercial loans, mortgage loans, home equity loans, retail loans and retail credit lines. The provisions of Statement of Financial Accounting Standard No. 114 ("SFAS No. 114"), Accounting by Creditors for Impairment of a Loan, and related pronouncements are applied to individually significant loans. Finally, individual reserves may be recorded based on a review of loans on the "watch list."
Summary of Allowance for Credit Losses (Dollars in thousands)
Commercial loans. All commercial loans within the portfolio are risk graded among nine risk grades based on management's evaluation of the overall credit quality of the loan, including the payment history, the financial position of the borrower, the underlying collateral value, an internal credit risk assessment and examination results. There is an increased reserve percentage for each successively higher risk grade. As a result, the allowance is adjusted upon any migration of a loan to a higher risk grade within the commercial loan portfolio. The accompanying table, "RISK GRADE CATEGORIES," details the risk-graded portfolio at December 31, 2004 and 2003.
The reserve percentages utilized have been determined by management to be appropriate based on historical loan loss levels and the risk for each corresponding risk grade. Reserve percentages for risk grade 6, risk grade 7, risk grade 8 and risk grade 9 remained constant in 2004. The Company had 94.3% of total commercial loans in risk grade 1 through 5 in 2004, compared to 96.2% in 2003.
Mortgage, home equity, and credit lines. Reserves are calculated on mortgage, home equity, and credit lines based on historical loss experience and current economic conditions. The average rolling eight-quarter net loss percentage is calculated for each of these loan categories. The reserve requirement also includes a reserve percentage for current economic conditions. The sum of these two components is applied to the dollar balance of loans in each of these categories to determine the required reserve.
Retail loans. The retail loans are pooled together to determine the reserve requirement. The average rolling twelve-quarter net loss percentage is calculated for this loan category. The reserve requirement also includes a reserve percentage for current economic conditions. The sum of these two components is applied to the dollar balance of retail loans to determine the required reserve for current loans and loans past due less than 90 days. A separate reserve is calculated for loans past due 90 days or more. A reserve amount equal to 25.0% of all retail loans past due 90 days or more is added to the above mentioned requirement to determine the total reserve requirement for retail loans.
Risk Grade Categories
Specific impairment under SFAS No. 114. Management evaluates individually significant loans in risk grade 7 and risk grade 8 on an individual basis for impairment. The specific allowance is calculated based upon a review of these loans and the estimated losses at the balance sheet date. At December 31, 2004 and 2003, the recorded investment in loans considered impaired was approximately $14,417,000 and $10,615,000, respectively. Impaired loans at December 31, 2004 consisted of $892,000 of retail loans past due 90 days or more, and $13,377,000 of risk grade 7 commercial loans and $148,000 of risk grade 8 commercial loans. Calculated reserves for impaired loans at December 31, 2004 totaled $915,000, compared to $2,085,000 a year ago.
Watch list review. Specific allowances may be determined based on a review of specific watch list loans. Specific losses are estimated at each measurement date. The Company has established a monthly procedure to review all loans placed on the watch list. The watch list primarily consist of loans classified as special mention, substandard and doubtful. An estimated loss amount and action plan is established for each watch list loan. By reviewing these watch list loans, the Company is able to update original probable loss amounts in light of developing conditions. This serves to reduce the differences between estimated and actual observed losses.
The 2004 provision for credit losses of $1.3 million represented a 10.9% decrease from the level in 2003. As of December 31, 2004, nonperforming assets totaled $10.4 million, primarily comprised of $3.5 million in nonaccrual loans and $5.6 million in other real estate owned. Those figures compare to $5.2 million in nonaccrual loans and $5.2 million in other real estate owned at the end of 2003, comprising $10.4 million in nonperforming assets. Net charge-offs decreased in 2004 to $1.0 million, or 0.17% of
average loans outstanding, compared with $1.4 million, or 0.24% of average loans outstanding in the prior year. At December 31, 2004 and 2003 the allowance for credit losses as a percentage of yearend loans was 1.11% and 1.23%, respectively.
During 2004 and at December 31, 2004, the commercial loan portfolio experienced a migration to risk grades indicative of higher credit risk as reflected in the table, "Risk Grade Categories." Risk grade loans classified special mention, substandard, doubtful increased from $13.5 million at yearend 2003 to $22.7 million at yearend 2004. The reserve requirement for this category of loans totaled $920,000 and $1.7 million for 2004 and 2003, respectively. A migration to lower credit risk occurred within the retail portfolio as retail loans past due 90 days or more decreased to $892,000 at December 31, 2004, compared to $1.4 million at the end of 2003. The reserve requirements for the retail loans past due 90 days or more were $223,000 and $350,000 at December 31, 2004 and 2003, respectively.
Nonperforming assets include nonaccrual loans, accruing loans contractually past due 90 days or more, restructured loans, and other real estate. Loans are placed on nonaccrual status when: (i) management has concerns relating to the ability to collect the loan principal and interest and (ii) generally when such loans are 90 days or more past due. No assurance can be given, however, that economic conditions will not adversely affect borrowers and result in increased credit losses.
Nonperforming Assets (In thousands)
Investment Activities
Our investment portfolio plays a primary role in management of liquidity and interest rate sensitivity and, therefore, is managed in the context of the overall balance sheet. The securities portfolio generates a substantial percentage of our interest income and serves as a necessary source of liquidity.
Management attempts to deploy investable funds into instruments that are expected to increase the overall return of the portfolio given the current assessment of economic and financial conditions, while maintaining acceptable levels of capital, and interest rate and liquidity risk.
The accompanying table presents the carrying values, fair values, and weighted average yields of our investment portfolio at December 31, 2004, 2003, and 2002; and the intervals of maturities or repricings at December 31, 2004:
Investment Securities (Dollars in thousands)
As of December 31, 2002 -------------------------------- Weighted Amortized Fair Average Cost Value Yield --------- --------- -------- U.S. government agencies and mortgage backed $ 115,309 $ 117,412 4.58% State and municipal obligations (1) 7,036 7,351 7.44 Other debt securities 306 321 6.83 Other equity 3,732 3,732 5.58 --------- --------- Total investment securities (1) $ 126,383 $ 128,816 4.58% ========= =========
As of December 31, 2004 ------------------------------------- After One Within Year to One Year Five Years ----------------- ----------------- Amount Yield Amount Yield -------- ------ -------- ------
U.S. government agencies and mortgage backed $ 10,381 2.14% $ 64,600 2.82% State and municipal obligations (1) 81 6.85 1,298 4.66 -------- -------- Total debt securities (1) $ 10,462 2.18% $ 65,898 2.86% ======== ========
- ---------- (1) Yields stated on a tax equivalent basis.
See also Note 3 in the Notes to Consolidated Financial Statements of this Annual Report on Form 10-K.
Off-Balance Sheet Arrangements
Information about the Company's off-balance sheet risk exposure is presented in Note 16 to the accompanying consolidated financial statements.
Market Risk
Market risk is the possible chance of loss from unfavorable changes in market prices and rates. These changes may result in a reduction of current and future period net interest income, which is the favorable spread earned from the excess of interest income on interest-earning assets, over interest expense on interest-bearing liabilities.
For a complete discussion on market risk and how the Company addresses this risk, see Item 7A
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Market risk is the possible chance of loss from unfavorable changes in market prices and rates. These changes may result in a reduction of current and future period net interest income, which is the favorable spread earned from the excess of interest income on interest-earning assets, over interest expense on interest-bearing liabilities.
Interest rate risk management is a part of the Company's overall asset/liability management process. The primary oversight of asset/liability management rests with the Company's Asset and Liability Committee, which is comprised of senior management and members of the Company's Board of Directors. The committee meets on a regular basis to review the asset/liability management activities of the Company and monitor compliance with established policies. An independent member of the Board of Directors chairs the committee and reports on its activities to the full Board.
A primary objective of interest rate sensitivity management is to ensure the stability and quality of the Company's primary earnings component, net interest income. This process involves monitoring the Company's balance sheet in order to determine the potential impact that changes in the interest rate environment may have on net interest income. Rate sensitive assets and liabilities have interest rates that are subject to change within a specific time period, due to either maturity or to contractual agreements which allow the instruments to reprice prior to maturity. Interest rate sensitivity management seeks to
ensure that both assets and liabilities react to changes in interest rates within a similar time period, thereby minimizing the risk to net interest income.
Interest Sensitivity Analysis (Dollars in thousands)
The measurement of the Company's interest rate sensitivity, or "gap", is a technique traditionally used in asset/liability management. The interest sensitivity gap is the difference between repricing assets and repricing liabilities for a particular time period. The table, "Interest Sensitivity Analysis," indicates a ratio of rate sensitive assets to rate sensitive liabilities within one year at December 31, 2004, to be 1.11%. This ratio indicates that a larger balance of assets compared to liabilities, could potentially reprice during the upcoming twelve-month period. Included in rate sensitive liabilities are certain deposit accounts (NOW, MMI, and savings) that are subject to immediate withdrawal and repricing, yet have no stated maturity. These balances are presented in the category that management believes best identifies their actual repricing patterns. This analysis assumes 60.0% of NOW and savings accounts, and 50.0% of MMI accounts, reprice within one year, and the remaining balances reprice after one year. The overall risk to net interest income is also influenced by the Company's level of variable rate loans. These are loans with a contractual interest rate tied to an index, such as the prime rate. A portion of these loans may reprice on multiple occasions during a one-year period due to changes in the underlying rate index. Approximately 64.2% of the total loan portfolio has a variable rate and reprices in accordance with the underlying rate index subject to terms of individual note agreements.
In addition to the traditional gap analysis, the Company also utilizes a computer based interest rate risk simulation model. This comprehensive model includes rate sensitivity gap analysis, rate shock net interest margin analysis, and asset/liability term and rate analysis. The Company uses this model to monitor interest rate risk on a quarterly basis and to detect trends that may affect the overall net interest income for the Company. This simulation incorporates the dynamics of balance sheet and interest rate changes and calculates the related effect on net interest income. As a result, this analysis more accurately
projects the risk to net interest income over the upcoming 12-month period. The Company's asset/liability policy provides guidance for levels of interest rate risk and potential remediations, if necessary, to mitigate excessive levels of risk. The modeling results indicate the Company is subject to an acceptable level of interest rate risk.
The Company considers interest rate risk to be its most significant market risk, which could potentially have the greatest impact on operating earnings. The Company is asset sensitive, which means that falling interest rates could result in a reduced amount of net interest income. The Company is not subject to other types of market risk, such as foreign currency exchange rate risk, commodity or equity price risk.
The table, "Market Sensitive Financial Instruments Maturities," presents the Company's financial instruments that are considered to be sensitive to changes in interest rates, categorized by contractual maturities, average interest rates and estimated fair values as of December 31, 2004.
Market Sensitive Financial Instruments Maturities (Dollars in thousands)
QUARTERLY FINANCIAL INFORMATION
The following table sets forth, for the periods indicated, certain of our consolidated quarterly financial information. This information is derived from our unaudited financial statements, which include, in the opinion of management, all normal recurring adjustments which management considers necessary for a fair presentation of the results for such periods. This information should be read in conjunction with our consolidated financial statements included elsewhere in this report. The results for any quarter are not necessarily indicative of results for any future period.
Quarterly Financial Data (Dollars in thousands, except per share data)
2004 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr ---- -------- -------- -------- --------
Interest income $ 12,317 $ 11,275 $ 10,441 $ 10,438 Interest expense 4,211 3,891 3,396 3,589 -------- -------- -------- --------
Net interest income 8,106 7,384 7,045 6,849 Provision for credit losses 330 285 272 388 -------- -------- -------- --------
Net interest income after provision for credit losses 7,776 7,099 6,773 6,461 -------- -------- -------- --------
Noninterest income 1,945 1,695 2,604 1,841 Noninterest expense 6,760 5,969 5,590 5,446 -------- -------- -------- --------
Income before income taxes 2,961 2,825 3,787 2,856 Provision for income taxes 941 913 1,274 961 -------- -------- -------- -------- Net income $ 2,020 $ 1,912 $ 2,513 $ 1,895 ======== ======== ======== ========
Earnings per share: Basic $ 0.37 $ 0.35 $ 0.45 $ 0.35 Diluted $ 0.35 $ 0.34 $ 0.44 $ 0.33
2003 4th Qtr 3rd Qtr 2nd Qtr 1st Qtr ---- -------- -------- -------- --------
Interest income $ 10,330 $ 10,323 $ 10,382 $ 10,552 Interest expense 3,733 4,118 4,382 4,532 -------- -------- -------- --------
Net interest income 6,597 6,205 6,000 6,020 Provision for credit losses 351 303 282 495 -------- -------- -------- --------
Net interest income after provision for credit losses 6,246 5,902 5,718 5,525 -------- -------- -------- --------
Noninterest income 1,853 2,011 1,767 1,794 Noninterest expense 5,185 5,012 4,758 4,612 -------- -------- -------- --------
Income before income taxes 2,914 2,901 2,727 2,707 Provision for income taxes 914 965 953 957 -------- -------- -------- --------
Net income $ 2,000 $ 1,936 $ 1,774 $ 1,750 ======== ======== ======== ======== Earnings per share: Basic $ 0.37 $ 0.35 $ 0.32 $ 0.31 Diluted $ 0.35 $ 0.34 $ 0.31 $ 0.30
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of FNB Financial Services Corporation (the Company) is responsible for preparing the Company's annual consolidated financial statements and for establishing and maintaining adequate internal control over financial reporting for the Company. Management has evaluated the effectiveness of the Company's internal control over financial reporting, including controls over the preparation of financial statements in accordance with the instructions to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C), as of December 31, 2004 based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2004.
The Company's registered public accounting firm that audited the Company's consolidated financial statements included in this annual report has issued an attestation report on management's assessment of internal control over financial reporting.
Management is also responsible for compliance with laws and regulations relating to safety and soundness which are designated by the FDIC and the appropriate federal banking agency. Management assessed its compliance with these designated laws and regulations relating to safety and soundness and believes that the Company complied, in all significant respects, with such laws and during the year ended December 31, 2004.
FNB Financial Services Corporation March 9, 2005
/s/ ERNEST J. SEWELL - ----------------------- Ernest J. Sewell President and Chief Executive Officer
/s/ PRESSLEY A. RIDGILL - ----------------------- Pressley A. Ridgill Executive Vice President and Chief Operating Officer
/s/ MICHAEL W. SHELTON - --------------------------- Michael W. Shelton Senior Vice President and Chief Financial Officer
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders FNB Financial Services Corporation
We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that FNB Financial Services Corporation (the "Company") maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because management's assessment and our audit were conducted to also meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), management's assessment and our audit of the Company's internal control over financial reporting included controls over the preparation of financial statements in accordance with the instructions to the Consolidated Financial Statements for Bank Holding Companies (form FR Y-9 C). A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that FNB Financial Services Corporation maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, FNB Financial Services Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control -- Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of FNB Financial Services Corporation as of December 31, 2004 and the related consolidated statements of income and comprehensive income, changes in shareholders' equity and cash flow for the year then ended, and our report dated March 9, 2005, expressed an unqualified opinion on these consolidated financial statements.
We do not express an opinion or any other form of assurance on management's statement referring to compliance with designated laws and regulations related to safety and soundness.
/s/ Dixon Hughes PLLC Sanford, North Carolina March 9, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders and the Board of Directors FNB Financial Services Corporation and Subsidiary Greensboro, North Carolina
We have audited the accompanying consolidated balance sheet of FNB Financial Services Corporation and Subsidiary as of December 31, 2004, and the related consolidated statements of income and comprehensive income, changes in shareholders' equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of FNB Financial Services Corporation and Subsidiary as of December 31, 2004 and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of FNB Financial Services Corporation's internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 9, 2005 expressed unqualified opinions on both management's assessment of the Company's internal control over financial reporting and the effectiveness of the Company's internal control over financial reporting.
/s/ Dixon Hughes PLLC
Sanford, North Carolina March 9, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of FNB Financial Services Corporation:
In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of income and comprehensive income, of changes in shareholders' equity, and of cash flows present fairly, in all material respects, the financial position of FNB Financial Services Corporation and its subsidiaries at December 31, 2003, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
Raleigh, North Carolina March 1, 2004
FNB Financial Services Corporation and Subsidiary Consolidated Balance Sheets
December 31, 2004 and 2003 (Dollars in thousands, except per share data)
See notes to consolidated financial statements
FNB Financial Services Corporation and Subsidiary Consolidated Statements of Income and Comprehensive Income
Years ended December 31, 2004, 2003 and 2002 (Dollars in thousands, except per share data)
See notes to consolidated financial statements
FNB Financial Services Corporation and Subsidiary Consolidated Statements of Changes in Shareholders' Equity
Years ended December 31, 2004, 2003 and 2002 (Dollars in thousands)
See notes to consolidated financial statements
FNB Financial Services Corporation and Subsidiary Consolidated Statements of Cash Flows
Years ended December 31, 2004, 2003 and 2002 (Dollars in thousands)
See notes to consolidated financial statements
FNB Financial Services Corporation and Subsidiary Notes to Consolidated Financial Statements
December 31, 2004, 2003 and 2002
Note 1 - Summary of significant accounting policies
Principles of consolidation
The accompanying consolidated financial statements include the accounts of FNB Financial Services Corporation (the "Company") and its wholly owned subsidiary FNB Southeast (the "Bank"). Also included are the accounts of FNB Southeast Mortgage Corporation, and FNB Southeast Investment Services, Inc., both of which are wholly owned subsidiaries of FNB Southeast. All significant intercompany balances and transactions have been eliminated in consolidation.
Nature of operations
FNB Southeast provides a variety of financial services to individual and corporate customers in North Carolina through its thirteen full-service branches in Reidsville, Madison, Eden, Ruffin, Greensboro, Burgaw, and Wilmington, North Carolina. A majority of the Bank's North Carolina customers are located in Rockingham, Guilford, and New Hanover Counties. The Bank also provides a variety of financial services to customers in Virginia through its four full-service branches in Norton, Harrisonburg, and Pennington Gap, Virginia. A majority of the Bank's Virginia customers are located in Wise, Russell, Lee, Rockingham, and Augusta Counties. FNB Southeast's primary deposit products are interest-bearing checking accounts, certificates of deposit and individual retirement accounts. Its primary lending products are commercial, real estate, and consumer loans.
Use of estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and their reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change relate to the determination of the allowance for credit losses on loans. A majority of the Bank's loan portfolio consists of loans in the geographic areas cited above. The local economies of these areas depend heavily on the industrial, agricultural, and service sectors. Accordingly, the ultimate collectibility of a large portion of the Bank's loan portfolio would be affected by changes in local economic conditions.
Cash and cash equivalents
Cash and cash equivalents include cash and due from banks and interest-bearing bank deposits. Cash and cash equivalents are defined as cash and short-term investments with maturities of three months or less.
Investment securities
The Company classifies its investment securities at the time of purchase into three categories as follows:
- Held to Maturity - reported at amortized cost,
- Trading - reported at fair value with unrealized gains and losses included in earnings, or
- Available for Sale - reported at fair value with unrealized gains and losses reported in other comprehensive income.
The Company is required to maintain certain levels of Federal Reserve Bank ("FRB") and Federal Home Loan Bank of Atlanta ("FHLB") stock based on various criteria established by the individual issuer.
Gains and losses on sales of securities are recognized when realized on a specific identification basis. Premiums and discounts are amortized into interest income using the level yield method.
Loans
Interest on loans is accrued and credited to income based on the principal amount outstanding. The accrual of interest on impaired loans is discontinued when, in management's opinion, the borrower may be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Loans are placed on nonaccrual status when: (i) management has concerns relating to the ability to collect the loan principal and interest and (ii) generally when such loans are ninety days or more past due. Interest income is subsequently recognized only to the extent cash payments are received. Mortgage loans held for sale are valued at the lower of cost or market as determined by outstanding commitments from investors or current investor yield requirements, calculated on the aggregate loan basis.
Loan origination fees and costs
Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield on the related loan.
Allowance for credit losses
The Company's allowance for credit losses is based on management's best estimate of probable loan losses incurred as of the balance sheet date. Factors impacting estimated probable loan losses include credit quality trends, past loan loss experience, current economic conditions, and loan volume among loan categories.
While management uses the best available information to establish the allowance for credit losses, future additions to the allowance may be necessary based on the factors cited above. In addition, the allowance is reviewed by regulatory agencies as an integral part of their examination processes. Such agencies may require the Company to recognize changes to the allowance based on their judgments about information available to them at the time of their examination.
Other real estate
Other real estate, acquired through partial or total satisfaction of loans, is carried at the lower of cost or fair market value, less estimated costs to sell, which becomes the property's new basis. At the date of acquisition, losses are charged to the allowance for credit losses. Subsequent write-downs are charged to expense in the period they are incurred.
Premises and equipment
Premises and equipment are stated at cost less accumulated depreciation and amortization. The provision for depreciation and amortization is computed principally by the straight-line method over the estimated useful lives of the assets. Useful lives are estimated at 20 to 40 years for buildings and 3 to 10 years for equipment. Leasehold improvements are amortized over the expected terms of the respective leases or the estimated useful lives of the improvements, whichever is shorter. Expenditures for maintenance and repairs are charged to operations, and the expenditures for major replacements and betterments are added to the premises and equipment accounts. The cost and accumulated depreciation of the premises and equipment retired or sold are eliminated from the appropriate asset accounts at the time of retirement or sale and the resulting gain or loss is reflected in current operations.
Income taxes
Provisions for income taxes are based on taxes payable or refundable for the current year (after exclusion of non-taxable income such as interest on state and municipal securities and non-deductible expenses) and deferred taxes on temporary differences between the tax bases of assets and liabilities and their reported
amounts in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
Common stock
A five-for-four stock split was effected in the form of a 25% stock dividend, effective December 29, 2003, with the issuance of 1,096,890 shares of stock and the transfer of $1,096,890 from retained earnings to the common stock account. All per share amounts in the financial statements have been recomputed to reflect this split.
Per share data
The Company follows Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share". SFAS No. 128 requires disclosure of two earnings per share amounts: basic net income per share of common stock and diluted net income per share of common stock. Basic net income per share of common stock is computed by dividing net income available to common shareholders by the weighted average number of shares of common stock outstanding during each year. Diluted net income per share of common stock is computed by dividing net income plus any adjustments to net income related to the issuance of dilutive potential common shares, comprised solely of outstanding options to purchase shares of common stock, by the weighted average number of shares of common stock outstanding during each year plus the number of potential dilutive common shares.
Sales of loans
Gains and losses on the sale of loans are accounted for by imputing gain or loss on those sales where a yield rate guaranteed to the buyer is more or less than the contract interest rate being collected. Such gains or losses are recognized in the financial statements during the year of sale.
Off balance sheet arrangements
In the ordinary course of business, the Bank enters into off balance sheet financial instruments consisting of commitments to extend credit, commitments under credit card arrangements, commercial letters of credit and standby letters of credit. Such financial instruments are recorded in the financial statements when they are funded or related fees are incurred or received.
Segment information
The Company follows the provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No. 131 requires that public business enterprises report certain information about operating segments in their annual financial statements and in condensed financial statements for interim periods issued to stockholders. It also requires that public business enterprises report related disclosures and descriptive information about products and services provided by significant segments, geographic areas, and major customers, differences between the measurements used in reporting segment information and those used in the enterprise's general-purpose financial statements, and changes in the measurement of segment amounts from period to period.
Operating segments are components of an enterprise with separate financial information available for use by the chief operating decision maker to allocate resources and to assess performance. The Company has determined that it has one significant operating segment, the providing of financial services, including banking, mortgage, and investment services, to customers located in Reidsville, Madison, Eden, Ruffin, Greensboro, Burgaw, and Wilmington, North Carolina; Norton, Harrisonburg, and Pennington Gap, Virginia; and surrounding communities. The various products are those generally offered by community banks, and the allocation of resources is based on the overall performance of the Company, rather than the individual branches or products.
There are no differences between the measurements used in reporting segment information and those used in the Company's general-purpose financial statements.
Stock based compensation
The proforma impact on net income and net income per share as if the fair value of stock-based compensation plans had been recorded as a component of compensation expense in the consolidated financial statements as of the date of grant of awards related to such plans, pursuant to the provisions of SFAS No. 123 and SFAS No. 148, is disclosed as follows.
Recent accounting pronouncements
In December 2004, the FASB issued SFAS No. 123(R), Accounting for Stock-Based Compensation (SFAS No. 123(R)). SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. This Statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires that the fair value of such equity instruments be recognized as an expense in the historical financial statements as services are performed. Prior to SFAS No. 123(R), only certain proforma disclosures of fair value were required. The provisions of this Statement are effective for the first interim reporting period that begins after June 15, 2005. Accordingly, we will adopt SFAS No. 123(R) commencing with the quarter ending September 30, 2005. If we had included the cost of employee stock option compensation in our consolidated financial statements, our net income for the fiscal years ended December 31, 2004, 2003 and 2002 would have decreased by approximately $346,000, $254,000, and $349,000, respectively. Accordingly, the adoption of SFAS No. 123(R) is expected to have a material effect on our consolidated financial statements.
In December 2003, the American Institute of Certified Public Accountants (AICPA) issued Statement of Position (SOP) 03-3, Accounting for Loans or Certain Debt Securities Acquired in a Transfer. The SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities acquired in a transfer if those differences relate to a deterioration of credit quality. The SOP also prohibits companies from "carrying over" or creating a valuation allowance in the initial accounting for loans acquired that meet the scope criteria of the SOP. The SOP is effective for loans acquired in fiscal years beginning after December 15, 2004. The adoption of this SOP is not expected to have a material impact on the Company's financial position or results of operations.
In March 2004, the Emerging Issues Task Force ("EITF") released EITF Issue 03-01, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. The Issue provides guidance for determining whether an investment is other-than-temporarily impaired and requires certain disclosures with respect to these investments. The recognition and measurement guidance for other-than-temporary impairment has been delayed by the issuance of FASB Staff Position EITF 03-1-1 on September 30, 2004. The adoption of Issue 03-1 did not result in any other-than-temporary impairment.
On March 9, 2004, the SEC Staff issued Staff Accounting Bulletin No. 105, Application of Accounting Principles to Loan Commitments ("SAB 105"). SAB 105 clarifies existing accounting practices relating to the valuation of issued loan commitments, including interest rate lock commitments ("IRLC"), subject to SFAS No. 149 and Derivative Implementation Group Issue C13, Scope Exceptions: When a Loan Commitment is included in the Scope of Statement 133. Furthermore, SAB 105 disallows the inclusion of the values of a servicing component and other internally developed intangible assets in the initial and subsequent IRLC valuation. The provisions of SAB 105 were effective for loan commitments entered into after March 31, 2004. The adoption of SAB 105 did not have a material impact on the consolidated financial statements.
Reclassification
Certain items for 2003 and 2002 have been reclassified to conform to the 2004 presentation. Such reclassifications had no effect on net income or shareholders' equity as previously reported.
Note 2 - Restriction on cash and due from banks
The Bank maintains average required reserve balances with the Federal Reserve. The average amounts of these reserve balances for the years ended December 31, 2004 and 2003 were $1,922,000 and $1,943,000, respectively.
Note 3 - Investment securities
Investment securities at December 31 consist of the following:
The aggregate cost of the Company's cost method equity investment, Federal Home Loan Bank stock and Federal Reserve Bank stock, totaled $4,442,000 at December 31, 2004. The Company estimated that the fair value equaled the cost of the investment (that is, the investment was not impaired) with an aggregate cost of $4,442,000.
The following table shows our investments' gross unrealized losses and fair value, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized position, at December 31, 2004 and 2003. The unrealized losses relate to debt securities that have incurred fair value reductions due to higher market interest rates since the securities were purchased. The unrealized losses are not likely to reverse unless and until market interest rates decline to the levels that existed when the securities were purchased. Since none of the unrealized losses relate to the marketability of the securities or the issuer's ability to honor redemption obligations, none of the securities are deemed to be other than temporarily impaired.
The amortized cost and estimated market value of debt securities at December 31, 2004, by contractual maturities, are shown in the accompanying schedule. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Amortized Estimated Cost Fair Value --------- ---------- (In thousands) Due in one year or less ............ $ 10,482 $ 10,462 Due after one through five years ... 66,852 65,898 Due after five through ten years ... 30,342 30,506 Due after ten years ................ 29,156 29,196 --------- --------- Total debt securities ........... $ 136,832 $ 136,062 ========= =========
Proceeds from the sale of investment securities available for sale, gross realized gains, and gross realized losses for the years ended December 31 were as follows:
2004 2003 2002 -------- --------- ------- (In thousands) Proceeds from sales ................. $ 15,195 $ 104,715 $ 3,913 Gross realized gains ................ 150 564 318 Gross realized losses ............... 41 -- --
At December 31, 2004 and 2003, investment securities with a carrying value of approximately $69,479,000 and $68,027,000, respectively, were pledged as collateral to secure public deposits and for other purposes.
Note 4 - Loans
Major classifications of loans at December 31, are as follows:
2004 2003 --------- --------- (In thousands) Commercial, financial and agricultural......... $ 83,332 $ 90,224 Consumer....................................... 137,332 118,557 Real estate: Residential mortgage........................ 124,436 95,939 Commercial mortgage......................... 166,491 159,953 Construction................................ 162,143 117,786 --------- --------- Subtotal loans................................. 673,734 582,459 Loans held for sale............................ 10,308 1,075 --------- --------- Gross loans....................... $ 663,426 $ 581,384 ========= =========
A loan is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Generally, a loan will be considered impaired if it exhibits the same level of underlying weakness and probability of loss as loans classified doubtful or loss.
The impairment evaluation compares the recorded book value of the loan, or loan relationship, to the present value of the expected future principal, interest and collateral value (if applicable) cash flows. The expected cash flows are discounted at the contractual interest rate for the individual note. A specific reserve is established if the present value of expected future cash flows is less than the recorded book value of the loan.
At December 31, 2004 and 2003, the recorded investment in loans considered impaired was approximately $14,417,000 and $10,615,000, respectively. The related allowance for credit losses on these impaired loans was approximately $915,000 and $2,085,000, respectively. The average recorded investment in impaired loans for the years ended December 31, 2004, 2003 and 2002 was approximately $11,851,000, $12,437,000, and $9,881,000 respectively.
Nonperforming loans include nonaccrual loans and loans past due 90 days or more and still accruing interest. Nonperforming loans at December 31, 2004 consisted of $3,450,000 of nonaccrual loans and $65,000 of loans 90 days or more past due and still accruing interest. Nonperforming loans at December 31, 2003 consisted of $5,174,000 of nonaccrual loans and $53,000 of loans 90 days or more past due and still accruing interest. Nonperforming loans at December 31, 2002 consisted of $3,314,000 of nonaccrual loans and $65,000 of loans 90 days or more past due and still accruing interest. The amount of interest income recorded on nonperforming loans during 2004, 2003 and 2002 amounted to $186,000, $142,000 and $475,000, respectively. Interest income on nonperforming loans is recorded when cash is actually received.
The amount of potential problem loans totaled $14,417,000 at December 31, 2004. These loans are considered impaired by the Company. There are no other identified potential problem loans at December 31, 2004.
Certain 1 to 4 family residential mortgage loans are held as collateral under a blanket floating lien to secure a portion of the Bank's borrowings (see Note 9).
Note 5 - Allowance for credit losses
Changes in the allowance for credit losses for the years ended December 31 were as follows:
2004 2003 2002 -------- -------- -------- (In thousands) Balance at beginning of year ... $ 7,124 $ 7,059 $ 6,731 Provision for credit losses .... 1,275 1,431 1,300 Recoveries ..................... 77 181 298 Losses charged off ............. (1,123) (1,547) (1,270) -------- -------- -------- Balance at end of year ......... $ 7,353 $ 7,124 $ 7,059 ======== ======== ========
Note 6 - Premises and equipment
Premises and equipment at December 31 is summarized as follows:
2004 2003 -------- -------- (In thousands) Land ............................................. $ 3,192 $ 3,724 Building and leasehold improvements .............. 8,241 8,385 Equipment ........................................ 14,790 12,549 -------- -------- Subtotal ......................................... 26,223 24,658 Less accumulated depreciation and amortization ... 13,079 11,627 -------- -------- Total premises and equipment, net ............. $ 13,144 $ 13,031 ======== ========
Note 7 - Deposits
The aggregate amount of jumbo certificates of deposit, each with a minimum denomination of $100,000, was approximately $126,472,000 and $194,802,000 in 2004 and 2003, respectively. The accompanying table presents the scheduled maturities of time deposits at December 31, 2004.
Year ending December 31, (In thousands) -------------------------- -------------- 2005 ..................... $ 324,272 2006 ..................... 88,685 2007 ..................... 19,754 2008 ..................... 10,500 2009 ..................... 9,655 Thereafter ............... 334 --------- Total time deposits ... $ 453,200 =========
Note 8 - Federal funds purchased, retail repurchase agreements and other borrowings
The following is a schedule of federal funds purchased, securities sold under agreements to repurchase and FHLB borrowings:
At December 31, 2004, the Bank had an approximately $130 million line of credit with the FHLB under which $45.0 million was outstanding. This line of credit is secured with FHLB stock and a blanket floating lien on qualifying 1 to 4 family residential mortgage loans and qualifying commercial real estate. The outstanding amounts consist of $20.0 million maturing in 2005, $15.0 million maturing in 2007, and $10.0 million maturing in 2011. The borrowings maturing in 2007 and 2011 both have one time call features, and may be converted to a floating rate based on the three month LIBOR rate at their respective call date.
Federal funds purchased represent unsecured overnight borrowings from other financial institutions by the Bank. Securities sold under agreements to repurchase represent short-term borrowings by the Bank, with overnight maturities collateralized by securities of the United States government or its agencies.
Note 9 - Income taxes
The components of income tax expense for the years ended December 31 are as follows:
2004 2003 2002 ------- ------- ------- (In thousands) Current tax expense Federal .......................... $ 3,864 $ 3,721 $ 2,928 State ............................ 623 397 275 ------- ------- ------- Total current ................. 4,487 4,118 3,203 ------- ------- ------- Deferred tax (benefit) expense Federal .......................... (290) (299) 282 State ............................ (107) (30) 42 ------- ------- ------- Total deferred ................ (397) (329) 324 ------- ------- ------- Total income tax expense ... $ 4,090 $ 3,789 $ 3,527 ======= ======= =======
The significant components of deferred tax assets at December 31 are as follows:
2004 2003 ------- ------ (In thousands) Deferred tax assets: Allowance for credit losses ............................ $ 2,855 $ 2,671 Non-qualified deferred compensation plans .............. 616 285 Deferred loan fees ..................................... 484 272 Nonaccrual interest .................................... 216 178 Net unrealized gain on securities available for sale ... 303 96 Other .................................................. 200 67 ------- ------- Total ............................................... 4,674 3,569 Deferred tax liabilities: Depreciable basis of property and equipment ............ 911 636 Prepaid expenses ....................................... 180 -- Other .................................................. 46 -- ------- ------- Total ............................................... 1,137 636 ------- ------- Net deferred tax assets ................................... $ 3,537 $ 2,933 ======= =======
There is no valuation allowance for deferred tax assets, as management believes that realization of the deferred tax assets will more likely than not be realized. The provision for income taxes differs from that computed by applying the federal statutory rate of 34% as indicated in the following analysis:
2004 2003 2002 ------- ------- ------- (In thousands) Tax based on statutory rates .................... $ 4,350 $ 3,825 $ 3,505 Increase (decrease) resulting from: Effect of tax-exempt income .................. (427) (326) (101) State income taxes, net of federal benefit ... 335 218 229 Other, net ................................... (168) 72 (106) ------- ------- ------- Total provision for income taxes ............. $ 4,090 $ 3,789 $ 3,527 ======= ======= =======
Note 10 - Lease commitments
The minimum annual lease commitments under noncancelable operating leases in effect at December 31, 2004, are as follows:
Year Ending December 31 (In thousands) - ------------------------------ --------------
2005 ......................... $ 686 2006 ......................... 748 2007 ......................... 754 2008 ......................... 608 2009 ......................... 590 Thereafter ................... 545 ------- Total lease commitments ... $ 3,931 =======
Rental expense was $722,000 in 2004, $458,000 in 2003, and $429,000 in 2002.
Note 11 - Related party transactions
The Bank had loans outstanding to principal officers and directors and their affiliated companies during each of the past three years. Such loans were made substantially on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other borrowers and do not involve more than the normal risks of collectibility. The following table summarizes the transactions for the past two years.
(In thousands) 2004 2003 -------- -------- Balance, beginning of year $ 4,695 $ 4,936 Advances during year 1,251 1,990 Repayments during year (2,355) (2,231) -------- -------- Balance, end of year $ 3,591 $ 4,695 ======== ========
---------- NOTE: Unused credit available at December 31, 2004 totaled $3,252,000.
Note 12 - Stock based compensation
The Company follows SFAS No. 123, "Accounting for Stock-Based Compensation." Under SFAS No. 123, the Company has elected to continue using the measurement prescribed in Accounting Principles Board ("APB") Opinion No. 25, and accordingly, SFAS No. 123 had no effect on the Company's financial position or results of operations. The Company has issued stock under both incentive and non-qualified stock options. The following is a summary of stock option activity and related information for the years ended December 31:
The following is a summary of information on outstanding and exercisable options at December 31, 2004:
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used in 2004, 2003, and 2002: dividend yield of 3.07% for 2004, 2.75% for 2003, and 3.30% for 2002; expected volatility of 16.0% for 2004, 15.0% for 2003, and 16.0% for 2002; risk free interest rates of 3.68% for 2004, 3.75% for 2003, and 3.47% for 2002, and expected lives of seven years for all years.
These plans provide that shares granted come from the Company's authorized but unissued or reacquired common stock. The price of the options granted pursuant to these plans will not be less than 100 percent of the fair market value of the shares on the date of grant. The options granted in 1996 and thereafter vest ratably over a four-year period. No option will be exercisable after ten years from the date granted.
Note 13 - Other comprehensive income
The Company follows the provisions of SFAS No. 130, "Reporting Comprehensive Income". SFAS No. 130 establishes requirements for the disclosure of comprehensive income in the Company's consolidated financial statements. Comprehensive income is defined as net income plus transactions and other occurrences, which are the result of non-owner changes in equity.
Other comprehensive income is defined as comprehensive income exclusive of net income. Unrealized gains (losses) on available for sale investment securities represent the sole component of the Company's other comprehensive income. Other comprehensive income (loss) at December 31 consists of the following:
Note 14 - Net income per share
The following is a reconciliation of the numerator and denominator of basic common stock and diluted net income per share of common stock as required by SFAS No. 128:
For the years ended December 31, 2004, 2003, and 2002, there were 138,542 options, 131,489 options, and 163,524 options, respectively, that were antidilutive since the exercise price exceeded the average market price for the year.
Note 15 - FNB Financial Services Corporation (Parent Company)
The parent company's principal asset is its investment in its subsidiary, FNB Southeast. The principal source of income of the parent company is dividends received from its subsidiary.
Note 16 - Off-balance sheet arrangements
The Company's consolidated financial statements do not reflect various commitments and contingent liabilities which arise in the normal course of business and which involve elements of credit risk, interest rate risk and liquidity risk. These commitments and contingent liabilities are commitments to extend credit and standby letters of credit. A summary of the contract amount of the Bank's exposure to off-balance sheet risk at December 31, is as follows:
Contract or Notional Amount --------------------- 2004 2003 --------- --------- (In thousands) Commitments to extend credit ......................... $ 167,405 $ 135,552 Commercial letters of credit ......................... 635 354 --------- --------- Total commitments and contingent liabilities ...... $ 168,040 $ 135,906 ========= =========
The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Note 17 - Employee benefit plans
The Company's non-contributory defined benefit pension plan covers substantially all of its employees. The plan calls for benefits to be paid to eligible employees at retirement based primarily upon years of service with the Company and a percentage of qualifying compensation during final years of employment. Contributions to the plan are based upon the projected unit credited actuarial funding method and comply with the funding requirements of the Employee Retirement Income Security Act. Contributions are intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. Plan assets consist primarily of cash and cash equivalents, U.S. government securities, and common stocks. The following table outlines the changes in the Company's pension obligations, assets and funded status for the years ended December 31, 2004 and 2003, and the assumptions and components of net periodic pension cost for the two years in the period ended December 31, 2004.
2004 2003 2002 ------ ------ ------ Components of net periodic pension cost (Dollars in thousands) Service $ 508 $ 371 $ 384 Interest 361 301 291 Expected return on plan (430) (799) (255) Amortization of prior service 54 528 55 ------ ------ ------ Net periodic pension $ 493 $ 401 $ 475 ====== ====== ====== Weighted-average assumptions Discount 6.00% 6.00% 7.25% Expected return on plan 9.00% 9.00% 9.00% Rate of compensation increase 5.00% 5.00% 5.00%
Market Weighted-average asset allocations @ December 31, 2004 Value Percent ------- -------- Debt securities: Federated US Government $ 931 15.9% Pimco Total 886 15.2 First Trust Institutional Money ................... 65 1.1 First Trust Money Market .......................... 1 -- ------- ----- 1,883 32.2 Equity securities: American Funds Washington 2,242 38.3 American Growth Fund .............................. 1,344 23.0 Fidelity Advisor MidCap ........................... 378 6.5 ------- ----- 3,964 67.8 ------- ----- Net $ 5,847 100.0% ======= =====
Target allocations are established based on periodic evaluation of risk/reward under various economic scenarios and with varying asset class allocations. The near-term and long-term impact on obligations and asset values are projected and evaluated for funding and financial accounting implications. Actual allocation and investment performance is reviewed quarterly. The current target allocation ranges, along with the actual allocation as of December 31, 2004 is included in the accompanying table.
Long-Term Actual Plan Assets Allocation Allocation @ Target December 31, ---------- ------------ Equity securities .................. 49% - 71% 67.8% Debt securities .................... 18% - 28% 32.2% Real estate ........................ 0% - 10% -- Other (primarily cash).............. 2% - 3% -- ---------- ---- Total ........................... 100% 100% ========== ====
The assumed expected return on assets considers the current level of expected returns on risk-free investments (primarily government bonds), the historical level of risk premium associated with the other asset classes in the portfolio and the expectation for future returns of each asset class. The expected return of each asset class is weighted based on the target allocation to develop the expected long-term rate of return on assets. This resulted in the selection of the 9.00% rate used in 2004 and to be used for 2005. There was no minimum required contribution for 2004 and no minimum contribution is expected for 2005. The expected benefit payments for the next five years are as follows: (1) 2005 - $175,953, (2) 2006 - $174,386, (3) 2007 - $219,085, (4) 2008 - $218,915, and (5) 2009 - $224,636.
The Company has a Supplemental Executive Retirement Plan ("SERP") that allows the Company to supplement the level of certain executives' retirement income over the amount obtainable through the tax-qualified retirement plan. Contributions to the SERP totaled $313,000 for 2004, $237,000 for 2003, and $234,000 for 2002. The net periodic pension cost for the years ended December 31, 2004, 2003, and 2002 was $431,000, 303,000, and 292,000, respectively. The corresponding liability related to this plan was $1,897,000 and $1,492,000 as of December 31, 2004 and 2003, respectively.
The Bank also has a separate contributory 401(k) savings plan covering substantially all employees. The plan allows eligible employees to contribute up to a fixed percentage of their compensation, with the Bank matching a portion of each employee's contribution. The Bank's contributions were $162,000 for 2004, $122,000 for 2003, and $130,000 for 2002.
A deferred compensation plan allows the directors and certain senior officers of the Company and the Bank to defer the compensation they earn for performance of their appointed duties for the Company and the Bank. Each plan participant makes an annual election to either receive that year's compensation currently or to defer receipt until his or her death, disability or retirement. Effective November 1, 1999, the deferred compensation balances were transferred to a Rabbi trust.
Note 18 - Regulatory matters
The primary source of funds for the dividends paid by the Company to its shareholders is dividends received from the Bank. The Bank is restricted as to dividend payout by state laws applicable to banks and may pay dividends only out of undivided profits. Additionally, dividends paid by the Company may be limited due to maintaining minimum capital requirements imposed by banking regulators. Management does not expect any of these restrictions to materially limit its ability to pay dividends comparable to those paid in the past. At December 31, 2004, the Bank had undivided profits of approximately $44.3 million.
The Bank is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possible additional discretionary - actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of
assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weighting, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital to average assets (as defined). Management believes, as of December 31, 2004, that the Bank meets all capital adequacy requirements to which they are subject.
The most recent notification from the North Carolina Commissioner of Banks categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in the accompanying table. Since that notification, the Bank has continued to experience asset growth.
Note 19 - Fair value of financial instruments
The following methods and assumptions were used to estimate the fair value for each class of the Company's financial instruments.
Cash and cash equivalents. The carrying amounts for cash and due from banks approximate fair value because of the short maturities of those instruments.
Investment securities. The fair value of investment securities is based on quoted market prices, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. The fair value of equity investments in the restricted stock of the Federal Reserve Bank and Federal Home Loan Bank equals the carrying value.
Loans. The fair value of fixed rate loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. Substantially all residential mortgage loans held for sale are pre-sold and their carrying value approximates fair value. The fair value of variable rate loans with frequent repricing and negligible credit risk approximates book value.
Deposits. The fair value of noninterest-bearing demand deposits and NOW, savings, and money market deposits is the amount payable on demand at the reporting date. The fair value of time deposits is estimated using the rates currently offered for deposits of similar remaining maturities.
Federal Funds Purchased and Retail Repurchase Agreements. The carrying value of federal funds purchased and retail repurchase agreements is considered to be a reasonable estimate of fair value.
Other borrowings. Other borrowings consist of FHLB borrowings with varying maturities. The fair values of these liabilities are estimated using the discounted values of the contractual cash flows. The discount rate is estimated using the rates currently in effect for similar borrowings.
Financial instruments with off-balance sheet risk. The fair value of financial instruments with off-balance sheet risk is considered to approximate carrying value, since the large majority of these future financing commitments would result in loans that have variable rates and/or relatively short terms to maturity. For other commitments, generally of a short-term nature, the carrying value is considered to be a reasonable estimate of fair value. The various financial instruments were disclosed in Note 16.
The estimated fair values of financial instruments at December 31 are as follows:
The fair value estimates are made at a specific point in time based on relevant market and other information about the financial instruments. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on current economic conditions, risk characteristics of various financial instruments, and such other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
For information on the Company's change in independent accountants on June 30, 2004, from PricewaterhouseCoopers LLP ("PwC") to Dixon Hughes PLLC ("DH"), see the Form 8-K filed with the SEC on July 7, 2004 and Form 8-K/A filed with the SEC on July 23, 2004.
During the fiscal years ended December 31, 2004, 2003 and 2002, there were no disagreements with DH or PwC on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedures which disagreements, if not resolved to the satisfaction of DH or PwC, would have caused DH or PwC to make reference thereto in their reports on the financial statements for such years.
During the fiscal years ended December 31, 2004, 2003 and 2002, there have been no "reportable events,"as that term is described in Item 304(a)(1)(v) of Regulation S-K.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
The Company's management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer of the Company (its principal executive officer and principal financial officer, respectively), has concluded based on its evaluation as of the end of the period covered by this Report, that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the applicable rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company 's management, including the Chief Executive Officer and the Chief Financial Officer of the Company, as appropriate to allow timely decisions regarding required disclosure.
Management's Report on Internal Control over Financial Reporting
Management, including the Company's chief executive officer, principal financial officer, and principal accounting officer, is responsible for establishing and maintaining adequate internal control over the Company's financial reporting. Management conducted an evaluation of the effectiveness of internal control over financial reporting based on the "Internal Control -- Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company's internal control over financial reporting was effective as of December 31, 2004.
Management's assessment of the effectiveness of internal control over financial reporting as of December 31, 2004, was audited by Dixon Hughes PLLC, an independent registered public accounting firm, as stated in their report beginning on page 46 of this report.
Changes in Internal Control over Financial Reporting
There have been no significant changes in internal control over financial reporting during the fourth quarter that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
Item 9B. Other Information
Not applicable.
PART III
Item 10. Directors and Executive Officers of the Registrant
(a) Directors and Executive Officers - The information required by this Item regarding directors and executive officers of the Company, the Company's Audit Committee and procedures for shareholder nominations is set forth under the sections captioned "Election of Directors," "Executive Officers," "Report of Audit Committee" and "Our Board of Directors and its Committees - How can a shareholder nominate someone for election to the Board?" in the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 19, 2005, which sections are incorporated by reference.
(b) Section 16(a) Compliance - The information required by this item regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 is set forth under the section "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 19, 2005, which section is incorporated by reference.
(c) Audit Committee Financial Expert - The Board of Directors of the Company has determined that Barry Z. Dodson, a member of the Audit Committee, qualifies as an " audit committee financial expert" and is "independent" as defined under applicable SEC and NASD rules and regulations.
(d) Code of Ethics - The Company has adopted its "Code of Business Conduct and Ethics", a code of ethics that applies to its directors, officers, and employees. The Code of Business Conduct and Ethics is accessible on the Company's website under the "Investor Information" section. The Company elects to disclose any amendments to or waivers of any Provisions of its Code of Business Conduct and Ethics applicable to its principal executive officers and senior financial officers on its website.
Item 11. Executive Compensation
Director compensation, executive compensation and executive compensation plan information are incorporated by reference to the sections captioned "Our Board of Directors and its Committees - How are our directors compensated?" and "Executive Compensation" in the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 19, 2005.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Incorporated by reference to the sections captioned "Stock Ownership" and "-Equity Compensation Plan Information" in the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 19, 2005.
Item 13. Certain Relationships and Related Transactions
Incorporated by reference to the section captioned "Transactions with Management" in the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 19, 2005.
Item 14. Principal Accountant Fees and Services
Incorporated by reference to the section captioned "Information About Our Independent Auditors in 2004" in the Company's definitive proxy statement, to be filed with the Securities and Exchange Commission with respect to the Annual Meeting of Shareholders to be held on May 19, 2005.
PART IV
Item 15. Exhibits and Financial Statement Schedules
(a)(1) Financial Statements. The following financial statements and supplementary data are included in Item 8