UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005 Commission File No. 000-22054
COMMUNITY BANKSHARES, INC.
-------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
South Carolina 57-0966962
--------------------------- ---------------------------
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
791 Broughton Street
Orangeburg, South Carolina 29115
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(Address of principal executive offices, zip code)
(803) 535-1060
--------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act).
Yes [ ] No [X]
Indicate the number of shares outstanding of each of the issuer's
classes of common stock, as of the latest practicable date: common stock, no par
or stated value, 4,404,303 shares outstanding on November 1, 2005.
COMMUNITY BANKSHARES, INC.
FORM 10-Q
Index
Page
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets .................................. 3
Consolidated Statements of Income ............................ 4
Consolidated Statements of Changes in Shareholders' Equity ... 5
Consolidated Statements of Cash Flows ........................ 6
Notes to Unaudited Consolidated Financial Statements ......... 7
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations .......... 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk ... 24
Item 4. Controls and Procedures ...................................... 24
PART II - OTHER INFORMATION
Item 6. Exhibits ..................................................... 25
SIGNATURES ................................................................ 26
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
COMMUNITY BANKSHARES, INC.
Consolidated Balance Sheets
(Unaudited)
September 30, December 31,
2005 2004
---- ----
(Dollars in thousands)
Assets
Cash and due from banks ................................................................. $ 18,239 $ 14,397
Federal funds sold ...................................................................... 23,999 12,571
--------- ---------
Total cash and cash equivalents .................................................. 42,238 26,968
Interest bearing deposits with other banks .............................................. 849 852
Securities available-for-sale ........................................................... 56,901 55,471
Securities held-to-maturity (estimated fair value $1,921 for 2005
and $1,907 for 2004) ............................................................... 1,925 1,925
Other investments ....................................................................... 2,980 2,642
Loans held for sale ..................................................................... 17,682 15,090
Loans receivable ........................................................................ 414,290 393,649
Less, allowance for loan losses ..................................................... (6,658) (4,347)
--------- ---------
Net loans ........................................................................ 407,632 389,302
Premises and equipment - net ............................................................ 8,289 7,739
Accrued interest receivable ............................................................. 2,779 2,419
Net deferred income tax assets .......................................................... 1,030 599
Goodwill ................................................................................ 4,321 4,321
Core deposit intangible assets .......................................................... 2,899 3,083
Prepaid expenses and other assets ....................................................... 2,055 1,966
--------- ---------
Total assets ..................................................................... $ 551,580 $ 512,377
========= =========
Liabilities
Deposits
Noninterest bearing ................................................................. $ 67,600 $ 67,046
Interest bearing .................................................................... 387,698 356,412
--------- ---------
Total deposits ................................................................... 455,298 423,458
Short-term borrowings ................................................................... 7,890 6,662
Long-term debt .......................................................................... 33,499 30,573
Accrued interest payable ................................................................ 1,216 691
Accrued expenses and other liabilities .................................................. 1,556 966
--------- ---------
Total liabilities ................................................................ 499,459 462,350
--------- ---------
Shareholders' equity
Common stock - no par value; 12,000,000 shares authorized; issued and
outstanding - 4,404,303 for 2005 and
4,390,784 for 2004 .................................................................. 30,202 30,042
Retained earnings ....................................................................... 22,247 20,075
Accumulated other comprehensive income (loss) ........................................... (328) (90)
--------- ---------
Total shareholders' equity ....................................................... 52,121 50,027
--------- ---------
Total liabilities and shareholders' equity ....................................... $ 551,580 $ 512,377
========= =========
See accompanying notes to unaudited consolidated financial statements.
3
COMMUNITY BANKSHARES, INC.
Consolidated Statements of Income
(Unaudited)
Period Ended September 30,
--------------------------
Three Months Nine Months
------------ -----------
2005 2004 2005 2004
---- ---- ---- ----
(Dollars in thousands, except per share)
Interest and dividend income
Loans, including fees .................................... $ 7,593 $ 5,756 $ 21,331 $ 16,536
Interest bearing deposits with other banks ............... 11 4 30 12
Debt securities .......................................... 464 434 1,333 1,339
Dividends ................................................ 35 19 93 57
Federal funds sold ....................................... 192 40 355 145
-------- -------- -------- --------
Total interest and dividend income ................... 8,295 6,253 23,142 18,089
-------- -------- -------- --------
Interest expense
Time deposits $100M and over ............................. 818 360 1,975 996
Other deposits ........................................... 1,577 958 4,146 2,772
-------- -------- -------- --------
Total deposits ....................................... 2,395 1,318 6,121 3,768
Short-term borrowings .................................... 53 76 140 245
Long-term debt ........................................... 481 363 1,387 1,046
-------- -------- -------- --------
Total interest expense ............................... 2,929 1,757 7,648 5,059
-------- -------- -------- --------
Net interest income ........................................... 5,366 4,496 15,494 13,030
Provision for loan losses ..................................... 2,300 1,648 3,335 2,139
-------- -------- -------- --------
Net interest income after provision ........................... 3,066 2,848 12,159 10,891
-------- -------- -------- --------
Noninterest income
Service charges on deposit accounts ...................... 948 841 2,563 2,508
Securities gains (losses) ................................ - 10 (10) 5
Mortgage brokerage income ................................ 1,150 835 2,881 2,487
Other .................................................... 197 163 672 626
-------- -------- -------- --------
Total noninterest income ............................. 2,295 1,849 6,106 5,626
-------- -------- -------- --------
Noninterest expenses
Salaries and employee benefits ........................... 2,550 2,123 7,162 6,459
Premises and equipment ................................... 552 508 1,637 1,471
Other .................................................... 1,347 1,195 3,994 3,403
-------- -------- -------- --------
Total noninterest expenses ........................... 4,449 3,826 12,793 11,333
-------- -------- -------- --------
Income before income taxes .................................... 912 871 5,472 5,184
Income tax expense ............................................ 330 306 1,979 1,839
-------- -------- -------- --------
Net income .................................................... $ 582 $ 565 $ 3,493 $ 3,345
======== ======== ======== ========
Per share
Net income ............................................... $ 0.13 $ 0.13 $ 0.79 $ 0.77
Net income, assuming dilution ............................ 0.13 0.12 0.78 0.74
Cash dividends declared .................................. 0.10 0.10 0.30 0.30
See accompanying notes to unaudited consolidated financial statements.
4
COMMUNITY BANKSHARES, INC.
Consolidated Statements of Changes in Shareholders' Equity
(Unaudited)
Common Stock
------------ Accumulated
Number of Retained Other Comprehensive
Shares Amount Earnings Income (Loss) Total
------ ------ -------- ------------- -----
(Dollars in thousands, except per share)
Balance, January 1, 2004 .................................. 4,331,460 $ 29,402 $ 18,610 $ 58 $ 48,070
---------
Comprehensive income:
Net income ............................................ - - 3,345 - 3,345
---------
Unrealized holding gains and losses
on available-for-sale securities arising
during the period, net of income taxes of $14 ....... - - - 25 25
Reclassification adjustment for losses (gains)
realized in income, net of income taxes of $2 ....... - - - (3) (3)
---------
Total other comprehensive income .................... - - - - 22
---------
Total comprehensive income ........................ - - - - 3,367
---------
Exercise of employee stock options ........................ 32,902 384 - - 384
Cash dividends declared, $.30 per share ................... - - (1,305) - (1,305)
--------- --------- --------- --------- ---------
Balance, September 30, 2004 ............................... 4,364,362 $ 29,786 $ 20,650 $ 80 $ 50,516
========= ========= ========= ========= =========
Balance, January 1, 2005 .................................. 4,390,784 $ 30,042 $ 20,075 $ (90) $ 50,027
---------
Comprehensive income:
Net income ............................................ - - 3,493 - 3,493
---------
Unrealized holding gains and losses
on available-for-sale securities arising
during the period, net of income taxes of $136 ...... - - - (245) (245)
Reclassification adjustment for losses (gains)
realized in income, net of income taxes of $3 ....... - - - 7 7
---------
Total other comprehensive income (loss) ............. - - - - (238)
---------
Total comprehensive income ........................ - - - - 3,255
---------
Exercise of employee stock options ........................ 12,744 146 - - 146
Sale of common stock ...................................... 775 14 - - 14
Cash dividends declared, $.30 per share ................... - - (1,321) - (1,321)
--------- --------- --------- --------- ---------
Balance, September 30, 2005 ............................... 4,404,303 $ 30,202 $ 22,247 $ (328) $ 52,121
========= ========= ========= ========= =========
See accompanying notes to unaudited consolidated financial statements.
5
COMMUNITY BANKSHARES, INC.
Consolidated Statements of Cash Flows
(Unaudited)
Nine Months Ended
September 30,
-------------
2005 2004
---- ----
(Dollars in thousands)
Operating activities
Net income .................................................................................. $ 3,493 $ 3,345
Adjustments to reconcile net income to net
cash provided by operating activities
Depreciation and amortization ........................................................ 709 676
Amortization of intangibles .......................................................... 184 184
Net amortization of securities ....................................................... 60 134
Provision for loan losses ............................................................ 3,335 2,139
Net realized losses or (gains) on sales of securities ................................ 10 (5)
Net gain realized on sale of other real estate ....................................... (24) (9)
Proceeds of sales of loans held for sale ............................................. 159,289 137,427
Originations of loans held for sale .................................................. (161,881) (140,303)
Increase in accrued interest receivable .............................................. (360) (28)
Increase in other assets ............................................................. (585) (490)
Increase in accrued interest payable ................................................. 525 157
Increase (decrease) in other liabilities ............................................. 590 (404)
--------- ---------
Net cash provided by operating activities ........................................ 5,345 2,823
--------- ---------
Investing activities
Net decrease in interest bearing deposits with other banks .................................. 3 250
Purchases of available-for-sale securities .................................................. (11,244) (24,671)
Maturities, calls and paydowns of available-for-sale securities ............................. 4,959 29,466
Proceeds of sales of available-for-sale securities .......................................... 4,412 11,613
Purchases of other investments .............................................................. (338) (2)
Net increase in loans made to customers ..................................................... (21,665) (51,515)
Purchases of premises and equipment ......................................................... (1,259) (1,158)
Proceeds from sales of other real estate .................................................... 224 136
--------- ---------
Net cash used by investing activities ............................................ (24,908) (35,881)
--------- ---------
Financing activities
Net increase in deposits .................................................................... 31,840 14,863
Net increase (decrease) in short-term borrowings ............................................ 1,228 (5,665)
Proceeds from issuing long-term debt ........................................................ 3,000 10,506
Repayments of long-term debt ................................................................ (74) (70)
Exercise of employee stock options .......................................................... 146 384
Sale of common stock ........................................................................ 14 -
Cash dividends paid ......................................................................... (1,321) (1,305)
--------- ---------
Net cash provided by financing activities ........................................ 34,833 18,713
--------- ---------
Increase (decrease) in cash and cash equivalents ................................................. 15,270 (14,345)
Cash and cash equivalents, beginning of period ................................................... 26,968 41,875
--------- ---------
Cash and cash equivalents, end of period ......................................................... $ 42,238 $ 27,530
========= =========
Supplemental Disclosures of Cash Flow Information
Cash payments for interest, including $5 capitalized interest during construction ........... $ 7,128 $ 4,902
========= =========
Cash payments for income taxes .............................................................. $ 2,879 $ 2,438
========= =========
Supplemental Disclosures of Non-cash Investing Activities
Transfers of loans receivable to other real estate .......................................... $ - $ 87
========= =========
See accompanying notes to unaudited consolidated financial statements.
6
COMMUNITY BANKSHARES, INC.
Notes to Unaudited Consolidated Financial Statements
Accounting Principles - A summary of significant accounting policies and the
audited financial statements for 2004 are included in Community Bankshares,
Inc.'s (the "Company" or "CBI") Annual Report on Form 10-K for the year ended
December 31, 2004.
Management Opinion - The interim financial statements in this report are
unaudited. In the opinion of management, all the adjustments necessary to
present a fair statement of the results for the interim periods have been made.
Such adjustments are of a normal and recurring nature. The results of operations
for any interim period are not necessarily indicative of the results to be
expected for an entire year. These interim financial statements should be read
in conjunction with the annual financial statements and notes thereto contained
in the 2004 Annual Report on Form 10-K.
Nonperforming Loans - As of September 30, 2005, there were $10,213,000 in
nonaccrual loans and $417,000 in loans 90 or more days past due and still
accruing interest.
Earnings Per Share - Basic earnings per share is computed by dividing net income
applicable to common shares by the weighted average number of common shares
outstanding. Diluted earnings per share is computed by dividing applicable net
income by the weighted average number of shares outstanding and any dilutive
potential common shares and dilutive stock options. It is assumed that all
dilutive stock options are exercised at the beginning of each period and that
the proceeds are used to purchase shares of the Company's common stock at the
average market price during the period. Net income per share and net income per
share, assuming dilution, were computed as follows:
(Unaudited)
Period Ended September 30,
--------------------------
Three Months Nine Months
------------ -----------
2005 2004 2005 2004
---- ---- ---- ----
(Dollars in thousands, except per share amounts)
Net income per share, basic
Numerator - net income ............................... $ 582 $ 565 $ 3,493 $ 3,345
========== ========== ========== ==========
Denominator
Weighted average common shares
issued and outstanding ........................... 4,404,303 4,363,582 4,399,089 4,348,798
========== ========== ========== ==========
Net income per share, basic ...................... $ .13 $ .13 $ .79 $ .77
========== ========== ========== ==========
Net income per share, assuming dilution
Numerator - net income ............................... $ 582 $ 565 $ 3,493 $ 3,345
========== ========== ========== ==========
Denominator
Weighted average common shares
issued and outstanding ........................... 4,404,303 4,363,582 4,399,089 4,348,798
Effect of dilutive stock options ................... 97,744 298,929 100,297 185,142
---------- ---------- ---------- ----------
Total shares ............................ 4,502,047 4,662,511 4,499,386 4,533,940
========== ========== ========== ==========
Net income per share, assuming dilution ...... $ .13 $ .12 $ .78 $ .74
========== ========== ========== ==========
7
Stock Based Compensation - As discussed below, on April 14, 2005, the Securities
and Exchange Commission (the SEC) adopted a rule amending the compliance date
for the adoption of Statement of Financial Accounting Standards No. 123(R),
("SFAS 123(R)"), until the first interim or annual reporting period of the
registrant's first fiscal year beginning on or after June 15, 2005. The Company
has elected to continue using the methodology of Accounting Principles Board
Opinion No. 25 ("APB No. 25"), "Accounting for Stock Issued to Employees," to
account for compensation expenses related to stock-based compensation. Options
issued under the Company's plans have no intrinsic value at the grant date and
no compensation cost is recognized in accordance with APB No. 25. Statement of
Financial Accounting Standards No. 123 ("SFAS No. 123"), "Accounting for
Stock-Based Compensation," requires entities to provide pro forma disclosures of
net income, and earnings per share, as if the fair value based method of
accounting promulgated by that standard had been applied. The Company has
adopted and intends to continue using the disclosure provisions of SFAS No. 123,
as amended, until the required adoption of the provisions of SFAS 123(R) on
January 1, 2006. Had compensation cost for the Company's stock option plan been
determined based on the fair value as of the grant dates for awards under the
plans consistent with the method prescribed by SFAS No. 123, the Company's net
income and earnings per share would have been adjusted to the pro forma amounts
indicated below:
(Unaudited)
Period Ended September 30,
--------------------------
Three Months Nine Months
------------ -----------
2005 2004 2005 2004
---- ---- ---- ----
(Dollars in thousands, except per share amounts)
Net income, as reported ........................................ $ 582 $ 565 $ 3,493 $ 3,345
Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all awards,
net of any related tax effects ............................ 17 214 149 642
------- ------- --------- ---------
Pro forma net income ........................................... $ 565 $ 351 $ 3,344 $ 2,703
======= ======= ========= =========
Net income per share, basic
As reported ............................................... $ 0.13 $ 0.13 $ 0.79 $ 0.77
Pro forma ................................................. 0.13 0.08 0.76 0.62
Net income per share, assuming dilution
As reported ............................................... $ 0.13 $ 0.12 $ 0.78 $ 0.74
Pro forma ................................................. 0.13 0.08 0.75 0.60
In December 2004, the Financial Accounting Standards Board issued SFAS No.
123(R), which requires that the costs resulting from all share based payment
transactions be recognized in the financial statements. SFAS 123(R) replaces
SFAS 123 and supersedes APB No. 25, as well as several other related
pronouncements. As originally issued, SFAS 123(R) was effective as of the
beginning of the first interim or annual period beginning after June 30, 2005.
The Company originally stated in its Form 10-K filed for the period as of and
ending December 31, 2004 that it would adopt the provisions of SFAS 123(R) as
required. However, the SEC issued, effective April 21, 2005, an "Amendment to
Rule 4-01(a) of Regulation S-X Regarding the Effective Date for Statement of
Financial Accounting Standards No. 123 (Revised 2004), Share Based Payment."
This amendment changes the required SFAS 123(R) compliance date for registrants
that are not small business issuers to the beginning of the first interim or
annual reporting period of the registrant's first fiscal year beginning on or
after June 15, 2005. Early adoption is permitted. For CBI, this amendment has
the effect of delaying the required implementation of the provisions of SFAS
123(R) until the first quarter of 2006. CBI now intends to adopt the provisions
of SFAS 123(R) as of January 1, 2006. CBI is currently evaluating the impact of
8
the adoption of SFAS 123(R) on its financial position and results of operations,
including the valuation methods and support for the assumptions that underlie
the valuation of the awards.
Variable Interest Entity - On March 8, 2004, CBI sponsored the creation of a
Variable Interest Entity ("VIE"), SCB Capital Trust I (the "Trust"), and is the
sole owner of the common securities issued by the Trust. On March 10, 2004, the
Trust issued $10,000,000 in floating rate capital securities. The proceeds of
this issuance, and the amount of CBI's capital investment, were used to acquire
$10,310,000 principal amount of CBI's floating rate junior subordinated
deferrable interest debt securities ("Debentures") due April 7, 2034, which
securities, and the accrued interest thereon, now constitute the Trust's sole
assets. The interest rate associated with the debt securities, and the
distribution rate on the common securities of the Trust, was established
initially at 3.91% and is adjustable quarterly at 3 month LIBOR plus 280 basis
points. The index rate (LIBOR) may not be lower than 1.11%. CBI may defer
interest payments on the Debentures for up to twenty consecutive quarters, but
not beyond the stated maturity date of the Debentures. In the event that such
interest payments are deferred by CBI, the Trust may defer distributions on the
common securities. In such an event, CBI would be restricted in its ability to
pay dividends on its common stock and to perform under other obligations that
are not senior to the junior subordinated Debentures.
The Debentures are redeemable at par at the option of CBI, in whole or
in part, on any interest payment date on or after April 7, 2009. Prior to that
date, the Debentures are redeemable at 105% of par upon the occurrence of
certain events that would have a negative effect on the Trust or that would
cause it to be required to be registered as an investment company under the
Investment Company Act of 1940 or that would cause trust preferred securities
not to be eligible to be treated as Tier 1 capital by the Federal Reserve Board.
Upon repayment or redemption of the Debentures, the Trust will use the proceeds
of the transaction to redeem an equivalent amount of trust preferred securities
and trust common securities. The Trust's obligations under the trust preferred
securities are unconditionally guaranteed by CBI.
FASB Interpretation 46 (FIN 46), "Consolidation of Variable Interest
Entities," was issued by the Financial Accounting Standards Board (FASB) in
January 2003. FIN 46 requires the primary beneficiary of a variable interest
entity's activities to consolidate the VIE. FIN 46 defines a VIE as an entity in
which the equity investors do not have substantive voting rights and there is
not sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support. The primary beneficiary is the party
that absorbs a majority of the expected losses and/or receives a majority of the
expected residual returns of the VIE's activities. In December 2003, the FASB
issued FIN 46(R), which supersedes and amends certain provisions of FIN 46. FIN
46(R) retains many of the concepts and provisions of FIN 46, provides additional
guidance related to the application of FIN 46, provides for certain additional
scope exceptions, and incorporates several FASB Staff Positions issued related
to the application of FIN 46. The provisions of FIN 46 are immediately
applicable to VIEs created, or interests in VIEs obtained, after January 31,
2003 and the provisions of FIN 46(R) are required to be applied to such
entities, except for special purpose entities, by the end of the first reporting
period ending after March 15, 2004 (March 31, 2004 for CBI).
As a result of FIN 46(R) The Federal Reserve announced new rules
governing the treatment of Trust Preferred Securities as Tier I capital. These
new rules, effective in April 2005, permit trust preferred securities to be
treated as Tier I capital for the first 25 years of the 30 year term of the
related junior subordinated debt securities. During the last five years the
amount included as capital will decline by twenty percent per year.
9
Since CBI is not the primary beneficiary of the VIE as defined by FIN
46 and FIN 46(R), the activities of this VIE have not been consolidated into the
consolidated financial statements of CBI. CBI's investment in the VIE is carried
in the consolidated balance sheet in other assets and the Debentures are
included in long-term debt.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
FORWARD LOOKING STATEMENTS
Statements included in this report which are not historical in nature
are intended to be, and are hereby identified as "forward looking statements"
for purposes of the safe harbor provided by Section 21E of the Securities
Exchange Act of 1934, as amended. Forward-looking statements include statements
concerning plans, objectives, goals, strategies, future events or performance
and underlying assumptions and other statements which are other than statements
of historical facts. Such forward-looking statements may be identified, without
limitation, by the use of the words "anticipates," "believes," "estimates,"
"expects," "intends," "plans," "predicts," "projects," and similar expressions.
The Company's expectations, beliefs, estimates and projections are expressed in
good faith and are believed by the Company to have a reasonable basis, including
without limitation, management's examination of historical operating trends,
data contained in the Company's records and other data available from third
parties, but there can be no assurance that management's expectations, beliefs,
estimates or projections will result or be achieved or accomplished. The Company
cautions readers that forward looking statements, including without limitation,
those relating to the Company's recent and continuing expansion, its future
business prospects, revenues, working capital, liquidity, capital needs,
interest costs, income, and adequacy of the allowance for loan losses, are
subject to risks and uncertainties that could cause actual results to differ
materially from those indicated in the forward-looking statements, due to
several important factors herein identified, among others, and other risks and
factors identified from time to time in the Company's reports filed with the
Securities and Exchange Commission. The Company undertakes no obligation to
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise.
REFERENCES TO OUR WEBSITE ADDRESS
References to our website address throughout this Quarterly Report on
Form 10-Q and in any documents incorporated into this Form 10-Q by reference are
for informational purposes only, or to fulfill specific disclosure requirements
of the Securities and Exchange Commission's rules or the American Stock Exchange
listing standards. These references are not intended to, and do not, incorporate
the contents of our website by reference into this Form 10-Q or the accompanying
materials.
CRITICAL ACCOUNTING POLICIES
CBI has adopted various accounting policies, which govern the
application of accounting principles generally accepted in the United States of
America in the preparation of CBI's financial statements. The significant
accounting policies of CBI are described in detail in the notes to CBI's audited
consolidated financial statements included in CBI's 2004 Annual Report on Form
10-K.
10
Certain accounting policies involve significant judgments and estimates
by management, which have a material impact on the carrying value of certain
assets and liabilities. Management considers such accounting policies to be
critical accounting policies. The judgments and estimates used by management are
based on historical experience and other factors, which are believed to be
reasonable under the circumstances. Because of the nature of the judgments and
assumptions made by management, actual results could differ from these judgments
and estimates, which could have a material impact on the carrying values of
assets and liabilities and the results of operations of CBI.
CBI is a holding company for four community banks and a mortgage
company and, as a financial institution, believes the allowance for loan losses
is a critical accounting policy that requires the most significant judgments and
estimates used in preparation of its consolidated financial statements. Refer to
the sections "Provision for Loan Losses," "Allowance for Loan Losses" and "The
Application of Critical Accounting Policies" in the Annual Report on Form 10-K
for 2004 for a detailed description of CBI's estimation process and methodology
related to the allowance for loan losses.
CHANGES IN FINANCIAL CONDITION
During the nine months ended September 30, 2005, loans increased by
$20,641,000, or 5.2%, over the amount as of December 31, 2004. However, loans
increased only $415,000 in the three months ended September 30, 2005, primarily
due to increases in interest rates and competitive pressures on loan pricing
that resulted in an increased amount of loan payoffs. The allowance for loan
losses increased by $2,311,000 since December 31, 2004 primarily as a result of
an increase of $5,552,000, or 109.3%, in nonperforming loans. See "Nonperforming
and Potential Problem Loans." Loans held for sale as of September 30, 2005 were
$2,592,000, or 17.2%, more than the December 31, 2004 amount. Federal funds sold
as of the end of the 2005 nine month period were $11,428,000, or 90.9% more than
the amount at the end of 2004 and $11,398,000 more than the June 30, 2005
amount. These increases were funded primarily by larger amounts of interest
bearing deposits, which increased by $31,286,000 during the 2005 nine month
period, and by $18,374,000 in the 2005 three month period.
RESULTS OF OPERATIONS
Earnings Performance
Increased yields on and larger volumes of earning assets, the Company's
ability to attract and manage deposits and other funding sources at reasonable
rates of interest, and a resurgence in noninterest income related to renewed
vigor in mortgage brokerage activities represented significant areas of
improvement during the 2005 periods. However, these positive developments were
offset by increased provisions for loan losses in both the three and nine month
periods of 2005 and CBI's net income was only slightly higher for each period
than for the same periods of 2004.
Three Months Ended September 30, 2005 and 2004
CBI earned consolidated net income of $582,000 for the quarter ended
September 30, 2005, compared with $565,000 for the comparable period of 2004.
Basic earnings per share was $.13 in the 2005 quarter, unchanged from the 2004
quarter. Diluted earnings per share was $.13 for the 2005 quarter compared with
$.12 for the 2004 quarter.
11
Summary Income Statement
------------------------
(Dollars in thousands)
For the Three Months Ended September 30, 2005 2004 Dollar Change Percentage Change
---- ---- ------------- -----------------
Interest income ..................................... $8,295 $6,253 $2,042 32.7%
Interest expense .................................... 2,929 1,757 1,172 66.7%
------ ------ ------
Net interest income ................................. 5,366 4,496 870 19.4%
Provision for loan losses ........................... 2,300 1,648 652 39.6%
Noninterest income .................................. 2,295 1,849 446 24.1%
Noninterest expenses ................................ 4,449 3,826 623 16.3%
Income tax expense .................................. 330 306 24 7.8%
------ ------ ------
Net income .......................................... $ 582 $ 565 $ 17 3.0%
====== ====== ======
Operating results for the third quarter of 2005 reflect increased net
interest income resulting from improved net interest margin and increased
volumes of earning assets. Although the Company's loan growth during the 2005
three month period was limited, loan growth was strong during the first six
months of 2005. Interest income from those loans was a significant factor in the
Company's improved net interest income in the 2005 third quarter. The Company's
deposit liabilities increased significantly during the 2005 third quarter.
Interest bearing deposits increased by $18,374,000 during that three month
period. Time deposits of $100,000 or more increased by $11,993,000 during the
2005 third quarter. Accordingly, interest expense for the 2005 quarter increased
significantly over the third quarter of 2004. Primarily because of the large
increase in nonperforming loans, the provision for loan losses in the 2005 third
quarter was $2,300,000, an increase of $652,000, or 39.6% over the amount for
the same period of 2004. See "Allowance for Loan Losses and Provision for Loan
Losses." Noninterest income was positively affected by increased service charges
assessed against deposit accounts and continuing strength in mortgage brokerage
activities. Noninterest expenses for the 2005 period were higher than for the
2004 period primarily as a result of increased salaries and employee benefits
and higher expenses related to premises and equipment.
Nine Months Ended September 30, 2005 and 2004
CBI's consolidated net income for the nine months ended September 30,
2005 was $3,493,000, an increase of $148,000 for the comparable 2004 period.
Basic earnings per share for the 2005 period was $.79, compared with $.77 per
share in 2004. Diluted earnings per share was $.78 for the 2005 period, compared
with $.74 for 2004.
Summary Income Statement
------------------------
(Dollars in thousands)
For the Nine Months Ended September 30, 2005 2004 Dollar Change Percentage Change
---- ---- ------------- -----------------
Interest income ...................................... $23,142 $18,089 $ 5,053 27.9%
Interest expense ..................................... 7,648 5,059 2,589 51.2%
------- ------- -------
Net interest income .................................. 15,494 13,030 2,464 18.9%
Provision for loan losses ............................ 3,335 2,139 1,196 55.9%
Noninterest income ................................... 6,106 5,626 480 8.5%
Noninterest expenses ................................. 12,793 11,333 1,460 12.9%
Income tax expense ................................... 1,979 1,839 140 7.6%
------- ------- -------
Net income ........................................... $ 3,493 $ 3,345 $ 148 4.4%
======= ======= =======
12
Net income for the first nine months of 2005 was positively affected by
increased net interest income and higher noninterest income. The repricing of
variable rate loans at higher interest rates and increases in the amounts of
loans outstanding and federal funds sold during the period contributed to higher
interest income in the 2005 period. Higher interest expenses in the 2005 period
resulted from higher interest rates paid for interest bearing deposits and
volume increases in that funding source. Primarily because of a large increase
in non-performing loans, the provision for loan losses in the 2005 nine month
period was $3,335,000, an increase of $1,196,000, or 55.9% over the amount for
the same period of 2004. See "Allowance for Loan Losses and Provision for Loan
Losses" and "Nonperforming and Potential Problem Loans." Noninterest income
increased for the 2005 nine month period primarily because of increased mortgage
brokerage activity. Noninterest expenses increased due to higher salaries and
employee benefits and expenses related to premises and equipment.
Net Interest Income
Net interest income is the amount of interest income earned on interest
earning assets (loans, securities, interest bearing deposits in other banks, and
federal funds sold), less the interest expense incurred on interest bearing
liabilities (interest bearing deposits and other borrowings), and is the
principal source of CBI's earnings. Net interest income is affected by the level
of interest rates, volume and mix of interest earning assets and interest
bearing liabilities and the relative funding of these assets.
Net interest income increased by $870,000, or 19.4%, in the 2005 third
quarter compared with the same 2004 quarter primarily due to increasing volumes
of earning assets and increasing yields and spreads.
During the 2005 nine month period, net interest income increased by
$2,464,000, or 18.9%, over the same period of 2004, primarily due to increased
volumes of loans and other categories of interest earning assets. Net yield on
earning assets increased to 4.13% for the 2005 nine month period from 3.95% for
the same 2004 period.
Total average interest earning assets for the 2005 nine month period
increased $59,804,000 or 13.6% over the same 2004 period. Average loans
outstanding for the 2005 period, including loans held for sale, increased by
$64,404,000, or 17.9%, over the 2004 period. As of September 30, 2005, loans,
including loans held for sale, were $23,233,000, or 5.7%, more than the amount
of such loans as of December 31, 2004. The average yield on loans, including
loans held for sale, increased to 6.69% for the 2005 nine month period, compared
with 6.11% for the same period of 2004. The average yields on other categories
of earning assets also increased for the 2005 nine month period.
Total average interest bearing liabilities for the 2005 nine months
increased $53,525,000 or 14.9% over 2004. Average short-term borrowings for the
2005 nine-month period fell $2,872,000, or 25.5%, below the average for the same
period of 2004, while long-term debt for the 2005 period increased by
$4,788,000, or 17.1%, primarily because of additional borrowings from the
Federal Home Loan Bank of Atlanta by the subsidiary banks during 2005. Average
savings and interest bearing transaction account balances grew significantly in
the 2005 nine month period, also, increasing $16,072,000, or 12.0%. Average time
deposits were significantly higher in the 2005 period, increasing by $35,537,000
or 19.2% over the prior year average. Management believes that higher average
rates paid for all of the Company's interest bearing deposit products in the
2005 nine month period contributed to these volume increases.
13
The following table provides details of the changes in the composition
of CBI's average balance sheet, its interest income and expense, and the
relationships between those items.
Average Balances, Yields and Rates
Nine Months Ended September 30,
-------------------------------
2005 2004
---- ----
Interest Interest
Average Income / Yields / Average Income / Yields /
Balances Expense Rates * Balances Expense Rates *
-------- ------- ------- -------- ------- -------
(Dollars in thousands)
Assets
Interest earning deposits ........................ $ 592 $ 30 6.76% $ 1,008 $ 12 1.59%
Investment securities - taxable .................. 52,925 1,262 3.18% 50,662 1,152 3.03%
Investment securities - tax exempt (1) ........... 6,388 164 3.42% 9,619 244 3.38%
Federal funds sold ............................... 14,650 355 3.23% 17,866 145 1.08%
Loans, including loans held for sale (1,2) ....... 425,127 21,331 6.69% 360,723 16,536 6.11%
--------- -------- --------- --------
Total interest earning assets .......... 499,682 23,142 6.18% 439,878 18,089 5.48%
Cash and due from banks .......................... 15,542 15,536
Allowance for loan losses ........................ (4,957) (4,283)
Premises and equipment, net ...................... 7,948 7,166
Intangible assets ................................ 7,311 7,557
Other assets ..................................... 4,286 4,014
--------- ---------
Total assets ........................... $ 529,812 $ 469,868
========= =========
Liabilities and shareholders' equity
Interest bearing deposits
Savings .................................... $ 87,894 $ 996 1.51% $ 78,882 $ 571 0.97%
Interest bearing transaction accounts ...... 61,873 308 0.66% 54,813 165 0.40%
Time deposits .............................. 221,094 4,817 2.90% 185,557 3,032 2.18%
--------- -------- --------- --------
Total interest bearing deposits ........ 370,861 6,121 2.20% 319,252 3,768 1.57%
Short-term borrowings ............................ 8,379 140 2.23% 11,251 245 2.90%
Long-term debt ................................... 32,731 1,387 5.65% 27,943 1,046 4.99%
--------- -------- --------- --------
Total interest bearing liabilities ..... 411,971 7,648 2.48% 358,446 5,059 1.88%
Noninterest bearing demand deposits .............. 63,927 59,704
Other liabilities ................................ 2,085 1,772
Shareholders' equity ............................. 51,829 49,946
--------- ---------
Total liabilities and
shareholders' equity ............... $ 529,812 $ 469,868
========= =========
Interest rate spread (3).......................... 3.70% 3.60%
Net interest income and net yield
on earning assets (4)....................... $ 15,494 4.13% $ 13,030 3.95%
* Yields and rates are annualized.
(1) Interest income on tax exempt loans and investment securities has not been
calculated on a tax-equivalent basis.
(2) Nonaccruing loans are included in the average balances and income from such
loans is recognized on a cash basis.
(3) Total interest earning assets yield less total interest bearing liabilities
rate.
(4) Net yield equals net interst income divided by total interest earning
assets.
14
Allowance for Loan Losses and Provision for Loan Losses
The Corporation operates four independent community banks in South
Carolina. Under the provisions of law and regulations governing banks, each
bank's board of directors is responsible for determining the adequacy of its
bank's loan loss allowance. In addition, each bank is supervised and regularly
examined by the Office of the Comptroller of the Currency (the "OCC") (or the
South Carolina State Board of Financial Institutions (the "State Board") and the
Federal Deposit Insurance Corporation (the "FDIC") in the case of the Ridgeway
bank. As a normal part of a safety and soundness examination, bank examiners
assess and comment on the adequacy of a bank's allowance for loan losses and may
require that changes be made in the allowance.
The purpose of the allowance is to provide a capital reserve to protect
the banks from credit loss risks inherent in their loan portfolios. Generally
accepted accounting principles control the methods by which banks estimate their
allowances for loan losses. The allowance for loan losses is increased by the
provision for loan losses, which is a direct charge to expense. Losses on
specific loans are charged against the allowance in the period in which
management determines that such loans, or a portion thereof, become
uncollectible. Recoveries of previously charged-off loans are credited to the
allowance.
The nature of community banking is such that the individual loan
portfolios are predominantly composed of small and medium size business and
individual loans. As community banks, there exists, by definition, a geographic
concentration of loans within each Bank's respective city or county. Management
at each bank monitors the loan concentrations and loan portfolio quality on an
ongoing basis including, but not limited to: quarterly analysis of loan
concentrations, monthly reporting of past dues, nonaccruals, and potential
problem loans, and quarterly reporting of loan charge-offs and recoveries. These
efforts focus on historical experience and are bolstered by quarterly analysis
of local and state economic conditions, which are part of the Banks' assessment
of the adequacy of their allowances for loan losses.
The activity in the allowance for loan losses is summarized in the
following table:
Nine Months Nine Months
Ended Year Ended Ended
September 30, December 31, September 30,
2005 2004 2004
---- ---- ----
(Dollars in thousands)
Allowance at beginning of period ................................. $ 4,347 $ 4,206 $ 4,206
Provision for loan losses ........................................ 3,335 5,102 2,139
Net charge-offs .................................................. (1,024) (4,961) (576)
--------- --------- ---------
Allowance at end of period ....................................... $ 6,658 $ 4,347 $ 5,769
========= ========= =========
Allowance as a percentage of loans outstanding ................... 1.61% 1.10% 1.51%
Loans at end of period ........................................... $ 414,290 $ 393,649 $ 382,958
========= ========= =========
The provision for loan losses for the third quarter of 2005 was
$2,300,000, an increase of $652,000, or 39.6%, over the same period of 2004. Net
charge-offs were $454,000 during the 2005 third quarter, compared with $164,000
during the same period of 2004. Of the 2005 third quarter net charge-offs,
15
$258,000 represents the charge-off of a loan that was included in the group of
nonperforming loans handled by a former lending officer that were discussed in
filings during 2004. During the third quarter of 2005, the provision for loan
losses included $108,000 related to the same $258,000 loan. The remainder of the
provision expense, approximately $2,192,000, was primarily attributable to
specific amounts allocated to nonperforming and potential problem loans and
other net charge-offs. The allowance for loan losses as a percentage of loans
outstanding (excluding loans held for sale) was 1.61% as of September 30, 2005
compared with 1.51% at the end of the third quarter of 2004.
The provision for loan losses for the nine month 2005 period was
$3,335,000, an increase of $1,196,000, or 55.9%, over the same period of 2004.
Net charge-offs were $1,024,000 during the 2005 nine month period, compared with
$576,000 during the same period of 2004. Of the 2005 amount, $801,000 represents
the charge-off of loans that were included in nonperforming loans handled by a
former lending officer as discussed in filings during 2004. Management
determined during the course of the 2005 nine month period that the collateral
associated with these loans had become worthless and the borrowers were not
likely to perform. The provision for loan losses for the nine month period ended
September 30, 2005 included $535,000 related to net charge offs during the
period of nonperforming loans of the same former lending officer. Of the
remainder of the provision for the 2005 nine month period, $35,000 was
attributable to growth in the loan portfolio and $2,765,000 was allocated
primarily to nonperforming and potential problem loans. The allowance for loan
losses stood at 1.61% of loans outstanding (excluding loans held for sale),
compared with 1.10% at the end of 2004.
Nonperforming and Potential Problem Loans
Nonperforming loans are defined as loans that are 90 or more days past
due and are still accruing interest and loans that are in nonaccrual status.
Potential problem loans, a lower level of concern, are defined as loans where
information about the borrowers' credit problems causes management to have more
than normal concern about the borrowers' ability to comply with the original
repayment terms.
Nonperforming loans totaled $10,630,000 as of the end of the 2005
period compared with $5,078,000 as of December 31, 2004, an increase of
$5,552,000 or 109.3%. Following is a summary of nonperforming loans and
potential problem loans for each of the past three quarters.
16
90 days + past Total
Nonaccrual due and still nonperforming % of total Potential % of total
$ amounts in thousands loans accruing loans loans problem loans loans
----- -------- ----- ----- ------------- -----
December 31, 2004 .................. $ 4,941 $ 137 $ 5,078 1.29% $ 4,628 1.20%
Net change ......................... 118 215 333 2,972
------- ------- ------- -------
March 31, 2005 ..................... 5,059 352 5,411 1.33% 7,600 1.87%
Net change ......................... 200 (9) 191 10,400
------- ------- ------- -------
June 30, 2005 ...................... 5,259 343 5,602 1.35% 18,000 4.35%
Net change ......................... 4,954 74 5,028 (4,107)
------- ------- ------- -------
September 30, 2005 ................. $10,213 $ 417 $10,630 2.57% $13,893 3.35%
======= ======= ======= =======
Nonaccrual loans increased $4,954,000 during the third quarter of 2005.
The major components of this increase are discussed below:
A commercial loan of $1,316,000 moved from potential problem loans into
nonaccrual status because of concerns about the borrower's ability to comply
with the loan's terms. The loan is substantially collateralized by real estate
and business furniture and fixtures. An appraisal completed in August 2005
indicates that the real estate collateral has a value of approximately
$1,200,000. Other collateral, consisting principally of the business furniture
and fixtures, has a cost value estimated at approximately $500,000.
Also, two unrelated loan relationships, aggregating $2,038,000,
involving borrowers in the manufactured housing business moved from potential
problem loans into nonaccrual status because of concern about the continued
deterioration of their financial condition and cash flows. Collateral pledged to
support the loans consists of receivables, mobile home inventories and display
model modular homes. Collateral values were estimated to be approximately
$1,490,000 as of September 30, 2005.
A fourth loan relationship totaling $999,000 was downgraded to
nonaccrual status. This relationship was a portion of the group of loans
identified in the third quarter of 2004 as originated by the former lending
officer referred to above. The borrower has performance weaknesses. Limited
guarantor strength and weakness in the collateral are reflected in a specific
allowance allocation for this credit.
CBI management has made specific loan loss allowance allocations for
these four relationships based on an assessment of collateral, the capacity of
the customer to perform, and related factors.
The major component of nonperforming loans existing prior to the third
quarter of 2005 is discussed below:
Approximately $2,434,000 of the September 30, 2005 nonperforming loan
amount represents the balance of a loan relationship that originated in July
2004 to finance the purchase of a business. During the fourth quarter of 2004,
management became aware that the business was not performing as expected and the
borrower stopped making the required payments. The borrower alleged that
financial information furnished by the seller and relied upon in establishing
the value of the business (and its purchase price) was fraudulent. Management
determined during the fourth quarter of 2004 that the loan had become collateral
dependent and wrote the loan down to the estimated net realizable value of the
17
collateral as of December 31, 2004. An independent appraisal of the real estate,
fixtures and equipment of the business was completed during the second quarter
of 2005 under the assumption that the business was not operating as a going
concern. That appraisal supports management's estimated net realizable value and
the loan's carrying amount has not since changed. CBI is presently exercising
forbearance with respect to this relationship and continues to work with the
borrower who is actively trying to sell the business as a going concern.
Management has retained legal counsel to assist with respect to this loan.
The remaining nonperforming loans consist of 74 loans to various
individuals and businesses with an aggregate balance of $3,426,000. The amounts
of the individual loans range up to approximately $500,000.
Loans that are 90 days or more past due and still accruing interest
represent loans with significant performance issues, but where management
believes that each loan's collateral position provides enough protection that
the bank expects full recovery of principal and interest on the loan. At
September 30, 2005 this category represented approximately .10% of the loan
portfolio.
At September 30, 2005, the Corporation had identified $13,893,000, or
3.4%, of the loan portfolio, as potential problem loans. This is an increase of
$9,265,000 over the amount as of December 31, 2004. The significant increase in
potential problem loans resulted largely from risk grade changes recommended by
a new loan review firm, discussed below, during their initial loan portfolio
reviews earlier in 2005. The substantial decrease during the third quarter was
associated with several of the credits being reclassified into nonaccrual
status, which are discussed above.
The amount of potential problem loans does not represent management's
estimate of potential losses since a significant portion of these loans are
secured by real estate and other forms of collateral. Approximately $654,000 of
potential problem loans were unsecured as of September 30, 2005.
Management will continue to closely monitor the levels of nonperforming
and potential problem loans and address the weaknesses in those credits to
enhance the amount of ultimate collection or recovery of these assets.
Management considers the levels and trends in nonperforming, past due and
potential problem loans in determining how the provision and allowance for loan
losses is estimated and adjusted.
Credit Risk Management System
Risk taking is inherent in the granting of credit. To control the
amounts and types of risks incurred, and to minimize losses, management has
established loan policies and practices. On an ongoing basis, management seeks
to better manage risk and improve internal control systems. As part of this
continuous process, management hired a Chief Credit Officer for the Corporation
in the second quarter of 2005. This officer has specific prior loan approval
authority over major loan relationships and also assists the subsidiary banks
and mortgage company in other areas of loan operation and administration. Also,
during the second quarter of 2005 management changed its outside independent
loan review provider. Their initial review covered essentially all loan
relationships greater than $400,000, the highest risk area of the portfolio.
Their preliminary reports were received late in the second quarter. CBI reviewed
these reports and disclosed a substantial increase in potential problem loans in
the second quarter and recorded an additional provision to the allowance for
loan losses in recognition of the increase.
18
During the third quarter of 2005 the Chief Credit Officer began a
systematic and ongoing review of the most significant problem loans within each
bank subsidiary's portfolio with each bank's senior management. This ongoing
process, combined with the recent loan review reports, and more currently
available information led to a determination by management that some of the most
problematic loans should be moved into nonaccrual status. Based on these
factors, CBI recorded a net increase in nonaccrual assets of $4,107,000 for the
quarter. This also accounts, in large part, for the decrease in potential
problem loans from the second quarter to the third quarter.
In a continuation of its efforts to measure and recognize the potential
issues related to its asset quality, during the fourth quarter CBI management
directed its external loan review firm to conduct a loan review of certain
segments of its loan portfolio they had previously not reviewed. Management
believes that it is possible an additional special provision for loan losses may
be required during the fourth quarter as a result of the current review.
Noninterest Income
Non-interest income for the 2005 quarter increased $446,000, or 24.1%
over the 2004 quarter. The majority of the increase was attributable to mortgage
brokerage income which increased $315,000, or 37.7%. Service charges on deposit
accounts increased by $107,000 for the 2005 quarter, primarily because of a more
disciplined approach to the assessment and collection of these revenues during
that period. Management intends to maintain this focus throughout the remainder
of 2005 and beyond. CBI realized gains of $10,000 from sales of
available-for-sale securities in the 2004 three-month period. There were no
sales of securities in the 2005 quarter.
Non-interest income for the 2005 nine month period increased $480,000,
or 8.5%, over the 2004 amount. Most of the increase was attributable to a
$394,000 or 15.8% increase in mortgage brokerage income. The Company's mortgage
brokerage activities in 2005 have been affected positively by relatively stable
mortgage interest rates which have allowed demand for mortgage loans to remain
strong. CBI recorded securities losses of $10,000 in the 2005 nine month period
compared with securities gains of $5,000 in the same 2004 period.
Noninterest Expenses
Noninterest expenses increased by $623,000, or 16.3%, for the third
quarter of 2005 compared with the 2004 quarter. Salaries and employee benefits
increased $427,000, or 20.1%, primarily due to additions made to the Company's
executive management and staffing a new branch office of Florence National Bank
that opened during the first quarter of 2005. Premises and equipment expenses
increased $44,000, or 9.5%, primarily due to the opening of the new leased
branch office.
During the first nine months of 2005, noninterest expenses increased
$1,460,000, or 12.9%, as compared with the same 2004 period. Salaries and
employee benefits increased $703,000, or 10.9%, due to additions made in 2005 to
the Company's executive management, the opening of a new office of Florence
National Bank in the first quarter of 2005 and normal periodic wage and salary
adjustments. For the first nine months of 2005, premises and equipment expenses
were up $166,000, or 11.3%, as compared with the 2004 period, primarily due to
expenses resulting from the opening of the new banking office. Other expenses
increased by $591,000 for the 2005 nine-month period due in large part to
expenses related to the Company's efforts to prepare to comply with the
requirements of the Sarbanes-Oxley Act of 2002 that will apply to the Company in
the near future.
19
Management believes that noninterest expenses will continue to increase
for the remainder of 2005 and through 2006 as a result of continuing growth and
expansion of the Company's network of banking offices. In addition, noninterest
expenses will be increased in the future by depreciation of the new corporate
headquarters building, which is currently under construction and is expected to
be completed by late November, and amortization and other costs of the new core
management information system, which will be implemented during the second
quarter of 2006.
Income Tax Expense
Income tax expense increased $24,000 and $140,000 for the third quarter
and nine months ended September 30, 2005, respectively, due to increased taxable
income. The average income tax rates applied to year-to-date income before
income taxes during 2005 and 2004 were approximately 36.2% and 35.5%,
respectively.
LIQUIDITY
Liquidity is the ability to meet current and future obligations through
liquidation or maturity of existing assets or the acquisition of additional
liabilities. Adequate liquidity is necessary to meet the requirements of
customers for loans and deposit withdrawals in a timely and economical manner.
The most manageable sources of liquidity are composed of liabilities, with the
primary focus of liquidity management being the ability to attract deposits
within CBI's market areas. Individual and commercial deposits are the primary
source of funds for credit activities, along with long-term borrowings from the
Federal Home Loan Bank of Atlanta and the proceeds of issuing $10,000,000 of
subordinated debentures. Cash and amounts due from banks and federal funds sold
are CBI's primary sources of asset liquidity. These funds provide a cushion
against short-term fluctuations in cash flow from both loans and deposits.
Securities available-for-sale are CBI's principal source of secondary asset
liquidity. However, the availability of this source is influenced by legal
requirements that CBI pledge investment securities as collateral for any local
government deposits not covered by FDIC insurance, repurchase agreement
collateral and by market conditions.
Total deposits at September 30, 2005 were $455,298,000, an increase of
$31,840,000 or 7.5% over the amount at December 31, 2004. As of September 30,
2005, the loan to deposit ratio, excluding loans held for sale, was 91.0%,
compared with 93.0% at December 31, 2004 and 97.3% as of September 30, 2004.
Management believes CBI's and its subsidiaries' liquidity sources are
adequate to meet their current and projected operating needs.
CAPITAL RESOURCES
CBI and its banking subsidiaries are subject to regulatory risk-based
capital adequacy standards. Under these standards, bank holding companies and
banks are required to maintain certain minimum ratios of capital to
risk-weighted assets and average total assets. Under the provisions of the
Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), federal
bank regulatory authorities are required to implement prescribed "prompt
corrective actions" upon the deterioration of the capital position of a bank. If
the capital position of an affected institution were to fall below certain
levels, increasingly stringent regulatory corrective actions are mandated.
20
The September 30, 2005 risk based capital ratios for CBI and its
banking subsidiaries are presented in the following table, compared with the
minimum required ratios and, in the case of the banks, the minimum "well
capitalized" ratios under the regulatory definitions and guidelines:
September 30, 2005
------------------
Tier 1 Total Capital Leverage
------ ------------- --------
Community Bankshares, Inc. .......................................... 13.40% 14.65% 10.29%
Orangeburg National Bank ............................................ 12.05% 13.23% 9.01%
Sumter National Bank ................................................ 9.47% 10.74% 7.50%
Florence National Bank .............................................. 10.20% 11.38% 8.78%
Bank of Ridgeway .................................................... 12.35% 13.60% 8.58%
Minimum "well capitalized" requirement* ............................. 6.00% 10.00% 6.00%
Minimum requirement ................................................. 4.00% 8.00% 4.00%
*This requirement only applies to the banks.
As shown in the table above, each of the banks' capital ratios exceed
the regulatory requirement for being considered "well capitalized." In the
opinion of management, the CBI and the banking subsidiaries' current and
projected capital positions are adequate.
OFF-BALANCE-SHEET ACTIVITIES
In the normal course of business, CBI engages in transactions that, in
accordance with generally accepted accounting principles, are not recorded in
the financial statements (generally commitments to extend credit) or are
recorded in amounts that differ from their notional amounts (generally
derivatives). These transactions involve elements of credit, interest rate and
liquidity risk of varying degrees. Such transactions are used by CBI for general
corporate purposes.
Variable Interest Entity
As discussed in the notes to unaudited consolidated financial
statements under "Variable Interest Entities," as of September 30, 2005, CBI
held an interest in, and guarantees the liabilities of, a non-consolidated
variable interest entity.
Commitments
CBI's banking and mortgage brokerage subsidiaries are parties to credit
related financial instruments with off-balance-sheet risk in the normal course
of business to meet the financing needs of their customers. These financial
instruments include commitments to extend credit and standby letters of credit.
Such commitments involve varying degrees of credit and interest rate risk in
excess of the amount recognized in the consolidated balance sheets. Exposure to
credit loss is represented by the contractual, or notional, amounts of these
commitments. The same credit policies are used in making commitments as for
on-balance-sheet instruments.
The following table sets forth the contractual amounts of commitments
which represent credit risk:
21
September 30, 2005
------------------
(Dollars in
thousands)
Loan commitments .......................................... $52,267
Standby letters of credit ................................. 2,144
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.
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 amount of collateral obtained, if deemed
necessary by management upon extension of credit, is based on management's
credit evaluation of the counter-party. Collateral held varies but may include
personal residences, accounts receivable, inventory, property, plant, and
equipment, and income-producing commercial properties.
Standby letters of credit are conditional commitments issued to
guarantee the performance of a customer to a third party. Those letters of
credit are primarily issued to support private borrowing arrangements. All
letters of credit are short-term guarantees. The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending loan
facilities to customers. Generally, collateral supporting those commitments is
held if deemed necessary. Since many of the standby letters of credit are
expected to expire without being drawn upon, the total letter of credit amounts
do not necessarily represent future cash requirements.
On March 22, 2005, CBI entered into a contract for the construction of
an approximately 16,000 square foot two-story office building to house its
corporate headquarters and operations center. The contract price for this
project is $1,476,000. Through October 31, 2005, $1,162,000 has been expended
for this project and related architectural and engineering fees. Management
expects completion of the building in late November 2005 and the Company will
relocate shortly thereafter.
On June 30, 2005, CBI reached an agreement with Jack Henry &
Associates, Inc. to obtain licensing rights for a new core management
information software system, known as Silverlake, to be used by the company and
each of its subsidiaries. The cost of this core system conversion will be
approximately $1,000,000. The agreement also requires CBI to pay various support
and maintenance costs throughout the license period. CBI estimates that during
the next five years costs will range from approximately $200,000 to $300,000 per
year. However, the exact amounts will be determined by future events, such as
asset growth, and cannot be determined precisely at this time. Management
expects to complete the conversion process during the second quarter 2006.
Derivative Financial Instruments
In April, 2003, the Financial Accounting Standards Board issued
Statement No. 149, "Amendment of Statement 133 on Derivative Instruments and
Hedging Activities." Among other requirements, this Statement provides that loan
commitment contracts entered into or modified after June 30, 2003 that relate to
the origination of mortgage loans that will be held for sale shall be accounted
for as derivative instruments by the issuer of the loan commitment. In March,
2004, the SEC issued its Staff Accounting Bulletin No 105 "Application of
Accounting Principles to Loan Commitments," which resulted in no changes in
CBI's accounting for such commitments. CBI issues mortgage loan rate lock
22
commitments to potential borrowers to facilitate its origination of home
mortgage loans that are intended to be sold. Between the time that CBI issues
its commitments and the time that the loans close and are sold, CBI is subject
to variability in the selling prices related to those commitments due to changes
in market rates of interest. However, CBI offsets this variability through the
use of so-called "forward sales contracts" to investors in the secondary market.
Under these arrangements, an investor agrees to purchase the closed loans at a
predetermined price. CBI generally enters into such forward sales contracts at
the same time that rate lock commitments are issued. These arrangements
effectively insulate CBI from the effects of changes in interest rates during
the time the commitments are outstanding, but the arrangements do not qualify as
fair value hedges. These derivative financial instruments are carried in the
balance sheet at estimated fair value and changes in the estimated fair values
of these derivatives are recorded in the statement of income in net gains or
losses on loans held for sale.
Derivative financial instruments are written in amounts referred to as
notional amounts. Notional amounts only provide the basis for calculating
payments between counterparties and do not represent amounts to be exchanged
between parties or a measure of financial risk. The following table includes the
notional principal amounts of rate lock commitments and forward sales contracts
as of September 30, 2005, and the estimated fair values of those financial
instruments included in other assets and liabilities in the balance sheet as of
that date.
September 30, 2005
------------------
Estimated
Fair Value
Notional Asset
Amount (Liability)
------ -----------
(Dollars in thousands)
Rate lock commitments to potential borrowers
to originate mortgage loans to be held for sale ..... $21,540 $ (119)
Forward sales contracts with investors
of mortgage loans to be held for sale ............... 21,540 119
ACCOUNTING AND REPORTING CHANGES
The American Institute of Certified Public Accountants' Accounting
Standards Executive Committee issued its Statement of Position ("SOP") 03-3,
"Accounting for Certain Loans or Debt Securities Acquired in a Transfer," which
is effective generally for loans acquired in fiscal years beginning after
December 15, 2004. The SOP addresses accounting for differences between
contractual cash flows and cash flows expected to be collected from an
investor's initial investment in loans or debt securities (loans) acquired in a
transfer if those differences are attributable, at least in part, to credit
quality. It includes loans acquired in business combinations and applies to all
nongovernmental organizations, including not-for-profit organizations. The SOP
does not apply to loans originated by the entity. For loans acquired in fiscal
years prior to this SOP's effective date and within the scope of Practice
Bulletin 6, the SOP also amends the application of Practice Bulletin 6 with
regard to accounting for decreases in cash flows expected to be collected. The
adoption of this SOP as of January 1, 2005 had no impact on the Company's
financial statements.
In May 2005, the FASB issued SFAS No. 154, "Accounting Changes and
Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No.
3" ("SFAS No. 154"). SFAS No. 154 establishes retrospective application as the
required method for reporting a change in accounting principle, unless it is
impracticable, in which case the changes should be applied to the latest
practicable date presented. SFAS No. 154 also requires that a correction of an
23
error be reported as a prior period adjustment by restating prior period interim
statements. SFAS No. 154 is effective for accounting changes and correction of
errors made in fiscal years beginning after December 15, 2005.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Market risk is the risk of loss from adverse changes in market prices
and rates. CBI's market risk arises principally from interest rate risk inherent
in its lending, deposit and borrowing activities. Management actively monitors
and manages its interest rate risk exposure. Although CBI manages other risks,
such as credit quality and liquidity risk in the normal course of business,
management considers interest rate risk to be its most significant market risk
and this risk could potentially have the largest material effect on CBI's
financial condition and results of operations. Other types of market risks such
as foreign currency exchange risk and commodity price risk do not arise in the
normal course of community banking activities.
CBI's Asset/Liability Committee uses a simulation model to assist in
achieving consistent growth in net interest income while managing interest rate
risk. According to the model, as of September 30, 2005, CBI is positioned so
that net interest income would increase $263,000 and net income would increase
$159,000 in the next twelve months if interest rates rose 100 basis points.
Conversely, net interest income would decline $263,000 and net income would
decline $159,000 in the next twelve months if interest rates declined 100 basis
points. In the current interest rate environment, it appears unlikely that there
will be any large rate decreases in the immediate future. Computation of
prospective effects of hypothetical interest rate changes are based on numerous
assumptions, including relative levels of market interest rates and loan
prepayment, and should not be relied upon as indicative of actual results.
Further, the computations do not contemplate any actions CBI, its customers and
the issuers of its investment securities could undertake in response to changes
in interest rates.
As of September 30, 2005, there was no significant change from the
interest rate sensitivity analysis for the various changes in interest rates
calculated as of December 31, 2004. The foregoing disclosures related to the
market risk of CBI should be read in connection with Management's Discussion and
Analysis of Financial Position and Results of Operations included in the 2004
Annual Report on Form 10-K.
Item 4. Controls and Procedures
Based on the evaluation required by 17 C.F.R. Section 240.13a-15(b) or
240.15d-15(b) of the Company's disclosure controls and procedures (as defined in
17 C.F.R. Sections 240.13a-15(e) and 240.15d-15(e)), the Company's chief
executive officer and chief financial officer concluded that such controls and
procedures, as of the end of the period covered by this quarterly report, were
effective.
There has been no change in the Company's internal control over
financial reporting during the most recent fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the Company's internal
control over financial reporting.
The Company qualifies for the extended compliance period provided for
in SEC Release 33-8392 for implementing Section 404 of the Sarbanes Oxley Act by
non-accelerated filers.
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PART II--OTHER INFORMATION
Item 6. Exhibits
Exhibits 31-1. Rule 13a-14(a)/15d-14(a) Certification of principal
executive officer
31-2. Rule 13a-14(a)/15d-14(a) Certification of principal
financial officer
32. Certifications Pursuant to 18 U.S.C. Section 1350
25
SIGNATURES
Pursuant to the requirements 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.
DATED: November 14, 2005
COMMUNITY BANKSHARES, INC.
By: s/ Samuel L. Erwin
-------------------------------------
Samuel L. Erwin
Chief Executive Officer
By: s/ William W. Traynham
-------------------------------------
William W. Traynham
President and Chief Financial Officer
(Principal Accounting Officer)
26
EXHIBIT INDEX
31-1 Rule 13a-14(a)/15d-14(a) Certification of principal executive officer
31-2 Rule 13a-14(a)/15d-14(a) Certification of principal financial officer
32 Certifications Pursuant to 18 U.S.C. Section 1350
27