ITEM 1. BUSINESS
General
First Financial Bankshares, Inc., a Texas corporation, is a financial holding company registered under the Bank Holding Company Act of 1956, or BHCA. As such, we are supervised by the Board of Governors of the Federal Reserve System, or Federal Reserve Board, as well as several other state and federal regulators. We were formed as a bank holding company in 1956 under the original name F & M Operating Company, but our banking operations date back to 1890, when Farmers and Merchants National Bank opened for business in Abilene, Texas. By
virtue of a series of reorganizations, mergers, and acquisitions since 1956, we now own, through our wholly-owned Delaware subsidiary, First Financial Bankshares of Delaware, Inc., ten banks, a trust company and a technology operating company, all organized and located in Texas. These subsidiaries are:
o First Financial Bank, National Association, Abilene, Texas; o First Technology Services, Inc., Abilene, Texas; o First Financial Trust & Asset Management Company, National Association, Abilene, Texas; o Hereford State Bank, Hereford, Texas; o First National Bank, Sweetwater, Texas; o First Financial Bank, National Association, Eastland, Texas; o First FinancialBank, National Association, Cleburne, Texas; o First Financial Bank, National Association, Stephenville, Texas; o San Angelo National Bank, San Angelo, Texas; o Weatherford National Bank, Weatherford, Texas; o First Financial Bank, National Association, Southlake, Texas; and o City National Bank, Mineral Wells, Texas.
As described in more detail below, we elected to be treated as a financial holding company in September 2001.
Our service centers are located primarily in North Central and West Texas. Considering the branches and locations of all our subsidiaries, as of December 31, 2004, we had 33 financial centers across Texas, with eight locations in Abilene, two locations in Cleburne, three locations in Stephenville, two locations in San Angelo, three locations in Weatherford, and one location each in Mineral Wells, Hereford, Sweetwater, Eastland, Southlake, Aledo, Willow Park, Alvarado, Burleson, Keller, Trophy Club, Roby, Trent, Granbury and Glen Rose. We added four additional banking centers in the first quarter of 2005 with the acquisition of The Peoples State Bank of Clyde. These branches are in Clyde, Moran, Ranger and Rising Star.
Information on our revenues, profits and losses and total assets appears in the discussion of our Results of Operations contained in Item 7 hereof.
First Financial Bankshares, Inc.
We provide management and technical resources and policy direction to our subsidiaries, which enables them to improve or expand their banking services while continuing their local activity and identity. Each of our subsidiaries operates under the day-to-day management of its own board of directors and officers, with substantial authority in making decisions concerning their own investments, loan policies, interest rates, and service charges. We provide resources and policy direction in, among other things, the following areas:
o asset and liability management;
o accounting, budgeting, planning, risk management, human resources and insurance;
o capitalization; and
o regulatory compliance.
In particular, we assist our subsidiaries with, among other things, decisions concerning major capital expenditures, employee fringe benefits, including retirement plans and group medical, dividend policies, and appointment of officers and directors and their compensation. We also perform, through corporate staff groups or by outsourcing to third parties, internal audits, compliance oversight and loan reviews of our subsidiaries. We provide advice and specialized services for our banks related to lending, investing, purchasing, advertising, public relations, and computer services.
We evaluate various potential financial institution acquisition opportunities and evaluate potential locations for new branch offices. We anticipate that funding for any acquisitions or expansions would be provided
from our existing cash balances, available dividends from subsidiary banks, utilization of available lines of credit and future debt or equity offerings.
Services Offered by Our Subsidiary Banks
Each of our subsidiary banks is a separate legal entity that operates under the day-to-day management of its own board of directors and officers. Each of our subsidiary banks provides general commercial banking services, which include accepting and holding checking, savings and time deposits, making loans, automated teller machines, drive-in and night deposit services, safe deposit facilities, transmitting funds, and performing other customary commercial banking services. Effective January 1, 2004, the activities of trust departments of First Financial Bank, National Association, Abilene, First National Bank, Sweetwater, First Financial Bank, National Association, Stephenville, and San Angelo National Bank were transferred to our new trust company, First Financial Trust & Asset Management Company, National Association. Through this new company, we administer pension plans, profit sharing plans and other employee benefit plans as well as administering estates, testamentary trusts, various types of living trusts, and agency accounts. We believe the structure of this new trust company results in a more effectively managed trust department and provides trust services to customers of our banks that do not currently have trust departments. In addition, First Financial Bank, National Association, Abilene, and San Angelo National Bank provide securities brokerage services through arrangements with an unrelated third party.
Competition
Commercial banking in Texas is highly competitive, and because we hold less than 1% of the state's deposits, we represent only a minor segment of the industry. To succeed in this industry, our management believes that our banks must have the capability to compete in the areas of (1) interest rates paid or charged; (2) scope of services offered; and (3) prices charged for such services. Our subsidiary banks compete in their respective service areas against highly competitive banks, thrifts, savings and loan associations, small loan companies, credit unions, mortgage companies, insurance companies, and brokerage firms, all of which are engaged in providing financial products and services and some of which are larger than our subsidiary banks in terms of capital, resources and personnel.
Our business does not depend on any single customer or any few customers, the loss of any one of which would have a materially adverse effect upon our business. Although we have a broad base of customers that are not related to us, our customers also occasionally include our officers and directors, as well as other entities with which we are affiliated. With our subsidiary banks we may make loans to officers and directors, and entities with which we are affiliated, in the ordinary course of business. We make these loans on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other persons. Loans to directors, officers and their affiliates are also subject to numerous restrictions under federal and state banking laws which we describe in greater detail below.
Employees
With our subsidiary banks we employed approximately 850 full-time equivalent employees at January 31, 2005. Our management believes that our employee relations have been and will continue to be good.
Supervision and Regulation
Both federal and state laws extensively regulate bank holding companies, financial holding companies and banks. These laws (and the regulations promulgated thereunder) are primarily intended to protect depositors and the deposit insurance fund of the Federal Deposit Insurance Corporation, or FDIC, although shareholders may also benefit. The following information describes particular laws and regulatory provisions relating to financial holding companies and banks. This discussion is qualified in its entirety by reference to the particular laws and regulatory provisions. A change in any of these laws or regulations may have a material effect on our business and the business of our subsidiary banks.
Bank Holding Companies and Financial Holding Companies
Historically, the activities of bank holding companies were limited to the business of banking and activities closely related or incidental to banking. Bank holding companies were generally prohibited from acquiring control of any company which was not a bank and from engaging in any business other than the business of banking or managing and controlling banks. The Gramm-Leach-Bliley Act, which took effect on March 12, 2000, dismantled many Depression-era restrictions against affiliation between banking, securities and insurance firms by permitting bank holding companies to engage in a broader range of financial activities, so long as certain safeguards are observed. Specifically, bank holding companies may elect to become "financial holding companies" that may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or incidental to a financial activity. Thus, with the enactment of the Gramm-Leach-Bliley Act, banks, securities firms and insurance companies find it easier to acquire or affiliate with each other and cross-sell financial products. The Act permits a single financial services organization to offer a more complete array of financial products and services than historically was permitted.
A financial holding company is essentially a bank holding company with significantly expanded powers. Under the Gramm-Leach-Bliley Act, in addition to traditional lending activities, the following activities are among those that will be deemed "financial in nature" for financial holding companies: securities underwriting, dealing in or making a market in securities, sponsoring mutual funds and investment companies, insurance underwriting and agency activities, activities which the Federal Reserve Board determines to be closely related to banking, and certain merchant banking activities.
We elected to become a financial holding company in September 2001. As a financial holding company, we have very broad discretion to affiliate with securities firms and insurance companies, make merchant banking investments, and engage in other activities that the Federal Reserve Board has deemed financial in nature. In order to continue as a financial holding company, we must continue to be well-capitalized, well-managed and maintain compliance with the Community Reinvestment Act. Depending on the types of financial activities that we may elect to engage in, under Gramm-Leach-Bliley's fractional regulation principles, we may become subject to supervision by additional government agencies. The election to be treated as a financial holding company increases our ability to offer financial products and services that historically we were either unable to provide or were only able to provide on a limited basis. As a result, we will face increased competition in the markets for any new financial products and services that we may offer. Likewise, an increased amount of consolidation among banks and securities firms or banks and insurance firms could result in a growing number of large financial institutions that could compete aggressively with us.
Mergers and Acquisitions
We generally must obtain approval from the banking regulators before we can acquire other financial institutions. We may not engage in certain acquisitions if we are undercapitalized. Furthermore, the BHCA provides that the Federal Reserve Board cannot approve any acquisition, merger or consolidation that may substantially lessen competition in the banking industry, create a monopoly in any section of the country, or be a restraint of trade. However, the Federal Reserve Board may approve such a transaction if the convenience and needs of the community clearly outweigh any anti-competitive effects. Specifically, the Federal Reserve Board would consider, among other factors, the expected benefits to the public (greater convenience, increased competition, greater efficiency, etc.) against the risks of possible adverse effects (undue concentration of resources, decreased or unfair competition, conflicts of interest, unsound banking practices, etc.).
Banks
Federal and state laws and regulations that govern banks have the effect of, among other things, regulating the scope of business, investments, cash reserves, the purpose and nature of loans, the maximum interest rate chargeable on loans, the amount of dividends declared, and required capitalization ratios.
National Banking Associations. Banks organized as national banking associations under the National Bank Act are subject to regulation and examination by the Office of the Comptroller of the Currency, or OCC. The OCC supervises, regulates and regularly examines First Financial Bank, National Association, Abilene, First National Bank, Sweetwater, First Financial Bank, National Association, Cleburne, First Financial Bank, National Association, Eastland, San Angelo National Bank, Weatherford National Bank, First Financial Bank, National Association, Southlake, First Financial Bank, National Association, Stephenville and City National Bank, Mineral Wells, as well as First Financial Trust & Asset Management Company, National Association and First Technology Services, Inc. The OCC's supervision and regulation of banks is primarily intended to protect the interests of depositors. The National Bank Act:
o requires each national banking association to maintain reserves against deposits,
o restricts the nature and amount of loans that may be made and the interest that may be charged, and
o restricts investments and other activities.
State Banks. Banks that are organized as state banks under Texas law are subject to regulation and examination by the Banking Commissioner of the State of Texas. The Commissioner regulates and supervises, and the Texas Banking Department regularly examines our one subsidiary state bank, Hereford State Bank. The Commissioner's supervision and regulation of banks is primarily designed to protect the interests of depositors. Texas law
o requires each state bank to maintain reserves against deposits,
o restricts the nature and amount of loans that may be made and the interest that may be charged, and
o restricts investments and other activities.
Because Hereford State Bank is a member of the FDIC, it is also subject to regulation at the federal level by the FDIC, and is subject to most of the federal laws described below.
Deposit Insurance
Each of our subsidiary banks is a member of the FDIC. The FDIC provides deposit insurance protection that covers all deposit accounts in FDIC-insured depository institutions and generally does not exceed $100,000 per depositor. Our subsidiary banks must pay assessments to the FDIC under a risk-based assessment system for federal deposit insurance protection. FDIC-insured depository institutions that are members of the Bank Insurance Fund pay insurance premiums at rates based on their risk classification. Institutions assigned to higher risk classifications (i.e., institutions that pose a greater risk of loss to their respective deposit insurance fund) pay assessments at higher rates than institutions assigned to lower risk classifications. An institution's risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to bank regulators. In addition, the FDIC can impose special assessments to cover the costs of borrowings from the U.S. Treasury, the Federal Financing Bank and the Bank Insurance Fund member banks. As of December 31, 2004, the assessment rate for each of our subsidiary banks is at the lowest level risk-based premium available.
Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, or FIRREA, an FDIC-insured depository institution can be held liable for any losses incurred by the FDIC in connection with (1) the "default" of one of its FDIC-insured subsidiaries or (2) any assistance provided by the FDIC to one of its FDIC-insured subsidiaries "in danger of default." "Default" is defined generally as the appointment of a conservator or receiver, and "in danger of default" is defined generally as the existence of certain conditions indicating that a default is likely to occur in the absence of regulatory assistance.
The Federal Deposit Insurance Act, or FDIA, requires that the FDIC review (1) any merger or consolidation by or with an insured bank, or (2) any establishment of branches by an insured bank. The FDIC is also empowered to regulate interest rates paid by insured banks. Approval of the FDIC is also required before an insured bank retires any part of its common or preferred stock, or any capital notes or debentures. Insured banks that are also members of the Federal Reserve System, however, are regulated with respect to the foregoing matters by the Federal Reserve System.
Payment of Dividends
We are a legal entity separate and distinct from our banking and other subsidiaries. We receive most of our revenue from dividends paid to us by our Delaware holding company subsidiary. Similarly, the Delaware holding company subsidiary receives dividends from our bank subsidiaries. Described below are some of the laws and regulations that apply when either we or our subsidiary banks pay dividends.
Each state bank that is a member of the Federal Reserve System and each national banking association is required by federal law to obtain the prior approval of the Federal Reserve Board and the OCC, respectively, to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank's net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. In addition, these banks may only pay dividends to the extent that retained net profits (including the portion transferred to surplus) exceed bad debts (as defined by regulation).
Our subsidiary banks paid aggregate dividends of approximately $37.4 million in 2004 and approximately $34.6 million in 2003. Under the dividend restrictions discussed above, as of December 31, 2004, our subsidiary banks, without obtaining governmental approvals, could have declared in the aggregate additional dividends of approximately $13.2 million from retained net profits. In connection with our acquisition of Southwestern Bancshares, Inc., First Financial Bank, National Association, Stephenville is restricted from declaring a dividend until its Tier 1 Capital Leverage ratio exceeds 7.35%. In addition, in connection with our acquisition of The Peoples State Bank, Clyde, Texas, which was completed in February 2005, First Financial Bank, National Association, Abilene is also restricted from declaring a dividend until its Tier I Capital Leverage ratio exceeds 7.35%.
In each case, the 7.35% limitation was imposed by the Office of the Comptroller of the Currency as a condition for granting its approval of the underlying acquisitions. In the short term, these restrictions will have the effect of limiting the amount of cash that may move from these subsidiary banks to us, which may in turn limit our ability to pay dividends to our shareholders, but we do not believe the restrictions will have a material adverse affect on our operations. We anticipate that the Tier 1 Capital Leverage ratio for each of these subsidiaries will exceed 7.35% by the end of our 2005 fiscal year.
To pay dividends, we and our subsidiary banks must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in, or is about to engage in, an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve Board and the OCC have each indicated paying dividends that deplete a bank's capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve Board, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends to the extent net income is sufficient to cover both cash dividends and a rate of earnings retention consistent with capital needs, asset quality and overall financial condition. No undercapitalized institution may pay a dividend.
Affiliate Transactions
The Federal Reserve Act, the FDIA and the rules adopted under these statutes restrict the extent to which we can borrow or otherwise obtain credit from, or engage in certain other transactions with, our depository subsidiaries. These laws regulate "covered transactions" between insured depository institutions and their subsidiaries, on the one hand, and their nondepository affiliates, on the other hand. "Covered transactions" include a loan or extension of credit to a nondepository affiliate, a purchase of securities issued by such an affiliate, a purchase of assets from such an affiliate (unless otherwise exempted by the Federal Reserve Board), an acceptance of securities issued by such an affiliate as collateral for a loan, and an issuance of a guarantee, acceptance, or letter of credit for the benefit of such an affiliate. The "covered transactions" that an insured depository institution and its subsidiaries are permitted to engage in with their nondepository affiliates are limited to the following amounts: (1) in the case of any one such affiliate, the aggregate amount of "covered transactions" cannot exceed ten percent of the capital stock and the surplus of the insured depository institution; and (2) in the case of all affiliates, the aggregate amount of "covered transactions" cannot exceed twenty percent of the capital stock and surplus of the insured
depository institution. In addition, extensions of credit that constitute "covered transactions" must be collateralized in prescribed amounts. Further, a bank holding company and its subsidiaries are prohibited from engaging in certain tie-in arrangements in connection with any extension of credit, lease or sale of property or furnishing of services. Finally, when we and our subsidiary banks conduct transactions internally among us, we are required to do so at arm's length.
During 2004, our wholly-owned subsidiary, First Financial Trust & Asset Management, National Association, purchased the trust assets and assumed the related trust liabilities previously owned by our subsidiary banks, First Financial Bank, National Association, Abilene, First National Bank, Sweetwater, San Angelo National Bank and First Financial Bank, National Association, Stephenville. These assets and assumed obligations were transferred at fair value as required by these regulations.
Loans to Directors, Executive Officers and Principal Shareholders
The authority of our subsidiary banks to extend credit to our directors, executive officers and principal shareholders, including their immediate family members and corporations and other entities that they control, is subject to substantial restrictions and requirements under Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O promulgated thereunder, as well as the Sarbanes-Oxley Act of 2002. These statutes and regulations impose specific limits on the amount of loans our subsidiary banks may make to directors and other insiders, and specified approval procedures must be followed in making loans that exceed certain amounts. In addition, all loans our subsidiary banks make to directors and other insiders must satisfy the following requirements:
o The loans must be made on substantially the same terms, including interest rates and collateral, as prevailing at the time for comparable transactions with persons not affiliated with us or the subsidiary banks;
o The subsidiary banks must follow credit underwriting procedures at least as stringent as those applicable to comparable transactions with persons who are not affiliated with us or the subsidiary banks; and
o The loans must not involve a greater than normal risk of repayment or other unfavorable features.
Furthermore, each subsidiary bank must periodically report all loans made to directors and other insiders to the bank regulators, and these loans are closely scrutinized by the regulators for compliance with Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O. Each loan to directors or other insiders must be pre-approved by the bank's board of directors with the applicable director abstaining from voting.
Capital
Bank Holding Companies and Financial Holding Companies. The Federal Reserve Board has adopted risk-based capital guidelines for bank holding companies and financial holding companies. The ratio of total capital to risk weighted assets (including certain off-balance-sheet activities, such as standby letters of credit) must be a minimum of eight percent. At least half of the total capital is to be composed of common shareholders' equity, minority interests in the equity accounts of consolidated subsidiaries and a limited amount of perpetual preferred stock, less goodwill, which is collectively referred to as Tier 1 Capital. The remainder of total capital may consist of subordinated debt, other preferred stock and a limited amount of loan loss reserves.
In addition, the Federal Reserve Board has established minimum leverage ratio guidelines for bank holding companies and financial holding companies. Bank holding companies and financial holding companies that meet certain specified criteria, including having the highest regulatory rating, must maintain a minimum Tier 1 Capital leverage ratio (Tier 1 Capital to average assets for the current quarter, less goodwill) of three percent. Bank holding companies and financial holding companies that do not have the highest regulatory rating will generally be required to maintain a higher Tier 1 Capital leverage ratio of three percent plus an additional cushion of 100 to 200 basis points. The Federal Reserve Board has not advised us of any specific minimum leverage ratio applicable to us. The guidelines also provide that bank holding companies and financial holding companies experiencing internal growth or making acquisitions will be expected to maintain strong capital positions. Such strong capital positions must be kept substantially above the minimum supervisory levels without significant reliance on intangible assets (e.g., goodwill, core
deposit intangibles and purchased mortgage servicing rights). As of December 31, 2004, our capital ratios were as follows: (1) Tier 1 Capital to Risk-Weighted Assets Ratio, 16.46%; (2) Total Capital to Risk-Weighted Assets Ratio, 17.49%; and (3) Tier 1 Capital Leverage Ratio, 9.80%.
Banks. The Federal Deposit Insurance Corporation Improvement Act of 1991, or FDICIA, established five capital tiers with respect to depository institutions: "well-capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." A depository institution's capital tier will depend upon where its capital levels are in relation to various relevant capital measures, including (1) risk-based capital measures, (2) a leverage ratio capital measure and (3) certain other factors. Regulations establishing the specific capital tiers provide that a "well-capitalized" institution will have a total risk-based capital ratio of ten percent or greater, a Tier 1 risk-based capital ratio of six percent or greater, and a Tier 1 leverage ratio of five percent or greater, and not be subject to any written regulatory enforcement agreement, order, capital directive or prompt corrective action derivative. For an institution to be "adequately capitalized," it will have a total risk-based capital ratio of eight percent or greater, a Tier 1 risk-based capital ratio of four percent or greater, and a Tier 1 leverage ratio of four percent or greater (in some cases three percent). For an institution to be "undercapitalized," it will have a total risk-based capital ratio that is less than eight percent, a Tier 1 risk-based capital ratio less than four percent or a Tier 1 leverage ratio less than four percent (or a leverage ratio less than three percent if the institution's composite rating is 1 in its most recent report of examination, subject to appropriate federal banking agency guidelines). For an institution to be "significantly undercapitalized," it will have a total risk-based capital ratio less than six percent, a Tier 1 risk-based capital ratio less than three percent, or a Tier 1 leverage ratio less than three percent. For an institution to be "critically undercapitalized," it will have a ratio of tangible equity to total assets equal to or less than two percent. FDICIA requires federal banking agencies to take "prompt corrective action" against depository institutions that do not meet minimum capital requirements. Under current regulations, we were "well capitalized" as of December 31, 2004 at all of our subsidiary banks, with the exception of First Financial Bank, Stephenville which was adequately capitalized.
FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be "undercapitalized." An "undercapitalized" institution must develop a capital restoration plan and its parent holding company must guarantee that institution's compliance with such plan. The liability of the parent holding company under any such guarantee is limited to the lesser of five percent of the institution's assets at the time it became "undercapitalized" or the amount needed to bring the institution into compliance with all capital standards. Furthermore, in the event of the bankruptcy of the parent holding company, such guarantee would take priority over the parent's general unsecured creditors. If a depository institution fails to submit an acceptable capital restoration plan, it shall be treated as if it is "significantly undercapitalized." "Significantly undercapitalized" depository institutions may be subject to a number of requirements and restrictions, including orders to sell sufficient voting stock to become "adequately capitalized," requirements to reduce total assets, and cessation of receipt of deposits from correspondent banks. "Critically undercapitalized" institutions are subject to the appointment of a receiver or conservator. Finally, FDICIA requires the various regulatory agencies to set forth certain standards that do not relate to capital. Such standards relate to the safety and soundness of operations and management and to asset quality and executive compensation, and permit regulatory action against a financial institution that does not meet such standards.
If an insured bank fails to meet its capital guidelines, it may be subject to a variety of other enforcement remedies, including a prohibition on the taking of brokered deposits and the termination of deposit insurance by the FDIC. Bank regulators continue to indicate their desire to raise capital requirements beyond their current levels.
In addition to FDICIA capital standards, Texas-chartered banks must also comply with the capital requirements imposed by the Texas Banking Department. Neither the Texas Finance Code nor its regulations specify any minimum capital-to-assets ratio that must be maintained by a Texas-chartered bank. Instead, the Texas Banking Department determines the appropriate ratio on a bank by bank basis, considering factors such as the nature of a bank's business, its total revenue, and the bank's total assets. As of December 31, 2004, our Texas-chartered banks exceeded the minimum ratios applied to them.
Our Support of Our Subsidiary Banks
Under Federal Reserve Board policy, we are expected to commit resources to act as a source of strength to support each of our subsidiary banks. This support may be required at times when, absent such Federal Reserve Board policy, we would not otherwise be required to provide it. In addition, any loans we make to our subsidiary banks would be subordinate in right of payment to deposits and to other indebtedness of our banks. In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of a subsidiary bank will be assumed by the bankruptcy trustee and be subject to a priority of payment.
Under the National Bank Act, if the capital stock of a national bank is impaired by losses or otherwise, the OCC is authorized to require the bank's shareholders to pay the deficiency on a pro-rata basis. If any shareholder refuses to pay the pro-rata assessment after three months notice, then the bank's board of directors must sell an appropriate amount of the shareholder's stock at a public auction to make up the deficiency. To the extent necessary, if a deficiency in capital still exists and the bank refuses to go into liquidation, then a receiver may be appointed to wind up the bank's affairs. Additionally, under the Federal Deposit Insurance Act, in the event of a loss suffered or anticipated by the FDIC (either as a result of the default of a banking subsidiary or related to FDIC assistance provided to a subsidiary in danger of default) our other banking subsidiaries may be assessed for the FDIC's loss.
Interstate Banking and Branching Act
Pursuant to the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, or Riegle-Neal Act, a bank holding company or financial holding company is able to acquire banks in states other than its home state. The Riegle-Neal Act also authorized banks to merge across state lines, thereby creating interstate branches. Furthermore, under this act, a bank is also able to open new branches in a state in which it does not already have banking operations, if the laws of such state permits it to do so. Accordingly, both the OCC and the Texas Banking Department accept applications for interstate merger and branching transactions, subject to certain limitations on ages of the banks to be acquired and the total amount of deposits within the state a bank or financial holding company may control. Since our primary service area is Texas, we do not expect that the ability to operate in other states will have any material impact on our growth strategy. We may, however, face increased competition from out-of-state banks that branch or make acquisitions in our primary markets in Texas.
Community Reinvestment Act of 1977
The Community Reinvestment Act of 1977, or CRA, subjects a bank to regulatory assessment to determine if the institution meets the credit needs of its entire community, including low- and moderate-income neighborhoods served by the bank, and to take that determination into account in its evaluation of any application made by such bank for, among other things, approval of the acquisition or establishment of a branch or other deposit facility, an office relocation, a merger, or the acquisition of shares of capital stock of another financial institution. The regulatory authority prepares a written evaluation of an institution's record of meeting the credit needs of its entire community and assigns a rating. These ratings are "Outstanding", "Satisfactory", "Needs Improvement" and "Substantial Non-Compliance." Institutions with ratings lower than "Satisfactory" may be restricted from engaging in the aforementioned activities. We believe our subsidiary banks have taken significant actions to comply with the CRA, and each has received at least a "satisfactory" rating in its most recent review by federal regulators with respect to its compliance with the CRA.
Monitoring and Reporting Suspicious Activity
Under the Bank Secrecy Act, IRS rules and other regulations, we are required to monitor and report unusual or suspicious account activity as well as transactions involving the transfer or withdrawal of amounts in excess of prescribed limits. In the wake of the tragic events of September 11, 2001, on October 26, 2001, the President signed the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism, or USA PATRIOT, Act of 2001. Under the USA PATRIOT Act, financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as enhanced due diligence and "know your customer" standards in their dealings with financial institutions and foreign customers.
For example, the enhanced due diligence policies, procedures and controls generally require financial institutions to take reasonable steps:
o to conduct enhanced scrutiny of account relationships to guard against money laundering and report any suspicious transaction;
o to ascertain the identity of the nominal and beneficial owners of, and the source of funds deposited into, each account as needed to guard against money laundering and report any suspicious transactions;
o to ascertain for any foreign bank, the shares of which are not publicly traded, the identity of the owners of the foreign bank, and the nature and extent of the ownership interest of each such owner; and
o to ascertain whether any foreign bank provides correspondent accounts to other foreign banks and, if so, the identity of those foreign banks and related due diligence information.
Under the USA PATRIOT Act, financial institutions are also required to establish anti-money laundering programs. The USA PATRIOT Act sets forth minimum standards for these programs, including:
o the development of internal policies, procedures, and controls;
o the designation of a compliance officer;
o an ongoing employee training program; and
o an independent audit function to test the programs.
In addition, under the USA PATRIOT Act, the Secretary of the Treasury has adopted rules addressing a number of related issues, including increasing the cooperation and information sharing between financial institutions, regulators, and law enforcement authorities regarding individuals, entities and organizations engaged in, or reasonably suspected based on credible evidence of engaging in, terrorist acts or money laundering activities. Any financial institution complying with these rules will not be deemed to violate the privacy provisions of the Gramm-Leach-Bliley Act that are discussed below. Finally, under the regulations of the Office of Foreign Asset Control, we are required to monitor and block transactions with certain "specially designated nationals" who OFAC has determined pose a risk to U.S. national security.
Consumer Laws and Regulations
We are also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the following list is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, The Fair and Accurate Credit Transactions Act and the Fair Housing Act, among others. These laws and regulations, among other things, prohibit discrimination on the basis of race, gender or other designated characteristics and mandate various disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. These and other laws also limit finance charges or other fees or charges earned in our activities. We must comply with the applicable provisions of these consumer protection laws and regulations as part of our ongoing customer relations.
Technology Risk Management and Consumer Privacy
State and federal banking regulators have issued various policy statements emphasizing the importance of technology risk management and supervision in evaluating the safety and soundness of depository institutions with respect to banks that contract with outside vendors to provide data processing and core banking functions. The use of technology-related products, services, delivery channels and processes exposes a bank to various risks, particularly operational, privacy, security, strategic, reputation and compliance risk. Banks
are generally expected to prudently manage technology-related risks as part of their comprehensive risk management policies by identifying, measuring, monitoring and controlling risks associated with the use of technology.
Under Section 501 of the Gramm-Leach-Bliley Act, the federal banking agencies have established appropriate standards for financial institutions regarding the implementation of safeguards to ensure the security and confidentiality of customer records and information, protection against any anticipated threats or hazards to the security or integrity of such records and protection against unauthorized access to or use of such records or information in a way that could result in substantial harm or inconvenience to a customer. Among other matters, the rules require each bank to implement a comprehensive written information security program that includes administrative, technical and physical safeguards relating to customer information.
Under the Gramm-Leach-Bliley Act, a financial institution must also provide its customers with a notice of privacy policies and practices. Section 502 prohibits a financial institution from disclosing nonpublic personal information about a customer to nonaffiliated third parties unless the institution satisfies various notice and opt-out requirements and the customer has not elected to opt out of the disclosure. Under Section 504, the agencies are authorized to issue regulations as necessary to implement notice requirements and restrictions on a financial institution's ability to disclose nonpublic personal information about customers to nonaffiliated third parties. Under the final rule the regulators adopted, all banks must develop initial and annual privacy notices which describe in general terms the bank's information sharing practices. Banks that share nonpublic personal information about customers with nonaffiliated third parties must also provide customers with an opt-out notice and a reasonable period of time for the customer to opt out of any such disclosure (with certain exceptions). Limitations are placed on the extent to which a bank can disclose an account number or access code for credit card, deposit or transaction accounts to any nonaffiliated third party for use in marketing.
Monetary Policy
Banks are affected by the credit policies of other monetary authorities, including the Federal Reserve Board, that affect the national supply of credit. The Federal Reserve Board regulates the supply of credit in order to influence general economic conditions, primarily through open market operations in United States government obligations, varying the discount rate on financial institution borrowings, varying reserve requirements against financial institution deposits, and restricting certain borrowings by financial institutions and their subsidiaries. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of banks in the past and are expected to continue to do so in the future.
Pending and Proposed Legislation
New regulations and statutes are regularly proposed containing wide-ranging proposals for altering the structures, regulations and competitive relationships of financial institutions operating in the United States. We cannot predict whether, or in what form, any proposed regulation or statute will be adopted or the extent to which our business may be affected by any new regulation or statute.
Enforcement Powers of Federal Banking Agencies
The Federal Reserve and other state and federal banking agencies and regulators have broad enforcement powers, including the power to terminate deposit insurance, issue cease-and-desist orders, impose substantial fees and other civil and criminal penalties and appoint a conservator or receiver. Our failure to comply with applicable laws, regulations and other regulatory pronouncements could subject us, as well as our officers and directors, to administrative sanctions and potentially substantial civil penalties.
Available Information
We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission. You may read and copy any document we file at the Securities and Exchange Commission's Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Please call the Securities and Exchange Commission at 1-800-SEC-0330 for further information on the public reference room. Our SEC filings are also available to the public at the Securities and Exchange Commission's web site at http://www.sec.gov. Our
web site is http://www.ffin.com. You may also obtain copies of our annual, quarterly and special reports, proxy statements and certain other information filed with the SEC, as well as amendments thereto, free of charge from our web site. These documents are posted to our web site as soon as reasonably practicable after we have filed them with the SEC. Our corporate governance guidelines, including our code of conduct applicable to all our employees, officers and directors, as well as the charters of our audit and nominating committees, are available at www.ffin.com. The foregoing information is also available in print to any shareholder who requests it. No information on any web site is incorporated into this Form 10-K or our other securities filings and is not a part of them.
ITEM 2.
ITEM 2. PROPERTIES
Our principal office is located in the First Financial Bank Building at 400 Pine Street in downtown Abilene, Texas. We lease two spaces in a building owned by First Financial Bank, National Association, Abilene. The lease of approximately 3,300 square feet of space expires December 31, 2010. The lease of approximately 1,135 square feet of space expires May 31, 2006. Our subsidiary banks collectively own 28 banking facilities, some of which are detached drive-ins, and also lease five banking facilities and 13 ATM locations. Our management considers all our existing locations to be well-suited for conducting the business of banking. We believe our existing facilities are adequate to meet our requirements and our subsidiary banks' requirements for the foreseeable future.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time we and our subsidiary banks are parties to lawsuits arising in the ordinary course of our banking business. However, there are no material pending legal proceedings to which we, our subsidiary banks or our other direct and indirect subsidiaries, or any of their properties, are currently subject. Other than regular, routine examinations by state and federal banking authorities, there are no proceedings pending or known to be contemplated by any governmental authorities.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our security holders during the fourth quarter of our 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 Information
Our common stock, par value $10.00 per share, is traded on the Nasdaq Stock Market under the trading symbol FFIN. See "Item 8 - -Financial Statements and Supplementary Data--Quarterly Financial Data" for the high, low and closing sales prices as reported by the Nasdaq National Market for our common stock for the periods indicated.
Holders
As of March 1, 2005, we had approximately 1,700 shareholders of record.
Dividends
See "Item 8 - -Financial Statements and Supplementary Data--Quarterly Results of Operations" for the frequency and amount of cash dividends paid by us. Also, see "Item 1 - Business - Supervision and Regulation - Payment of Dividends" and "Item 7 - Management's Discussion and Analysis of the Financial Condition and Results of Operations - Liquidity - Dividends" for restrictions on our present or future ability to pay dividends, particularly those restrictions arising under federal and state banking laws.
Recent Sales of Unregistered Securities
During the year ended December 31, 2004, the following sales of unregistered shares of common stock were made to employees in connection with their exercise of stock options:
Number of Common Aggregate Sales Date Shares Price Per Share Price ---- ------ --------------- ----- 01-07-04 537 $ 11.92 $ 6,401 01-07-04 1,375 23.42 32,203 02-12-04 549 23.42 12,858 03-01-04 100 11.92 1,192 03-01-04 600 11.92 7,152 03-04-04 64 23.42 1,499 03-04-04 625 11.92 7,450 03-04-04 700 11.92 8,344 03-04-04 500 11.92 5,960 03-05-04 500 23.86 11,930 03-05-04 93 16.64 1,548 ----- -------- Totals 5,643 $ 96,537 ===== ========
Each of the foregoing sales were made in reliance upon the exemption provided by Section 4(2) and Section 3(a)(10) of the Securities Act of 1933, as amended.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data presented below as of and for the years ended December 31, 2004, 2003, 2002, 2001, and 2000, have been derived from our audited consolidated financial statements. The selected financial data should be read in conjunction with "Item 7
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
As a multi-bank financial holding company, we generate most of our revenue from interest on loans and investments, trust fees, and service charges. Our primary source of funding for our loans are deposits we hold in our subsidiary banks. Our largest expenses are interest on these deposits and salaries and related employee benefits. We usually measure our performance by calculating our return on average assets, return on average equity, our regulatory leverage and risk based capital ratios, and our efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax equivalent basis and noninterest income.
You should read the following discussion and analysis of the major elements of our consolidated balance sheets as of December 31, 2004 and 2003, and consolidated statements of earnings for the years 2002 through 2004 in conjunction with our consolidated financial statements, accompanying notes, and selected financial data presented elsewhere in this Form 10-K. All prices and per share data related to our common stock have been adjusted to give effect to all stock splits and stock dividends, including the five-for-four stock split in the form of a 25% stock dividend effective June 2, 2003 for shareholders of record on May 16, 2003.
Critical Accounting Policies
We prepare consolidated financial statements based on the selection of certain accounting policies, generally accepted accounting principles and customary practices in the banking industry. These policies, in certain areas, require us to make significant estimates and assumptions.
We deem a policy critical if (1) the accounting estimate required us to make assumptions about matters that are highly uncertain at the time we make the accounting estimate; and (2) different estimates that reasonably could have been used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the financial statements.
The following discussion addresses our allowance for loan loss and its provision for loan losses, which we deem to be our most critical accounting policy. We have other significant accounting policies and continue to evaluate the materiality of their impact on our consolidated financial statements, but we believe these other policies either do not generally require us to make estimates and judgments that are difficult or subjective, or it is less likely they would have a material impact on our reported results for a given period.
The allowance for loan losses is an amount we believe will be adequate to absorb inherent estimated losses on existing loans in which full collectibility is unlikely based upon our review and evaluation of the loan portfolio, including letters of credit, lines of credit and unused commitments to provide financing. The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries).
Our periodic evaluation of the adequacy of the allowance is based on general economic conditions, the financial condition of the borrower, the value and liquidity of collateral, delinquency, prior loan loss experience, and the results of periodic reviews of the portfolio by our independent loan review department and regulatory examiners. We have developed a consistent, well-documented loan review methodology that includes allowances assigned to specific loans and nonspecific allowances, which are based on the factors noted above. While each subsidiary bank is responsible for the adequacy of its allowance, our independent loan review department is responsible for reviewing this evaluation for all of our subsidiary banks to ensure consistent methodology and overall adequacy for us.
Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A downturn in the economy and employment could result in increased levels of nonperforming assets and charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of their examination process, bank regulatory agencies periodically review our
allowance for loan losses. The bank regulatory agencies could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination.
Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, the borrower's financial condition is such that collection of interest is doubtful.
Our policy requires measurement of the allowance for an impaired collateral dependent loan based on the fair value of the collateral. Other loan impairments are measured based on the present value of expected future cash flows or the loan's observable market price.
Results of Operations
Performance Summary. Net earnings for 2004 were $39.2 million, an increase of $3.9 million, or 11.0% over net earnings for 2003 of $35.3 million. Net earnings for 2002 were $34.0 million. The increase in net earnings for 2004 over 2003 was primarily attributable to growth in net interest income and in noninterest income. The increase in net earnings for 2003 over 2002 was primarily attributable to growth in noninterest income and a decline in the provision for loan losses. The improvement in loan loss provision experienced in 2003 over 2002 was due to decreases in net charge-offs and nonperforming loans.
On a basic net earnings per share basis, net earnings were $2.53 for 2004 as compared to $2.28 for 2003 and $2.20 for 2002. Return on average assets was 1.82% for 2004 as compared to 1.75% for 2003 and 1.78% for 2002. Return on average equity was 15.09% for 2004 as compared to 14.40% for 2003 and 14.97% for 2002.
Acquisitions. On March 4, 2004, we entered into a stock purchase agreement with the principal shareholders of Liberty National Bank, Granbury, Texas. On July 26, 2004 the transaction was completed. Pursuant to the purchase agreement, the Company paid approximately $12.3 million for all of the outstanding shares of Liberty National Bank. At closing, Liberty National Bank became a direct subsidiary of First Financial Bankshares of Delaware, Inc., our wholly owned Delaware bank holding company and, effective November 1, 2004, it was merged with our wholly owned bank subsidiary, First Financial Bank, National Association, Stephenville. The total purchase price exceeded the estimated fair value of tangible net assets acquired by approximately $7.5 million, of which approximately $359,000 was assigned to an identifiable intangible asset with the balance recorded by the Company as goodwill. See Note 17 to the Consolidated Financial Statements for additional information.
On September 7, 2004, we entered into a stock purchase agreement with the shareholders of Southwestern Bancshares, Inc., the parent Company of The First National Bank, Glen Rose, Texas. On December 1, 2004, the transaction was completed. Pursuant to the purchase agreement, the Company paid approximately $13.4 million for all outstanding shares of Southwestern Bancshares, Inc. At closing, Southwestern Bancshares and The First National Bank, Glen Rose, were merged into our wholly-owned bank subsidiary, First Financial Bank, National Association, Stephenville. The total purchase price exceeded the estimated fair value of tangible net assets acquired by approximately $8.7 million, of which approximately $433,000 was assigned to an identifiable intangible asset with the balance recorded by the Company as goodwill. See Note 17 to the Consolidated Financial Statements for additional information.
On October 25, 2004, we entered into a stock purchase agreement with the shareholders of Clyde Financial Corporation, the parent company of The Peoples State Bank in Clyde, Texas. On February 1, 2005, the transaction was completed. Pursuant to the purchase agreement, we paid approximately $25.4 million for all outstanding shares of Clyde Financial Corporation.
Net Interest Income. Net interest income is the difference between interest income on earning assets and interest expense on liabilities incurred to fund those assets. Our earning assets consist primarily of loans and investment securities. Our liabilities to fund those assets consist primarily of noninterest-bearing and interest-bearing deposits. Tax-equivalent net interest income was $88.9 million in 2004 as compared to $82.3 million in 2003 and $83.6 million in 2002. The increase in 2004 compared to 2003 was the result of improving net interest spreads and increases in the volume of earning assets. The decrease in 2003 compared to 2002 was the result of declining net interest spreads offset by increases in volume of earning assets. Average earning assets
were $1.979 billion in 2004, as compared to $1.856 billion in 2003 and $1.748 billion in 2002. The 2004 increase in average earning assets is attributable to our acquisitions and strong loan growth. The 2003 increase in average earning assets was attributable to a larger volume of investment securities, which increased $118.1 million, and higher average loans. Table 1 allocates the change in tax-equivalent net interest income between the amount of change attributable to volume and to rate.
Table 1 -- Changes in Interest Income and Interest Expense (in thousands):
The net interest margin, which measures tax-equivalent net interest income as a percentage of average earning assets, is illustrated in Table 2 for the years 2002 through 2004. As the prime rate increased from 4.00% to 5.25% in 2004, we repriced our earning assets and raised rates on interest bearing deposits accordingly as the market allowed or required which resulted in a slightly higher net interest margin. While rates increased 125 basis points in 2004, the increase did not begin until July 2004 and in 25 basis point increments and as a result overall, interest rates had a negative effect on our interest margins until the latter part of 2004. In 2003, as the prime rate declined from 4.25% to 4.00%, we repriced our earning assets correspondingly as the market required but were unable to reduce interest bearing deposit rates by the same amounts as some deposits had been previously reduced to the lowest rates we believed the market would bear. This resulted in a lower net interest margin in 2003.
Table 2 -- Average Balances and Average Yields and Rates (in thousands, except percentages):
Noninterest Income. Noninterest income for 2004 was $38.8 million, an increase of $4.7 million, or 13.8%, as compared to 2003. The increase is primarily attributable to an increase in (1) service charges on deposits of $4.7 million as a result of our enhanced overdraft protection product, (2) gain on sale of student loans of $696 thousand resulting from sales of $80 million in student loans in 2004 versus $70 million in 2003 and (3) securities gains of $363 thousand from sales of securities to provide necessary liquidity for our acquisitions. These increases were partially offset by (1) a $941 thousand decrease in mortgage origination fees as rates rose and refinancing activity significantly declined and (2) nonrecurring other real estate sales in 2003.
Noninterest income for 2003 was $34.1 million, an increase of $4.0 million, or 13.2%, as compared to 2002. The increase resulted primarily from (1) an increase in real estate mortgage fees of $1.1 million from a continued high volume of mortgage originations and refinancing transactions generated by low mortgage rates; (2) an increase in the gain from sale of student loans of $1.1 million resulting from increased fees received from the sale, (3) an increase in the gain on sale of other real estate of $736 thousand, primarily from the sale of two properties, (4) an increase of $415 thousand in ATM transaction fees which reflects our effort to increase the cardholder base and the usage of check cards; and (5) an increase of $176 thousand in check printing fees.
Table 3 provides comparisons for other categories of noninterest income.
Table 3 -- Noninterest Income (in thousands):
Noninterest Expense. Total noninterest expense for 2004 was $66.1 million, an increase of $5.0 million, or 8.1%, as compared to 2003. Noninterest expense for 2003 amounted to $61.2 million, an increase of $2.1 million or 3.5% as compared to 2002. An important measure in determining whether a banking company effectively manages noninterest expenses is the efficiency ratio, which is calculated by dividing noninterest expense by the sum of net interest income on a tax-equivalent basis and noninterest income. Lower ratios indicate better efficiency since more income is generated with a lower noninterest expense total. Our efficiency ratio for 2004 was 51.78% compared to 52.52% for 2003, and 51.96% for 2002.
Salaries and employee benefits for 2004 totaled $35.5 million, an increase of $2.2 million, or 6.5%, as compared to 2003. Salaries for 2004 were up $1.6 million with the increase attributable to normal pay increases and a higher number of full time equivalent employees due to our acquisitions. Medical and other benefits decreased $190 thousand in 2004 from 2003 due primarily to lower claims experience in the Company's self insured health plan. Profit sharing expense for 2004 increased $1.3 million, due to the overall percentage increase in net income for 2004 over 2003. Pension expense was $1.3 million less in 2004 than in 2003 as a result of our freezing the pension plan effective January 1, 2004, whereby no additional service costs will accrue in the future (unless the plan is reinstated). This decrease is partially offset by the cost of our matching of employee deferrals into our 401(k) plan, which amounted to $708 thousand in 2004. Effective January 1, 2004, we began matching a maximum of 4% on employee deferrals of 5% of their compensation.
Net occupancy expense for 2004 was up $255 thousand from the prior year, principally due to higher utility costs, which reflect the current energy market, and higher real estate taxes. Equipment expense was up $664 thousand in 2004 over 2003. Equipment depreciation expense was $691 thousand more in 2004 than in 2003 as a result of our continued investment in our technology infrastructure and our expansion. Intangible asset amortization resulting from the core deposit intangibles related to our acquisitions increased by $27 thousand in connection with the acquisitions by our Stephenville subsidiary. Data processing and operations fees decreased $635 thousand due to our terminating a third party data processing contract for item processing services for our eastern banks and bringing those services in house as a part of our technology company. Costs associated with these services are included in salaries and employee benefits and equipment expense in 2004. Our ATM expenses were $262 thousand more in 2004 than in 2003, primarily due to increased debit card usage by our customers. Other professional fees in 2004 were $500 thousand more than in 2003, principally due to costs associated with our enhanced overdraft protection products and information technology consulting. Telephone expense was $137 thousand more in 2004 than in 2003 as a result of upgrading our voice and data network infrastructure. Operational losses were $604 thousand more in 2004 than in 2003; this increase is attributable to the increase in
charge offs in our enhanced overdraft product, which was also largely responsible for the $4.7 million increase in service fees on deposit accounts.
Salaries and employee benefits for 2003 totaled $33.3 million, an increase of $1.4 million, or 4.2%, as compared to 2002. Salaries for 2003 were up $1.5 million with the increase attributable to normal pay increases and a higher number of full time equivalent employees. Medical and other benefits increased $688 thousand in 2003 over 2002 due primarily to adverse claims experience in the Company's self insured health plan. Profit sharing expenses for 2003 decreased $1.2 million, as compared to the prior year, due to a lower percentage increase in net income for 2003 over 2002. Pension expense for 2003 increased $196 thousand, or 16.7%, over 2002 primarily from the increased amortization of unrecognized net loss on plan assets.
Net occupancy expense and equipment expense for 2003 was virtually unchanged from the prior year. Intangible asset amortization resulting from the core deposit intangible from the Mineral Wells acquisition was the same for 2003 and 2002. Other professional and service fees increased by $340 thousand in 2003 as compared to 2002, primarily as a result of a consulting agreement with Mr. Ken Murphy, the chairman of our board of directors, and fees paid for information technology consulting.
Table 4 -- Noninterest Expense (in thousands):
Income Taxes. Income tax expense was $15.8 million for 2004 as compared to $14.6 million for 2003 and $14.6 million for 2002. Our effective tax rates on pretax income were 28.7%, 29.3% and 30.1%, respectively, for the years 2004, 2003 and 2002. The decreases in the effective tax rates are a result of an increase in interest earned on tax exempt securities and the deductibility of dividends paid to our employee stock ownership plan implemented effective July 1, 2003.
Balance Sheet Review
Loans. Our portfolio is comprised of loans made to businesses, individuals, and farm and ranch operations located in the primary trade areas served by our subsidiary banks. Real estate loans represent loans primarily for new home construction and owner-occupied real estate. The structure of loans in the real estate mortgage classification generally provides repricing intervals to minimize the interest rate risk inherent in long-term fixed rate mortgage loans. As of December 31, 2004, total loans were $1,164.2 million, an increase of $176.7 million, as compared to December 31, 2003. As compared to year-end 2003, real estate loans increased $138.1 million and commercial, financial and agriculture loans increased $51.4 million. Consumer loans as of year-end 2004 decreased $12.7 million as compared to 2003 due primarily to increased competition from zero/low interest rates on automobile loans. Loans averaged $1,044.0 million during 2004, an increase of $97.8 million over the prior year average.
Table 5 -- Composition of Loans (in thousands):
Table 6 -- Maturity Distribution and Interest Sensitivity of Loans at December 31, 2004 (in thousands):
The following tables summarize maturity and yield information for the commercial, financial, and agricultural and the real estate-construction portion of our loan portfolio as of December 31, 2004:
Maturities After One Year ------------ Loans with fixed interest rates.................... $ 67,973 Loans with floating or adjustable interest rates... 63,683 ------------ $ 131,656
Asset Quality. Loan portfolios of each of our subsidiary banks are subject to periodic reviews by our centralized independent loan review group as well as periodic examinations by state and federal bank regulatory agencies. Loans are placed on nonaccrual status when, in the judgment of management, the collectibility of principal or interest under the original terms becomes doubtful. Nonperforming assets, which consist of nonperforming loans and foreclosed assets, were $5.0 million at December 31, 2004, as compared to $3.2 million at December 31, 2003 and $4.3 million at December 31, 2002. As a percent of loans and foreclosed assets, nonperforming assets were 0.43% at December 31, 2004, as compared to 0.32% at December 31, 2003 and 0.44% at December 31, 2002.
The increase in nonperforming assets is primarily due to our Granbury and Glen Rose bank acquisitions. We consider the level of nonperforming assets to be manageable and are not aware of any material classified credit not properly disclosed as nonperforming at December 31, 2004.
Table 7 -- Nonperforming Assets (in thousands, except percentages):
We record interest payments received on impaired loans as interest income unless collections of the remaining recorded investment are doubtful, at which time we record payments received as reductions of principal. We recognized interest income on impaired loans of approximately $127,000, $46,000 and $111,000 during the years ended December 31, 2004, 2003, and 2002, respectively, of which approximately $1,000, $4,000 and $2,000 represented cash interest payments received and recorded as interest income. If interest on impaired loans had been recognized on a full accrual basis during the years ended December 31, 2004, 2003, and 2002, respectively, such income would have approximated $320,000, $207,000 and $317,000.
Provision and Allowance for Loan Losses. The allowance for loan losses is the amount we determine as of a specific date to be adequate to provide for losses on loans that we deem are uncollectible. We determine the allowance and the required provision expense by reviewing general loss experiences and the performances of specific credits. The provision for loan losses was $1.6 million for 2004 as compared to $1.2 million for 2003 and $2.4 million for 2002. The increase in 2004 over 2003 in our provision was due to overall loan growth and changes to individual loan grades. As a percent of average loans, net loan charge-offs were 0.12% during 2004, 0.09% during 2003 and 0.19% during 2002. The allowance for loan losses as a percent of loans was 1.19% as of December 31, 2004, as compared to 1.17% as of December 31, 2003. The growth in our allowance for loan losses at December 31, 2004 compared to December 31, 2003 was a result of the reasons noted above for the growth in our provision and from our acquisitions of the Granbury and Glen Rose banks. A key indicator of the adequacy of the allowance for loan losses is the ratio of the allowance to nonperforming loans, which consist of nonaccrual loans, loans past due 90 days, and restructured loans. This ratio for the past five years is disclosed in Table 7. Table 9 provides an allocation of the allowance for loan losses based on loan type and the percent of total loans that each major loan type represents. Other than the loan types presented in Table 9, we had no loan concentration at December 31, 2004 that represented more than 10% of total loans.
Although we believe we use the best information available to make loan loss allowance determinations, future adjustments could be necessary if circumstances or economic conditions differ substantially from the assumptions used in making our initial determinations. A downturn in the economy and employment could result in increased levels of nonperforming assets and charge-offs, increased loan loss provisions and reductions in income. Additionally, as an integral part of their examination process, bank regulatory agencies periodically review our allowance for loan losses. The banking agencies could require the recognition of additions to the loan loss allowance based on their judgment of information available to them at the time of their examination.
Table 8 -- Loan Loss Experience and Allowance for Loan Losses (in thousands, except percentages):
Table 9 -- Allocation of Allowance for Loan Losses (in thousands):
Percent of Total Loans:
Certain loans classified for regulatory purposes as doubtful, substandard, or special mention are included in the nonperforming asset table. Also included in classified loans are certain other loans that are deemed to be potential problems. Potential problem loans are those loans that are currently performing but where known information about trends or uncertainties or possible credit problems of the borrowers causes management to have serious doubts as to the ability of such borrowers to comply with present repayment terms, possibly resulting in the transfer of such loans to nonperforming status. These potential problem loans totaled $3.7 million as of December 31, 2004.
Investment Securities. Investment securities totaled $854.3 million as of December 31, 2004, as compared to $910.3 million at December 31, 2003 and $772.3 million at December 31, 2002. At December 31, 2004, securities with an amortized cost of $90.1 million were classified as securities held-to-maturity and securities with a market value of $764.3 million were classified as securities available-for-sale. As compared to December 31, 2003, the overall portfolio at
December 31, 2004, reflected (1) a decrease of $14.8 million in U.S. Treasury securities and obligations of U.S. government sponsored-enterprises and agencies; (2) a decrease of $6.8 million in obligations of states and political subdivisions; (3) a $12.0 million decrease in corporate bonds and other securities; and (4) a $22.4 million decrease in mortgage-backed securities. These declines were due to maturities that were not reinvested but, rather, used to fund loan growth. As compared to December 31, 2002, the portfolio at December 31, 2003 reflected (1) an increase of $54.7 million in U.S. Treasury securities and obligations of U.S. government sponsored-enterprises and agencies; (2) an increase of $55.7 million in obligations of states and political subdivisions; (3) a $12.7 million decrease in corporate bonds and other securities; and (4) a $40.5 million increase in mortgage-backed securities. The overall portfolio yield of 4.7% at the end of 2004 was down from the prior year-end yield of 4.9% due to lower average interest rates. We did not hold any high risk collateralized mortgage obligations or structured notes as of December 31, 2004. See Note 2 to the Consolidated Financial Statements for additional disclosures relating to the maturities and fair values of the investment portfolio at December 31, 2004 and 2003.
Table 10 -- Composition of Investment Securities (dollars in thousands):
Table 11 -- Maturities and Yields of Investment Securities Held at December 31, 2004 (in thousands, except percentages):
All yields are computed on a tax-equivalent basis assuming a marginal tax rate of 35%. Maturities of mortgage-backed securities are based on contractual maturities and could differ due to prepayments of underlying mortgages.
Table 12 -- Disclosure of Investment Securities with Continuous Unrealized Loss
The following table discloses, as of December 31, 2004, our investment securities that have been in a continuous unrealized-loss position for less than 12 months and those that have been in a continuous unrealized-loss position for 12 or more months (in thousands):
We believe the investment securities in the table above are within ranges customary for the banking industry. The number of investment positions in this unrealized loss position totals 355. We do not believe these unrealized losses are "other than temporary" as (1) the Company has the ability and intent to hold the investments to maturity, or a period of time sufficient to allow for a recovery in market value, (2) it is not probable that the Company will be unable to collect the amounts contractually due and (3) no decision to dispose of the investments were made prior to the balance sheet date. The unrealized losses noted are interest rate related due to rising short-term and intermediate interest rates at December 31, 2004, in relation to previous rates. The duration of these investments is less than 5 years for all securities other than the municipal bonds, which is less than 15 years. We have not identified any issues related to the ultimate repayment of principal as a result of credit concerns on these securities.
The Emerging Issues Task Force (EITF) has issued EITF #03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," that could effect in the future how the Company accounts for unrealized losses on its available-for-sale securities. As issued, EITF #03-1 was to be effective September 30, 2004 but was delayed while certain implementation issues are clarified. The Company continues to monitor the provisions of EITF #03-1 but to date does not believe implementation will have a significant effect on the Company's results of operations or financial condition, although the Company in the future may be restricted somewhat in its sale of its available-for-sale securities as an asset/liability and liquidity management tool.
Deposits. Deposits held by subsidiary banks represent our primary source of funding. Total deposits were $1.994 billion as of December 31, 2004, as compared to $1.796 billion as of December 31, 2003 and $1.712 billion as of December 31, 2002. Table 13 provides a breakdown of average deposits and rates paid over the past three years and the remaining maturity of time deposits of $100,000 or more.
Table 13 -- Composition of Average Deposits and Remaining Maturity of Time Deposits of $100,000 or More (in thousands, except percentages):
December 31, 2004 ----------------- Three months or less............................... $ 122,110 Over three through six months...................... 62,670 Over six through twelve months..................... 50,873 Over twelve months................................. 44,829 --------- Total time deposits of $100,000 or more.......... $ 280,482 =========
Capital Resources
We assess capital resources by our ability to maintain adequate regulatory capital ratios to do business in the banking industry. Issues related to capital resources arise primarily when we are growing at an accelerated rate but not retaining a significant amount of our profits or when we experience significant asset quality deterioration.
By way of background, total shareholders' equity was $265.5 million, or 11.47% of total assets, at December 31, 2004, as compared to $251.5 million, or 12.02% of total assets, at December 31, 2003. During 2004, total shareholders' equity averaged $259.5 million, or 12.08% of average assets, as compared to $245.1 million, or 12.13% of average assets, during 2003.
Banking regulators measure capital adequacy by means of the risk-based capital ratio and leverage ratio. The risk-based capital rules provide for the weighting of assets and off-balance-sheet commitments and contingencies according to prescribed risk categories ranging from 0% to 100%. Regulatory capital is then divided by risk-weighted assets to determine the risk-adjusted capital ratios. The leverage ratio is computed by dividing shareholders' equity less intangible assets by quarter-to-date average assets less intangible assets. Regulatory minimums for risk-based and leverage ratios are 8.00% and 3.00%, respectively. As of December 31, 2004, our total risk-based and leverage ratios were 17.49% and 9.80%, respectively, as compared to total risk-based and leverage ratios of 19.83% and 10.60% as of December 31, 2003. The decline in these ratios is due to the accounting for intangible assets from our Granbury and Glen Rose bank acquisitions in 2004. We believe by all measurements our capital ratios remain well above regulatory minimums.
Interest Rate Risk. Interest rate risk results when the maturity or repricing intervals of interest-earning assets and interest-bearing liabilities are different. Our exposure to interest rate risk is managed primarily through our strategy of selecting the types and terms of interest-earning assets and interest-bearing liabilities that generate favorable earnings while limiting the potential negative effects of changes in market interest rates. We use no off-balance-sheet financial instruments to manage interest rate risk.
Each of our subsidiary banks has an asset liability committee that monitors interest rate risk and compliance with investment policies; there is also a holding company-wide committee that monitors the aggregate company's interest rate risk and compliance with investment policies. Each subsidiary bank tracks interest rate risk by, among other things, interest-sensitivity gap and simulation analysis. Table 14 sets forth the interest rate sensitivity of our consolidated assets and liabilities as of December 31, 2004, and sets forth the repricing dates of our consolidated interest-earning assets and interest-bearing liabilities as of that date, as well as our projected consolidated interest rate sensitivity gap percentages for the periods presented. The table is based on our estimates and assumptions as to when assets and liabilities will reprice in a changing interest rate environment. Assets and liabilities indicated as maturing or otherwise repricing within a stated period may, in fact, mature or reprice at different times and at different volumes than those estimated. Also, the renewal or repricing of certain assets and liabilities can be discretionary and subject to competitive and other pressures. Therefore, the following table does not, and cannot, necessarily indicate the actual future impact of general interest rate movements on our consolidated net interest income.
Should we be unable to maintain a reasonable balance of maturities and repricing of our interest-earning assets and our interest-bearing liabilities, we could be required to dispose of our assets in an unfavorable manner or pay a higher than market rate to fund our activities. Our asset liability committees oversee and monitor this risk.
Table 14 -- Interest Sensitivity Analysis (in thousands, except percentages):
As of December 31, 2003, our 2004 interest-sensitivity gap was $587.7 million and our 2004 ratio of interest sensitive assets to interest sensitive liabilities was 54.69%.
We estimate that, as of December 31, 2004, an upward shift of interest rates by 150 basis points would result in a 3.69% increase in projected net interest income over the next twelve months, and a downward shift of interest rates by 150 basis points would result in a 9.11% reduction in projected net interest income over the next twelve months. These are good faith estimates and assume that the composition of our interest sensitive assets and liabilities existing at each year-end will remain constant over the relevant twelve month measurement period and that changes in market interest rates are instantaneous and sustained across the yield curve regardless of duration of pricing characteristics of specific assets or liabilities. Also, this analysis does not contemplate any actions that we might undertake in response to changes in market interest rates. We believe, these estimates are not necessarily indicative of what actually could occur in the event of immediate interest rate increases or decreases of this magnitude. We also believe that it is unlikely that such changes would occur in a short time period. As interest-bearing assets and liabilities reprice at different time frames and proportions to market interest rate movements, various assumptions must be made based on historical relationships of these variables in reaching any conclusion. Since these correlations are based on competitive and market conditions we anticipate that our future results will likely be different from the foregoing estimates, and such differences could be material.
Liquidity
Liquidity is our ability to meet cash demands as they arise. Such needs can develop from loan demand, deposit withdrawals or acquisition opportunities. Potential obligations resulting from the issuance of standby letters of credit and commitments to fund future borrowings to our loan customers are other factors affecting our liquidity needs. Many of these obligations and commitments are expected to expire without being drawn upon; therefore the total commitment amounts do not necessarily represent future cash requirements affecting our liquidity position. The potential need for liquidity arising from these types of financial instruments is represented by the contractual notional amount of the instrument, as detailed in Tables 15 and 16. Asset liquidity is provided by cash and assets, which are readily marketable or which will mature in the near future. Liquid assets include cash, federal funds sold, and short-term investments in time deposits in banks. Liquidity is also provided by access to funding sources, which include core depositors and correspondent banks that maintain accounts with and sell federal funds to our subsidiary banks. Other sources of funds include our ability to borrow from short-term sources, such as purchasing federal funds from correspondents and sales of securities under agreements to repurchase, which amounted to $35.7 million at December 31, 2004, and an unfunded $50.0 million line of credit established with a nonaffiliated bank which matures on December 31, 2005.
On December 31, 2004, the Company entered into a loan agreement with The Frost National Bank, pursuant to which the Company is permitted to draw up to $50.0 million on a revolving line of credit. Interest is paid quarterly at LIBOR plus 100 basis points. If a balance exists at December 31, 2005, the principal balance coverts to a term facility payable quarterly over five years. The line of credit is unsecured for an outstanding balance equal to or under $25.0 million and secured by the stock of a subsidiary bank should the balance exceed $25.0 million. Among other provisions in the credit agreement, the Company must satisfy certain financial covenants during the term of the loan agreement, including without limitation, covenants that require the Company to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, that among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. The Company has historically declared dividends as a percentage of its consolidated net income in a range of 37% in 1995 to 53% in 2003. Although the agreement was executed on December 31, 2004, the Company has not borrowed any funds through the date of this report.
Given the strong core deposit base and relatively low loan to deposit ratios maintained at our subsidiary banks, we consider our current liquidity position to be adequate to meet our short- and long-term liquidity needs.
In addition, we anticipate that any future acquisition of financial institutions and expansion of branch locations could also place a demand on our cash resources. Available cash at our parent company, which totaled $31.0 million at December 31, 2004, available dividends from subsidiary banks which totaled $13.1 million at December 31, 2004, utilization of available lines of credit, and future debt or equity offerings are expected to be the source of funding for these potential acquisitions or expansions. - Table 15 -- Contractual Obligations As of December 31, 2004 (in thousands):
Amounts above for deposits do not include related accrued interest.
On February 1, 2005, we completed the acquisition of Clyde Financial Corporation, the parent company of The Peoples State Bank, Clyde, Texas for $25.4 million.
Off-Balance Sheet Arrangements. We are a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include unfunded lines of credit commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in our consolidated balance sheets.
Our exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. We generally use the same credit policies in making commitments and conditional obligations as we do for on-balance-sheet instruments.
Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, as we deem necessary upon extension of credit, is based on our credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment and income-producing commercial properties.
Standby letters of credit are conditional commitments we issue to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount.
Table 16 - Commitments As of December 31, 2004 (in thousands):
We believe we have no other off-balance sheet arrangements or transactions with unconsolidated, special purpose entities that would expose us to liability that is not reflected on the face of the financial statements.
Parent Company Funding. Our ability to fund various operating expenses, dividends, and cash acquisitions is generally dependent solely on our own earnings (without giving effect to our subsidiaries), cash reserves and funds derived from our subsidiary banks. These funds historically have been produced by intercompany dividends and management fees that are limited to reimbursement of actual expenses. We anticipate that our recurring cash sources will continue to include dividends and management fees from our subsidiary banks. At December 31, 2004, approximately $13.1 million was available for the payment of intercompany dividends by the subsidiary banks without the prior approval of regulatory agencies. Our subsidiary banks paid aggregate dividends of $37.4 million in 2004 and $34.6 million in 2003.
On December 31, 2004, the Company entered into a loan agreement with The Frost National Bank, pursuant to which the Company is permitted to draw up to $50.0 million on a revolving line of credit. Interest is paid quarterly at LIBOR plus 100 basis points and the line of credit matures December 31, 2005. If a balance exists at December 31, 2005, the principal balance coverts to a term facility payable quarterly over five years. The line of credit is unsecured for an outstanding balance equal to or under $25.0 million and secured by the stock of a subsidiary bank should the balance exceed $25.0 million. Among other
provisions in the credit agreement, the Company must satisfy certain financial covenants during the term of the loan agreement, including without limitation, covenants that require the Company to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, that among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrence of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. The Company has historically declared dividends as a percentage of its consolidated net income in a range of 37% in 1995 to 53% in 2003. Although the agreement was executed on December 31, 2004, the Company has not borrowed any funds through the date of this report
Dividends. Our long-term dividend policy is to pay cash dividends to our shareholders of between 40% and 55% of net earnings while maintaining adequate capital to support growth. The cash dividend payout ratios have amounted to 52.6%, 53.1% and 49.1% of net earnings, respectively, in 2004, 2003 and 2002. Given our current strong capital position and projected earnings and asset growth rates, we do not anticipate any significant change in our current dividend policy. Also see "Payments of Dividends" on page 6.
Each state bank that is a member of the Federal Reserve System and each national banking association is required by federal law to obtain the prior approval of the Federal Reserve Board and the OCC, respectively, to declare and pay dividends if the total of all dividends declared in any calendar year would exceed the total of (1) such bank's net profits (as defined and interpreted by regulation) for that year plus (2) its retained net profits (as defined and interpreted by regulation) for the preceding two calendar years, less any required transfers to surplus. In addition, these banks may only pay dividends to the extent that retained net profits (including the portion transferred to surplus) exceed bad debts (as defined by regulation).
To pay dividends, we and our subsidiary banks must maintain adequate capital above regulatory guidelines. In addition, if the applicable regulatory authority believes that a bank under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice (which, depending on the financial condition of the bank, could include the payment of dividends), the authority may require, after notice and hearing, that such bank cease and desist from the unsafe practice. The Federal Reserve Board and the OCC have each indicated that paying dividends that deplete a bank's capital base to an inadequate level would be an unsafe and unsound banking practice. The Federal Reserve Board, the OCC and the FDIC have issued policy statements that recommend that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our management considers interest rate risk to be a significant market risk for us. See "Item 7 - -Management's Discussion and Analysis of Financial Condition and Results of Operations--Balance Sheet Review--Interest Rate Risk" for disclosure regarding this market risk.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our consolidated financial statements begin on page.
Quarterly Results of Operations (in thousands, except per share and common stock data):
The following tables set forth certain unaudited historical quarterly financial data for each of the eight consecutive quarters in fiscal 2004 and 2003. This information is derived from unaudited consolidated financial statements that include, in our opinion, all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation when read in conjunction with our consolidated financial statements and notes thereto included elsewhere in this Form 10-K. All prices and per share data related to our common stock have been adjusted to give effect to all stock splits and stock dividends, including the five-for-four stock split in the form of a 25% stock dividend effective June 2, 2003 for shareholders of record on May 16, 2003.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
As of December 31, 2004, we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Securities Exchange Act Rule 15d-15. Our management, including the principal executive officer and principal financial officer, does not expect that our disclosure controls and procedures will prevent all errors and all fraud.
A control system, no matter how well conceived and operated, can provide only reasonable not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. Our principal executive officer and principal financial officer have concluded, based on our evaluation of our disclosure controls and procedures, that our disclosure controls and procedures under Rule 13a-14 (c) and Rule 15d-14 (c) of the Securities Exchange Act of 1934 are effective at the reasonable assurance level as of December 31, 2004.
During the last fiscal quarter and subsequent to our evaluation, there were no significant changes in internal controls or other factors that could significantly affect these internal controls.
MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANICAL REPORTING
The Management of First Financial Bankshares, Inc. and subsidiaries is responsible for establishing and maintaining adequate internal control over financial reporting. First Financial Bankshares, Inc. and subsidiaries' internal control system was designed to provide reasonable assurance to the Company's management and board of directors regarding the preparation and fair presentation of published financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
First Financial Bankshares, Inc. and subsidiaries' management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2004. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on our assessment we believe that, as of December 31, 2004, the Company's internal control over financial reporting, as such term is defined in Exchange Act Rule 13a-15(f), is effective based on those criteria.
First Financial Bankshares, Inc. and subsidiaries' independent auditors have issued an audit report, dated February 22, 2005, on our assessment of the Company's internal control over financial reporting. This report appears on page.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 is hereby incorporated by reference from our proxy statement for our 2005 annual meeting of shareholders.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is hereby incorporated by reference from our 2005 proxy statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 related to security ownership of certain beneficial owners and management is hereby incorporated by reference from our 2005 proxy statement. The following chart gives aggregate information under our equity compensation plans as of December 31, 2004.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is hereby incorporated by reference from our 2005 proxy statement.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by Item 14 is hereby incorporated by reference from our 2005 proxy statement.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this report:
(1) Financial Statements - Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting Consolidated Balance Sheets as of December 31, 2004 and 2003 Consolidated Statements of Earnings for the years ended December 31, 2004, 2003 and 2002 Consolidated Statements of Comprehensive Earnings for the years ended December 31, 2004, 2003 and 2002 Consolidated Statements of Shareholders' Equity for the years ended December 31, 2004, 2003 and 2002 Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002 Notes to the Consolidated Financial Statements
(2) Financial Statement Schedules - These schedules have been omitted because they are not required, are not applicable or have been included in our consolidated financial statements.
(3) Exhibits - The information required by this Item 15(a)(3) is set forth in the Exhibit Index immediately following our signature pages. The exhibits listed herein will be furnished upon written request to J. Bruce Hildebrand, Executive Vice President, First Financial Bankshares, Inc., 400 Pine Street, Abilene, Texas 79601, and payment of a reasonable fee that will be limited to our reasonable expense in furnishing such exhibits.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
FIRST FINANCIAL BANKSHARES, INC.
Date: March 4, 2005 By: /s/ F. SCOTT DUESER ----------------------------------------------- F. SCOTT DUESER President, Chief Executive Officer and Director
The undersigned directors and officers of First Financial Bankshares, Inc. hereby constitute and appoint J. Bruce Hildebrand, with full power to act and with full power of substitution and resubstitution, our true and lawful attorney-in-fact with full power to execute in our name and behalf in the capacities indicated below any and all amendments to this report and to file the same, with all exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission and hereby ratify and confirm all that such attorney-in-fact or his substitute shall lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Item 6. Exhibits
(a) The following exhibits are filed as part of this report:
3.1 -- Articles of Incorporation, and all amendments thereto, of the Registrant (incorporated by reference from Exhibit 1 of the Registrant's Amendment No. 2 to Form 8-A filed on Form 8-A/A No. 2 on November 21, 1995).
3.2 -- Amended and Restated Bylaws, and all amendments thereto, of the Registrant (incorporated by reference from Exhibit 2 of the Registrant's Amendment No. 1 to Form 8-A filed on Form 8-A/A No. 1 on January 7, 1994).
3.3 -- Amendment to the Articles of Incorporation of the Registrant dated April 27, 2004 (incorporated by reference from Exhibit 3.3 of the Registrant's Form 10-Q Quarterly Report for the quarter ended March 31, 2004).
3.4 -- Amendment to Amended and Restated Bylaws of the Registrant dated April 27, 1994 (incorporated by reference from Exhibit 3.4 of the Registrant's Form 10-Q Quarterly Report for the quarter ended March 31, 2004).
3.5 -- Amendment to Amended and Restated Bylaws of the Registrant, dated October 23, 2001 (incorporated by reference from Exhibit 3.5 of the Registrant's Form 10-Q Quarterly Report for the quarter ended March 31 2004).
4.1 -- Specimen certificate of First Financial Common Stock incorporated by reference from Exhibit 3 of the Registrant's Amendment No. 1 to Form 8-A filed on Form 8-A/A No. 1 on January 7, 1994).
10.1 -- Deferred Compensation Agreement, dated October 28, 1992, between the Registrant and Kenneth T. Murphy (incorporated by reference from Exhibit 10.1 of the Registrant's Form 10-K Annual Report for the year ended December 31, 2002).
10.2 -- Revised Deferred Compensation Agreement, dated December 28, 1995, between the Registrant and Kenneth T. Murphy (incorporated by reference from Exhibit 10.2 of the Registrant's Form 10-K Annual Report for the year ended December 31, 2002).
10.3 -- Executive Recognition Plan(incorporated by reference from Exhibit 10.3 of the Registrant's Form 10-K Annual Report for year ended December 31, 2002).
10.4 -- Form of Executive Recognition Agreement(incorporated by reference from Exhibit 10.4 of the Registrant's Form 10-K Annual Report for the year ended December 31, 2002).
10.5 -- 1992 Incentive Stock Option Plan (incorporated by reference from Exhibit 10.5 of the Registrant's Form 10-K Annual Report for the fiscal year ended December 31, 1998).
10.6 -- 2002 Incentive Stock Option Plan (incorporated by reference from Appendix A of the Registrant's Schedule 14a Definitive Proxy Statement for the 2002 Annual Meeting of Shareholders)
*10.7 -- Revised Consulting Agreement dated January 1, 2005 between the Registrant and Kenneth T. Murphy.
*21.1 -- Subsidiaries of the Registrant.
23.1 -- Consent of Ernst & Young LLP.
24.1 -- Power of Attorney (included on signature page of this Form 10-K).
*31.1 -- Rule 13a-14(a) / 15(d)-14(a) Certification of Chief Executive Officer of First Financial Bankshares, Inc.
*31.2 -- Rule 13a-14(a) / 15(d)-14(a) Certification of Chief Financial Officer of First Financial Bankshares, Inc.
*32.1 -- Section 1350 Certification of Chief Executive Officer of First Financial Bankshares, Inc.
*32.2 -- Section 1350 Certification of Chief Financial Officer of First Financial Bankshares, Inc.
------------- *Filed herewith
Exhibit 10.7 ------------
CONSULTING AGREEMENT
This Consulting Agreement (the "Agreement") is made and entered into as of the 1st day of January, 2005 (the "Effective Date"), by and between FIRST FINANCIAL BANKSHARES, INC. (the "Company"), and KENNETH T. MURPHY ("Murphy").
WITNESSETH:
WHEREAS, following December 31, 2002, Murphy retired as an officer of the Company, and served in a consulting capacity during the calendar years 2003 and 2004; and
WHEREAS, the Company recognizes the experience, leadership, knowledge and relationships of Murphy continue to be of great value to the Company and its Shareholders; and
WHEREAS, the Company desires to retain Murphy's services as a consultant to: (i) participate in the identification and evaluation of prospects for acquisition or merger with the Company or a subsidiary of the Company; (ii) negotiate with potential sellers and recommend terms and conditions of such transaction(s); (iii) be accessible to the executive management of the Company for advice as to opportunities for growth and expansion, to review planning decisions, to build relationships and develop strategies which are intended to enhance the business interests of the Company for the benefit of its Shareholders (the "Services"); and
WHEREAS, Murphy is willing to provide the Services to the Company; and
WHEREAS, the parties desire to enter into this Agreement in a spirit of mutual respect, congeniality, and a desire to work together in harmony for the continued success of the Company;
NOW, THEREFORE, for and in consideration of the premises and of the mutual representation, warranties, covenants and agreements contained herein, and of other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, and upon the terms and subject to the conditions hereinafter set forth, the parties, intending to be legally bound, hereby agree as follows:
1. Duties and Term of Consultancy. The Company hereby engages Murphy, and Murphy hereby accepts engagement, as a consultant to provide the Services as reasonably requested by the Company. The term of this Agreement shall commence on the Effective Date and continue for a period of twelve (12) months ending on December 31, 2005.
2. Commitment of Time. No specific time requirement shall be a part of this Agreement. Rather, Murphy shall be reasonably available during the term of this Agreement, whether it be in his office or by telephone conference, to provide the Services as requested by the Company.
3. Means to Perform Services. Murphy shall be provided the necessary means for the performance of the Services, including an office and secretarial support, use of the Company's aircraft for travel related to the provision of the Services, use of membership in Abilene Country Club, and membership(s) in appropriate state and national banking organizations as determined by the Company.
4. Compensation for Services. As compensation for the Services rendered under this Agreement, the Company shall pay Murphy a fee of $5,000.00 per month and shall reimburse Murphy for his reasonable business expenses incurred in the provision of the Services.
5. Termination. Either party hereto may terminate this Agreement without cause upon thirty (30) days written notice to the other party. In the event of termination of this Agreement prior to December 31, 2005, the Company shall pay Murphy the amount earned through the date of termination. This Agreement and the obligations of the Company shall terminate in the event of the death of Murphy as of the date of death.
Consulting Agreement
IN WITNESS WHEREOF, the parties hereto have signed this Agreement to take effect as of January 1, 2005.
FIRST FINANCIAL BANKSHARES, INC.
By: /s/ F. Scott Dueser -------------------
Name: F. Scott Dueser
Title: President and Chief Executive Officer
"Company"
/s/ Kenneth T. Murphy --------------------- KENNETH T. MURPHY
"Murphy"
Exhibit 21.1 ------------
SUBSIDIARIES OF REGISTRANT
Exhibit 23.1 ------------
Consent of Independent Registered Public Accounting Firm
We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 333-114121) pertaining to the 2002 Incentive Stock Option Plan and 1992 Incentive Stock Option Plan for Key Employees of First Financial Bankshares, Inc. and its Subsidiaries of our reports dated February 22, 2005, with respect to the consolidated financial statements of First Financial Bankshares, Inc., First Financial Bankshares, Inc.'s management's assessment of the effectiveness of internal control over financial reporting, and the effectiveness of internal control over financial reporting of First Financial Bankshares, Inc. included in this Annual Report (Form 10-K) for the year ended December 31, 2004.
/s/Ernst & Young LLP
Dallas, Texas March 4, 2005
Exhibit 31.1 ------------
Certification of Chief Executive Officer of First Financial Bankshares, Inc.
I, F. Scott Dueser, President and Chief Executive Officer of First Financial Bankshares, Inc., certify that:
1. I have reviewed this Form 10-K of First Financial Bankshares, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15 (e) and 15d-15(e)) for the registrant and have:
a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;
c. Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectives of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d. Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting; and
Date: March 4, 2005
By: /s/ F. SCOTT DUESER -------------------------------------------- F. Scott Dueser President and Chief Executive Officer
Exhibit 31.2 ------------
Certification of Chief Financial Officer of First Financial Bankshares, Inc.
I, J. Bruce Hildebrand, Executive Vice President and Chief Financial Officer of First Financial Bankshares, Inc., certify that:
1. I have reviewed this Form 10-K of First Financial Bankshares, Inc.;
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for the periods presented in this report;
4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15 (e) and 15d-15(e)) for the registrant and have:
a. Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b. Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;
c. Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectives of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d. Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions):
a. All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
b. Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting; and
Date: March 4, 2005
By: /s/ J. Bruce Hildebrand ----------------------------------- J. Bruce Hildebrand Executive Vice President and Chief Financial Officer
Exhibit 32.1 ------------
Certification of Chief Executive Officer of First Financial Bankshares, Inc.
This certification is provided pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States code) and accompanies the annual report on Form 10-K (the "Form 10-K") for the year ended December 31, 2004 of First Financial Bankshares, Inc.
I, F. Scott Dueser, the President and Chief Executive Officer of the Issuer certify that:
1. the Form 10-K fully complies with the requirements of section 13(a) or section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)); and
2. the information contained in the Form 10-K fairly presents, in all material respects, the financial condition and results of operations of the Company.
Dated: March 4, 2005
By: /s/ F. SCOTT DUESER ------------------- F. Scott Dueser Chief Executive Officer
Subscribed and sworn to before me this 4th of March 2005.
/s/ Gaila N. Kilpatrick Gaila N. Kilpatrick Notary Public
My commission expires: April 15, 2005
Exhibit 32.2 ------------
Certification of Chief Financial Officer of First Financial Bankshares, Inc.
This certification is provided pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States code) and accompanies the annual report on Form 10-K (the "Form 10-K") for the year ended December 31, 2004 of First Financial Bankshares, Inc.
I, J. Bruce Hildebrand, the Executive Vice President and Chief Financial Officer of the Issuer certify that:
1. the Form 10-K fully complies with the requirements of section 13(a) or section 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)); and
2. the information contained in the Form 10-K fairly presents, in all material respects, the financial condition and results of operations of the Company.
Dated: March 4, 2005
By: /s/ J. Bruce Hildebrand ----------------------- J. Bruce Hildebrand Chief Financial Officer
Subscribed and sworn to before me this 4th of March 2005.
/s/ Gaila N. Kilpatrick Gaila N. Kilpatrick Notary Public
My commission expires: April 15, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of First Financial Bankshares, Inc.
We have audited the accompanying consolidated balance sheets of First Financial Bankshares, Inc. (a Texas corporation) and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of earnings, comprehensive earnings, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2004. 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 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 audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of First Financial Bankshares, Inc. and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U. S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of First Financial Bankshares, Inc.'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 February 22, 2005, expressed an unqualified opinion thereon.
Ernst & Young LLP
Dallas, Texas February 22, 2005
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING
To the Board of Directors and Shareholders of First Financial Bankshares, Inc.
We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting, that First Financial Bankshares, Inc. 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 COSO criteria). First Financial Bankshares, Inc.'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. 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 First Financial Bankshares, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, First Financial Bankshares, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2004 financial statements of First Financial Bankshares, Inc. and our report dated February 22, 2005 expressed an unqualified opinion thereon.
Ernst & Young LLP
Dallas, Texas February 22, 2005
FIRST FINANCIAL BANKSHARES, INC. AND SUBSIDIARIES Consolidated Balance Sheets December 31, 2004 and 2003
FIRST FINANCIAL BANKSHARES, INC. AND SUBSIDIARIES Consolidated Statements of Earnings Years Ended December 31, 2004, 2003 and 2002
FIRST FINANCIAL BANKSHARES, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Earnings Years Ended December 31, 2004, 2003 and 2002
The accompanying notes are an integral part of these consolidated financial statements.
FIRST FINANCIAL BANKSHARES, INC. AND SUBSIDIARIES Consolidated Statements of Shareholders' Equity Years Ended December 31, 2004, 2003 and 2002
The accompanying notes are an integral part of these consolidated financial statements.
FIRST FINANCIAL BANKSHARES, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows Years Ended December 31, 2004, 2003 and 2002
The accompanying notes are an integral part of these consolidated financial statements.
FIRST FINANCIAL BANKSHARES, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements December 31, 2004, 2003 and 2002
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: -------------------------------------------
Nature of Operations - --------------------
First Financial Bankshares, Inc. (a Texas corporation) ("Bankshares") is a financial holding company which owns (through its wholly-owned Delaware subsidiary) all of the capital stock of ten banks located in Texas as of December 31, 2004. Those subsidiary banks are First Financial Bank, National Association, Abilene; Hereford State Bank; First National Bank, Sweetwater; First Financial Bank, National Association, Eastland; First Financial Bank, National Association, Cleburne; First Financial Bank, National Association, Stephenville; San Angelo National Bank; Weatherford National Bank; First Financial Bank, National Association, Southlake and City National Bank, Mineral Wells. Each subsidiary bank's primary source of revenue is providing loans and banking services to consumers and commercial customers in the market area in which the subsidiary is located. In addition, the Company owns First Financial Trust & Asset Management Company, National Association and First Technology Services, Inc., an information technology subsidiary.
A summary of significant accounting policies of Bankshares and subsidiaries (collectively, the "Company") applied in the preparation of the accompanying consolidated financial statements follows. The accounting principles followed by the Company and the methods of applying them are in conformity with both accounting principles generally accepted in the United States and prevailing practices of the banking industry.
Stock Split - -----------
All prices and per share data related to our common stock have been adjusted to give effect to all stock splits and stock dividends, including the five-for-four stock split in the form of a 25% stock dividend effective June 2, 2003 for shareholders of record on May 16, 2003.
Use of Estimates in Preparation of Financial Statements - -------------------------------------------------------
The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 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 in the near term relate to the determination of the allowance for loan losses, the valuations of foreclosed real estate, deferred income tax assets, and the fair value of financial instruments.
Consolidation - -------------
The accompanying consolidated financial statements include the accounts of Bankshares and its subsidiaries, all of which are wholly-owned. All significant intercompany accounts and transactions have been eliminated.
Investment Securities - ---------------------
Management classifies debt and equity securities as held-to-maturity, available-for-sale, or trading based on its intent. Debt securities that management has the positive intent and ability to hold to maturity are classified as held-to-maturity and recorded at cost, adjusted for amortization of premiums and accretion of discounts, which are recognized as adjustments to interest income using the interest method. Securities not classified as held-to-maturity or trading are classified as available-for-sale and recorded at estimated fair value, adjusted for amortization of premiums and accretion of discounts, with unrealized gains and losses, net of deferred income taxes, excluded from earnings and reported in a separate component of shareholders' equity. Available for-sale securities that have unrealized losses that are judged other than temporary are included in gain (loss) on sale of securities and a new cost basis is established. Securities classified as trading are recorded at estimated fair value, with unrealized gains and losses included in earnings. The Company had no trading securities at December 31, 2004, 2003, or 2002.
Loans and Allowance for Loan Losses - -----------------------------------
Loans are stated at the amount of unpaid principal, reduced by unearned income and an allowance for loan losses. Interest on loans is calculated by using the simple interest method on daily balances of the principal amounts outstanding. Beginning in 2004 the Company defers and amortizes net loan origination costs as an adjustment to yield. Prior to 2004, the Company expensed its net loan origination costs, a method which did not materially differ from deferring and amortizing such amounts as an adjustment to yield. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes the collectibility of the principal is unlikely.
The allowance is an amount management believes will be adequate to absorb estimated inherent losses on existing loans that are deemed uncollectible based upon management's review and evaluation of the loan portfolio. The allowance is comprised of specific reserves for impaired loans and an estimate of losses inherent in the portfolio at the balance sheet date, but not yet identified with specific loans. The allowance for loan losses is increased by charges to income and decreased by charge-offs (net of recoveries). Management's periodic evaluation of the adequacy of the allowance is based on general economic conditions, the financial condition of borrowers, the value and liquidity of collateral, delinquency, prior loan loss experience, and the results of periodic reviews of the portfolio. For purposes of determining our general allocations, all loans, other than consumer, are segregated by credit grades which are assigned an allocation percentage. Our methodology is constructed so that specific allocations are increased in accordance with deterioration in credit quality and a corresponding increase in risk of loss. In addition, we adjust our allowance for qualitative factors such as national, state and local economic conditions, changes in trends in delinquencies or non-accruals, deterioration in concentration of credit and results of independent and regulatory loan review. This additional allocation based on qualitative factors serves to compensate for additional areas of uncertainty inherent in our portfolio. Accrual of interest is discontinued on a loan when management believes, after considering economic and business conditions and collection efforts, the borrower's financial condition is such that collection of interest is doubtful. Generally all loans past due greater than 90 days are placed on non-accrual.
The Company's policy requires measurement of the allowance for an impaired collateral dependent loan based on the fair value of the collateral. Other loan impairments are measured based on the present value of expected future cash flows or the loan's observable market price. At December 31, 2004 and 2003, all significant impaired loans have been determined to be collateral dependent and the allowance for loss has been measured utilizing the estimated fair value of the collateral.
Other Real Estate - -----------------
Other real estate is foreclosed property held pending disposition and is valued at the lower of its fair value, less estimated costs to sell, or the recorded investment in the related loan. At foreclosure, if the fair value, less estimated costs to sell, of the real estate acquired is less than the Company's recorded investment in the related loan, a write-down is recognized through a charge to the allowance for loan losses. Any subsequent reduction in value is recognized by a charge to income. Operating expenses of such properties, net of related income, and gains and losses on their disposition are included in noninterest expense.
Bank Premises and Equipment - ---------------------------
Bank premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed principally on a straight-line basis over the estimated useful lives of the related assets. Leasehold improvements are amortized over the life of the respective lease or the estimated useful lives of the improvements, whichever is shorter.
Business Combinations, Goodwill and Other Intangible Assets - -----------------------------------------------------------
The Company accounts for all business combinations under the purchase method of accounting. Tangible and intangible assets and liabilities of the acquired entity are recorded at fair value on the purchase date. Intangible assets with finite useful lives continue to be amortized and goodwill and intangible assets with indefinite lives are not amortized, but rather tested annually for impairment.
Other identifiable intangible assets recorded by the Company represent the future benefit associated with the acquisition of the core deposits and are being amortized over seven years, utilizing a method that approximates the expected attrition of the deposits.
Goodwill arising from acquisitions that qualify as an asset purchase for federal income tax purposes amounting to approximately $28,000,000 and $13,000,000, respectively, at December 31, 2004 and 2003, is deductible for federal income tax purposes.
Securities Sold Under Agreements To Repurchase - ----------------------------------------------
Securities sold under agreements to repurchase, which are classified as secured borrowings, generally mature within one to four days from the transaction date. Securities sold under agreements to repurchase are reflected at the amount of the cash received in connection with the transaction. The Company may be required to provide additional collateral based on the estimated fair value of the underlying securities.
Segment Reporting - -----------------
The Company has determined that it operates one line of business (community banking) located in a single geographic area (Texas).
Statements of Cash Flows - ------------------------
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, and federal funds sold.
Accounting for Income Taxes - ---------------------------
The Company's provision for income taxes is based on income before income taxes adjusted for permanent differences between financial reporting and taxable income. Deferred tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.
Stock Based Compensation - ------------------------
The Company grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. The Company accounts for stock option grants using the intrinsic value method prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25"). Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Had compensation cost for the plan been determined consistent with Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation," the Company's net earnings and earnings per share would have been reduced by insignificant amounts on a pro forma basis for the years ended December 31, 2004, 2003 and 2002. Note 15 provides additional information on the Company's stock option plan.
In December 2004, SFAS No. 123R, "Share-Based Payment," was issued. SFAS No. 123R requires companies to recognize in the statement of earnings the grant-date fair value of stock options issued to employees. The statement is effective for the third quarter of 2005 and, due to the low volume of stock options granted
and outstanding, is not expected to have a significant effect on the Company's earnings. The Company expects to utilize the modified prospective method for transition to the new rules whereby grants after June 30, 2005 will be measured and accounted for under SFAS No. 123R as well as unvested awards granted prior to June 30, 2005.
Stock Repurchase - ----------------
On April 22, 2003, the Company's Board of Directors authorized the repurchase of up to 500,000 shares of common stock over the next three years. The plan authorizes management to repurchase the stock at such time as repurchases are considered beneficial to stockholders. Any repurchases of the stock will be through the open market or in privately negotiated transactions in accordance with applicable laws and regulations. No stock has been repurchased under this plan as of December 31, 2004.
Per Share Data - --------------
Net earnings per share ("EPS") are computed by dividing net earnings by the weighted average number of shares of common stock outstanding during the period. The Company calculates dilutive EPS assuming all outstanding options to purchase common stock have been exercised at the beginning of the year (or the time of issuance, if later.) The dilutive effect of the outstanding options is reflected by application of the treasury stock method, whereby the proceeds from the exercised options are assumed to be used to purchase common stock at the average market price during the period. The following table reconciles the computation of basic EPS to dilutive EPS:
New Accounting Pronouncement - ----------------------------
Statement of Position 03-3, "Accounting for Certain Loans or Debt Securities Acquired in a Transfer" was issued in December 2003 and is effective for 2005 and prohibits "carrying over" of an allowance for loan losses in the initial accounting for all loans acquired in a transaction. As such, loans acquired in a business combination must generally be recorded net of the difference between the contractual cash flows over the cash flows expected to be collected. The Company will apply the provisions of this SOP in conjunction with its acquisition of Clyde Financial Corporation completed on February 1, 2005. The Company expects that implementation of this SOP will change the balance sheet presentation of loans acquired but will not have a significant impact on the Company's results of operations.
Reclassifications - -----------------
Certain 2003 and 2002 amounts have been reclassified to conform to the 2004 presentation.
2. CASH AND INVESTMENT SECURITIES: -------------------------------
The amortized cost, estimated fair values, and gross unrealized gains and losses of the Company's investment securities as of December 31, 2004 and 2003, are as follows:
The Company invests in mortgage-backed securities that have expected maturities that differ from their contractual maturities. These differences arise because borrowers may have the right to call or prepay obligations with or without a prepayment penalty. These securities include collateralized mortgage obligations (CMOs) and other asset backed securities. The expected maturities of these securities at December 31, 2004 and 2003, were computed by using scheduled amortization of balances and historical prepayment rates. At December 31, 2004 and 2003, the Company did not hold any CMOs that entail higher risks than standard mortgage-backed securities.
The amortized cost and estimated fair value of debt securities at December 31, 2004, by contractual and expected maturity, are shown below.
The following table discloses, as of December 31, 2004, the Company's investment securities that have been in a continuous unrealized-loss position for less than 12 months and those that have been in a continuous unrealized-loss position for 12 or more months (in thousands):
We believe the investment securities in the table above are within ranges customary for the banking industry. The number of investment positions in this unrealized loss position totals 355. We do not believe these unrealized losses are "other than temporary" as (1) the Company has the ability and intent to hold the investments to maturity, or a period of time sufficient to allow for a recovery in market value, (2) it is not probable that the Company will be unable to collect the amounts contractually due and (3) no decision to dispose of the investment were made prior to the balance sheet date. The unrealized losses noted are interest rate related due to rising short-term and intermediate interest rates at December 31, 2004, in relation to previous rates. The duration of these investments is less than 5 years for all securities other than the municipal bonds, which is less than 15 years. We have not identified any issues related to the ultimate repayment of principal as a result of credit concerns on these securities.
The Emerging Issues Task Force (EITF) has issued EITF #03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments," that could effect in the future how the Company accounts for unrealized losses on its available-for-sale securities. As issued, EITF #03-1 was to be effective September 30, 2004 but was delayed while certain implementation issues are clarified. The Company continues to monitor the provisions of EITF #03-1 but to date does not believe implementation will have a significant effect on the Company's results of operations or financial condition, although the Company in the future may be restricted somewhat in its sale of its available-for-sale securities as an asset/liability and liquidity management tool.
Securities, carried at approximately $304,917,000 and $275,342,000 at December 31, 2004 and 2003, respectively, were pledged as collateral for public or trust fund deposits and for other purposes required or permitted by law.
During 2004, 2003, and 2002 sales of investment securities that were classified as available-for-sale totaled approximately $22,591,000 $50,617,000, and $30,077,000 respectively. Gross realized gains from sales in 2004 were
approximately $388,000. There were no sales at losses during 2004. Gross realized gains and losses from 2003 sales were approximately $296,000 and $271,000, respectively. Gross realized gains and losses from 2002 sales were approximately $24,000 and $8,000, respectively. The specific identification method was used to determine cost in computing the realized gains and losses.
Certain subsidiary banks are required to maintain reserve balances with the Federal Reserve Bank. During 2004 and 2003, such average balances totaled approximately $8,298,000 and $15,727,000, respectively.
3. LOANS AND ALLOWANCE FOR LOAN LOSSES: ------------------------------------
Major classifications of loans are as follows:
December 31, -------------------------------- 2004 2003 -------------- --------------
Commercial, financial, and agricultural $385,193,304 $333,840,269
Real estate - construction 107,148,495 77,833,890
Real estate - mortgage 494,524,409 385,770,437
Consumer 177,357,173 190,078,507 -------------- -------------- Total loans $1,164,223,381 $ 987,523,103 ============== ==============
Included in real estate-mortgage and consumer loans above are $2.6 million and $32.4 million, respectively, in loans held for sale at December 31, 2004 and $2.6 million and $53.6 million in loans held for sale at December 31, 2003 in which the carrying amount approximates market.
The Company's recorded investment in impaired loans and the related valuation allowance are as follows:
December 31, 2004 December 31, 2003 -------------------------- ------------------------- Recorded Valuation Recorded Valuation Investment Allowance Investment Allowance ---------- ---------- ---------- ---------- $4,174,317 $ 941,989 $1,741,278 $ 332,927 ========== ========== ========== ==========
The average recorded investment in impaired loans for the years ended December 31, 2004 and 2003, was approximately $2,958,000 and $2,738,000, respectively. The Company had approximately $5,041,000 and $3,171,000 in nonperforming assets at December 31, 2004 and 2003, respectively. No additional funds are committed to be advanced in connection with impaired loans.
Interest payments received on impaired loans are recorded as interest income unless collections of the remaining recorded investment are doubtful, at which time payments received are recorded as reductions of principal. The Company recognized interest income on impaired loans of approximately $127,000, $46,000 and $111,000 during the years ended December 31, 2004, 2003, and 2002, respectively, of which approximately $1,000, $4,000 and $2,000 represented cash interest payments received and recorded as interest income. If interest on impaired loans had been recognized on a full accrual basis during the years ended December 31, 2004, 2003, and 2002, respectively, such income would have approximated $320,000, $207,000 and $317,000.
The allowance for loan losses as of December 31, 2004 and 2003, is presented below. Management has evaluated the adequacy of the allowance for loan losses by estimating the losses in various categories of the loan portfolio which are identified below:
Changes in the allowance for loan losses are summarized as follows:
An analysis of the changes in loans to officers, directors, principal shareholders, or associates of such persons for the years ended December 31, 2004 and 2003 (determined as of each respective year-end) follows:
In the opinion of management, those loans are on substantially the same terms, including interest rates and collateral requirements, as those prevailing at the time for comparable transactions with unaffiliated persons.
4. BANK PREMISES AND EQUIPMENT: ----------------------------
The following is a summary of bank premises and equipment:
Depreciation expense for the years ended December 31, 2004, 2003 and 2002 amounted to $4,859,912, $4,168,411, and $4,284,473, respectively and is included in the captions net occupancy expense and equipment expense in the accompanying consolidated statements of earnings.
The Company is lessor for portions of its banking premises. Total rental income for all leases included in net occupancy expense is approximately $1,630,000, $1,605,000 and $1,578,000, for the years ended December 31, 2004, 2003, and 2002, respectively.
5. TIME DEPOSITS - ----------------
Time deposits of $100,000 or more totaled approximately $280,482,000 and $220,067,000 at December 31, 2004 and 2003, respectively. Interest expense on these deposits was approximately $4,500,000, $4,885,000, and $5,694,000 during 2004, 2003, and 2002, respectively.
At December 31, 2004, the scheduled maturities of time deposits (in thousands) were, as follows:
Year ending December 31, ------------------------ 2005 $486,589 2006 72,104 2007 20,941 2008 7,650 2009 12,946 Thereafter 1,304 -------- $601,534 ========
6. LINE OF CREDIT --------------
Effective December 31, 2004, the Company renewed its line of credit with a nonaffiliated bank under which it can borrow up to $50,000,000. The line of credit is unsecured for balances less than $25 million and secured by stock of a subsidiary bank if amounts borrowed exceed $25 million. The line of credit matures on December 31, 2005. The Company paid no fee to secure the unused line of credit and, accordingly, did not estimate a fair value of the unused line of credit at December 31, 2004 or 2003. The line of credit carries an interest rate of the London Interbank Offering Rate plus 1.0%. If a balance exists at December 31, 2005, the principal balance converts to a term facility payable quarterly over five years. The line of credit is unsecured for an outstanding balance
equal to or under $25.0 million and secured by the stock of a subsidiary bank should the balance exceed $25.0 million. Among other provisions in the credit agreement, the Company must satisfy certain financial covenants during the term of the loan agreement, including without limitation, covenants that require the Company to maintain certain capital, tangible net worth, loan loss reserve, non-performing asset and cash flow coverage ratios. In addition, the credit agreement contains certain operational covenants, that among others, restricts the payment of dividends above 55% of consolidated net income, limits the incurrent of debt (excluding any amounts acquired in an acquisition) and prohibits the disposal of assets except in the ordinary course of business. Management believes the Company was in compliance with the financial covenants at December 31, 2004. There was no outstanding balance under the line of credit as of December 31, 2004 or 2003.
7. INCOME TAXES: -------------
The Company files a consolidated federal income tax return. Income tax expense is comprised of the following:
Income tax expense, as a percentage of pretax earnings, differs from the statutory federal income tax rate as follows:
The approximate effects of each type of difference that gave rise to the Company's deferred tax assets and liabilities at December 31, 2004 and 2003 are as follows:
8. FAIR VALUE OF FINANCIAL INSTRUMENTS: ------------------------------------
The Company is required to disclose the estimated fair value of its financial instrument assets and liabilities. For the Company, as for most financial institutions, substantially all of its assets and liabilities are considered financial instruments as defined. Many of the Company's financial instruments, however, lack an available trading market as characterized by a willing buyer and willing seller engaging in an exchange transaction.
Estimated fair values have been determined by the Company using the best available data, as generally provided in the Company's regulatory reports, and an estimation methodology suitable for each category of financial instruments. For those loans and deposits with floating interest rates, it is presumed that estimated fair values generally approximate the carrying value.
The estimated fair values and carrying values at December 31, 2004 and 2003, were as follows:
Financial instruments actively traded in a secondary market have been valued using quoted available market prices. Financial instruments with stated maturities have been valued using a present value discounted cash flow with a discount rate approximating current market for similar assets and liabilities. Financial instrument assets with variable rates and financial instrument liabilities with no stated maturities have an estimated fair value equal to both the amount payable on demand and the carrying value. Changes in assumptions or estimation methodologies may have a material effect on these estimated fair values.
The Company's remaining assets and liabilities, which are not considered financial instruments, have not been valued differently than customary with historical cost accounting.
The carrying value and the estimated fair value of the Company's contractual off-balance-sheet unfunded lines of credit, loan commitments and letters of credit, which are generally priced at market at the time of funding, are not material.
Reasonable comparability between financial institutions may not be likely due to the wide range of permitted valuation techniques and numerous estimates which must be made given the absence of active secondary markets for many of the financial instruments. This lack of uniform valuation methodologies also introduces a greater degree of subjectivity to these estimated fair values.
9. COMMITMENTS AND CONTINGENCIES: ------------------------------
The Company is engaged in legal actions arising from the normal course of business. In management's opinion, the Company has adequate legal defenses with respect to these actions, and the resolution of these matters will have no material adverse effects upon the results of operations or financial condition of the Company.
The Company leases a portion of its bank premises and equipment under operating leases. At December 31, 2004, future minimum lease commitments were: 2005 - $511,000; 2006 - $483,000; 2007 - $253,000; 2008 - $84,000; 2009 - $61,000 and thereafter - $19,000.
10. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK: --------------------------------------------------
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include unfunded lines of credit, commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for unfunded lines of credit, commitments to extend credit and standby letters of credit is represented by the contractual notional amount of these instruments. The Company generally uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Contract or Notional Amount at December 31, 2004 ------------ Financial instruments whose contract amounts represent credit risk: Unfunded lines of credit $150,062,518 Unfunded commitments to extend credit 81,383,121 Standby letters of credit 10,651,460 ------------ $242,097,099 ============ Unfunded lines of credit and commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. These commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management's credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant, and equipment, livestock, and income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The average collateral value held on letters of credit usually exceeds the contract amount.
The Company has no other off-balance sheet arrangements or transactions that would expose the Company to liability that is not reflected on the face of the financial statements.
11. CONCENTRATION OF CREDIT RISK: -----------------------------
The Company grants commercial, retail, agriculture, and residential loans to customers primarily in North Central and West Texas. Although the Company has a diversified loan portfolio, a substantial portion of its debtors' ability to honor their contracts is dependent upon this local economic sector.
12. PENSION AND PROFIT SHARING PLANS: ---------------------------------
The Company's defined benefit pension plan was frozen effective January 1, 2004 whereby no additional years of service will accrue to participants, unless the pension plan is reinstated at a future date. The pension plan covered substantially all of the Company's employees. The benefits were based on years of service and a percentage of the employee's qualifying compensation during the final years of employment. The Company's funding policy was and is to contribute annually the amount necessary to satisfy the Internal Revenue Service's funding standards. Contributions to the pension plan through December 31, 2003 were intended to provide not only for benefits attributed to service to date but also for those expected to be earned in the future. As a result of freezing the pension plan, we do not expect contributions or pension expense to be significant in future years.
Using an actuarial measurement date of September 30, benefit obligation activity and fair value of plan assets for the years ended December 31, 2004 and 2003, and a statement of the funded status as of December 31, 2004 and 2003 are as follows:
The Company recorded an additional minimum liability in the year ended December 31, 2004 and 2003 to reflect the underfunded status of the plan. The accrued pension liability at December 31, 2004 and 2003 represents the difference between the fair value of plan assets and the accumulated benefit obligation. The accumulated benefit obligation is the actuarial present value of benefits attributed by the pension benefit formula to employee service rendered prior to that date and based on current and past compensation levels. The accumulated benefit obligation differs from the projected benefit obligation in that it assumes no increase in future compensation. As the plan was frozen effective in 2004, the projected benefit obligation and the accumulated benefit obligation are the same.
Net periodic pension cost for the years ended December 31, 2004, 2003, and 2002, included:
The following table sets forth the rates used in the actuarial calculations of the present value of benefit obligations and net periodic pension cost and the rate of return on plan assets:
The expected long-term rate of return on plan assets is based on historical returns and expectations of future returns based on asset mix, after consultation with our investment advisors and actuaries. In 2002, the expected long-term rate of return was downwardly adjusted to 6.5% to reflect the declining equity markets. In 2003, the expected long-term rate of return was returned to 8.5% based on our estimate of changes to the markets in which our investments reside after consultation with our investment advisors and actuaries. The expected long-term rate of return was adjusted to 7.75% for 2004 after discussions with our actuaries and investment advisors and taking into account the impact on investment strategies from the plan being frozen.
The major type of plan assets in the pension plan and the targeted allocation percentage as of December 31, 2004 and 2003 is as follows:
The range and weighted average maturities of debt securities held in the pension plan as of December 31, 2004 are 5 months to 14 years and approximately 5.3 years, respectively.
First Financial Trust & Asset Management Company, National Association, a wholly owned subsidiary of the Company, manages the pension plan assets as well as the profit sharing plan assets (see below). The investment strategy and targeted allocations are based on similar strategies First Financial Trust & Asset
Management Company, National Association employs for most of its managed accounts whereby appropriate diversification is achieved. First Financial Trust & Asset Management Company, National Association is prohibited from high risk investments, including the use of derivatives.
An estimate of the undiscounted projected future payments to eligible participants for the next five years and the following five years in the aggregate is as follows (dollars in thousands):
Year Ending December 31, ------------------------ 2005 $ 962 2006 990 2007 1,070 2008 1,152 2009 1,163 2010 and thereafter 6,990
No contribution was made to the pension plan in 2004 and no contribution, either discretionary or by regulation, is expected in 2005.
As of December 31, 2004 and 2003, the pension plan's assets included Company common stock valued at approximately $690,000 and $634,000, respectively.
The Company also provides a profit sharing plan, which covers substantially all full-time employees. The profit sharing plan is a defined contribution plan and allows employees to contribute up to 5% of their base annual salary. Employees are fully vested to the extent of their contributions and become fully vested in the Company's contributions over a seven-year vesting period. Costs related to the Company's defined contribution plan totaled approximately $2,737,000, $1,473,000 and $2,681,000 in 2004, 2003 and 2002, respectively, and are included in salaries and employee benefits in the accompanying consolidated statements of earnings. As of December 31, 2004 and 2003, the profit sharing plan's assets included Company common stock valued at approximately $19,035,000 and $18,348,000, respectively.
In 2004, we replaced our frozen pension plan with a matching of employee salary deferrals into the 401(k) plan. Effective January 1, 2004, we match a maximum of 4% on employee deferrals of 5% of their employee compensation. Total expense for this matching in 2004 was $708,000 and is included in salaries and employee benefits in the statement of earnings.
The Company has a directors' deferred compensation plan whereby the directors may elect to defer up to 100% of their directors' fees. All deferred compensation is invested in the Company's common stock held in a rabbi trust. The stock is held in the name of the trustee, and the principal and earnings of the trust are held separate and apart from other funds of the Company, and are used exclusively for the uses and purposes of the deferred compensation agreement. The accounts of the trust have been consolidated in the financial statements of the Company.
13. DIVIDENDS FROM SUBSIDIARIES: ----------------------------
At December 31, 2004, approximately $13.1 million was available for the declaration of dividends by the Company's subsidiary banks without the prior approval of regulatory agencies.
14. REGULATORY MATTERS: -------------------
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Company's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, each of Bankshares' subsidiaries must meet specific capital guidelines that involve quantitative measures of the subsidiaries' assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The subsidiaries'
capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require Bankshares and each of its subsidiaries to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined), to average assets (as defined). Management believes as of December 31, 2004 and 2003, that Bankshares and each of its subsidiaries meet all capital adequacy requirements to which they are subject.
As of December 31, 2004 and 2003, the most recent notification from each respective subsidiaries' primary regulator categorized each of Bankshares' subsidiaries as well-capitalized, with the exception of First Financial Bank, Stephenville, under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the subsidiaries must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the following table.
There are no conditions or events since that notification that management believes have changed the institutions' categories. Bankshares' and its significant subsidiaries' actual capital amounts and ratios are presented in the table below:
The First Financial Bank, Stephenville total capital ratio at December 31, 2004 was 9.84% which is under amounts to be considered well capitalized although management believes it has adequate capital in this bank and expects this ratio to exceed 10% in the near future from earnings.
In connection with our Trust Company's application to obtain its trust charter, we are required to maintain tangible net assets of $2.0 million at all times. As of December 31, 2004, our Trust Company had tangible assets totaling $3.0 million.
15. STOCK OPTION PLAN: ------------------
The Company has an incentive stock plan to provide for the granting of options to senior management of the Company at prices not less than market at the date of grant. At December 31, 2004, the Company had allocated 702,076 shares of stock for issuance under the plan. The plan provides that options granted are exercisable after two years from date of grant at a rate of 20% each year cumulatively during the 10-year term of the option. An analysis of stock option activity for the years ended December 31, 2004, 2003, and 2002, is presented in the table and narrative below:
The options outstanding at December 31, 2004, have exercise prices between $11.92 and $30.80 with a weighted average remaining contractual life of 4.74 years. Stock options have been adjusted retroactively for the effects of stock dividends and splits.
The following table summarizes information concerning outstanding and vested stock options as of December 31, 2004:
Remaining Number Contracted Exercise Price Outstanding Life (Years) Number Vested -------------- ----------- ------------ ------------- $11.92 10,151 0.8 10,151 18.15 547 2.0 547 23.42 22,638 3.2 22,638 16.64 37,993 5.2 19,667 23.86 3,250 6.5 1,000 24.40 2,500 7.1 500 30.80 67,185 8.3 -
The Company accounts for this plan under APB 25 under which no compensation cost has been recognized for options granted. The fair value of the options granted in 2003 and 2002, was estimated using the Black-Scholes options pricing model with the following weighted-average assumptions: risk-free interest rate of 3.22% and 4.75% respectively; expected dividend yield of 3.94% and 4.43% respectively; expected life of 6.0 and 6.0 years, respectively; and expected volatility of 28.18% and 26.9%, respectively.
In January 2005, the Company granted 75,800 stock options to senior management under the terms described above. The strike price at grant date was $44.10, which was market price at date of grant.
16. CONDENSED FINANCIAL INFORMATION - PARENT COMPANY: -------------------------------------------------
Condensed Balance Sheets-December 31, 2004 and 2003 - ---------------------------------------------------
Condensed Statements of Earnings- For the Years Ended December 31, 2004, 2003, and 2002 -----------------------------------------------------
Condensed Statements of Cash Flows- For the Years Ended December 31, 2004, 2003, and 2002 -----------------------------------------------------
17. ACQUISITIONS: -------------
On March 4, 2004, we entered into a stock purchase agreement with the principal shareholders of Liberty National Bank, Granbury, Texas. On July 26, 2004 the transaction was completed. Pursuant to the purchase agreement, the Company paid approximately $12.3 million for all of the outstanding shares of Liberty National Bank. At closing, Liberty National Bank became a direct subsidiary of First Financial Bankshares of Delaware, Inc., our wholly owned Delaware bank holding company and effective November 1, 2004, it was merged with our wholly owned bank subsidiary, First Financial Bank, National Association, Stephenville. The total purchase price exceeded the estimated fair value of tangible net assets acquired by approximately $7.5 million, of which approximately $359,000 was assigned to an identifiable intangible asset with the balance recorded by the Company as goodwill. The identifiable intangible asset represents the future benefit associated with the acquisition of the core deposits and is being amortized over seven years utilizing a method that approximates the expected attrition of the deposits.
The primary purpose of the acquisition was to expand the Company's market share in areas with close proximity to Dallas/Ft. Worth, Texas. Factors that contributed to a purchase price resulting in goodwill include Liberty's historic record of earnings, capable management, the Granbury market and its geographic location, which complements the Company's existing service locations. The results of operations of Liberty National Bank are included in the consolidated earnings of the Company commencing July 27, 2004.
The following is a condensed balance sheet disclosing the preliminary estimated fair value amounts assigned to the major asset and liability captions at the acquisition date.
ASSETS
Cash and cash equivalents $ 3,763,765 Investment in securities 7,954,831 Loans, net 45,689,723 Goodwill 7,139,535 Identifiable intangible asset 359,176 Other assets 3,089,372 -----------
Total assets $67,996,402 ===========
LIABILITIES AND SHAREHOLDER'S EQUITY
Noninterest-bearing deposits $ 6,509,685 Interest-bearing deposits 46,849,196 Other liabilities 2,341,372 Shareholder's equity 12,296,149 -----------
Total liabilities and shareholder's equity $67,996,402 ===========
Goodwill recorded in the acquisition of Liberty will be accounted for in accordance with SFAS No. 142. Accordingly, goodwill will not be amortized, rather it will be tested for impairment annually. The goodwill and identifiable intangible asset recorded are expected to be deductible for federal income tax purposes.
Cash flow information relative to the acquisition of Liberty is as follows:
Fair value of assets acquired $67,996,402 Cash paid for the capital stock of Liberty 12,296,149 -----------
Liabilities assumed $55,700,253 ===========
The proforma impact of this acquisition to the Company's financial statements is insignificant.
On September 7, 2004, we entered into a stock purchase agreement with the shareholders of Southwestern Bancshares, Inc., the parent company of The First National Bank, Glen Rose, Texas. On December 1, 2004, the transaction was completed. Pursuant to the purchase agreement, the Company paid approximately $13.38 million for all of the outstanding shares of Southwestern Bancshares, Inc. At closing, Southwestern Bancshares and The First National Bank, Glen Rose, were merged into our wholly owned bank subsidiary, First Financial Bank, National Association, Stephenville. The total purchase price exceeded the estimated fair value of tangible net assets acquired by approximately $8.7 million, of which approximately $433,000 was assigned to an identifiable intangible asset with the balance recorded by the Company as goodwill. The identifiable intangible asset represents the future benefit associated with the acquisition of the core deposits and is being amortized over seven years utilizing a method that approximates the expected attrition of the deposits.
The primary purpose of the acquisition was to expand the Company's market share in areas with close proximity to Dallas/Ft. Worth, Texas. Factors that contributed to a purchase price resulting in goodwill include First National Bank, Glen Rose's historic record of earnings, capable management, the growth potential for Glen Rose and its geographic location, which complements the Company's existing service locations. The results of operations of First National Bank are included in the consolidated earnings of the Company commencing December 1, 2004.
The following is a condensed balance sheet disclosing the preliminary estimated fair value amounts assigned to the major asset and liability captions at the acquisition date.
ASSETS
Cash and cash equivalents $15,612,964 Investment in securities 2,232,328 Loans, net 29,390,798 Goodwill 8,234,680 Identifiable intangible asset 432,539 Other assets 1,302,651 -----------
Total assets $57,205,960 ===========
LIABILITIES AND SHAREHOLDER'S EQUITY
Deposits $43,253,978 Other liabilities 574,138 Shareholder's equity 13,377,844 -----------
Total liabilities and shareholder's equity $57,205,960 ===========
Goodwill recorded in the acquisition of First National Bank will be accounted for in accordance with SFAS No. 142. Accordingly, goodwill will not be amortized, rather it will be tested for impairment annually. The goodwill and identifiable intangible asset recorded are expected to be deductible for federal income tax purposes.
Cash flow information relative to the acquisition of First National Bank is as follows:
Fair value of assets acquired $57,205,960 Cash paid for the capital stock of First National Bank 13,377,844 -----------
Liabilities assumed $43,828,116 ===========
The proforma impact of this acquisition to the Company's financial statements is insignificant.
On October 25, 2004, we entered into a stock purchase agreement with the shareholders of Clyde Financial Corporation, the parent company of The Peoples State Bank in Clyde, Texas. On February 1, 2005, the transaction was completed. Pursuant to the purchase agreement, we paid approximately $25.4 million for all of the outstanding shares of Clyde Financial Corporation.
The main office of The Peoples State Bank is located in the city of Clyde, Callahan County, Texas, approximately 12 miles east of Abilene, Texas. As of December 31, 2004, The Peoples State Bank had assets totaling approximately $121 million and shareholder's equity of approximately $12.9 million. The Peoples State Bank operates branches in Ranger, Rising Star and Moran, Texas, for a total of four banking offices.
18. CASH FLOW INFORMATION: ----------------------
Supplemental information on cash flows and noncash transactions is as follows:
19. SUBSEQUENT EVENT (UNAUDITED): -----------------------------
During February 2005, the Company received $2.98 million from the special distribution of proceeds from its interest in PULSE EFT Association that merged with Discover Financial Services. This amount, net of related income tax, will be recorded into income in the financial results of the Company in the first quarter of 2005.