10-K 1 cs2267.txt ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004 COMMISSION FILE NUMBER: 0-23971 CITIZENS SOUTH BANKING CORPORATION ------------------------------------------------------ (Exact name of Registrant as specified in its Charter) Delaware 54-2069979 ------------------------ ------------------------------------ (State of Incorporation) (I.R.S. Employer Identification No.) 519 South New Hope Road, Gastonia, North Carolina 28054-4040 ------------------------------------------------------------ (Address of principal executive office) (704) 868-5200 ---------------------------------------------------- (Registrant's telephone number, including area code) Securities Registered Pursuant to Section 12(b) of the Act: None Securities Registered Pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value (Title of Class) 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 twelve months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in the definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. [X] Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) YES [X] NO [ ] As of March 3, 2005, 7,313,044 shares of common stock, $0.01 par value, were outstanding. As of March 3, 2005, the aggregate market value of the voting stock held by non-affiliates was $80.6 million. Documents Incorporated by Reference PART III: Portions of the Definitive Proxy Statement dated April 4, 2005, as filed pursuant to Section 14 of the Securities Exchange Act of 1934 in connection with the 2004 Annual Meeting of Shareholders. ================================================================================ CITIZENS SOUTH BANKING CORPORATION AND SUBSIDIARIES FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004 TABLE OF CONTENTS
PAGE ---- Part I ------ Item 1. Business...................................................................................... 1 Item 2. Properties.................................................................................... 8 Item 3. Legal Proceedings............................................................................. 9 Item 4. Submission of Matters to a Vote of Security Holders........................................... 9 Part II ------- Item 5. Market for Registrant's Common Stock and Related Shareholder Matters.......................... 10 Item 6. Selected Financial Data....................................................................... 11 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations......... 12 Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................................... 36 Item 8. Financial Statements and Supplementary Data................................................... 37 Independent Auditors' Report.................................................................. 37 Consolidated Statements of Financial Condition................................................ 38 Consolidated Statements of Operations......................................................... 39 Consolidated Statements of Comprehensive Income............................................... 40 Consolidated Statements of Changes in Stockholders Equity..................................... 41 Consolidated Statements of Cash Flows......................................................... 42 Notes to Consolidated Financial Statements.................................................... 43 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.......... 68 Item 9A. Controls and Procedures....................................................................... 68 Management's Annual Report on Internal Control over Financial Reporting....................... 68 Report of Independent Registered Public Accounting Firm....................................... 69 Item 9B. Other Information............................................................................. 70 Part III -------- Item 10. Directors and Executive Officers of the Registrant............................................ 70 Item 11. Executive Compensation........................................................................ 70 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.......................................................................... 70 Item 13. Certain Relationships and Related Transactions................................................ 70 Item 14. Principal Accountant Fees and Services........................................................ 70 Item 15. Exhibits, Financial Statement Schedules, and Reports on Forms 8-K............................. 71 Signatures
PART I ------ ITEM 1. BUSINESS CITIZENS SOUTH BANKING CORPORATION Citizens South Banking Corporation (also referred to as the "Company", the "Registrant", "We", "Us", or "Our") is a Delaware corporation that owns all of the outstanding shares of common stock of Citizens South Bank (the "Bank"). The common stock of the Company trades on the Nasdaq National Market under the ticker symbol "CSBC." The Company became the holding company for the Bank on September 30, 2002, in connection with the mutual-to-stock conversion of Citizens South Holdings, MHC, the mutual holding company (the "Mutual Holding Company") of Citizens South Banking Corporation, a federal corporation ("Citizens Federal"), formerly named Gaston Federal Bancorp, Inc. As a result of the mutual-to-stock conversion, the Company succeeded to all of the rights of Citizens Federal. As part of the mutual-to-stock conversion, the Company sold 5,259,945 shares of common stock at $10.00 per share in a stock offering. The shares sold represented the Mutual Holding Company's ownership interest in Citizens Federal. Shares owned by stockholders of Citizens federal other than the Mutual Holding Company received new shares of the Company. The net proceeds of the stock offering were $45.5 million. Management has been utilizing a number of strategies to leverage the Company's excess capital and enhance shareholder value. These strategies are discussed throughout this report and include: 1) constructing new full-service offices in growth markets; 2) expanding into other financial-related business fields; 3) pursuing the acquisition of existing branch offices; 4) growing the retail and commercial banking segments of our business; and 5) patiently pursuing the acquisition of other financial institutions or related businesses. Also, as a part of the Company's capital management strategy, the Board has authorized a stock repurchase program that is currently being executed by management, and has approved the payment of cash dividends to the Company's shareholders. These strategies are constantly being evaluated and modified as necessary. The Company's principal business activities are overseeing and directing the business of the Bank and investing the net stock offering proceeds retained by the Company. The Company's assets consist primarily of the outstanding capital stock of the Bank, deposits held at the Bank, and investment securities. The Company's executive office is located at 519 South New Hope Road, P.O. Box 2249, North Carolina 28053-2249. Its telephone number at this address is (704) 868-5200. The Company also maintains a website at www.citizenssouth.com that includes important information on our Company, including a list of our products and services, branch locations, current financial information, and links to the Company's 1934 Securities Exchange Act filings with the SEC. CITIZENS SOUTH BANK Citizens South Bank is a federally chartered savings bank headquartered in Gastonia, North Carolina. The Bank's principal business activity is offering deposit accounts to local customers through its 11 branch offices and investing those deposits, together with funds generated from operations and borrowings, in residential and nonresidential real estate loans, construction loans, commercial business loans, consumer loans, investment securities, and mortgage-backed securities. The Bank also acts as a broker in both the origination of loans secured by one-to-four family dwellings and in the sale of uninsured financial products. The Bank's results of operations are heavily dependent on net interest income, which is the difference between the interest earned on loans and securities and the interest paid on deposits and borrowings. Results of operations are also materially affected by the Bank's provision for loan losses, gains or losses from the sales of assets, fee income generated from deposit and loan accounts, commissions earned from the sale of uninsured investment products, and noninterest expenses. The Bank's noninterest expense primarily consists of compensation and employee benefits, occupancy expense, professional services, advertising, and other noninterest expenses. Results of operations are also significantly affected by general economic and competitive conditions, changes in interest rates, and actions of regulatory and governmental authorities. 1 Citizens South Bank is the successor entity to Gaston Federal Bank, which was established on December 31, 1904, as Gastonia Mutual Building and Loan Association ("Gastonia Mutual") under a charter from the State of North Carolina. Gastonia Mutual converted to a Federal charter and became Gaston Federal Savings and Loan Association ("Gaston Federal") on June 10, 1981. On April 30, 1982, Mount Holly Federal Savings and Loan Association merged into Gaston Federal and on April 9, 1998, Gaston Federal reorganized and sold stock and became Gaston Federal Bank, a wholly-owned subsidiary of Gaston Federal Bancorp, Inc. Citizens South Bank has 11 full-service branch offices in the North Carolina Counties of Gaston, Rowan, and Iredell. The Bank's executive office is located at 519 South New Hope Road, P.O. Box 2249, Gastonia, North Carolina 28053-2249. Its telephone number at this address is (704) 868-5200. MARKET AREA AND COMPETITION We consider our primary market area to be the North Carolina Counties of Gaston, Rowan, Iredell, Mecklenburg, Cabarrus, Lincoln, and Cleveland, and the South Carolina County of York. Our market area predominately centers in the suburbs surrounding the metropolitan area of Charlotte, North Carolina. The metropolitan area of Charlotte has a diverse economic base that includes business sectors in banking and finance, insurance, manufacturing, textiles, apparel, fabricated metals, construction, health care, transportation, retail trade, telecommunications, government services, and education. The Bank's corporate headquarters is located in Gastonia, North Carolina, which is located in the I-85 corridor, approximately 20 miles west of Charlotte. The Bank's corporate headquarters and six of its branch offices are located in Gaston County, North Carolina. These offices are located in the cities of Gastonia (four offices), Dallas, Mount Holly, and Stanley. According to data provided by the FDIC as of June 30, 2004, there were 12 banks and thrifts operating in Gaston County with $1.7 billion in deposits. As of June 30, 2004, the Bank had $186.1 million in deposits in Gaston County, or 10.7% of the total County deposits. This represents the third highest market share in Gaston County. We also operate two branch offices in Rowan County, North Carolina, which is approximately 60 miles northeast of the corporate headquarters. These offices are located in the cities of Salisbury and Rockwell. According to data provided by the FDIC as of June 30, 2004, there were 11 banks and thrifts operating in Rowan County with $1.2 billion in deposits. As of June 30, 2004, the Bank had $117.7 million in deposits in Rowan County, or 9.8% of the total County deposits. This represents the fourth highest market share in the County. We also have two branch offices in Iredell County, North Carolina, in the cities of Statesville and Mooresville. These offices are approximately 60 miles north of the corporate office. According to data provided by the FDIC as of June 30, 2004, there were 15 banks and thrifts operating in Iredell County with $1.6 billion in deposits. As of June 30, 2004, the Bank had $70.0 million in deposits in Iredell County, or 4.5% of the total County deposits. This represents the eighth highest market share in the County. EMPLOYEES As of December 31, 2004, the Company had 104 full-time and nine part-time employees, none of whom is represented by a collective bargaining unit. The Company provides employee benefit programs, including an Employee Stock Ownership Plan, matching contributions to a 401(k) retirement/savings plan, group life, heath, and dental insurance, and paid vacation and sick leave. Management believes its relationship with its employees is good. SUPERVISION AND REGULATION Citizens South Banking Corporation is a unitary savings and loan holding company, subject to regulation and supervision by the Office of Thrift Supervision ("OTS"). The OTS has enforcement authority over Citizens South Banking Corporation and its non-savings institution subsidiaries. This authority permits the OTS to restrict or prohibit activities that are determined to be a risk to Citizens South Bank. Federal law prohibits a savings and loan holding company from acquiring control of another savings institution or holding company 2 thereof, without prior written approval of the OTS. It also prohibits the acquisition or retention of, with specified exceptions, more than 5% of the equity securities of a company engaged in activities that are not closely related to banking or financial in nature or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the OTS must consider the financial and managerial resources, future prospects of the savings institution involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community and competitive factors. Citizens South Bank is a federal savings bank and derives its lending and investment powers from the Home Owners' Loan Act, as amended, and the regulations of the OTS. Under these laws and regulations, Citizens South Bank may invest in mortgage loans secured by residential and commercial real estate, commercial business and consumer loans, certain types of debt securities and certain other assets. Citizens South Bank also may establish subsidiaries that may engage in activities not otherwise permissible for Citizens South Bank, including real estate investment and securities and insurance brokerage. Citizens South Bank is a federally chartered SAIF-insured stock savings bank, subject to examination, supervision, and regulation by the OTS, as its primary federal regulator, and the Federal Deposit Insurance Corporation ("FDIC"), as the deposit insurer. Citizens South Bank is also a member of and owns stock in the Federal Home Loan Bank of Atlanta, which is a part of the Federal Home Loan Bank System. The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers or acquisitions. This regulation and supervision establishes a comprehensive framework of activities in which an institution may engage and is intended primarily for the protection of the insurance fund and depositors. Under this system of federal regulation, financial institutions are periodically examined to ensure that they satisfy applicable standards with respect to their capital adequacy, assets, management, earnings, liquidity and sensitivity to market interest rates. Citizens South Bank is also regulated to a lesser extent by the Board of Governors of the Federal Reserve System, governing reserves to be maintained against deposits and other matters. Citizens South Bank's relationship with its depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in matters concerning the ownership of deposit accounts and the form and content of Citizens South Bank's loan documents. The following discussion summarizes certain material elements of the regulatory framework applicable to Citizens South Banking Corporation and its subsidiaries. These summaries of statutes and regulations are not intended to be complete and such summaries are qualified in their entirety by reference to such statutes and regulations. A change in the statutes, regulations, or regulatory policies applicable to the Company, or its subsidiaries, could have a material effect on the business of the Company. Standards for Safety and Soundness. Federal law requires each federal banking agency to prescribe certain standards for all insured depository institutions. These standards relate to, among other things, internal controls, information systems and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, and other operational and managerial standards as the agency deems appropriate. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan. The OTS has primary enforcement responsibility over federal savings institutions and has the authority to bring enforcement action against all "institution-affiliated parties," including stockholders, and attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive, a cease and desist order, removal of officers and/or directors of the institution, receivership, conservatorship, civil penalties, or the termination of deposit insurance. The FDIC also has the authority to recommend to the Director of the OTS that enforcement action be taken with respect to a particular savings institution. If action is not taken by the Director, the FDIC has authority to take action under specified circumstances. OTS regulations require savings banks to meet three minimum capital standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8% risk-based capital ratio. At December 31, 2004, Citizens South Bank's capital exceeded all applicable requirements. Under prompt corrective action regulations, the OTS is required and authorized to take supervisory actions against undercapitalized savings banks. For this purpose, a savings 3 bank is placed in one of the following five categories based on the bank's capital: 1) well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and 10% total risk-based capital); 2) adequately capitalized (at least 4% leverage capital, 4% tier 1 risk-based capital and 8% total risk-based capital); 3) undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based capital or 3% leverage capital); 4) significantly undercapitalized (less than 6% total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital); and 5) critically undercapitalized (less than 2% tangible capital). At December 31, 2004, Citizens South Bank met the criteria for being considered "well-capitalized." OTS regulations govern capital distributions by a federal savings bank, which include cash dividends, stock repurchases and other transactions charged to the capital account. A savings bank must file an application for approval of a capital distribution if; (1) the total capital distributions for the applicable calendar year exceed the sum of the savings bank's net income for that year to date plus the savings bank's retained net income for the preceding two years; (2) the bank would not be at least adequately capitalized following the distribution; (3) the distribution would violate any applicable statute, regulation, agreement or OTS-imposed condition; or (4) the savings bank is not eligible for expedited treatment of its filings. Even if an application is not otherwise required, every savings bank that is a subsidiary of a holding company must still file a notice with the OTS at least 30 days before the board of directors declares a dividend or approves a capital distribution. The OTS may disapprove a notice or application if; (1) the savings bank would be undercapitalized following the distribution; (2) the proposed capital distribution raises safety and soundness concerns; or (3) the capital distribution would violate a prohibition contained in any statute, regulation or agreement. Community Reinvestment Act and Fair Lending Laws. All savings banks have a responsibility under the Community Reinvestment Act and related regulations of the OTS to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In connection with its examination of a federal savings bank, the OTS is required to assess the savings bank's record of compliance with the Community Reinvestment Act. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. A bank's failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in regulatory restrictions on its activities. The failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the OTS, as well as other federal regulatory agencies and the Department of Justice. Citizens South Bank received a "Satisfactory" Community Reinvestment Act rating in its most recent federal examination. Transactions with Affiliates. A federal savings bank's authority to engage in transactions with its "affiliates" is limited by OTS regulations and by Sections 23A and 23B of the Federal Reserve Act (the "FRA"). The term "affiliates" for these purposes generally means any company that controls or is under common control with an institution. Citizens South Banking Corporation and its non-savings institution subsidiaries are affiliates of Citizens South Bank. In general, transactions with affiliates must be on terms that are as favorable to the savings bank as comparable transactions with non-affiliates. In addition, certain types of these transactions are restricted to an aggregate percentage of the savings bank's capital. Collateral in specified amounts must usually be provided by affiliates in order to receive loans from the savings bank. In addition, OTS regulations prohibit a savings bank from lending to any of its affiliates that are engaged in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary. Citizens South Bank's authority to extend credit to its directors, executive officers and 10% shareholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the FRA and Regulation O of the Federal Reserve Board. Among other things, these provisions require that extensions of credit to insiders (i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features, and (ii) not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of Citizens South Bank's capital. In addition, extensions of credit in excess of certain limits must be approved by Citizens South Bank's Board of Directors. 4 Qualified Thrift Lender Test. As a federal savings bank, Citizens South Bank is subject to a qualified thrift lender, or "QTL," test. Under the QTL test, Citizens South Bank must maintain at least 65% of its portfolio assets in qualified thrift investments in at least nine months of the most recent 12-month period. Portfolio assets generally means total assets of a savings institution, less the sum of specified liquid assets up to 20% of total assets, goodwill and other intangible assets, and the value of property used in the conduct of the savings bank's business. Qualified thrift investments includes various types of loans made for residential and housing purposes, investments related to such purposes, including certain mortgage-backed and related securities, and loans for personal, family, household and certain other purposes up to a limit of 20% of portfolio assets. Qualified thrift investments also include 100% of an institution's credit card loans, education loans and small business loans. Citizens South Bank also may satisfy the QTL test by qualifying as a "domestic building and loan association" as defined in the Internal Revenue Code of 1986. A savings bank that fails the qualified thrift lender test must either convert to a bank charter or operate under specified restrictions. At December 31, 2004, Citizens South Bank maintained approximately 70% of its portfolio assets in qualified thrift investments. Insurance of Deposit Accounts. Deposit accounts in Citizens South Bank are insured by the Savings Association Insurance Fund of the Federal Deposit Insurance Corporation, generally up to a maximum of $100,000 per separately insured depositor. Citizens South Bank's deposits therefore are subject to FDIC deposit insurance assessments. The FDIC has adopted a risk-based system for determining deposit insurance assessments. The FDIC is authorized to raise the assessment rates as necessary to maintain the required ratio of reserves to insured deposits of 1.25%. In addition, all FDIC-insured institutions must pay assessments to the FDIC at an annual rate of approximately 0.015% of insured deposits to fund interest payments on bonds maturing in 2017 issued by a federal agency to recapitalize the predecessor to the Savings Association Insurance Fund. Federal Home Loan Bank System. Citizens South Bank is a member of the Federal Home Loan Bank System ("FHLB"), which provides a central credit facility primarily for member institutions. As a member of the FHLB of Atlanta, Citizens South Bank is required to acquire and hold shares of capital stock in the FHLB in an amount at least equal to 1% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its borrowings from the FHLB, whichever is greater. As of December 31, 2004, Citizens South Bank was in compliance with this requirement. Federal Reserve System. The Federal Reserve Board regulations require savings banks to maintain non-interest-earning reserves against their transaction accounts, such as negotiable order of withdrawal and regular checking accounts. At December 31, 2004, Citizens South Bank was in compliance with these reserve requirements. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements imposed by the Office of Thrift Supervision. The Gramm-Leach-Bliley Financial Modernization Act of 1999. The Gramm-Leach-Bliley Act ("G-L-B Act") was enacted in November 1999. The G-L-B Act restricted unitary savings and loan holding companies to those activities permissible for financial holding companies or for multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, including underwriting equity securities and insurance, incidental to financial activities or complementary to a financial activity. A multiple savings and loan holding company is generally limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the OTS, and certain additional activities authorized by OTS regulations. Sarbanes-Oxley Act of 2002. In July 2002, the President signed into law the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley"), which implemented legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board that will enforce auditing, quality control and independence standards and will be funded by fees from all publicly traded companies, Sarbanes-Oxley places certain restrictions on the scope of services that may be provided by accounting firms to their public company audit clients. Any non-audit services being provided to a public company audit client will require preapproval by the company's audit committee. In addition, Sarbanes-Oxley makes certain changes to the requirements for audit partner rotation after a period of time. Sarbanes-Oxley requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with 5 the Securities and Exchange Commission, subject to civil and criminal penalties if they knowingly or willingly violate this certification requirement. The Company's Chief Executive Officer and Chief Financial Officer have signed certifications to this Form 10-K as required by Sarbanes-Oxley. In addition, under Sarbanes-Oxley, counsel will be required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief legal officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself. Under Sarbanes-Oxley, longer prison terms will apply to corporate executives who violate federal securities laws; the period during which certain types of suits can be brought against a company or its officers is extended; and bonuses issued to top executives prior to restatement of a company's financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from trading the company's securities during retirement plan "blackout" periods, and loans to company executives (other than loans by financial institutions permitted by federal rules and regulations) are restricted. In addition, a provision directs that civil penalties levied by the Securities and Exchange Commission as a result of any judicial or administrative action under Sarbanes-Oxley be deposited to a fund for the benefit of harmed investors. The Federal Accounts for Investor Restitution provision also requires the Securities and Exchange Commission to develop methods of improving collection rates. The legislation accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a company's securities within two business days of the change. Sarbanes-Oxley also increases the oversight of, and codifies certain requirements relating to audit committees of public companies and how they interact with the company's "registered public accounting firm." Audit committee members must be independent and are absolutely barred from accepting consulting, advisory or other compensatory fees from the company. In addition, companies must disclose whether at least one member of the committee is a "financial expert" (as such term is defined by the Securities and Exchange Commission) and if not, why not. Under Sarbanes-Oxley, a company's registered public accounting firm is prohibited from performing statutorily mandated audit services for a company if such company's chief executive officer, chief financial officer, comptroller, chief accounting officer or any person serving in equivalent positions had been employed by such firm and participated in the audit of such company during the one-year period preceding the audit initiation date. Sarbanes-Oxley also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent accountant engaged in the audit of the company's financial statements for the purpose of rendering the financial statements materially misleading. The USA PATRIOT Act. In response to the events of September 11, 2001, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, was signed into law in October 2001. The USA PATRIOT Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act. Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions: 1) all financial institutions must establish anti-money laundering programs that include, at minimum: (i) internal policies, procedures, and controls; (ii) specific designation of an anti-money laundering compliance officer; (iii) ongoing employee training programs; and (iv) an independent audit function to test the anti-money laundering program; 2) minimum standards must be established with respect to customer identification at the time new accounts are opened; 3) financial institutions that establish, maintain, administer, or manage private banking accounts or correspondence accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering; 4) financial institutions are prohibited 6 from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and will be subject to certain record keeping obligations with respect to correspondent accounts of foreign banks and 5) bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications. Federal Securities Laws. Citizens South Banking Corporation common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. Citizens South Banking Corporation is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act of 1934. Shares of common stock purchased by persons who are not affiliates of Citizens South Banking Corporation may be resold without registration. Shares purchased by an affiliate of Citizens South Banking Corporation will be subject to the resale restrictions of Rule 144 under the Securities Act of 1933. If Citizens South Banking Corporation meets the current public information requirements of Rule 144 under the Securities Act of 1933, each affiliate of Citizens South Banking Corporation that complies with the other conditions of Rule 144, including those that require the affiliate's sale to be aggregated with those of other persons, would be able to sell in the public market, without registration, a number of shares not to exceed, in any three-month period, the greater of 1% of the outstanding shares of Citizens South Banking Corporation, or the average weekly volume of trading in the shares during the preceding four calendar weeks. In the future, Citizens South Banking Corporation may permit affiliates to have their shares registered for sale under the Securities Act of 1933. TAXATION Federal. The Company and the Bank are subject to the provisions of the Internal Revenue Code of 1986, as amended (the "Code") in the same general manner as other corporations. For federal income tax purposes, the Bank reports its income and expenses on the accrual method of accounting and uses a tax year ending December 31 for filing its federal income tax returns. The Small Business Protection Act of 1996 (the "1996 Act") eliminated the use of the reserve method of accounting for bad debt reserves by savings institutions, effective for taxable years beginning after 1995. Prior to the 1996 Act, the Bank was permitted to establish a reserve for bad debts and to make annual additions to the reserve. As a result of the 1996 Act, the Bank was required to use the specific charge off method in computing its bad debt deduction beginning with its 1996 federal tax return. In addition, the 1996 Act required the recapture of the excess of tax bad debt reserves at September 30, 1996 over those established as of September 30, 1988. The reserve was recaptured over a six-year period and was completely amortized as of December 31, 2004. State of North Carolina. Under North Carolina law, the corporate income tax is 7.0% of federal taxable income as computed under the Code, subject to certain prescribed adjustments. In addition, an annual state franchise tax is imposed at a rate of 0.15% applied to the greatest of the company's capital stock, surplus and undivided profits, investment in tangible property in North Carolina or 55% of the appraised valuation of property in North Carolina. State of Delaware. Delaware franchise taxes are imposed on the Company. Two methods are provided for calculating the tax and the lesser tax is payable. The first method is based on the authorized number of shares. The tax under this method is $90.00 for the first 10,000 authorized number of shares plus $50.00 for each additional 10,000 shares or part thereof. The second method is based on an assumed par value capital. The tax rate under this method is $200 per $1,000,000 or portion thereof of assumed par value capital. Assumed par is computed by dividing total assets by total issued shares (including treasury shares). Assumed par value capital is calculated by multiplying the lesser of assumed par or stated par value by total authorized shares. 7 ITEM 2. PROPERTIES The following table sets forth certain information regarding offices currently in operation at December 31, 2004. Management considers the facilities to be well maintained and sufficiently suitable for present operations. The net book value of the properties, including land, building, and improvements, net of accumulated depreciation was $13.5 million at December 31, 2004.
Approximate Owned Location Principal Use Facility Size or Leased --------------------------------------- ---------------------- ------------- --------- (square feet) 519 South New Hope Road Headquarters and 22,400 Owned Gastonia, North Carolina 28054-4040 Banking Office 245 West Main Avenue Banking Office and 12,400 Owned Gastonia, North Carolina 28052-4140 Back Office Processing 1630 East Franklin Boulevard Hispanic Banking 180 Leased Gastonia, North Carolina 28054-4747 Office 233 South Main Street Banking Office 2,370 Owned Mount Holly, North Carolina 28120-1620 1670 Neal Hawkins Road Banking Office and 5,320 Owned Gastonia, North Carolina 28056-6429 Mortgage Center 3135 Dallas High Shoals Highway Banking Office 3,225 Owned Dallas, North Carolina 28034-1307 412 South Highway 27 Banking Office 3,225 Owned Stanley, North Carolina 28164-2055 401 West Innes Street Banking Office 5,560 Owned Salisbury, North Carolina 28144-4232 106 West Main Street Banking Office 1,500 Owned Rockwell, North Carolina 28138-8859 307 North Center Street Banking Office and 8,260 Owned Statesville, North Carolina 28677-4063 Leased Space 649 Brawley School Road Banking Office 3,800 Owned Mooresville, North Carolina 28177-9121
8 ITEM 3. LEGAL PROCEEDINGS Periodically, there have been various claims and lawsuits involving the Company or the Bank, such as claims to enforce liens, condemnation proceedings on properties in which we hold security interests, claims involving the making and servicing of real property loans and other issues incident to our business. We are not a party to any pending legal proceedings that we believe would have a material adverse effect on the financial condition, operations, or cash flows of the Company or the Bank. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders during the fourth quarter of 2004. 9 PART II ------- ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK, RELATED STOCKHOLDER MATTERS, AND PURCHASES OF EQUITY SECURITIES The Company's common stock, $0.01 par value, trades on the Nasdaq National Market under the symbol CSBC. Price and volume information is contained in The Wall Street Journal and other daily newspapers in the Nasdaq section under the National Market System listings. As of February 1, 2005, the Company had 1,234 stockholders of record (excluding the number of persons or entities holding stock in street name through various brokerage firms), and 7,432,144 shares outstanding. The following brokers made a market in the Company's stock during 2004: Citigroup Global Markets, Inc. 1-800-223-7743 Fig Partners, LLC 1-404-601-7200 Friedman, Billings, Ramsey & Co. 1-800-688-3272 FTN Midwest Securities Corp. 1-800-880-7264 Goldman, Sachs & Co. 1-212-902-1000 Hill, Thompson, Magid and Co. 1-800-631-3083 Keefe, Bruyette & Woods, Inc. 1-800-342-5529 Knight Equity Markets, L.P. 1-800-222-4910 McDonald Investments (Trident) 1-404-495-2050 Merrill Lynch, Pierce, Fenner 1-800-937-0501 Moors & Cabot, Inc. 1-800-723-9866 Morgan Stanley & Co., Inc. 1-800-223-6559 Ryan Beck & Co., Inc. 1-800-325-7926 Sandler O'Neill & Partners 1-212-466-8020 UBS Capital Markets L.P. 1-212-804-3437 The following table sets forth quarterly market sales price ranges, dividend information, and repurchase activity for the Company's common stock over the past two years.
2004 QUARTER 1 QUARTER 2 QUARTER 3 QUARTER 4 ------------------------------ ---------- ---------- ---------- ---------- Price Range High $ 14.40 $ 13.74 $ 13.27 $ 14.27 Low 13.37 12.60 12.41 12.41 Dividend 0.065 0.065 0.065 0.065 Shares Repurchased 242,000 909,438 70,000 20,000 Avg. Price Paid Per Share $ 13.64 $ 13.03 $ 12.98 $ 12.69
2003 Quarter 1 Quarter 2 Quarter 3 Quarter 4 ------------------------------ ---------- ---------- ---------- ---------- Price Range High $ 11.89 $ 13.71 $ 15.24 $ 15.15 Low 10.04 11.99 12.90 13.70 Dividend 0.06 0.06 0.06 0.06 Shares Repurchased 0 210,000 132,200 353,235 Avg. Price Paid Per Share $ 0.00 $ 12.98 $ 14.76 $ 14.51
10 ITEM 6. SELECTED FINANCIAL DATA The following table sets forth certain information concerning the financial position of Citizens South Banking Corporation and its subsidiaries as of and for the dates indicated. The consolidated data is derived from, and should be read in conjunction with the Consolidated Financial Statements of the Company and its subsidiaries and related notes presented in Item 8.
AT AND FOR THE TWELVE MONTHS ENDED DECEMBER 31, -------------------------------------------------------------- 2004 2003 2002 2001 2000 ---------- ---------- ---------- ---------- ---------- (Dollars in thousands, except per share data) (unaudited) Income Statement Data: Interest income ............................................ $ 21,110 $ 21,969 $ 24,716 $ 16,382 $ 16,833 Interest expense ........................................... 7,943 8,732 10,195 9,770 9,684 ---------- ---------- ---------- ---------- ---------- Net interest income ........................................ 13,167 13,237 14,521 6,612 7,149 Provision for loan losses .................................. 330 60 225 120 53 ---------- ---------- ---------- ---------- ---------- Net interest income after provision for loan losses ........ 12,837 13,177 14,296 6,492 7,096 Noninterest income ......................................... 4,824 5,561 4,121 3,006 2,473 Noninterest expense ........................................ 13,629 13,891 11,381 7,092 6,975 ---------- ---------- ---------- ---------- ---------- Income before income taxes ................................. 4,032 4,847 7,036 2,406 2,594 Income tax expense ......................................... 1,077 1,456 2,528 702 846 ---------- ---------- ---------- ---------- ---------- Net income ................................................. $ 2,955 $ 3,391 $ 4,508 $ 1,704 $ 1,748 ========== ========== ========== ========== ========== Per Share Data (1): Basic net income ........................................... $ 0.39 $ 0.39 $ 0.51 $ 0.20 $ 0.20 Diluted net income ......................................... 0.38 0.39 0.51 0.20 0.20 Cash dividends declared .................................... 0.26 0.24 0.16 0.14 0.11 Period-end book value ...................................... 9.74 10.11 10.64 4.62 4.40 Balance Sheet Data: Total assets ............................................... $ 508,961 $ 495,751 $ 492,873 $ 447,581 $ 252,750 Loans receivable, net ...................................... 314,127 295,026 299,906 334,321 158,820 Mortgage-backed and related securities ..................... 81,169 89,168 70,409 25,405 22,955 Investment securities ...................................... 52,407 56,233 39,594 25,946 32,822 Deposits ................................................... 374,744 342,446 340,862 353,692 167,931 Borrowings ................................................. 55,772 58,981 47,575 42,057 42,737 Stockholders' equity ....................................... 72,394 87,669 96,383 41,630 39,763 Performance Ratios: Return on average assets ................................... 0.59% 0.68% 0.98% 0.65% 0.71% Return on average equity ................................... 3.78 3.61 7.61 4.17 4.46 Avg. interest-earning assets to avg. interest-bearing liabilities ............................................... 110.96 118.65 109.19 116.08 117.85 Noninterest expense to average total assets ................ 2.81 2.81 2.48 2.70 2.85 Interest rate spread ....................................... 2.78 2.57 3.26 2.05 2.34 Net interest margin (2) .................................... 2.63 2.67 3.17 2.52 2.92 Asset Quality Ratios: Allowance for loan losses to total loans at the end of period .................................................... 0.95% 1.00% 0.99% 0.93% 0.97% Nonperforming loans to total loans ......................... 0.30 0.18 0.17 0.35 0.30 Nonperforming assets to total assets ....................... 0.34 0.14 0.37 0.59 0.19 Capital Ratios: Average equity to average total assets ..................... 15.64% 18.96% 12.93% 15.55% 16.02% Equity to assets at period end ............................. 14.22 17.68 19.56 9.30 15.73 Dividend payout ratio (1) (3) ............................. 66.67 61.54 31.37 70.00 55.00
(1) All per share data for periods prior to September 30, 2002, has been adjusted to reflect the exchange ratio of 2.1408-to-1 in conjunction with the Company's stock offering. (2) Net interest margin is calculated by dividing net interest income by average assets for the period. (3) Dividend payout ratio is calculated by dividing cash dividends per share declared for the period by net income per share for the period. Citizens South Holdings, MHC, the former mutual holding company for Citizens South Banking Corporation, began waiving dividends in August 2000 and as of September 30, 2002, had waived dividends totaling approximately $1.8 million. The MHC owned between 53% and 58% of the outstanding common stock of the Company during the period in which the dividends were waived. 11 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Citizens South Banking Corporation (the "Company") is a Delaware corporation that owns all of the outstanding shares of common stock of Citizens South Bank (the "Bank"), a federally chartered savings bank headquartered in Gastonia, North Carolina. The Company's principal business activities are overseeing and directing the business of the Bank and investing the net stock offering proceeds retained by the Company. The Company's assets consist primarily of the outstanding capital stock of the Bank, deposits held at the Bank, and investment securities. The Bank's principal business activity is offering FDIC-insured deposit accounts to local customers through its eleven branch offices and investing those deposits, together with funds generated from operations and borrowings, in residential and nonresidential real estate loans, construction loans, commercial business loans, consumer loans, investment securities, and mortgage-backed securities. The Bank also acts as a broker in both the origination of loans secured by one-to-four family dwellings and in the sale of uninsured financial products (see Item 1. "Business" of this report). Our primary business strategy since our initial public stock offering in 1998 has been to transform the Bank from a traditional retail savings bank to a full-service community bank, offering a complete array of both commercial and retail loan and deposits, wealth management services, mortgage banking activities, brokerage services, and other related financial services. In executing this strategy, the Company has 1) concentrated much of its lending efforts on nonresidential real estate and construction loans, 2) originated substantially all fixed rate one-to-four family residential loans as a broker for a third party, and 3) focused its deposit gathering efforts on core deposits (demand deposit accounts, money market accounts, and savings accounts). As a result, nonresidential real estate and construction loans comprised approximately 44% of the Company's loan portfolio at December 31, 2004, compared to approximately 11% at December 31, 2000. Also, during the same period, the Company's portfolio of one-to-four family residential loans decreased from 68% of the Company's loan portfolio at December 31, 2000, to 29% of the Company's loan portfolio at December 31, 2004. Core deposits have increased as a percentage of total deposits from approximately 34% at December 31, 2002 to approximately 43% at December 31, 2004. Management expects to continue to execute this business strategy in 2005. On September 30, 2002, the Company completed its mutual-to-stock conversion and related stock offering, resulting in an equity to assets ratio of 19.56% at December 31, 2002. In order to properly leverage the Company's capital position, the Company has executed a number of strategies including 1) repurchasing Company stock at prices that are considered attractive, 2) paying dividends on outstanding stock, 3) building new banking offices in areas that the Company believes improves the value of the franchise, and 4) patiently pursuing acquisitions of other financial institutions or related companies. As of December 31, 2004, the Company had repurchased a total of 1,945,435 shares, or 21.5% of the outstanding shares of common stock, at an average price of $13.48. As a result of the execution of these capital management strategies, the Company's equity to assets ratio was 14.22% at December 31, 2004. Management plans to continue to execute these strategies until the Company's capital is appropriately leveraged. The Bank's results of operations are heavily dependent on net interest income, which is the difference between the interest earned on loans and securities and the interest paid on deposits and borrowings. Results of operations are also materially affected by the Bank's provision for loan losses, gains or losses from the sales of assets, fee income generated from deposit and loan accounts, commissions earned from the sale of uninsured investment products, and noninterest expenses. The Bank's noninterest expense primarily consists of compensation and employee benefits, occupancy expense, professional services, advertising, and other noninterest expenses. Results of operations are also significantly affected by general economic and competitive conditions, changes in interest rates, and actions of regulatory and governmental authorities. Net income was $3.0 million, or $0.38 per diluted share, for the year ended December 31, 2004, compared to $3.4 million, or $0.39 per diluted share, for the year ended December 31, 2003. The earnings provided a return on average equity of 3.78% in 2004, compared to 3.61% in 2003, and a return on average assets of 0.59% in 2004, compared to 0.68% in 2003. 12 Certain actions have been taken have adversely impacted our results of operations for the years ended December 31, 2004 and 2003. Specifically, during 2003, we recognized a $1.3 million pre-tax prepayment penalty associated with the restructuring of $15.0 million in borrowed funds. This action was taken by the Company in an effort to capitalize on historically low interest rates, lower the Company's cost of funds, and improve the Company's net interest margin. This restructuring reduced the average interest rate paid on these borrowed funds from 5.8% to 1.8%, resulting in an immediate reduction in interest expense of $150,000 per quarter for the first year. The reduction in interest expense is expected to amount to approximately $1.7 million over the next five years. Also, during 2004, we determined that unrealized losses on $2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0 million in perpetual preferred stock issued by Freddie Mac were "other-than-temporary" impairments. As a result, management recorded a noncash, pretax loss of $983,000. The unrealized losses on these securities were considered to be "other-than-temporary" by management for the following reasons: 1) both Fannie Mae and Freddie Mac have experienced recent accounting irregularities that have resulted in restated financial results from prior periods; 2) the yield on perpetual preferred stock recently issued by Fannie Mae is much higher than the yield of the preferred stock held by the Company, which decreases the value of the Company's security; 3) the preferred stock for Fannie Mae was recently downgraded and the preferred stock for both Companies are on a negative watch list; 4) the Freddie Mac preferred stock repriced in December 2004, yet it continued to have significant unrealized losses at year end; 5) neither of the preferred stock issues have stated maturity dates, so the recovery of the unrealized losses is not expected to occur in the foreseeable future. The credit issues facing Fannie Mae and Freddie Mac only impact the performance of the Company's perpetual preferred stock. The Company does not have any other perpetual preferred stock on its books at December 31, 2004. Management's Discussion and Analysis is provided to assist in understanding and evaluating the results of operations and financial condition of the Company and its subsidiaries. The following discussion should be read in conjunction with the consolidated financial statements and related notes included in Item 8. of this report. FORWARD-LOOKING STATEMENTS This report may contain certain "forward-looking statements" that represent the Company's expectations or beliefs concerning future events. Such forward-looking statements are about matters that are inherently subject to certain risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Factors that could cause such a difference include, but are not limited to, the timing and amount of revenues that may be recognized by the Company, continuation of current revenue and expense trends (including trends affecting chargeoffs and provisions for loan losses), unforeseen changes in the Company's markets, legal and regulatory changes, and general changes in the economy. Because of the risks and uncertainties inherent in forward-looking statements, readers are cautioned not to place undue reliance on these statements. The Company assumes no obligation to update or revise these forward-looking statements to reflect events or circumstances that occur after the date of this report. Readers should carefully review the risk factors described in other documents the Company files from time to time with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K. CRITICAL ACCOUNTING POLICIES The accounting and financial policies of the Company and its subsidiaries are prepared in accordance with accounting principles generally accepted in the United States and conform to general practices in the banking industry. We consider accounting policies that require significant judgment and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies. Changes in underlying factors, assumptions or estimates could have a material impact on our future financial condition and results of operations. Based on the size of the item or significance of the estimate, the following accounting policies are considered critical to our financial results. 13 Allowance for Loan Losses. The allowance for loan losses is calculated with the objective of maintaining an allowance sufficient to absorb estimated probable loan losses. Management's determination of the adequacy of the adequacy of the allowance is based on quarterly evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective, as it requires an estimate of the loss for each type of loan and for each impaired loan, an estimate of the amounts and timing of expected future cash flows, and an estimate of the value of the collateral. Management has established a systematic method for periodically evaluating the credit quality of the loan portfolio in order to establish an allowance for loan losses. The methodology is set forth in a formal policy and includes a review of all loans in the portfolio on which full collectibility may or may not be reasonably assured. The loan review considers among other matters, the estimated fair value of the collateral, economic conditions, historical loan loss experience, our knowledge of inherent losses in the portfolio that are probable and reasonable estimable and other factors that warrant recognition in providing an appropriate loan loss allowance. Specific allowances are established for certain individual loans that management considers impaired under Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan." The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis. In originating loans, we recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower, the term of the loan, general economic conditions, and in the case of a secured loan, the quality of the collateral. We increase our allowance for loan losses by charging provisions for loan losses against our current period income. Management's periodic evaluation of the adequacy of the allowance is consistently applied and is based on our past loan loss experience, particular risks inherent in the different kinds of lending that we engage in, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, current economic conditions, and other relevant internal and external factors that affect loan collectibility. Management believes this is a critical accounting policy because this evaluation involves a high degree of complexity and requires us to make subjective judgments that often require assumptions or estimates about various matters. Other-Than-Temporary Impairment of Securities. We have historically reviewed investment securities with significant declines in fair value for potential other-than-temporary impairment pursuant to the guidance provided by SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Effective December 31, 2004, management determined that unrealized losses on $2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0 million in perpetual preferred stock issued by Freddie Mac were "other-than-temporary" impairments. As a result, management recorded a noncash, pretax loss of $983,000. The unrealized losses on these securities were considered to be "other-than-temporary" by management for the following reasons: 1) both Fannie Mae and Freddie Mac have experienced recent accounting irregularities that have resulted in restated financial results from prior periods; 2) the yield on perpetual preferred stock recently issued by Fannie Mae is much higher than the yield of the preferred stock held by the Company, which decreases the value of the Company's security; 3) the preferred stock for Fannie Mae was recently downgraded and the preferred stock for both Companies are on a negative watch list; 4) the Freddie Mac preferred stock repriced in December 2004, yet it continued to have significant unrealized losses at year end; 5) neither of the preferred stock issues have stated maturity dates, so the recovery of the unrealized losses is not expected to occur in the foreseeable future. The credit issues facing Fannie Mae and Freddie Mac only impact the performance of the Company's perpetual preferred stock. The Company did not own any other perpetual preferred stock at December 31, 2004. 14 COMPARISON OF FINANCIAL CONDITION FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003 Total assets increased by $13.2 million, or 2.7%, from $495.8 million at December 31, 2003, to $509.0 million at December 31, 2004. Most of this asset growth was funded from a $32.3 million increase in deposits, the effects of which were partly offset by a $3.3 million decrease in borrowed money and stock repurchases totaling $16.4 million. Cash and cash equivalents increased by $3.4 million, or 41.1%, from $8.2 million at December 31, 2003, to $11.6 million at December 31, 2004. This increase in cash and cash equivalents was primarily the result of deposit growth of $32.3 million, a $3.8 million decrease in investment securities, an $8.0 million decrease in mortgage-backed securities, and earnings of $3.0 million, the effects of which were partly offset by a $19.1 million increase in net loans, $16.4 million in stock repurchases, a $3.3 million decrease in borrowed money, $2.0 million in dividend payments, and $3.7 million in building and improvements. Investment securities decreased by $3.8 million, or 6.8%, from $56.2 million at December 31, 2003, to $52.4 million at December 31, 2004. This decrease was the result of $22.4 million in maturities and calls of investments, $1.8 million in sales of investment securities, and the purchase of $20.3 million in investments during 2004. Management expects that fewer investment securities will be called during 2005 due to the recent increase in short-term interest rates. Mortgage-backed securities decreased by $8.0 million, or 9.0%, from $89.2 million at the end of 2003, to $81.2 million at the end of 2004. This decrease was primarily due to the maturity and principal amortization of $22.7 million of mortgage-backed securities, the sale of $6.4 million of mortgage-backed securities, and the purchase of $21.3 million of mortgage-backed securities during the year. Management expects that the principal amortization of its mortgage-backed securities portfolio will decrease in 2005 if an expected increase in mortgage loan interest rates occurs during the year. Management plans to reinvest the proceeds received from investment and mortgage-backed securities into higher-yielding commercial and consumer loans as cash flows are generated from these investments through maturities and principal and interest payments. Net outstanding loans increased by $19.1 million, or 6.5%, from $295.0 million at December 31, 2003, to $314.1 million at December 31, 2004. Management continues to emphasize the origination of shorter-term commercial and consumer loans in order to reduce the Company's vulnerability to rising interest rates. During 2004, these loans, which include construction loans, multifamily residential loans, nonresidential real estate loans, consumer loans, and commercial business loans, increased by $30.3 million, or 15.5%, to $225.5 million at December 31, 2004. Also during 2004, the Company's portfolio of one-to-four family residential loans decreased from $102.8 million to $91.7 million. This decrease of $11.1 million, or 10.8%, was primarily due to the high level of mortgage loan refinancings during 2004 resulting from continued low mortgage interest rates. The Company originates and closes substantially all new fixed-rate one-to-four family residential loans as a broker for an independent third party on a servicing-released basis. This generates additional fee income and reduces the potential adverse effects of rising interest rates on the Company's future earnings that normally result from holding long-term fixed-rate loans. Management expects that in 2005 the Company's portfolio of one-to-four family dwelling loans will stabilize while the remaining loan portfolio continues to experience strong growth due to the recent expansion into the Cornelius, North Carolina market with a loan production office and the continued strong local economy of the Charlotte metropolitan area. Also during 2004, the Company completed the construction of its new corporate office in Gastonia, North Carolina, which resulted in the consolidation and sale of an existing office, opened a Hispanic banking office in Gastonia, and upgraded its computer system in order to offer check imaging, online banking, cash management services, and document imaging. As a result, premises and equipment increased by $2.4 million, or 16.2%, to $17.4 million at December 31, 2004. The Company plans to complete construction of its twelfth banking office, to be located in Belmont, North Carolina, during the third quarter of 2005 and plans to enter into the York County, South Carolina market in 2006. Total liabilities increased by $28.5 million, or 7.0%, from $408.1 million at December 31, 2003, to $436.6 million at December 31, 2004. This increase was primarily due to a $32.3 million increase in deposits, the effects of which were offset by a $3.3 million decrease in borrowed money. Total deposits increased from $342.4 million at December 31, 2003, to $374.7 million at December 31, 2004. This represents an increase of $32.3 million, or 9.4%, during 2004. The majority of the increase in deposits came from core deposits, 15 which management considers to be checking accounts, money market accounts, and savings accounts. The Company's core deposits increased by $31.2 million, or 24.2%, to $159.7 million at December 31, 2004. This increase in core deposits reflects management's commitment to building new and enhancing existing customer relationships through improving technology and an expanding branch network. Certificates of deposit, which tend to be more transactional in nature and are a higher-costing source of funds compared to core deposits, increased by $1.2 million, or 0.5%, to $215.0 million at December 31, 2004. Borrowed money decreased by $3.3 million, or 5.7%, due to normal maturities of advances. Management will continue to use borrowed money in the future to fund any liquidity needs that may arise. Total stockholders' equity decreased by $15.3 million, or 17.4%, from $87.7 million at December 31, 2003 to $72.4 million at December 31, 2004. This decrease was primarily due to the repurchase of 1,250,000 shares of common stock for $16.4 million at an average price of $13.12 per share. These shares were repurchased as a part of stock repurchase plans announced in October 2003 and May 2004. The plan announced in October 2003 provided for the repurchase of 879,900 shares of stock, or approximately 10% of the outstanding shares. All of the shares authorized under this plan were repurchased by May 2004. The May 2004 repurchase plan provides for the repurchase of up to 815,000 shares of stock, or approximately 10% of the outstanding shares. As of December 31, 2004, the Company had repurchased 726,000 shares under the plan and had 89,000 shares remaining to be repurchased. Management plans to continue to repurchase shares of common stock in the Company at prices that are considered to be attractive and in the best interests of both the Company and its stockholders. Total stockholders' equity also decreased in 2004 as a result of the payment of $2.0 million in cash dividends, or $0.26 per share, and a $379,000 increase in accumulated net unrealized losses on investments available for sale. These decreases were partly offset by $3.0 million in net income and $281,000 in vesting of stock issued under the Citizens South Banking Corporation 2003 Recognition and Retention Plan which is described in more detail in "Note 12 - Employee Benefit Plans" under Item 8. of this report. RESULTS OF OPERATIONS The following discussion relates to operations for the year ended December 31, 2004, compared to the year ended December 31, 2003, as well as the year ended December 31, 2003, compared to the year ended December 31, 2002. The net income of the Company is heavily dependent upon net interest income. Net interest income is the difference between the interest earned on loans, investment and mortgage-backed securities, and interest-bearing deposits in other banks, offset by the interest paid on deposits and borrowings. COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003 Net income was $3.0 million, or $0.38 per diluted share, for the year ended December 31, 2004, compared to $3.4 million, or $0.39 per diluted share, for the year ended December 31, 2003. The earnings provided a return on average equity of 3.78% in 2004, compared to 3.61% in 2003, and a return on average assets of 0.59% in 2004, compared to 0.68% in 2003. Net interest income, the Company's largest source of income, decreased slightly in 2004 by $70,000, or 0.5%. This decrease was due in part to the declining ratio of average interest-earning assets to average interest-bearing liabilities during 2004. The Company's ratio of average interest-earning assets to average interest-bearing liabilities decreased from 118.65% in 2003 to 110.96% in 2004 due primarily from the repurchase of 1,250,000 shares of common stock for $16.4 million. This also contributed to a slight decrease in the Company's net interest margin from 2.67% in 2003 to 2.63% in 2004. However, the spread between the yield on interest-earning assets and the cost of interest-bearing liabilities has improved by 21 basis points from 2.57% in 2003 to 2.78% in 2004. This increase was largely due to a series of 25 basis point increases in the federal funds rate by the Federal Reserve Board that resulted in a 1.25% increase in the prime-lending rate during the year to 5.25% at December 31, 2004. Approximately 57% of the Company's loan portfolio reprices each month, the majority of which are tied to the prime lending rate. As such, management believes that the Company's net interest margin and resulting net interest income will improve in 2005, if short-term interest rates continue to increase, prepayments on loans and mortgage-backed securities slow to more normalized levels, and loan demand improves. However, if short-term interest rates decline, loan prepayments accelerate, or loan demand slows, management's expectations for 2005 may not be realized. 16 Interest income for the year ended December 31, 2004, decreased by $859,000, or 3.9%, to $21.1 million. This decrease was primarily due to a $682,000, or 4.1%, reduction in interest income on loans. During the year, average outstanding loans decreased by $2.9 million, or 1.0%, from $297.5 million to $294.6 million, while the average yield on loans decreased from 5.7% to 5.5%. These changes were primarily the result of a continued high level of loan prepayments and refinancings that reduced both yields and outstanding balances. The reduction in average outstanding loans was primarily concentrated in the Company's portfolio of one-to-four family residential loans due to the fact that the Company originates and closes substantially all new fixed-rate residential loans as a broker for an independent third party. This reduces the Company's vulnerability to increases in interest rates and provides current period fee income. During 2004 loans secured by one-to-four family residences decreased by $11.1 million, or 10.8%, to $91.7 million at December 31, 2004, while the remaining loan portfolio, which consists of construction loans, multifamily residential loans, commercial real estate loans, commercial business loans and consumer loans, increased by $30.3 million, or 15.5%, to $225.5 million at December 31, 2004. The Company has expanded into the high growth market of Cornelius, North Carolina with a loan production office and has recently hired three additional commercial lenders and one additional mortgage loan originator. Management believes that these actions, coupled with the recent increases in the prime lending rate, will improve the level of outstanding loans and the yield on the loan portfolio in 2005. Interest earned on interest-bearing bank balances decreased by $107,000, or 43.0%, to $142,000 in 2004. The average balance of interest-bearing bank balances decreased by $11.2 million, or 49.3%, to $11.6 million. These funds were primarily used to repurchase stock and purchase higher yielding investment securities. The average yield on these interest-earning bank balances increased slightly from 1.09% in 2003 to 1.22% in 2004. Interest earned on investment securities increased by $410,000, or 27.4%, to $1.9 million in 2004. This increase in interest income was primarily due to a $15.7 million, or 40.8%, increase in the average outstanding balance of investment securities. These additional securities were funded primarily by deposit growth and existing interest-bearing bank balances. The average yield on investment securities decreased by 37 basis points to 3.51% for 2004 due to the historically low levels of short-term interest rates during 2004. Interest income from mortgage-backed securities decreased by $480,000, or 14.0%, to $2.9 million in 2004. This decrease was largely due to a $9.9 million, or 10.8%, decrease in the average balance of mortgage-backed securities during 2004, resulting in part from the sale of $6.4 million of mortgage-backed securities during the year. These proceeds were used, in part, to repurchase shares of the Company's common stock in the Company. Also, during 2004, the average yield on mortgage-backed securities decreased from 3.73% to 3.59%, due in part to higher prepayment levels resulting from attractive mortgage interest rates during the year. Management expects the levels of investment and mortgage-backed securities will decline during 2005, with the proceeds of any sales, maturities, and normal amortization, to be used to fund additional loan originations and stock repurchases. Interest expense for the year ended December 31, 2004 decreased $789,000, or 9.0%, to $7.9 million. This decrease was due to a $374,000, or 5.8%, decrease in interest expense on deposits and a $415,000, or 18.6%, decrease in interest expense on borrowed funds. Average interest-bearing deposits increased $17.0 million, or 5.2%, to $345.7 million at December 31, 2004. Most of this increase was attributable to a $13.6 million increase in average core deposits, which includes checking accounts, money market demand accounts, and savings accounts. The remaining increase of $3.4 million was attributable to certificates of deposits. This change in the deposit mix reflects management's commitment to building new and enhancing existing customer relationships by focusing on a customer's primary financial needs such as checking accounts, savings accounts, and money market demand accounts. The average interest rate paid on deposits decreased from 1.97% in 2003 to 1.73% in 2004 due to lower market rates and an emphasis on lower-costing core deposits. Average borrowings increased by $1.8 million, or 3.5%, to $53.1 million at December 31, 2004, while the average rate paid on borrowings decreased from 4.35% in 2003 to 3.42% in 2004 due to lower market interest rates in 2004 and the restructuring of $15.0 million in Federal Home Loan Bank advances in 2003. This restructuring reduced the average interest rate on these $15.0 million in advances from 5.8% to 1.8%. Management expects that the cost of funds for deposits and borrowings will increase in 2005 if short-term interest rates continue to increase. 17 The Company provided $330,000 and $60,000 in loan loss provisions for the years ended December 31, 2004 and 2003, respectively. The allowance for loan losses as a percentage of loans was 0.95% at December 31, 2004, and 1.00% at December 31, 2003. The provision for loan losses increased due to strong growth in the Company's loan portfolio of $19.1 million, coupled with net charge-offs of $270,000 during the year. The level of nonperforming loans increased by $417,000 to $946,000 at December 31, 2004. Most of this increase was attributable to a $434,000 increase in nonperforming one-to-four family residential loans, which are secured by real estate. As a result, the ratio of nonperforming loans to net loans increased from 0.18% at December 31, 2003, to 0.30% at December 31, 2004. Also, real estate owned increased by $661,000 to $806,000 at December 31, 2004. All of the properties acquired through foreclosure are one-to-four family residential properties that are in various stages of disposition. As a result, the ratio of nonperforming assets to total assets increased from 0.14% at December 31, 2003, to 0.34% at December 31, 2004. Refer to the "Allowance for Loan Losses" section of Item 7. of this report for further discussion. For the year ended December 31, 2004, noninterest income decreased by $737,000, or 13.3%, from $5.6 million to $4.8 million. Excluding the net gain on sale of securities and other assets of $674,000 for the year ended December 31, 2004, and $1.0 million for the year ended December 31, 2003, noninterest income decreased by $390,000, or 8.6%. The primary reasons for the decrease were a $286,000 reduction in mortgage banking and loan fee income and a $134,000 reduction in the fair value adjustment on rabbi trust accounts. The decrease in mortgage-banking and loan fee income was primarily due to a reduced number of residential loan originations in 2004 as compared to 2003. This was largely due to a moderate increase in longer-term mortgage interest rates during 2004. Management expects that mortgage lending activity will continue to slow down in 2005 if long-term mortgage interest rates continue to rise during the year. The reduction in the fair value adjustment on rabbi trust accounts is offset by a corresponding decrease in compensation expense, resulting in no net impact on net income. The Company also realized moderate decreases in fee income on deposit accounts, commissions on sale of uninsured products, dividends on FHLB stock, and other income. Fee income on deposit accounts decreased by $23,000, or 1.0%, due to a slight reduction of fees generated from overdrawn checking accounts. Management believes that a continued focus on growing retail and commercial checking accounts will result in a moderate improvement in fee income on deposit accounts in 2005. Commissions earned from the sale of uninsured products decreased by $41,000, or 25.6%, to $120,000 for the year ending December 31, 2004. During 2004, the Company changed brokerage vendors from UVEST to Raymond James and hired an additional sales representative. Management believes that these actions will result in increased commissions during 2005. The $6,000 decrease on dividends on FHLB stock is directly related to the rate paid by the FHLB and the number of outstanding shares (based on outstanding advances). Management expects that the dividend rate paid by the FHLB will increase in 2005 due to recent increases in short-term interest rates. Other income decreased by only $1,000, and is expected to be at a comparable level in 2005. Gain on sale of securities decreased by $567,000, or 55.6%, from 2003 to 2004. During the year ended December 31, 2004, the Company sold $1.8 million in investment securities and $6.4 million in mortgage-backed securities at a net gain of $454,000. The proceeds from these sales were used to generate funds to repurchase shares of stock and originate loans. During the year ended December 31, 2003, the Company sold $8.1 million in investment securities and $12.2 million in mortgage-backed securities at a net gain of $1.0 million. These gains were used to offset the impact of vesting a portion of the shares of common stock granted in the Citizens South Banking Corporation 2003 Recognition and Retention Plan, which is described in "Note - 12 Employee Benefit Plans" under Item 8. of this report. The Company also recognized a $219,000 increase in net gain on sale of other assets from 2003 to 2004. This increase was primarily due to the sale of a branch office in 2004 that resulted in a gain of $218,000. The operations of this office were consolidated into the new corporate office in May 2004 and the office was subsequently vacated. The office was sold for $374,000 in December 2004. Noninterest expense decreased by $262,000, or 1.9%, from $13.9 million in 2003 to $13.6 million in 2004. The primary reasons for this decrease were a $702,000 decrease in compensation, a $1.3 million prepayment penalty on FHLB advances in 2003, and a $249,000 reduction in the amortization of intangible assets. The $702,000, or 9.6%, decrease in compensation was largely due to a $694,000 reduction in the vesting expense of the common stock granted in the Citizens South Banking Corporation 2003 Recognition and Retention Plan. The vesting schedule for this stock is 30% in 2003 and 10% in 2004 and each year thereafter 18 until completely vested. Management expects that compensation expense will increase in 2005 as additional loan officers are hired to increase loan production, personnel are hired to staff a new office in Belmont, North Carolina and a loan production office in Cornelius, North Carolina, and unvested options are expensed in accordance with SFAS No. 123 (revised), Share Based Payment. The $1.3 million prepayment penalty in 2003 was associated with the restructuring of $15.0 million in borrowed funds. This action was taken by the Company in an effort to capitalize on historically low interest rates, lower the Company's cost of funds, and improve the Company's net interest margin. This restructuring is expected to reduce interest expense by approximately $1.7 million over a five-year period. The amortization of intangible assets decreased by $249,000, or 37.0%, during 2004. The Company's core deposit intangible is being amortized over a seven-year period on an accelerated basis. The unamortized balance of the core deposit intangible as of December 31, 2004, was $783,000. Management expects the expense from the amortization of intangible assets to continue to decrease in 2005. The Company also realized moderate decreases in NOW account expenses, professional expenses, and deposit insurance. Management expects that these expenses will increase moderately in 2005, as the number of checking accounts is expected to increase and additional professional services are expected to be needed due to changing laws and regulations. The decreases in noninterest expenses listed above were partly offset by increases in occupancy expense, data processing, advertising, and other noninterest expenses. Occupancy expense increased by $434,000, or 32.3%, to $1.8 million in 2004. This increase was primarily due to the opening of the corporate office in 2004 and a new banking office in the third quarter of 2003. The Company sold a banking office in December 2004 that was vacant as a result of the opening of the new corporate office in May 2004. Management expects that office occupancy will increase in 2005 as the Company opens a full-service banking office in Belmont, North Carolina during the third quarter 2005 and obtains leased space for its loan production office in Cornelius, North Carolina. Data processing increased by $106,000, to $222,000 for the year ending December 31, 2004. During 2004 the Company upgraded its technology capabilities in the areas of online banking, cash management services, document imaging and core processing. These new capabilities allow the Company to offer a higher level of service to its existing customers, and to better compete for new customers. Management expects that data processing costs will moderately increase in 2005. Advertising expense increased by $60,000, or 21.4% during 2004 to $341,000. The Company has focused much of its marketing efforts on increasing its core deposits. The Company will continue to focus on building new retail and commercial loan and deposit relationships in 2005. Advertising costs are expected to decrease slightly in 2005. Other noninterest expenses, which includes expenses related to employee travel and training, deposit operations, loan administration, financial reporting, franchise and other taxes, and other miscellaneous items, increased by $471,000, or 33.9%. A large portion of the increase was due to training on the new computer system and enhanced products, relocating to the corporate office, and costs associated with supporting a larger number of deposit and loan accounts. Management expects that other noninterest expenses will decrease slightly in 2005. There were also moderate increases in expenses related to office supplies and telephone and communications. These expenses are expected to remain flat in 2005 due to reduced per item costs prescribed in new vendor contracts for office supplies and telecommunications. Effective December 31, 2004, management determined that unrealized losses on $2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0 million in perpetual preferred stock issued by Freddie Mac were "other-than-temporary" impairments. As a result, management recorded a noncash, pretax loss of $983,000. The unrealized losses on these securities were considered to be "other-than-temporary" by management for the following reasons: 1) both Fannie Mae and Freddie Mac have experienced recent accounting irregularities that have resulted in restated financial results from prior periods; 2) the yield on perpetual preferred stock recently issued by Fannie Mae is much higher than the yield of the preferred stock held by the Company, which decreases the value of the Company's security; 3) the preferred stock for Fannie Mae was recently downgraded and the preferred stock for both Companies are on a negative watch list; 4) the Freddie Mac preferred stock repriced in December 2004, yet it continued to have significant unrealized losses at year end; 5) neither of the preferred stock issues have stated maturity dates, so the recovery of the unrealized losses is not expected to occur in the foreseeable future. The credit issues facing Fannie Mae and Freddie Mac only impact the performance of the Company's perpetual preferred stock. The Company did not own any other perpetual preferred stock at December 31, 2004. 19 The Company's provision for income taxes was $1.1 million and $1.5 million for the years ended December 31, 2004 and 2003, respectively. The change was primarily due to an $815,000 decrease in pretax income. The effective tax rate decreased from 30.2% to 26.7% due to a larger percentage of income being derived from tax-advantaged assets such as municipal securities, U.S. Government Agency securities, and bank-owned life insurance that generate tax-exempt income. Management expects that the effective tax rate for 2005 will increase as a smaller percentage of pretax income is expected to be derived from tax-advantaged assets. COMPARISON OF RESULTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 2003 AND 2002 Net income was $3.4 million, or $0.39 per share, for the year ended December 31, 2003, compared to $4.5 million, or $0.51 per share, for the year ended December 31, 2002. The earnings provided returns on average equity of 3.61% in 2003, compared to 7.61% in 2002, and returns on average assets of 0.68% in 2003, compared to 0.98% in 2002. Net interest income, the Company's largest source of income, decreased by $1.3 million, or 8.8%, due in part to the decreasing spread between the yield on interest-earning assets and the cost of interest-bearing liabilities caused by the historically low interest rate environment. The interest rate spread between interest-earning assets and interest-bearing liabilities decreased from 3.26% in 2002 to 2.57% in 2003, resulting in a decrease in the net interest margin from 3.17% to 2.67% during the same period. The compression in the Company's net interest margin reached its low point of 2.43% during the third quarter of 2003, and showed signs of considerable improvement in the fourth quarter of 2003, reaching 2.68%, an increase of 25 basis points from the previous quarter. Interest income for the year ended December 31, 2003, decreased by $2.7 million, or 11.1%, to $22.0 million. This decrease was primarily due to a $4.4 million, or 20.9%, reduction in interest income on loans. During the year, average outstanding loans decreased by $23.0 million, or 7.2%, from $320.5 million to $297.5 million, while the average yield on loans decreased from 6.6% to 5.7%. These changes were primarily the result of a 25 basis point decrease in the prime lending rate in June 2003, and an abnormally high level of loan prepayments and refinancings that reduced both yields and outstanding balances. The reduction in average outstanding loans was primarily due to the fact that the Bank originates and closes substantially all new fixed-rate residential loans as a broker for an independent third party. This reduces the Bank's vulnerability to increases in interest rates. The level of prepayments and refinancings slowed during the fourth quarter of 2003 as interest rates began to stabilize. Interest income on interest-bearing bank deposits also decreased, with a reduction of $351,000, or 58.5%. Average balances of interest-bearing bank deposits decreased by $15.1 million, or 39.8%, to $22.8 million. This reduction was primarily due to the investment of the proceeds received in the 2002 stock offering (see the "Business" section of Item 1. for further discussion) into higher-yielding investment and mortgage-backed securities. Also, the average yield on interest-bearing bank deposits decreased to from 1.6% to 1.1%, as short-term interest rates continued to decrease in 2003. Interest earned on investment securities increased slightly to $1.5 million. The average balance of investment securities increased by $9.0 million, or 30.5%, to $38.5 million; however, this increase was offset by a decrease in the yield from 5.0% to 3.9%. Interest earned on mortgage-backed securities increased by $2.0 million, or 144.4%. This increase was due to a $63.1 million, or 219.6% increase in average outstanding balances to $91.9 million for 2003. These average balances increased due to the investment in net proceeds received in the September 2002 stock offering (see the "Business" section of Item 1. for further discussion), the reinvestment of funds received from loan prepayments, and the investment of funds received from borrowed money. The increase in average balances was partly offset in a decrease in the average yield from 4.9% to 3.7%. Management plans to reinvest the cash flows generated from these mortgage-backed securities into new consumer and commercial loan originations. Interest expense for the year ended December 31, 2003, decreased $1.5 million, or 14.3%, to $8.7 million. This decrease was due to a $1.5 million, or 18.3%, decrease in interest paid on deposits. Average interest-bearing deposits decreased $8.7 million, or 2.6%, to $328.7 million. Most of this decrease was attributable to a $19.0 million decrease in higher-costing certificates of deposit. All other deposits, including demand deposits, money market demand accounts, and savings accounts, increased by $10.3 million. This change in the deposit 20 mix reflects management's commitment to building new and enhancing existing customer relationships by focusing on a customer's primary financial needs such as checking accounts, savings accounts, and money market demand accounts. Average deposit balances decreased from 2002 to 2003 primarily as a result of the maturity of higher-costing certificates of deposit acquired in the acquisition of Innes Street in December 2001, which is detailed in the "Business" section in Item 1. of this report. Actual year-end deposit balances increased by $1.5 million from 2002 to 2003. The average interest rate paid on deposits decreased from 2.3% to 1.9% due to lower market rates. Average borrowings increased by $7.0 million, or 15.8%, to $51.2 million, while the rate paid on borrowings decreased from 5.1% to 4.4% due to lower market interest rates and the restructuring of $15.0 million in Federal Home Loan Bank advances. This restructuring reduced the average interest rate on these advances from 5.8% to 1.8%. These changes resulted in minor reduction of interest paid on borrowings to $2.2 million. The Company provided $60,000 and $225,000 in loan loss provisions for the years ended December 31, 2003 and 2002, respectively. The allowance for loan losses as a percentage of loans was 1.00% at December 31, 2003, and 0.99% at December 31, 2002. The ratio of allowances to total loans has remained flat due to the stable ratio of nonperforming loans to total loans of 0.17% at December 31, 2002, and 0.18% at December 31, 2003. Refer to the "Allowance for Loan Losses" section of Item 7. of this report for further discussion. For the year ended December 31, 2003, noninterest income increased by $1.4 million, or 35.0%, from $4.1 million to $5.6 million. The primary reasons for the change were a $161,000 increase in fees on deposit accounts, a $62,000 increase in mortgage banking loan fee income, a $779,000 increase in gains on sale of assets, and a $311,000 increase in the fair value adjustment on deferred compensation assets. The increase in fees on deposit accounts resulted from our continued emphasis on building our portfolio of fee-generating demand deposit accounts and a competitive fee structure on deposit products. Mortgage banking loan fee income increased due to a higher number of loan originations resulting, in part, from lower interest rates. We originated and closed many of these residential loans as a broker for a third party, resulting in immediate fee income for the Bank. The increase in the fair value adjustment on investments associated with deferred compensation assets totaled $311,000, which was offset by a corresponding $311,000 adjustment to compensation expense, resulting in no net impact on net income. During the year ended December 31, 2003, the Company sold $8.1 million in investment securities and $12.1 million in mortgage-backed securities at a net gain of $1.0 million. These gains were used to offset the impact of vesting a portion of the common stock granted in the Citizens South Banking Corporation 2003 Recognition and Retention Plan, which is described in "Note - 12 Employee Benefit Plans" under Item 8. of this report. During the fiscal year ended December 31, 2002, the Company sold $4.0 million in investment securities, $5.0 million in mortgage-backed securities, and $1.4 million of residential loans at a gain of $243,000. Noninterest expense increased by $2.5 million, or 22.1%, from $11.4 million in 2002 to $13.9 million in 2003. The primary reasons for the increase were a $1.7 million increase in compensation, a $1.3 million prepayment penalty on FHLB advances, a $255,000 increase in professional services, a $101,000 increase in telephone expense, and a $238,000 increase in other noninterest expenses. Compensation increased due in part to the vesting of a portion of the common stock granted in the Citizens South Banking Corporation 2003 Recognition and Retention Plan, the opening of the Company's tenth full service office, and fair value adjustments made on deferred compensation plans. These fair value adjustments totaled $311,000 in 2003 and are offset by a corresponding $311,000 adjustment to other noninterest income, resulting in no net impact on net income. During 2003, we recognized a $1.3 million pre-tax prepayment penalty associated with the restructuring of $15.0 million in borrowed funds. This action was taken by the Company in an effort to capitalize on historically low interest rates, lower the Company's cost of funds, and improve the Company's net interest margin. This restructuring reduced the average interest rate paid on these borrowed funds from 5.8% to 1.8%, resulting in an immediate reduction in interest expense of $150,000 per quarter for the first year. The reduction in interest expense is expected to amount to approximately $1.7 million over the next five years. Professional services increased by $255,000, or 78.0%, during 2003 due, in part, to additional outside services being needed to ensure proper corporate governance in light of new regulatory requirements. Telephone expense increased by $101,000, or 48.5%, due partly to the opening of a new branch office and enhanced data communications service at the existing Bank offices. Other noninterest expense increased by $238,000, or 16.7% due, in part, to franchise tax payments to the state of Delaware and other miscellaneous operating expenses. 21 These increases in noninterest expenses were partially offset by a $428,000, or 38.8%, reduction in the amortization of the core deposit intangible. The core deposit intangible was created as a result of the acquisition of Innes Street in 2001, which is described in the "Business" section of Item 1. of this report. It is being amortized over a seven-year period on an accelerated basis. The unamortized balance of the core deposit intangible as of December 31, 2003, was $1.1 million. The Company also experienced decreased expenses associated with data processing expenses, office supplies and advertising totaling $260,000, or 27.1%. These decreases were primarily attributable to higher than normal expenses experienced in 2002 relating to the changing of the Bank's name and the consolidation of the Bank's computer systems following the acquisition of Innes Street in December 2001, which is described in the "Business" section of Item 1. of this report. The Company's provision for income taxes was $1.5 million and $2.5 million for the years ended December 31, 2003 and 2002, respectively. The change was primarily due to a $2.2 million decrease in pretax income. The effective tax rate decreased from 35.9% to 30.2% due to a larger percentage of income being derived from tax-advantaged assets such as municipal securities, U.S. Government Agency securities, and bank-owned life insurance that generate tax-exempt income. 22 NET INTEREST INCOME The net income of the Company is heavily dependent upon net interest income. Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income also depends on the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rate earned or paid on them, respectively. The following table sets forth certain information relating to the Company for the years ended December 31, 2004, 2003 and 2002. For the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resultant yields, as well as the interest expense on average interest-bearing liabilities, is expressed both in dollars and rates. No tax equivalent adjustments were made. TABLE 1 AVERAGE BALANCES AND NET INTEREST INCOME ANALYSIS
December 31, 2004 December 31, 2003 -------------------------------------- ------------------------------------- Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ (Dollars in Thousands) Balance Expense Cost Balance Expense Cost ---------------------------------------- ---------- ---------- ---------- ---------- ---------- ---------- Assets: Interest-earning assets: Loans receivable (1) ................. $ 294,647 $ 16,116 5.47% $ 297,517 $ 16,798 5.65% Interest-bearing bank deposits ....... 11,598 142 1.22 22,847 249 1.09 Investment securities ................ 54,234 1,906 3.51 38,523 1,496 3.88 Mortgage-backed securities ........... 82,025 2,946 3.59 91,939 3,426 3.73 ---------- ---------- ---------- ---------- ---------- ---------- Total interest-earning assets .......... 442,504 21,110 4.77 450,826 21,969 4.87 Noninterest-earning assets. ............ 57,433 44,372 ---------- ---------- Total assets............................ $ 499,937 $ 495,198 ========== ========== Liabilities and Stockholders' Equity: Interest-bearing liabilities: Demand deposit accounts .............. $ 32,964 $ 103 0.31% $ 28,525 $ 91 0.32% Money market deposit accounts ........ 59,121 842 1.42 43,097 550 1.28 Savings accounts ..................... 32,802 165 0.50 39,705 305 0.77 Certificates of deposit .............. 220,838 5,017 2.27 217,395 5,555 2.56 Borrowed funds ....................... 53,053 1,816 3.42 51,238 2,231 4.35 ---------- ---------- ---------- ---------- ---------- ---------- Total interest-bearing liabilities ..... 398,779 7,943 1.99 379,960 8,732 2.30 ---------- ---------- Noninterest-bearing liabilities ........ 22,966 21,365 ---------- ---------- Total liabilities....................... 421,745 401,325 Stockholders' equity.................... 78,192 93,873 ---------- ---------- Total liabilities and equity ........... $ 499,937 $ 495,198 ========== ========== Net interest income..................... $ 13,167 $ 13,237 ========== ========== Interest rate spread (2)................ 2.78% 2.57% ========== ========== Net interest margin (3)................. 2.63% 2.67% ========== ========== Net yield on interest-earning assets (4)............................. 2.98% 2.94% ========== ========== Ratio of average interest-earning assets to avg. interest-bearing liabilities............................ 110.96% 118.65% ========== ========== December 31, 2002 ------------------------------------ Interest Average Average Income/ Yield/ (Dollars in Thousands) Balance Expense Cost ---------------------------------------- ---------- ---------- ---------- Assets: Interest-earning assets: Loans receivable (1) ................. $ 320,505 $ 21,232 6.62% Interest-bearing bank deposits ....... 37,963 600 1.58 Investment securities ................ 29,515 1,482 5.02 Mortgage-backed securities ........... 28,765 1,402 4.87 ---------- ---------- ---------- Total interest-earning assets .......... 416,748 24,716 5.93 Noninterest-earning assets. ............ 41,568 ---------- Total assets............................ $ 458,316 ========== Liabilities and Stockholders' Equity: Interest-bearing liabilities: Demand deposit accounts .............. 23,485 93 0.40% Money market deposit accounts ........ 32,285 498 1.54 Savings accounts ..................... 45,292 638 1.41 Certificates of deposit .............. 236,360 6,733 2.85 Borrowed funds ....................... 44,242 2,233 5.05 ---------- ---------- ---------- Total interest-bearing liabilities ..... 381,664 10,195 2.67 ---------- Noninterest-bearing liabilities ........ 17,409 ---------- Total liabilities....................... 399,073 Stockholders' equity.................... 59,243 ---------- Total liabilities and equity ........... $ 458,316 ========== Net interest income..................... $ 14,521 ========== Interest rate spread (2)................ 3.26% ========== Net interest margin (3)................. 3.17% ========== Net yield on interest-earning assets (4)............................. 3.48% ========== Ratio of average interest-earning assets to avg. interest-bearing liabilities............................ 109.19% ==========
---------- (1) Average loan balances include nonaccrual loans. (2) Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-earning liabilities. (3) Net interest margin is calculated by dividing net interest income by average assets for the period. (4) Net yield on interest-earning assets represents net interest income as a percentage of average interest-earning assets. 23 Changes in interest income and expense can result from changes in both volume and rates. The following table sets forth information regarding changes in our interest income and interest expense for the periods indicated. For each category of our interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (changes in volume multiplied by old rate); (ii) changes in rate (changes in rate multiplied by old volume); (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate. TABLE 2 VOLUME AND RATE VARIANCE ANALYSIS
For The Year Ended For the Year Ended December 31, 2004 vs December 31, 2003 December 31, 2003 vs December 31, 2002 Increase (Decrease) Increase (Decrease) Due to Due to -------------------------------------- ------------------------------------- (In Thousands) Volume Rate Net Volume Rate Net ---------------------------------------- ---------- ---------- ---------- ---------- ---------- ---------- Interest income: Loans receivable ..................... $ (161) $ (521) $ (682) $ (1,449) $ (2,985) $ (4,434) Interest-bearing bank deposits ....... (143) 36 (107) (197) (154) (351) Investment securities ................ 534 (124) 410 55 (41) 14 Mortgage-backed securities ........... (359) (121) (480) 2,267 (243) 2,024 ---------- ---------- ---------- ---------- ---------- ---------- Total interest income .................. (129) (730) (859) 676 (3,423) (2,747) ---------- ---------- ---------- ---------- ---------- ---------- Interest expense: Deposits ............................. 234 (608) (374) (415) (1,046) (1,461) Borrowed funds ....................... 82 (497) (415) (15) 13 (2) ---------- ---------- ---------- ---------- ---------- ---------- Total interest expense ................. 316 (1,105) (789) (430) (1,033) (1,463) ---------- ---------- ---------- ---------- ---------- ---------- Net interest income .................... $ (445) $ 375 $ (70) $ 1,106 $ (2,390) $ (1,284) ========== ========== ========== ========== ========== ==========
LOANS The Company generally makes consumer loans, commercial loans and residential mortgage loans within its market area. In the past, we concentrated our lending activities on conventional first mortgage loans secured by one-to-four family properties. However, since converting to a stock-owned company in 1998, the Company has focused more of its lending activities on construction loans, nonresidential real estate loans, commercial business loans and consumer loans. A substantial portion of our loan portfolio is secured by real estate, either as primary or secondary collateral, located in our primary market area. The Company has a diversified loan portfolio with no material concentrations to any one borrower or industry. Our lending activities are subject to the written, non-discriminatory, underwriting standards and loan origination procedures established by management and approved by our Board of Directors. Loan originations come from a number of sources including real estate agents, home builders, walk-in customers, referrals and existing customers. Loan officers also call on local businesses soliciting commercial products. We advertise our loan products in various print media including the local newspaper. In our marketing, we emphasize our community ties, personalized customer service, and an efficient underwriting and approval process. All real estate collateral is appraised or evaluated in accordance with regulatory requirements. On new loan originations, we require hazard, title and, to the extent applicable, flood insurance on all security property. The amounts and types of loans outstanding over the past five years are shown on the following table. 24 TABLE 3 LOAN PORTFOLIO
December 31, 2004 December 31, 2003 December 31, 2002 ------------------------ ------------------------ ----------------------- Amount Percent Amount Percent Amount Percent ---------- ---------- ---------- ---------- ---------- ---------- (Dollars in Thousands) Real estate loans: One-to-four family residential ....... $ 91,714 28.92% $ 102,751 34.48% $ 140,360 46.32% Multifamily residential .............. 10,632 3.35 11,987 4.02 8,962 2.96 Construction ......................... 25,033 7.89 8,913 2.99 9,903 3.27 Nonresidential ....................... 114,551 36.12 94,357 31.66 69,313 22.88 ---------- ---------- ---------- ---------- ---------- ---------- Total real estate loans ................ 241,930 76.28 218,008 73.15 228,538 75.43 Commercial business loans .............. 14,002 4.41 14,001 4.70 12,084 3.99 Consumer loans ......................... 61,245 19.31 66,020 22.15 62,368 20.58 ---------- ---------- ---------- ---------- ---------- ---------- Total gross loans ...................... 317,177 100.00% 298,029 100.00% 302,990 100.00% ========== ========== ========== Less: Deferred loan fees, net .............. 21 34 89 Allowance for loan losses ............ 3,029 2,969 2,995 ---------- ---------- ---------- Total loans, net ....................... $ 314,127 $ 295,026 $ 299,906 ========== ========== ==========
December 31, 2001 December 31, 2000 ----------------------- ----------------------- Amount Percent Amount Percent ---------- ---------- ---------- ---------- (Dollars in Thousands) ---------- ---------- ---------- ---------- Real estate loans: One-to-four family residential ....... $ 191,522 56.74% $ 109,907 68.40% Multifamily residential .............. 8,696 2.58 2,003 1.25 Construction ......................... 11,219 3.32 4,839 3.01 Nonresidential ....................... 53,110 15.74 12,925 8.04 ---------- ---------- ---------- ---------- Total real estate loans ................ 264,547 78.38 129,674 80.70 Commercial business loans .............. 6,930 2.05 12,834 7.99 Consumer loans ......................... 66,058 19.57 18,183 11.31 ---------- ---------- ---------- ---------- Total gross loans ...................... 337,535 100.00% 160,691 100.00% ========== ========== Less: Deferred loan fees, net .............. 78 305 Allowance for loan losses ............ 3,136 1,566 ---------- ---------- Total loans, net ....................... $ 334,321 $ 158,820 ========== ==========
Our Board of Directors must approve all loans in excess of $3.0 million or more, or in any amount to borrowers with existing exposure to us in excess of $3.0 million, or in any amount that when added to the borrower's existing exposure to us causes such total exposure to be in excess of $3.0 million. In addition, all unsecured loans in excess of $500,000, or in any amount when added to a borrower's existing unsecured exposure to us causes such unsecured exposure to be in excess of $500,000, must be approved by our Board of Directors. Loans of $3.0 million or less, or customers with exposure (including the proposed loan) of $3.0 million or less, or unsecured loans of $500,000 or less, or customers with unsecured exposure (including the proposed loan) of $500,000 or less, as applicable, may be approved individually or jointly by our lending officers within loan approval limits delegated by our Board of Directors. In addition, the Board of Directors has delegated "incremental" loan approval limits to certain lending officers which allows them to approve a new loan to an existing customer in an amount equal to, or less than, their incremental loan limit that would otherwise require approval by the Board of Directors or the additional approval of another lending officer. Any loan approved by a lending officer using their incremental loan limit must be ratified by the Board of Directors or approved by another lending officer, as applicable, after the loan has been made. 25 The following table represents the maturity distribution of the Company's loans by type, including fixed rate loans, as of December 31, 2004. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as becoming due within one year. Loan balances do not include undisbursed loan proceeds, unearned discounts, unearned income and allowance for loan losses. TABLE 4 MATURITY DISTRIBUTION OF LOAN PORTFOLIO
One year One to Over Five or Less Five Years Years Total ---------- ---------- ---------- ---------- (In thousands) Real Estate: One-to-four family residential ....... $ 305 $ 5,389 $ 86,020 $ 91,714 Multifamily residential .............. 454 9,016 1,162 10,632 Construction ......................... 12,375 10,194 2,464 25,033 Nonresidential ....................... 15,331 78,746 20,474 114,551 Commercial business .................... 4,106 9,718 178 14,002 Consumer ............................... 2,267 3,034 55,944 61,245 ---------- ---------- ---------- ---------- Total loans ............................ $ 34,838 $ 116,097 $ 166,242 $ 317,177 ========== ========== ========== ==========
The following table sets forth the dollar amount of all loans as of December 31, 2004, for which final payment is not due until after December 31, 2005. The table also shows the amount of each type of loan that has a fixed rate of interest and those that have an adjustable rate of interest. TABLE 5 INTEREST RATE DISTRIBUTION OF LOAN PORTFOLIO
Adjustable Fixed Rates Rates Total ------------ ------------ ------------ (In thousands) Real Estate Loans: One-to-four family residential ....... $ 32,698 $ 58,711 $ 91,409 Multifamily residential .............. 1,530 8,648 10,178 Construction ......................... 3,442 9,216 12,658 Nonresidential ....................... 17,940 81,280 99,220 ------------ ------------ ------------ Total real estate loans ................ 55,610 157,855 213,465 Commercial business .................... 3,361 6,535 9,896 Consumer loans ......................... 3,995 54,983 58,978 ------------ ------------ ------------ Total loans .......................... $ 62,966 $ 219,373 $ 282,339 ============ ============ ============
Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of a loan is substantially less than its contractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give us the right to declare loans immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase, however, when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are substantially higher than current mortgage loan market rates. Nonperforming Assets and Delinquencies. When a borrower fails to make a required payment on a loan, we attempt to cure the deficiency by contacting the borrower and collecting the payment. Computer generated late notices are mailed 15 days after a payment is due. In most cases, deficiencies are cured promptly. If a delinquency continues, additional contact is made either through a notice or other means and we will attempt to work out a payment schedule and actively encourage delinquent residential mortgage borrowers to seek home ownership counseling. While we generally prefer to work with borrowers to resolve such problems, we will institute foreclosure or other proceedings, as necessary, to minimize any potential loss. Loans are placed on nonaccrual status generally if, in the opinion of management, principal or interest payments are not likely in accordance with the terms of the loan agreement, or when principal or interest is past due 90 days or more. 26 Interest accrued but not collected at the date the loan is placed on nonaccrual status is reversed against income in the current period. Loans may be reinstated to accrual status when payments are under 90 days past due and, in the opinion of management, collection of the remaining past due balances can be reasonably expected. Our Board of Directors is informed monthly of the total amount of loans which are more than 30 days delinquent. Loans that are more than 90 days delinquent or in foreclosure are reviewed by the Board on an individual basis each month. The following table sets forth information with respect to our nonperforming assets at the dates indicated. As of such dates, we had no restructured loans within the meaning of SFAS No. 15. TABLE 6 SCHEDULE OF NONPERFORMING ASSETS
December 31, ------------------------------------------------------------------ 2004 2003 2002 2001 2000 ---------- ---------- ---------- ---------- ---------- (Dollars in thousands) Loans accounted for on a nonaccrual basis: Real estate loans: One-to-four family residential ............ $ 627 $ 193 $ 329 $ 756 $ 236 Multifamily residential ................... 0 0 0 70 71 Construction .............................. 0 0 90 0 0 Nonresidential real estate ................ 209 20 0 0 0 Commercial business ......................... 30 203 21 150 75 Consumer .................................... 80 113 76 196 97 ---------- ---------- ---------- ---------- ---------- Total nonaccrual loans ...................... 946 529 516 1,172 479 Accruing loans which were contractually past due 90 days or more ................... 0 0 0 0 0 ---------- ---------- ---------- ---------- ---------- Total nonperforming loans ................... 946 529 516 1,172 479 Real estate owned ........................... 806 145 1,307 1,470 0 ---------- ---------- ---------- ---------- ---------- Total nonperforming assets .................. $ 1,752 $ 674 $ 1,823 $ 2,642 $ 479 ========== ========== ========== ========== ========== Nonperforming loans to net loans ............ 0.30% 0.18% 0.17% 0.35% 0.30% Nonperforming assets to total assets ........ 0.34% 0.14% 0.37% 0.59% 0.19%
Real Estate Acquired in Settlement of Loans. Real estate acquired by us as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate acquired in settlement of loans until sold. Generally, foreclosed assets are held for sale and such assets are carried at the lower of cost or market value minus estimated cost to sell the property. After the date of acquisition, all costs incurred in maintaining the property are expensed and costs incurred for the improvement or development of such property are capitalized up to the extent of their net realizable value. At December 31, 2004, we had $806,000 in real estate acquired in settlement of loans. This balance is comprised of 15 single-family residences located in the Bank's normal lending area. Thirteen of these properties are investor rental properties that were acquired in 2004 from three separate borrowers. The Company has no other direct material exposure to these three borrowers. These single-family residences are in various stages of disposition. Restructured Loans. Under accounting principles generally accepted in the United States of America ("GAAP"), we are required to account for certain loan modifications or restructuring as a "troubled debt restructuring." In general, the modification or restructuring of a debt constitutes a troubled debt restructuring if we, for economic or legal reasons related to the borrower's financial difficulties, grant a concession to the borrowers that we would not otherwise consider. Debt restructurings or loan modifications for a borrower do not necessarily always constitute troubled debt restructurings, however, and troubled debt restructurings do not necessarily result in nonaccrual loans. We had no restructured loans as of December 31, 2004. 27 Asset Classification. The OTS has adopted various regulations regarding problem assets of financial institutions. The regulations require that each insured institution review and classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, OTS examiners have the authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. If an asset or portion thereof is classified as loss, we establish specific allowances for loan losses for the full amount of the portion of the asset classified as loss. All or a portion of general loan loss allowances established to cover possible losses related to assets classified substandard or doubtful can be included in determining an institution's regulatory capital, while specific valuation allowances for loan losses generally do not qualify as regulatory capital. Assets that do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated "special mention" and monitored by us. As of December 31, 2004, we had $3.5 million in assets classified substandard, $202,000 classified doubtful, and no assets classified as loss. The aggregate amount designated special mention as of December 31, 2004, was $5.0 million. Pursuant to Statement of Financial Accounting Standards ("SFAS") No. 114, "Accounting by Creditors for Impairment of a Loan," management determined that impaired loans were not material as of December 31, 2004. As of December 31, 2003, we had $2.6 million classified as substandard, $203,000 classified as doubtful and no assets classified as loss. The aggregate amount designated special mention was $3.1 million. Pursuant to SFAS 114, management determined that impaired loans were not material as of December 31, 2003. ALLOWANCE FOR LOAN LOSSES Management has established a systematic methodology for evaluating the adequacy of the Company's allowance for loan losses. The methodology is set forth in a formal policy and considers all loans in the portfolio. Specific allowances are established for certain individual loans that management considers impaired under SFAS 114. The remainder of the portfolio is segmented into groups of loans with similar risk characteristics for evaluation and analysis. In originating loans, we recognize that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower, the term of the loan, general economic conditions, and in the case of a secured loan, the quality of the collateral. We increase our allowance for loan losses by charging provisions for loan losses against our current period income. Management's periodic evaluation of the adequacy of the allowance is consistently applied and is based on our past loan loss experience, particular risks inherent in the different kinds of lending that we engage in, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, current economic conditions, and other relevant internal and external factors that affect loan collectibility. At December 31, 2004, we had an allowance for loan losses of $3.0 million. Management believes that this amount meets the requirement for losses on loans that management considers to be impaired, for known losses, and for risks inherent in the remaining loan portfolios. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly adversely affected if circumstances differ substantially from the assumptions used in making the determinations. The allowance for loan losses is subject to periodic evaluation by various regulatory authorities and may be subject to adjustment upon their examination. The following table sets forth an analysis of our allowance for loan losses. 28 TABLE 7 ALLOWANCE OF LOAN LOSSES
At and For the Twelve Months Ended December 31, -------------------------------------------------------- 2004 2003 2002 2001 2000 -------- -------- -------- -------- -------- (Dollars in Thousands) Allowance at beginning of period ................. $ 2,969 $ 2,995 $ 3,136 $ 1,566 $ 1,517 Charge-offs: One-to-four family residential ................. 14 0 16 0 0 Nonresidential mortgage loans .................. 174 0 175 0 0 Commercial business loans ...................... 76 0 150 0 0 Consumer loans ................................. 14 94 42 104 4 -------- -------- -------- -------- -------- Total charge-offs ................................ $ 278 $ 94 $ 383 $ 104 $ 4 Recoveries: One-to-four family residential ................. 0 0 0 0 0 Nonresidential mortgage loans .................. 1 0 0 0 0 Commercial business loans ...................... 4 0 0 0 0 Consumer loans ................................. 3 8 17 1 1 -------- -------- -------- -------- -------- Total recoveries ................................. $ 8 $ 8 $ 17 $ 1 $ 1 -------- -------- -------- -------- -------- Net charge-offs .................................. $ 270 $ 86 $ 366 $ 103 $ 3 Provision for loan losses ........................ 330 60 225 120 52 Allowance acquired in acquisition ................ 0 0 0 1,553 0 -------- -------- -------- -------- -------- Allowance at end of period ..................... $ 3,029 $ 2,969 $ 2,995 $ 3,136 $ 1,566 ======== ======== ======== ======== ======== Allowance for loan losses to total gross loans ... 0.95% 1.00% 0.99% 0.93% 0.97% Net charge-offs to average loans ................. 0.09% 0.03% 0.11% 0.06% 0.00%
29 The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated. Management believes that the allowance can be allocated by category only on an approximate basis. The allocation of the allowance to each category is not necessarily indicative of future losses and does not restrict the use of the allowance to absorb losses in any other category. TABLE 8 ALLOCATION OF ALLOWANCE FOR LOAN LOSSES
December 31, 2004 December 31, 2003 December 31, 2002 ------------------- ------------------- ------------------- % of % of % of Total Total Total Amount Loans Amount Loans Amount Loans -------- -------- -------- -------- -------- -------- (dollars in thousands) Real estate loans: One-to-four family residential .. $ 250 28.92% $ 399 33.48% $ 475 46.32% Multifamily residential ......... 100 3.35 100 4.02 100 2.96 Construction .................... 300 7.89 150 2.99 150 3.27 Nonresidential .................. 609 36.12 550 31.66 500 22.88 -------- -------- -------- -------- -------- -------- Total real estate loans ........... 1,259 76.28 1,199 73.15 1,225 75.43 Commercial business ............... 600 4.41 600 4.70 600 3.99 Consumer loans .................... 1,171 19.31 1,170 22.15 1,170 20.58 -------- -------- -------- -------- -------- -------- Total allowance for loan losses ... $ 3,029 100.00% $ 2,969 100.00% $ 2,995 100.00% ======== ======== ======== ======== ======== ========
December 31, 2001 December 31, 2000 ------------------- ------------------- % of % of Total Total Amount Loans Amount Loans -------- -------- -------- -------- (dollars in thousands) Real estate loans: One-to-four family residential .. $ 800 56.74% $ 400 68.40% Multifamily residential ......... 100 2.58 50 1.25 Construction .................... 150 3.32 55 3.01 Nonresidential .................. 225 15.74 70 8.04 -------- -------- -------- -------- Total real estate loans ........... 1,275 78.38 575 80.70 Commercial business ............... 744 2.05 500 7.99 Consumer loans .................... 1,117 19.57 491 11.31 -------- -------- -------- -------- Total allowance for loan losses ... $ 3,136 100.00% $ 1,566 100.00% ======== ======== ======== ========
DEPOSITS Our deposit products include a broad selection of deposit instruments, including checking accounts, money market deposit accounts, savings accounts, individual retirement accounts, and term certificate accounts. We offer these products to both retail and commercial customers. Deposit account terms vary with the principal difference being the minimum balance deposit, early withdrawal penalties and the interest rate. We review our deposit mix and pricing weekly. We do not utilize brokered deposits, nor have we aggressively sought jumbo certificates of deposit. We believe that we are competitive in the type of accounts and interest rates we offer on our deposit products. We do not seek to pay the highest deposit rates, but a competitive rate. Management determines the rates paid based on a number of conditions, including rates paid by competitors, rates on U.S. Treasury securities, rates offered on alternative lending programs, and the deposit growth rate we are seeking to achieve. The following table sets forth information concerning our deposit accounts. 30 TABLE 9 DEPOSIT PORTFOLIO COMPOSITION
December 31, 2004 December 31, 2003 December 31, 2002 ----------------------- ----------------------- ----------------------- Average Average Average Actual Interest Actual Interest Actual Interest Category Balance Rate Balance Rate Balance Rate ------------------------------ ---------- ---------- ---------- ---------- ---------- ---------- (dollars in thousands) Noninterest bearing demand ... $ 19,734 0.0% $ 12,906 0.0% $ 11,203 0.0% Interest bearing demand ...... 32,949 0.3 30,780 0.3 25,773 0.4 Money market deposit ......... 77,924 1.4 48,189 1.3 35,811 1.5 Savings accounts ............. 29,174 0.5 36,754 0.8 43,670 1.4 Certificates of deposit ...... 214,962 2.3 213,817 2.6 224,405 2.9 ---------- ---------- ---------- ---------- ---------- ---------- Total Deposits ............... $ 374,744 1.7% $ 342,446 1.9% $ 340,862 2.3% ========== ========== ========== ========== ========== ==========
The following table indicates the amount of our time deposits (also referred to as certificates of deposits) with a principal balance greater than $100,000 by time remaining until maturity as of December 31, 2004. TABLE 10 MATURITIES OF TIME DEPOSITS OVER $100,000 Maturity Period Time Deposits --------------------------------------------- ------------- (In Thousands) Within three months ......................... $ 10,209 Three to six months ......................... 15,464 Six through twelve months ................... 14,342 Over twelve months .......................... 22,496 ------------- Total time deposits over $100,000 ......... $ 62,511 ============= The following table sets forth the amount of time deposits in the Bank categorized by rates as of December 31st at the dates indicated. TABLE 11 TIME DEPOSIT INTEREST RATE COMPOSITION At December 31, ------------------------------------ 2004 2003 2002 ---------- ---------- ---------- (In Thousands) Interest Rate Less than 2.00% ........................ $ 74,951 $ 85,060 $ 38,066 2.01-4.00% ............................. 118,275 108,170 159,893 4.01-6.00% ............................. 21,616 20,470 24,145 6.01-8.00% ............................. 120 117 2,301 ---------- ---------- ---------- $ 214,962 $ 213,817 $ 224,405 ========== ========== ========== 31 The following table sets forth the amount of time deposits in the Bank categorized by rates and maturities at December 31, 2004. TABLE 12 TIME DEPOSIT MATURITY SCHEDULE
During the Years Ended December 31, ------------------------------------------------------------------ 2008 Interest Rate 2005 2006 2007 or Later Total ---------------------------------------- ---------- ---------- ---------- ---------- ---------- (In Thousands) Less than 2.0% ......................... $ 73,171 $ 1,723 $ 57 $ 0 $ 74,951 2.01-4.0% .............................. 74,347 28,965 10,556 4,407 118,275 4.01-6.0% .............................. 8,487 245 4,259 8,625 21,616 6.01-8.0% .............................. 120 0 0 0 120 ---------- ---------- ---------- ---------- ---------- Total .................................. $ 156,125 $ 30,933 $ 14,872 $ 13,032 $ 214,962 ========== ========== ========== ========== ==========
CAPITAL ADEQUACY AND RESOURCES OTS regulations require savings banks to meet three minimum capital standards: a 1.5% tangible capital ratio, a 4% leverage ratio and an 8% risk-based capital ratio. At December 31, 2004, Citizens South Bank's capital exceeded all applicable requirements. Under prompt corrective action regulations, the OTS is required and authorized to take supervisory actions against undercapitalized savings banks. For this purpose, a savings bank is placed in one of the following five categories based on the bank's capital: 1) well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and 10% total risk-based capital); 2) adequately capitalized (at least 4% leverage capital, 4% tier 1 risk-based capital and 8% total risk-based capital); 3) undercapitalized (less than 8% total risk-based capital, 4% tier 1 risk-based capital or 3% leverage capital); 4) significantly undercapitalized (less than 6% total risk-based capital, 3% tier 1 risk-based capital or 3% leverage capital); and 5) critically undercapitalized (less than 2% tangible capital). At December 31, 2004, Citizens South Bank met the criteria for being considered "well-capitalized." Funding for future growth is dependent upon the earnings of the Company and its subsidiaries. At December 31, 2004, the Company had a capital to assets ratio of 14.22%. As such, the Company fully expects to be able to meet future capital needs caused by growth and expansion as well as regulatory requirements. A primary reason for the Company's strong capital position was the successful stock offering that was completed in September 2002 that raised net proceeds of $45.5 million as discussed in the "Business" section of Item 1. of this report. The Company plans to continue to repurchase its common stock in the open market from time to time as market conditions warrant. During 2004, the Company repurchased 1,250,000 shares of common stock for $16.4 million. LIQUIDITY The objectives of the Company's liquidity management policy include providing adequate funds to meet the cash needs of both borrowers and depositors, to provide for the on-going operations of the Company, and to capitalize on opportunities for expansion. Liquidity management addresses the Company's ability to meet deposit withdrawals on demand or at contractual maturity, to repay borrowings as they mature, and to fund new loans and investments as opportunities arise. The primary sources of internally generated funds are principal and interest payments on loans receivable, increases in local deposits, cash flows generated from operations, and cash flows generated by investments. If the Company requires funds beyond its internal funding capabilities, it may rely upon external sources of funds such in brokered deposits and Federal Home Loan Bank ("FHLB") advances. The Company has $71.8 million in additional advances available from its line of credit from the FHLB. The FHLB functions as a central reserve bank providing credit for member financial institutions. As a member of the FHLB, we are required to own capital stock in the FHLB and we are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities that are obligations of, or guaranteed by, the U.S. Government) provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on 32 the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit. The Company may also solicit brokered deposits for providing funds for asset growth; however, to date, the Company has not used such deposits to supplement its liquidity position. In the normal course of business, various commitments are outstanding that are not reflected in the consolidated financial statements. Commitments to extend credit and undisbursed advances on customer lines of credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. The funding of these commitments and previously approved undisbursed lines of credit could effect the Company's liquidity position. At December 31, 2004, the Company had loan commitments of $15.9 million and unused lines of credit of $62.4 million. The Company believes that it has adequate resources to fund loan commitments and lines of credit as they arise. The Company does not have any special purpose entities of other similar forms of off-balance sheet financing. Under existing contractual obligations, the Company will be required to make payments in future periods. The following table presents aggregated information about payments due under such contractual obligations at December 31, 2004. The Company expects that a portion of the deposits will not be renewed upon maturity. If there is a higher than normal level of time deposits that are not renewed at maturity, then the Company may experience a decrease in liquidity. This may result in the Company offering higher than market interest rates to maintain deposits, which would increase interest expense. Transaction deposit accounts with indeterminate maturities have been classified as having payments due in one year or less. TABLE 13 CONTRACTUAL MATURITIES
Payments Due by Period at December 31, 2004 ------------------------------------------------------------------- One Year One to Three to Over Five Or Less Three Years Five Years Years Total ----------- ----------- ----------- ----------- ----------- (in thousands) Borrowed Funds ............... $ 13,771 $ 20,500 $ 11,500 $ 10,000 $ 55,771 Deposits ..................... 315,907 45,805 13,032 0 374,744 Lease Obligations ............ 46 119 0 0 165 ----------- ----------- ----------- ----------- ----------- Total ........................ $ 329,724 $ 66,424 $ 24,532 $ 10,000 $ 430,680 =========== =========== =========== =========== ===========
MARKET RISKS Market risk reflects the risk of economic loss resulting from adverse changes in market price and interest risks. The risk of loss can be reflected in diminished market values and/or reduced net interest income in future periods. The Company's most significant form of market risk is interest rate risk, as the majority of the Company's assets and liabilities are sensitive to changes in interest rates. The structure of the Company's loan and deposit portfolios is such that significant declines in interest rates could adversely impact net market values and net interest income. The Company does not maintain a trading account, nor is it subject to currency exchange risk or commodity price risk. The Company's Asset/Liability Committee ("ALCO") is responsible for monitoring and managing exposure to interest rate risk, as discussed below in "Interest Rate Sensitivity". INTEREST RATE SENSITIVITY The Company's ALCO monitors the Company's level of interest rate sensitivity and ensures that the level of sensitivity of the Company's net portfolio value is maintained within limits established by the Board of Directors. Through such management, the ALCO seeks to reduce the vulnerability of the Company's operations to changes in interest rates. During the past year, the ALCO utilized the following strategies to manage interest rate risk: (1) emphasizing the origination and retention of short-term commercial business loans and nonresidential mortgage loans; (2) emphasizing the origination of adjustable-rate home equity lines of credit; (3) emphasizing the origination and retention of one-to-four family residential adjustable-rate mortgage loans; (4) originating all new fixed-rate mortgage loans as a broker for a third party; and (5) investing in shorter-term investment securities. 33 The Office of Thrift Supervision requires the computation of amounts by which the net present value of the Bank's cash flow from assets, liabilities, and off balance sheet items (the Bank's net portfolio value or "NPV") and the net interest income ("NII") of the Bank would change in the event of a range of assumed changes in market interest rates. These computations estimate the effect on a bank's NPV and NII from instantaneous and permanent one hundred- to three hundred-basis point increases and decreases in market interest rates. The following table presents the Bank's projected change in NPV and NII at December 31, 2004, as calculated by an independent third party, based upon information provided by the Bank. The Bank's level of sensitivity, given a hypothetical, immediate, and sustained change in interest rates from + 300 basis points to - 300 basis points, is within the range of acceptable sensitivity established by the Board of Directors. TABLE 14 INTEREST RATE SENSITIVITY
Estimated Theoretical Estimated Theoretical Hypothetical, Immediate, Net Interest Income Net Portfolio Value and Sustained ----------------------- ----------------------- Changes in Interest Rates Amount % Change Amount % Change ------------------------------ ---------- ---------- ---------- ---------- (dollars in thousands) 300 basis point rise $ 16,051 15.5% $ 77,650 -2.3% 200 basis point rise 15,428 11.1% 78,700 -1.0% 100 basis point rise 14,709 5.9% 79,462 -0.1% No change 13,894 0.0% 79,508 0.0% 100 basis point decline 12,552 -9.7% 76,944 -3.2% 200 basis point decline 11,092 -20.2% 73,014 -8.2% 300 basis point decline 9,564 -31.2% 68,405 -14.0%
Certain shortcomings are inherent in the methodology used in the above interest rate risk measurement. Modeling changes in NPV require the making of certain assumptions, which may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the NPV table presented assumes that the composition of the interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Accordingly, although the NPV table provides an indication of the Bank's interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Bank's net interest income and will differ from actual results. IMPACT OF INFLATION AND CHANGING PRICES The consolidated financial statements and related notes have been prepared in accordance with GAAP which require the measurement of financial position and operating results in terms of historical dollars, without considering the change in the relative purchasing power of money over time due to inflation. Unlike most industrial companies, nearly all the assets and liabilities of the Company are financial in nature. As a result, interest rates have a more significant impact on the Company's performance than the effect of inflation. Interest rates do not necessarily change in the same magnitude as the price of goods and services. 34 TABLE 15 QUARTERLY FINANCIAL DATA (UNAUDITED)
First Second Third Fourth Quarter Quarter Quarter Quarter ---------- ---------- ---------- ---------- (in thousands, except per share data) 2004 Interest income .................................. $ 5,155 $ 4,995 $ 5,318 $ 5,642 Interest expense ................................. 1,871 1,911 2,058 2,103 ---------- ---------- ---------- ---------- Net interest income .............................. 3,284 3,084 3,260 3,539 Provision for loan losses ........................ 30 30 60 210 ---------- ---------- ---------- ---------- Net int. income after provision for loan losses .. 3,254 3,054 3,200 3,329 Noninterest income ............................... 1,326 1,165 1,076 1,257 Noninterest expense .............................. 3,197 2,862 3,265 4,305 ---------- ---------- ---------- ---------- Income before income taxes ....................... 1,383 1,357 1,011 281 Income taxes ..................................... 422 409 241 5 ---------- ---------- ---------- ---------- Net income ....................................... $ 961 $ 948 $ 770 $ 276 ========== ========== ========== ========== Per share data: Net income: Basic ........................................ $ 0.12 $ 0.12 $ 0.11 $ 0.04 Diluted ...................................... 0.12 0.12 0.11 0.04 Cash dividends declared ........................ 0.065 0.065 0.065 0.065 Common stock price: High ......................................... 14.40 13.74 13.27 14.27 Low .......................................... 13.37 12.60 12.41 12.41 2003 Interest income .................................. $ 5,903 $ 5,645 $ 5,206 $ 5,215 Interest expense ................................. 2,328 2,286 2,202 1,916 ---------- ---------- ---------- ---------- Net interest income .............................. 3,575 3,359 3,004 3,299 Provision for loan losses ........................ 15 15 15 15 ---------- ---------- ---------- ---------- Net int. income after provision for loan losses .. 3,560 3,344 2,989 3,284 Noninterest income ............................... 1,085 1,358 1,159 1,959 Noninterest expense .............................. 2,763 3,131 4,148 3,849 ---------- ---------- ---------- ---------- Income before income taxes ....................... 1,882 1,571 0 1,394 Income taxes ..................................... 675 447 (94) 428 ---------- ---------- ---------- ---------- Net income ....................................... $ 1,207 $ 1,124 $ 94 $ 966 ========== ========== ========== ========== Per share data: Net income: Basic ........................................ $ 0.14 $ 0.13 $ 0.01 $ 0.11 Diluted ...................................... 0.14 0.13 0.01 0.11 Cash dividends declared ........................ 0.06 0.06 0.06 0.06 Common stock price: High ......................................... 11.89 13.71 15.24 15.15 Low .......................................... 10.04 11.99 12.90 13.70
35 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Information responsive to this item in contained in Item 7. above under the captions "Management of Market Risk" and "Liquidity and Capital Resources". 36 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA [LOGO OF CHERRY BEKAERT & HOLLAND] REPORT OF INDEPENDENT REGISTERD PUBLIC ACCOUNTING FIRM The Board of Directors Citizens South Banking Corporation We have audited the accompanying consolidated statements of condition of Citizens South Banking Corporation and subsidiaries as of December 31, 2004 and 2003 and the related consolidated statements of operations, comprehensive income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2004. These financial statements are the responsibility of 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Citizens South Banking Corporation and subsidiaries as of December 31, 2004 and 2003 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. /s/ Cherry, Bekaert & Holland, L.L.P. Gastonia, North Carolina March 3, 2005 37 CITIZENS SOUTH BANKING CORPORATION Consolidated Statements of Condition
DECEMBER 31, ------------------------------- 2004 2003 -------------- -------------- Assets Cash and due from banks $ 5,799,611 $ 5,374,150 Interest-earning bank balances 5,790,650 2,840,035 -------------- -------------- Cash and cash equivalents 11,590,261 8,214,185 Investment securities available-for-sale 52,407,378 56,233,140 Mortgage-backed and related securities available-for-sale 81,169,479 89,168,143 Loans, net of deferred fees 317,156,086 297,994,856 Allowance for loan losses (3,029,108) (2,968,510) -------------- -------------- Loans, net 314,126,978 295,026,346 Premises and equipment, net 17,362,825 14,938,818 Accrued interest receivable 1,662,085 1,942,899 Federal Home Loan Bank stock 3,460,700 2,915,000 Intangible assets 7,559,512 7,984,320 Bank owned life insurance 12,885,164 12,317,201 Other assets 6,736,962 7,010,742 -------------- -------------- Total assets $ 508,961,344 $ 495,750,794 ============== ============== Liabilities and Equity Deposits $ 374,744,428 $ 342,445,676 Advances from Federal Home Loan Bank 55,000,000 58,300,000 Repurchase agreements 771,538 681,394 Deferred compensation 5,850,061 6,164,432 Other liabilities 201,060 490,384 -------------- -------------- Total liabilities 436,567,087 408,081,886 Commitments and contingencies Stockholders' Equity Preferred stock, 10,000,000 shares authorized, none issued - - Common stock, $0.01 par value, 20,000,000 shares authorized in 2004 and 2003, issued and outstanding 9,062,727 in 2004 and 2003 90,628 90,628 Additional paid-in-capital 68,380,746 68,280,596 Unallocated common stock held by Employee Stock Ownership Plan (1,795,877) (1,978,722) Unearned compensation related to Recognition and Retention Plan (1,698,424) (1,979,449) Retained earnings, substantially restricted 29,765,725 28,823,864 Accumulated unrealized loss on securities available-for-sale, net of tax (418,552) (39,963) Treasury stock of 1,630,583 shares at December 31, 2004, and 392,414 shares at December 31, 2003, at cost (21,929,989) (5,528,046) -------------- -------------- Total stockholders' equity 72,394,257 87,668,908 -------------- -------------- Total liabilities and stockholders' equity $ 508,961,344 $ 495,750,794 ============== ==============
See notes to consolidated financial statements. 38 CITIZENS SOUTH BANKING CORPORATION Consolidated Statements of Operations
YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2004 2003 2002 ------------ ------------ ------------ Interest income Loans $ 16,115,649 $ 16,797,651 $ 21,232,156 Investment securities 2,048,161 1,745,240 2,082,359 Mortgage-backed and related securities 2,946,442 3,426,438 1,401,924 ------------ ------------ ------------ Total interest income 21,110,252 21,969,329 24,716,439 Interest expense Deposits 6,127,372 6,501,361 7,961,809 Borrowed funds 1,815,867 2,230,995 2,233,383 ------------ ------------ ------------ Total interest expense 7,943,239 8,732,356 10,195,192 ------------ ------------ ------------ Net interest income 13,167,013 13,236,973 14,521,247 Provision for loan losses 330,000 60,000 225,000 ------------ ------------ ------------ Net interest income after provision for loan losses 12,837,013 13,176,973 14,296,247 Noninterest income Fee income on deposit accounts 2,426,137 2,448,921 2,287,598 Fee income on mortgage banking activities 545,948 831,806 769,337 Gain on sale of securities 453,725 1,020,673 243,233 Gain on sale of other assets 220,543 1,213 - Commissions on sales of financial products 120,035 161,296 161,951 Dividends on FHLB stock 96,289 102,057 177,119 Fair market adjustment on deferred compensation assets 177,983 312,230 2,356 Increase in value of bank owned life insurance 591,862 490,082 325,215 Other income 191,755 192,833 153,704 ------------ ------------ ------------ Total noninterest income 4,824,277 5,561,111 4,120,513 Noninterest expense Compensation and benefits 6,579,309 7,281,487 5,555,507 Occupancy 1,779,070 1,345,107 1,430,026 Office supplies expense 321,375 303,640 377,080 NOW account expense 212,926 261,490 251,300 Advertising 340,773 280,597 384,620 Professional services 534,723 581,321 326,596 Telephone 317,665 310,356 208,959 Data processing 221,678 115,192 197,764 Deposit insurance 53,916 59,666 61,475 Loss on sale of assets - - 137,647 Amortization of intangible assets 424,808 674,184 1,102,873 Prepayment penalty on FHLB advances - 1,289,000 65,059 Impairment on investment securities 982,893 - - Other expense 1,859,693 1,389,071 1,281,868 ------------ ------------ ------------ Total noninterest expense 13,628,829 13,891,111 11,380,774 ------------ ------------ ------------ Income before income taxes 4,032,461 4,846,973 7,035,986 Provision for income taxes 1,077,040 1,456,407 2,528,052 ------------ ------------ ------------ Net income $ 2,955,421 $ 3,390,566 $ 4,507,934 ============ ============ ============ Earnings per share Basic earnings per share $ 0.39 $ 0.39 $ 0.51 Diluted earnings per share $ 0.38 $ 0.39 $ 0.51
See notes to consolidated financial statements 39 CITIZENS SOUTH BANKING CORPORATION Consolidated Statements of Comprehensive Income
YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2004 2003 2002 ------------ ------------ ------------ Net income $ 2,955,421 $ 3,390,566 $ 4,507,934 Other comprehensive income, net of tax: Unrealized gains (losses) on securities Unrealized holding gains (losses) arising during period, net of tax effect of $49,616, $520,397, and $(324,917), respectively (88,205) (925,151) 577,630 Reclassification adjustment for gains included in net income, net of tax effect of $163,341, $367,442, and $87,564, respectively (290,384) (653,231) (155,669) ------------ ------------ ------------ Other comprehensive income (378,589) (1,578,382) 421,961 ------------ ------------ ------------ Comprehensive income $ 2,576,832 $ 1,812,184 $ 4,929,895 ------------ ------------ ------------
See notes to consolidated financial statements. 40 CITIZENS SOUTH BANKING CORPORATION Consolidated Statements of Changes in Stockholders' Equity
Additional Unallocated Preferred Common Paid-In Common Stock Stock Stock Capital Held by ESOP -------------- -------------- -------------- -------------- Balance, December 31, 2001 $ - $ 4,581,034 $ 16,843,428 $ (1,239,831) Comprehensive results: Net income - - - - Other comprehensive results, net of tax - - - - Loan to ESOP for purchase of common stock - - - (1,051,980) Allocation from shares purchased with loan to ESOP - - 143,733 130,245 Exercise of options - 24,052 264,572 - Issuance of common stock - (4,514,458) 50,923,990 - Cash dividends declared on common stock - - - - -------------- -------------- -------------- -------------- Balance, December 31, 2002 - 90,628 68,175,723 (2,161,566) Comprehensive results: Net income - - - - Other comprehensive results, net of tax - - - - Allocation from shares purchased with loan to ESOP - - 104,873 182,844 Repurchase of common stock - - - - Issuance of Recognition and Retention Plan stock - - - - Vesting of Recognition and Retention Plan - - - - Exercise of options - - - - Cash dividends declared on common stock - - - - -------------- -------------- -------------- -------------- Balance, December 31, 2003 - 90,628 68,280,596 (1,978,722) Comprehensive results: Net income - - - - Other comprehensive results, net of tax - - - - Allocation from shares purchased with loan to ESOP - - 100,150 182,845 Repurchase of common stock - - - - Issuance of Recognition and Retention Plan stock - - - - Vesting of Recognition and Retention Plan - - - - Exercise of options - - - - Issuance of common stock (100 shares) - - - - Cash dividends declared on common stock - - - - -------------- -------------- -------------- -------------- Balance, December 31, 2004 $ - $ 90,628 $ 68,380,746 $ (1,795,877) ============== ============== ============== ============== Unearned Retained Accumulated Compensaton Earnings Unrealized Total Related to Substantially Gains(Losses), Treasury Stockholders' RRP Restricted net of tax Stock Equity -------------- -------------- -------------- ------------- -------------- Balance, December 31, 2001 $ - $ 25,105,261 $ 1,116,458 $ (4,776,003) $ 41,630,347 Comprehensive results: Net income - 4,507,934 - - 4,507,934 Other comprehensive results, net of tax - - 421,961 - 421,961 Loan to ESOP for purchase of common stock - - - - (1,051,980) Allocation from shares purchased with loan to ESOP - - - - 273,978 Exercise of options - - - - 288,624 Issuance of common stock - - - 4,776,003 51,185,535 Cash dividends declared on common stock - (873,719) - - (873,719) -------------- -------------- -------------- ------------- -------------- Balance, December 31, 2002 - 28,739,476 1,538,419 - 96,382,680 Comprehensive results: Net income - 3,390,566 - - 3,390,566 Other comprehensive results, net of tax - - (1,578,382) - (1,578,382) Allocation from shares purchased with loan to ESOP - - - - 287,717 Repurchase of common stock - - - (9,801,707) (9,801,707) Issuance of Recognition and Retention Plan stock (2,954,297) - - 2,954,297 - Vesting of Recognition and Retention Plan 974,848 - - - 974,848 Exercise of options - (1,169,571) - 1,319,364 149,793 Cash dividends declared on common stock - (2,136,607) - - (2,136,607) -------------- -------------- -------------- ------------- -------------- Balance, December 31, 2003 (1,979,449) 28,823,864 (39,963) (5,528,046) 87,668,908 Comprehensive results: Net income - 2,955,421 - - 2,955,421 Other comprehensive results, net of tax - - (378,589) - (378,589) Allocation from shares purchased with loan to ESOP - - - - 282,995 Repurchase of common stock - - - (16,403,258) (16,403,258) Issuance of Recognition and Retention Plan stock - - - - - Vesting of Recognition and Retention Plan 281,025 - - - 281,025 Exercise of options - - - - - Issuance of common stock (100 shares) - - - 1,315 1,315 Cash dividends declared on common stock - (2,013,560) - - (2,013,560) -------------- -------------- -------------- ------------- -------------- Balance, December 31, 2004 $ (1,698,424) $ 29,765,725 $ (418,552) $ (21,929,989) $ 72,394,257 ============== ============== ============== ============= ==============
See notes to consolidated financial statements. 41 CITIZENS SOUTH BANKING CORPORATION Consolidated Statements of Cash Flows
YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, 2004 2003 2002 -------------- -------------- -------------- Operating Activities Net Income $ 2,955,421 $ 3,390,566 $ 4,507,934 Adjustments to reconcile net income to net cash provided by operating activities Provision for loan losses 330,000 60,000 225,000 Depreciation 1,036,209 697,578 744,650 Impairment on investment securities 982,893 - - Deferred income tax (benefit) (40,661) (238,800) 198,052 (Gain) on sale of investments available-for-sale (453,725) (1,020,673) (243,233) (Gain) loss on sale of other assets (220,543) (1,213) (31,756) Deferred loan origination fees (74,330) 176,411 12,191 Amortization of intangible assets 424,808 674,184 1,102,873 Allocation of shares to the ESOP 282,995 287,717 273,978 Vesting of shares issued for the RRP Plan 281,025 974,848 - (Increase) decrease in interest receivable 280,814 (30,289) (185,996) Purchase of bank-owned life insurance - (5,000,000) - Net (increase) in other operating assets (1,821,284) (1,359,526) (66,885) -------------- -------------- -------------- Net cash (used in) provided by operating activities 3,963,622 (1,389,197) 6,536,808 Investing Activities Net decrease(increase) in loans made to customers (19,256,152) 4,642,964 33,094,308 Proceeds from the sale of loans - - 1,418,648 Proceeds from the sale of premises and equipment 428,835 25,000 26,281 Proceeds from the sale of investment securities 1,810,745 8,051,817 4,000,000 Proceeds from the sale of mortgage-backed and related securities 6,381,533 12,153,771 5,043,176 Proceeds from sale of REO 64,909 1,014,791 300,357 Maturities and prepayments of investment securities 22,363,848 16,109,679 6,856,814 Maturities and prepayments of mortgage-backed and related securities 22,733,334 33,630,059 11,257,899 Purchases of investment securities (20,302,959) (41,263,571) (24,200,000) Purchases of mortgage-backed and related securities (21,330,211) (65,652,143) (60,754,560) Purchases (sales) of FHLB stock (545,700) (275,500) 1,253,200 Purchases of premises and equipment (3,668,508) (6,852,372) (934,824) -------------- -------------- -------------- Net cash used in investing activities (11,320,326) (38,415,505) (22,638,701) Financing Activities Net increase (decrease) in deposits 32,298,752 1,583,744 (8,143,224) Issuance of common stock 1,315 - 45,446,376 Dividends to stockholders (2,013,560) (2,136,607) (873,719) Exercise of options - 149,793 288,624 Repurchase of common stock (16,403,258) (9,801,707) - Advances from FHLB 20,000,000 17,800,000 7,500,000 Repayments of advances from FHLB (23,300,000) (6,000,000) (1,500,000) Increase (decrease) in repurchase agreements 90,144 (393,788) (481,510) Decrease in advances from borrowers for insurance and taxes 59,387 (181,336) (75,180) -------------- -------------- -------------- Net cash provided by financing activities 10,732,780 1,020,099 42,161,367 Net increase (decrease) in cash and cash equivalents 3,376,076 (38,784,603) 26,059,474 Cash and cash equivalents at the beginning of the year 8,214,185 46,998,788 20,939,314 -------------- -------------- -------------- Cash and cash equivalents at the end of the year $ 11,590,261 $ 8,214,185 $ 46,998,788 -------------- -------------- --------------
See notes to consolidated financial statements. 42 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Citizens South Banking Corporation (the "Company"), formerly Gaston Federal Bancorp, Inc., is a stock holding company whose activities are primarily limited to holding the stock of Citizens South Bank, formerly Gaston Federal Bank (the "Bank"). The Bank is a community-oriented federal stock savings bank engaged primarily in the business of offering deposits to customers through its branch offices and investing those deposits, together with funds generated from operations and borrowings, in residential, commercial and consumer loans and in mortgage-backed and investment securities. The Bank's wholly-owned subsidiary, Citizens South Financial Services, Inc. (doing business as Citizens South Investment Services) acts as an independent agent selling various uninsured financial products. The Board of Directors of the Citizens South Holdings, MHC (the "MHC") a federal mutual holding company which owned a majority of the Company's outstanding shares of common stock, the Company and the Bank approved the Plan of Conversion and Reorganization (the "Plan") on May 23, 2002. Pursuant to the Plan, the MHC converted from the mutual holding company form of organization to the fully public form and merged into the Bank. Pursuant to the plan, the Company, which owned 100% of the Bank, was succeeded by a new Delaware corporation with the same name, Citizens South Banking Corporation. As part of the conversion, shares of common stock of Citizens South Banking Corporation representing the ownership interest of the MHC were offered for sale in the offering. The existing publicly held shares of the Company, which represented the remaining ownership interest in the Company, were exchanged for new shares of common stock of Citizens South Banking Corporation, the new Delaware corporation. The exchange ratio of 2.1408 shares of $0.01 par value common stock for each share of $1.00 par value common stock ensured that immediately after the reorganization and the share exchange, the public stockholders of the Company owned the same aggregate percentage of Citizens South Banking Corporation common stock that they owned immediately prior to the reorganization. At the time of the Conversion, the Bank established a memo liquidation account in an amount equal to its equity for the benefit of eligible account holders and supplemental eligible account holders who continue to maintain their accounts at the Bank after the Conversion. On September 30, 2002, the mutual-to-stock conversion of Citizens South Holdings, MHC, and the related stock offering of the Mutual Holding Company's ownership in Citizens South Banking Corporation were completed. In conjunction with the stock offering, the Company sold 5,259,945 shares of common stock at $10.00 per share, which represented the "super maximum" range of the stock offering. Gross proceeds from the stock offering amounted to $52.6 million. Net proceeds amounted to $45.5 million and reflect the following reductions from gross proceeds: 1) $1.4 million in costs incurred related to the stock offering; 2) $1.0 million used to purchase stock for the ESOP; and 3) $4.7 million in withdrawals from Citizens South Bank deposit accounts (the stock purchased by the ESOP via loan and the application of deposits for shares are non-cash financing activities). As a result of the conversion, all historical financial information that is based on or derived from the actual or average number of outstanding shares of common stock during any period prior to September 30, 2002, has been appropriately adjusted to reflect the exchange ratio of 2.1408-to-1. The conversion was accounted for as a change in corporate form with no subsequent change in historical basis for the Company's assets, liabilities and equity. Principles of Consolidation - The consolidated financial statements include the accounts of Citizens South Banking Corporation, its wholly-owned subsidiary, Citizens South Bank, and the Bank's wholly-owned subsidiary, Citizens South Financial Services, Inc. All significant intercompany accounts and transactions have been eliminated. 43 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Use of Estimates - The financial statements are prepared in accordance with accounting principles generally accepted in the United States of America which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Cash and Cash Equivalents - The Company considers cash on hand, cash due from banks, which are maintained in financial institutions, and interest-earning deposits, which are maintained with the Federal Home Loan Bank (FHLB), as cash and cash equivalents. Securities - Management determines the appropriate classification of securities at the time of purchase. Securities classified as available-for-sale are carried at fair value. Such securities are used to execute asset/liability management strategies and to manage liquidity. Purchases and sales of securities are recorded on a trade-date basis. Gains and losses are determined using the specific identification method. Adjustments for unrealized gains or losses, net of related income tax effect, are recorded as an addition or deduction from equity in the form of other comprehensive results. The Company has no securities classified as held-to-maturity. Amortization of premiums and accretion of discounts are included in interest income over the life of the related security, or in the case of mortgage-backed and related securities, the estimated life of the security. Gains or losses on the sale of securities are recognized on a specific identification, trade-date basis. Loans and Allowance for Loan Losses - Loans are carried at their principal amount outstanding. Income on loans is accrued based upon the outstanding principal balance. Generally, loans are classified as nonaccrual, and the accrual of interest is discontinued, when the contractual payment of principal and interest has become 90 days past due or when, in management's judgment, principal or interest is not collectible in accordance with the terms of the obligation. Cash receipts on nonaccrual loans are applied to principal. The accrual of interest resumes when the loan returns to performing status. The Company evaluates impairment of its residential mortgage and consumer loans on a collective basis. Commercial loans are considered to be impaired when, based on current information, it is probable that the Company will not collect all amounts due in accordance with contractual terms. Management monitors internally generated reports, including past due reports, payment histories, criticized asset reports, which include loans with historical payment problems or borrowers in troubled industries as well as other sources of information such as borrower financial statements, the value collateral, etc. to identify impaired loans. Discounted cash flow analyses or the estimated fair value of collateral are used in determining the fair value of impaired loans. When the ultimate collectibility of the principal balance of an impaired loan is in doubt, cash receipts are applied to principal. The allowance for loan losses is determined by management and maintained at a level based on losses inherent in the portfolio that are probable and reasonably estimated at the balance sheet date. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, historical loan loss experience, availability and quality of collateral, changes in economic conditions, and the quality of the loan portfolio. Loans are charged to the allowance at the time they are determined to be losses. Subsequent recoveries are credited to the allowance. Mortgage Servicing Rights - Statement of Financial Accounting Standards ("SFAS") No. 140 requires the recognition of mortgage servicing rights ("MSRs") as assets by allocating total costs incurred between the originated loan sold and the servicing rights retained based on their relative fair values. MSRs are amortized in proportion to the servicing income over the estimated life of the related mortgage loan using the interest method. 44 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Concentrations of Credit Risk - The Company makes loans to individuals and small businesses primarily in the Company's normal lending area which includes the North Carolina Counties of Gaston, Rowan, and Iredell Counties, and the surrounding counties. The Company has a diversified loan portfolio, and the borrowers' ability to repay their loans is not dependent upon any specific economic segment. Premises and Equipment - Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed over the estimated useful lives of the assets (from 3 to 30 years) primarily by the straight-line method. Leasehold improvements are amortized on a straight-line basis over the shorter of the estimated useful life of the improvement or the lease term. Goodwill and Other Intangible Assets - SFAS No. 142, Goodwill and Other Intangible Assets, requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with its provisions. In connection with adoption of SFAS No. 142, the Company is required to perform an initial assessment of whether there is an indication that goodwill is impaired. During the second quarter of 2002, the Company completed its initial analysis of potential impairment under the provisions of SFAS No. 142, and determined based on that analysis that goodwill was not impaired. The Company also completed its annual impairment tests at December 31, 2004 and 2003 and determined based on that analysis that goodwill was not impaired. Goodwill will be tested for impairment annually, or between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. The Company had no goodwill related to acquisitions initiated prior to July 1, 2001, or other intangible assets recorded prior to the adoption of the provisions of SFAS No. 142 whose carrying amounts or amortization were changed by the adoptions of the provisions of SFAS No. 142. SFAS No. 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values. In accordance with SFAS No. 142 the Company's core deposit intangibles, are amortized over their estimated useful life of seven years. Other Real Estate Owned - Other real estate owned is comprised of real estate properties acquired in partial or total satisfaction of problem loans. The properties are recorded at the lower of cost or fair value less estimated costs to sell at the date acquired. Losses arising at the time of acquisition of such properties are charged against the allowance for loan losses. Subsequent write-downs that may be required to the carrying value of these properties are charged to noninterest expenses. Gains and losses realized from the sale of other real estate owned are included in noninterest income. Loan Origination Fees - Origination fees received and direct costs incurred are deferred and amortized to interest income over the contractual lives of the loans, using the level yield method. Income Taxes - Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Amounts provided for deferred income taxes relate primarily to differences between tax and financial reporting for unrealized gains and losses on securities available-for-sale, allowances for loan losses, depreciation, and deferred compensation. Advertising - Advertising costs are expensed as incurred. 45 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) Reclassifications - Certain of the prior year amounts have been reclassified to conform to current year presentation. Such reclassifications are immaterial to the financial statements. Comprehensive Income - SFAS No. 130, Reporting Comprehensive Income, establishes standards for the reporting and display of comprehensive income and its components in financial statements. SFAS No. 130 defines comprehensive income as net income, as currently reported, as well as unrealized gains and losses on assets available for sale and certain other items not currently included in the income statement. The disclosure requirements of SFAS No. 130 have been included in the Consolidated Statements of Comprehensive Income. Operating Segments - SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the way public business enterprises report information about operating segments. This statement also establishes standards for related disclosures about products, services, geographic areas and major customers. In adopting SFAS No. 131, the Company has determined that, using the definitions contained in the statement, all of its activities constitute only one reportable operating segment. Stock-Based Compensation - SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure - An Amendment of FASB Statement No. 123, was issued in December 2002 and provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The Company applies the provisions of Accounting Principles Board Opinion No. 25 in accounting for the plans and accordingly, no compensation expense has been recognized in connection with the granting of the stock options. In accordance with SFAS No. 123, Accounting for Stock-Based Compensation, the Company adopted the disclosure-only option and elected to apply the provisions of APB No. 25 for financial statement purposes. The Company recognizes compensation expense for fixed awards with pro rata vesting on a straight-line basis. Had the compensation cost for the Company's stock option plan been determined in accordance with the fair-value accounting provisions of SFAS No. 123, net income, basic earnings per share, and diluted earnings per share would have been as follows: Year Ended Year Ended Year Ended December 31 December 31 December 31 2004 2003 2002 ------------- ------------- ------------- Net income: As reported $ 2,955,421 $ 3,390,566 $ 4,507,934 Pro forma $ 2,860,909 $ 1,847,027 $ 4,398,801 Basic earnings per share: As reported $ 0.39 $ 0.39 $ 0.51 Pro forma $ 0.38 $ 0.21 $ 0.50 Diluted earnings per share: As reported $ 0.38 $ 0.39 $ 0.51 Pro forma $ 0.37 $ 0.21 $ 0.50 46 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 1 - ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for the year ended December 31, 2004: dividend yield of 1.97%, expected volatility of 31%, a risk-free interest rate of 3.32%, and expected lives of 6 years. The following weighted average assumptions were used for the year ended December 31, 2003: dividend yield of 1.85%, expected volatility of 30%, a risk-free interest rate of 3.50%, and expected lives of 5 years. The following weighted average assumptions were used for the years ended December 31, 2002; dividend yield of 3.27%, expected volatility of 34%, a risk-free interest rate of 5.00%, and expected lives of 7 years for the options. SFAS No. 123 (revised), Share Based Payment, was issued by the FASB in December 2004 and establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity's equity instruments or that may be settled by the issuance of those equity instruments. The primary focus of this statement is on accounting for transactions in which an entity obtains employee services in exchange for share-based payment transactions. This Statement is effective for the beginning of the first interim or annual reporting period that begins after June 15, 2005. SFAS No. 123 (revised) will be adopted by the Company beginning with the third quarter ending September 30, 2005. Based on the unvested options outstanding at December 31, 2004, the Company expects that the adoption of SFAS 123 (revised) will result in additional compensation expense of $65,000 during 2005 and $125,000 during 2006. SFAS No. 153, Exchanges of Nonmonetary Assets, was issued by the FASB in December 2004. This Statement amends APB Opinion No. 29, Accounting for Nonmonetary Transactions, and is based on the principle that exchanges on nonmonetary assets should be measured based on the fair value of the assets exchanged. The provisions of this statement are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of FAS No. 153 is not expected to have a material impact on the consolidated financial statements of the Company. Staff Accounting Bulletin ("SAB") No. 105, Application of Accounting Principles to Loan Commitments, was issued in March 2004 by the SEC. This SAB summarizes the application of accounting principles generally accepted in the United States to loan commitments accounted for as derivative instruments. The provisions of this SAB were effective after March 31, 2004. The adoption of this Staff Accounting Bulletin did not have a material impact on the consolidated financial statements of the Company. 47 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 2 - INVESTMENT SECURITIES The aggregate book and fair values, as well as gross unrealized gains and losses, of investment securities as of December 31 were as follows:
December 31, 2004 ------------------------------------------------------------- Book Unrealized Unrealized Fair Value Gains Losses Value ------------- ------------- ------------- ------------- Investment securities Available for Sale U.S. government agencies $ 34,293,006 $ 13,764 $ (257,255) $ 34,049,515 Municipals 10,319,824 263,472 (7,466) 10,575,830 Corporate bonds 2,000,000 - (60,000) 1,940,000 Trust preferred securities 2,000,000 34,000 - 2,034,000 Fannie Mae preferred stock 1,439,428 - - 1,439,428 Freddie Mac preferred stock 1,577,678 - - 1,577,678 Other equity securities 759,690 31,237 - 790,927 ------------- ------------- ------------- ------------- Total available-for-sale $ 52,389,626 $ 342,473 $ (324,721) $ 52,407,378 ============= ============= ============= =============
December 31, 2004 ------------------------------------------------------------- Book Unrealized Unrealized Fair Value Gains Losses Value ------------- ------------- ------------- ------------- Mortgage-backed and related securities Available-for-Sale Fannie Mae $ 47,660,078 $ 85,638 $ (536,615) $ 47,209,101 Freddie Mac 27,879,867 64,831 (319,674) 27,625,024 Ginnie Mae 3,140,070 4,117 (18,041) 3,126,146 CMO 1,913,759 - (3,886) 1,909,873 SBA's 1,280,960 18,375 - 1,299,335 ------------- ------------- ------------- ------------- Total mortgage-backed and related securities $ 81,874,734 $ 172,961 $ (878,216) $ 81,169,479 ============= ============= ============= =============
48 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 2 - INVESTMENT SECURITIES (CONTINUED)
December 31, 2003 ------------------------------------------------------------- Book Unrealized Unrealized Fair Value Gains Losses Value ------------- ------------- ------------- ------------- Investment securities Available for Sale U.S. government agencies $ 35,476,026 $ 387,200 $ (17,909) $ 35,845,317 Municipals 11,048,565 324,965 (9,493) 11,364,037 Corporate bonds 2,000,000 - - 2,000,000 Trust preferred securities 2,000,000 - - 2,000,000 Fannie Mae preferred stock 2,000,000 - (361,770) 1,638,230 Freddie Mac preferred stock 2,051,806 - (139,791) 1,912,015 Other equity securities 1,254,817 218,724 - 1,473,541 ------------- ------------- ------------- ------------- Total available-for-sale $ 55,831,214 $ 930,889 $ (528,963) $ 56,233,140 ============= ============= ============= =============
December 31, 2003 ------------------------------------------------------------- Book Unrealized Unrealized Fair Value Gains Losses Value ------------- ------------- ------------- ------------- Mortgage-backed and related securities Available-for-Sale Fannie Mae $ 56,528,234 $ 125,231 $ (429,795) $ 56,223,670 Freddie Mac 23,836,379 105,262 (227,679) 23,713,962 Ginnie Mae 4,746,663 4,877 (21,919) 4,729,621 CMO 2,972,800 - (17,270) 2,955,530 SBA's 1,551,636 - (6,276) 1,545,360 ------------- ------------- ------------- ------------- Total mortgage-backed and related securities $ 89,635,712 $ 235,370 $ (702,939) $ 89,168,143 ============= ============= ============= =============
49 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 2 - INVESTMENT SECURITIES (CONTINUED) The book value and estimated fair value of debt securities at December 31, 2004, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. December 31, 2004 ----------------------------- Book Fair Value Value ------------- ------------- Available-for-Sale Due in one year or less $ 2,501,249 $ 2,509,920 Due after one year through five years 34,205,523 34,025,649 Due after five years through ten years 3,697,205 3,774,448 Due after ten years 8,208,853 8,289,328 Equities 3,776,796 3,808,033 ------------- ------------- $ 52,389,626 $ 52,407,378 ============= ============= Mortgage-backed and related securities $ 81,874,734 $ 81,169,479 ============= ============= Gross realized gains on the sale of securities available for sale were $453,725, $1,105,627, and $256,661 for the years ended December 31, 2004, December 31, 2003, and December 31, 2002, respectively. Gross realized losses on the sale of securities available for sale were $0, $84,954, and $13,428 for the years ended December 31, 2004, December 31, 2003, and December 31, 2002, respectively. After-tax net gains on the sale of securities were $290,384, $653,231, and $155,669 for the years ended December 31, 2004, December 31, 2003, and December 31, 2002, respectively. Investment securities having a carrying amount of approximately $28,815,000 have been pledged as collateral to secure public deposits at December 31, 2004. Investment securities having a carrying amount of $3,000,000 have been pledged as collateral for repurchase agreements at December 31, 2004. Interest earned from municipal securities, which is exempt from income taxes, for the past three years were $405,335, $329,101, and 270,827, for the years ending December 31, 2004, December 31, 2003, and December 31, 2002, respectively. 50 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 2 - INVESTMENT SECURITIES (CONTINUED) The unrealized losses and fair value of the investments by investment type segregated between those that have been in a continuous unrealized loss position for less than twelve months and more than twelve months at December 31, 2004 and December 31, 2003 are as follows:
December 31, 2004 ----------------------------------------------------------------------------------------- Less than 12 months 12 months or more Total --------------------------- --------------------------- --------------------------- Fair Unrealized Fair Unrealized Fair Unrealized Description of Securities Value Loss Value Loss Value Loss ------------------------------ ------------ ------------ ------------ ------------ ------------ ------------ US government agencies $ 25,079,444 $ (220,009) $ 2,962,754 $ (37,246) $ 28,042,198 $ (257,255) Municipals 1,006,887 (348) 1,382,271 (7,118) 2,389,158 (7,466) Federal agency mortgage backed securities 20,930,494 (132,840) 42,036,013 (745,376) 62,966,507 (878,216) Corporate bonds 1,940,000 (60,000) - - 1,940,000 (60,000) ------------ ------------ ------------ ------------ ------------ ------------ Subtotal, debt securities 48,956,825 (413,197) 46,381,038 (789,740) 95,337,863 (1,202,937) Preferred stock - - - - - - ------------ ------------ ------------ ------------ ------------ ------------ Total temporarily impaired securities $ 48,956,825 $ (413,197) $ 46,381,038 $ (789,740) $ 95,337,863 $ (1,202,937) ============ ============ ============ ============ ============ ============
December 31, 2003 ----------------------------------------------------------------------------------------- Less than 12 months 12 months or more Total --------------------------- --------------------------- --------------------------- Fair Unrealized Fair Unrealized Fair Unrealized Description of Securities Value Loss Value Loss Value Loss ------------------------------ ------------ ------------ ------------ ------------ ------------ ------------ US agency securities $ 7,981,023 $ (17,909) $ - $ - $ 7,981,023 $ (17,909) Municipals 1,778,144 (9,493) - - 1,778,144 (9,493) Federal agency mortgage backed securities 62,299,543 (696,663) 1,541,026 (6,276) 63,840,569 (702,939) ------------ ------------ ------------ ------------ ------------ ------------ Subtotal, debt securities 72,058,710 (724,065) 1,541,026 (6,276) 73,599,736 (730,341) Preferred stock 1,912,015 (139,791) 1,638,230 (361,770) 3,550,245 (501,561) ------------ ------------ ------------ ------------ ------------ ------------ Total temporarily impaired securities $ 73,970,725 $ (863,856) $ 3,179,256 $ (368,046) $ 77,149,981 $ (1,231,902) ============ ============ ============ ============ ============ ============
Management considers all of the unrealized losses that have been outstanding for 12 or more months to be temporary impairments since these impairments are primarily due to changes in interest rates. Management has the ability and intent to hold these securities until they are no longer considered to be impaired, which may be maturity. 51 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 2 - INVESTMENT SECURITIES (CONTINUED) Effective December 31, 2004, management determined that unrealized losses on $2.0 million in perpetual preferred stock issued by Fannie Mae and $2.0 million in perpetual preferred stock issued by Freddie Mac were "other-than-temporary" impairments. As a result, management recorded a noncash, pretax loss of $983,000. The unrealized losses on these securities were considered to be "other-than-temporary" by management for the following reasons: 1) both Fannie Mae and Freddie Mac have experienced recent accounting irregularities that have resulted in restated financial results from prior periods; 2) the yield on perpetual preferred stock recently issued by Fannie Mae is much higher than the yield of the preferred stock held by the Company, which decreases the value of the Company's security; 3) the preferred stock for Fannie Mae was recently downgraded and the preferred stock for both Companies are on a negative watch list; 4) the Freddie Mac preferred stock repriced in December 2004, yet it continued to have significant unrealized losses at year end; 5) neither of the preferred stock issues have stated maturity dates, so the recovery of the unrealized losses is not expected to occur in the foreseeable future. The credit issues facing Fannie Mae and Freddie Mac only impact the performance of the Company's perpetual preferred stock. The Company does not have any other perpetual preferred stock on its books at December 31, 2004. NOTE 3 - LOANS AND ALLOWANCE FOR LOAN LOSSES The following is a summary of loans outstanding by category at December 31: 2004 2003 -------------- -------------- Real estate: One-to-four family residential $ 91,714,382 $ 102,750,899 Multi-family residential 10,632,018 11,987,054 Commercial mortgage 85,617,699 72,503,276 Construction 25,033,055 8,912,874 Land 28,932,963 21,853,560 Commercial 14,001,972 14,001,527 Consumer 61,245,859 66,019,917 -------------- -------------- Gross loans 317,177,948 298,029,107 Less: Deferred loan fees, net 21,862 34,251 Allowance for loan losses 3,029,108 2,968,510 -------------- -------------- Net loans $ 314,126,978 $ 295,026,346 ============== ============== The Company evaluates impairment of its residential mortgage and consumer loans on a collective basis. Commercial loans individually evaluated and considered impaired under SFAS No. 114 at December 31, 2004 and 2003 were immaterial. 52 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 3 - LOANS AND ALLOWANCE FOR LOAN LOSSES (CONTINUED) Changes in the allowance for loan losses for the years ended December 31, 2004, December 31, 2003 and December 31, 2002 were as follows:
Year Ended Year Ended Year Ended December December December 2004 2003 2002 ----------- ----------- ----------- Balance at beginning of year $ 2,968,510 $ 2,994,576 $ 3,136,058 Provision for loan losses 330,000 60,000 225,000 Loans charged off (277,818) (94,008) (383,515) Recoveries on loans previously charged off 8,416 7,942 17,033 ----------- ----------- ----------- Balance at end of year $ 3,029,108 $ 2,968,510 $ 2,994,576 =========== =========== ===========
Directors, executive officers, and associates of such persons were customers of and had transactions with the Bank in the ordinary course of business. Included in such transactions are outstanding loans and commitments, all of which were made under normal credit terms and did not involve more than normal risk of collection. The aggregate amounts of these loans were $11,487,133 and $7,630,171 at December 31, 2004 and 2003, respectively. During the year ended December 31, 2004, new loans of $5,071,988 were made and payments totaled $1,215,026. During the year ended December 31, 2003, new loans of $1,984,678 were made, payments totaled $1,387,759 and seven previously existing loans in the aggregate amount of $3,429,035 to newly appointed directors of the Company's subsidiary Bank were included at December 31, 2003. The Bank held no loans for sale at December 31, 2004 and 2003. NOTE 4 - PREMISES AND EQUIPMENT Premises and equipment at December 31 are summarized as follows: 2004 2003 -------------- -------------- Land $ 4,206,470 $ 4,542,235 Buildings 12,194,563 10,559,124 Land Improvements 260,944 289,599 Furniture and equipment 3,823,638 3,173,267 -------------- -------------- 20,485,615 18,564,225 Less: accumulated depreciation 3,122,790 3,625,407 -------------- -------------- $ 17,362,825 $ 14,938,818 ============== ============== NOTE 5 - BANK OWNED LIFE INSURANCE The Company owns bank-owned life insurance to fund certain employee benefit plans. The Company purchased $5,000,000 of bank-owned life insurance during the year ended December 31, 2003. No purchases of bank-owned life insurance were made during the years ended December 31, 2004, and December 31, 2002. The bank-owned life insurance policies are recorded in other assets at their cash surrender values of $12,885,164 and $12,317,201 at December 31, 2004 and 2003, respectively. 53 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 6 - INTANGIBLE ASSETS Amortized intangible assets at December 31, 2004 and 2003 are summarized as follows: December 31, 2004 December 31, 2003 ----------------- ----------------- Core deposit intangible $ 2,447,000 $ 2,447,000 Mortgage servicing rights 673,896 673,896 ----------------- ----------------- 3,120,896 3,120,896 Less: accumulated amortization 2,231,906 1,807,098 ----------------- ----------------- $ 888,990 $ 1,313,798 ================= ================= Amortization expense for intangible assets subject to amortization was $424,808 during the year ended December 31, 2004, $674,184 during the year ended December 31, 2003, and $1,102,873 during the year ended December 31, 2002. The fair value of MSRs at December 31, 2004 and 2003 approximated carrying value. The total amount of loans serviced for others at December 31, 2004, December 31, 2003, and December 31, 2002 were $12,640,595, $17,550,135, and $33,503,785, respectively. Estimated amortization expense for the next five succeeding years ending December 31 are as follows: 2005 $ 327,000 2006 $ 250,000 2007 $ 180,000 2008 $ 132,000 2009 $ 0 The balance of goodwill was $6,670,522 at December 31, 2004 and 2003. NOTE 7 - DEPOSITS Deposit balances and interest expense and average rates paid for the years ended December 31, 2004, December 31, 2003, and December 31, 2002 are summarized as follows:
December 31, December 31, 2004 2003 --------------------------------------------- --------------------------------------------- Actual Interest Average Actual Interest Average Balance Expense Rate Balance Expense Rate ------------- ------------ ------------- ------------- ------------ ------------- Noninterest bearing $ 19,734,227 $ - - $ 12,906,002 $ - - Interest bearing checking 32,949,447 103,320 0.3% 30,779,656 91,383 0.3% Money market deposit 77,924,198 841,817 1.4% 48,188,873 549,917 1.3% Savings 29,174,129 164,700 0.5% 36,754,570 305,298 0.8% Certificates of deposit 214,962,427 5,017,535 2.3% 213,816,575 5,554,763 2.6% ------------- ------------ ------------- ------------- ------------ ------------- $ 374,744,428 $ 6,127,372 1.7% $ 342,445,676 $ 6,501,361 1.9% ============= ============ ============= ============= ============ =============
54 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 7 - DEPOSITS (CONTINUED) December 31, 2002 --------------------------------------------- Actual Interest Average Balance Expense Rate ------------- ------------- ------------- Noninterest bearing $ 11,203,428 $ - - Interest bearing checking 25,772,621 93,452 0.4% Money market deposit 35,810,998 497,398 1.5% Savings 43,670,086 637,769 1.4% Certificates of deposit 224,404,799 6,733,190 2.9% ------------- ------------- ------------- $ 340,861,932 $ 7,961,809 2.3% ============= ============= ============= Contractual maturities of certificates of deposit as of December 31, 2004 and 2003 are as follows: 2004 2003 --------------- --------------- Under 1 year $ 156,125,605 $ 176,956,932 1 to 2 years 30,933,304 25,646,184 2 to 3 years 14,871,833 4,134,446 3 to 4 years 4,318,059 5,869,583 4 years or greater 8,713,626 1,209,430 --------------- --------------- $ 214,962,427 $ 213,816,575 =============== =============== Certificates of deposit in excess of $100,000 totaled $62,511,274 and $56,639,500 at December 31, 2004 and 2003, respectively, and may not be fully insured by the FDIC. Interest paid on deposits and other borrowings was $7,566,978 for the year ended December 31, 2004, and $8,941,122 for the year ended December 31, 2003, and $10,186,555 for the year ended December 31, 2002. Directors, executive officers, and associates of such persons were customers of and had transactions with the Bank in the ordinary course of business. Included in such transactions are deposit accounts, all of which were made under normal terms. The aggregate amount of these deposit accounts was $539,837 and $1,668,391 at December 31, 2004 and 2003, respectively. The deposits of the Bank are insured by the Savings Association Insurance Fund (SAIF), one of two funds administered by the FDIC. The Bank's annual SAIF premium rates were $0.015, $0.016, and $0.020, per $100 of deposits for the years ended December 31, 2004, December 31, 2003 and December 31, 2002, respectively. NOTE 8 - ADVANCES FROM THE FEDERAL HOME LOAN BANK Advances from the Federal Home Loan Bank of Atlanta are pursuant to lines of credit and are collateralized by a lien on qualifying first mortgage loans in an amount necessary to satisfy outstanding indebtedness plus accrued interest. Advances had interest rates ranging from 1.15% to 6.25% at December 31, 2004 and 1.18% to 6.25% at December 31, 2003. The total amount available on the line of credit is 25% of total assets of the Bank. The unused portion of the line of credit available to the Company at December 31, 2004 was approximately $71.8 million. 55 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 8 - ADVANCES FROM THE FEDERAL HOME LOAN BANK (CONTINUED) Maturities of advances at December 31 are as follows: 2004 2003 --------------- --------------- Advances from FHLB due: Less than 1 year $ 13,000,000 $ 21,300,000 1 to 2 years 18,000,000 10,000,000 2 to 3 years 2,500,000 4,000,000 3 to 4 years 8,500,000 2,000,000 4 to 5 years 3,000,000 8,000,000 5 to 10 years 10,000,000 13,000,000 After 10 years - - --------------- --------------- $ 55,000,000 $ 58,300,000 =============== =============== Interest rates on certain convertible advances may be reset on certain dates at the option of the Federal Home Loan Bank in accordance with the terms of the note. The Bank has the option of repaying the outstanding advance or converting the interest rate from a fixed rate to a floating rate at the time the advance is called by the Federal Home Loan Bank. The Bank has one $5.0 million advance that will be callable quarterly beginning November 2005 until it matures in November 2012. The Bank also has one $5.0 million advance that has a one time call feature in November 2005, that matures in November 2010. During the year ended December 31, 2003, the Company refinanced $15.0 million of advances with the Federal Home Loan Bank to take advantage of significantly lower finance rates. As a result of the early extinguishment of the advances, the Company paid a prepayment penalty of approximately $1.2 million. NOTE 9 - INCOME TAXES The provision for income taxes is summarized below:
Year Ended Year Ended Year Ended December December December 2004 2003 2002 --------------- --------------- --------------- Currently payable Federal $ 971,417 $ 1,457,207 $ 1,978,000 State 146,284 238,000 352,000 --------------- --------------- --------------- 1,117,701 1,695,207 2,330,000
56 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 9 - INCOME TAXES (CONTINUED) Year Ended Year Ended December December December Year Ended 2004 2003 2002 --------------- --------------- --------------- Deferred Federal (35,339) (229,800) 207,052 State (5,322) (9,000) (9,000) --------------- --------------- --------------- (40,661) (238,800) 198,052 --------------- --------------- --------------- Total income taxes $ 1,077,040 $ 1,456,407 $ 2,528,052 =============== =============== =============== The reasons for the difference between consolidated income tax expense and the amount computed by applying the statutory federal income tax rate of 34% to income before income taxes were as follows:
Year Ended Year Ended Year Ended December December December 2004 2003 2002 --------------- --------------- --------------- Federal income taxes at statutory rate $ 1,371,000 $ 1,648,000 $ 2,392,000 State income taxes, net of federal benefit 86,000 151,000 226,000 Effect of federal tax exempt interest (137,000) (112,000) (92,000) Effect of earnings on life insurance (161,000) (161,000) (109,000) Other (81,960) (69,593) 111,052 --------------- --------------- --------------- $ 1,077,040 $ 1,456,407 $ 2,528,052 =============== =============== =============== Effective tax rate 26.7% 30.2% 35.9% =============== =============== ===============
Income taxes paid for the years ended December 31, 2004, 2003, and 2002 were $1,978,000, $2,119,000, and $2,530,000 respectively. 57 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 9 - INCOME TAXES (CONTINUED) The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities at December 31 are as follows: 2004 2003 ------------- ------------- Deferred tax assets Deferred compensation $ 1,250,021 $ 1,132,374 Unrealized loss on securities Available-for-sale 268,951 - Allowance for loan losses 1,209,925 1,196,047 Other 159,616 117,552 ------------- ------------- Gross deferred tax assets 2,888,513 2,445,973 Deferred tax liabilities Excess carrying value of assets acquired for financial reporting purposes over tax basis 1,275,184 1,112,913 Deferred loan fees 191,034 181,650 Other - 13,098 ------------- ------------- Gross deferred tax liabilities 1,466,218 1,307,661 ------------- ------------- Net deferred tax asset $ 1,422,295 $ 1,138,312 ============= ============= The Company, in accordance with SFAS No. 109, did not record a deferred tax liability of approximately $3,140,000 as of December 31, 2004 related to the cumulative special bad debt deduction for savings and loan associations recognized for income tax reporting prior to September 30, 1988, Citizen South Bank's base year. Management believes that the Company will fully realize deferred tax assets based on future taxable temporary differences, refundable income taxes from carryback years, and current levels of operating income. 58 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 10 - COMMITMENTS Commitments to extend credit are agreements to lend 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 commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. These commitments represent no more than normal lending risk that the Bank commits to its borrowers and management believes that these commitments can be funded through normal operations. Commitments to extend credit as of December 31 are as follows: 2004 2003 ------------ ------------ $ 3,397,000 $ 2,215,000 Residential mortgage loan commitments Non-residential mortgage loan commitments 10,976,000 23,668,000 Commercial loan commitments 904,000 1,125,000 Consumer loan commitments 551,000 577,400 Unused lines of credit Commercial 15,776,000 23,631,000 Consumer 46,621,000 47,013,000 NOTE 11 - REGULATORY CAPITAL REQUIREMENTS The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Under the capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of assets, liabilities, and certain commitments as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly discretionary, actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. The Bank is required to maintain: tangible capital of at least 1.5% of adjusted total assets; core capital of at least 4.0% of adjusted total assets; and total capital of at least 8.0% of risk weighted assets. At December 31, 2004, the Bank's tangible capital and core capital were both $59,775,000, or 11.95% of tangible assets, and total capital was $62,804,000, or 17.12% of risk-weighted assets. The Company's primary regulator, the Office of Thrift Supervision, informed the Bank that it was in the well-capitalized category as of the most recent regulatory examination, and management is not aware of any events that have occurred since that would have changed its classification. 59 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 11 - REGULATORY CAPITAL REQUIREMENTS (CONTINUED)
To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions --------------------------- --------------------------- --------------------------- Amount Ratio Amount Ratio Amount Ratio ------------ ------------ ------------ ------------ ------------ ------------ (dollars in thousands) (dollars in thousands) (dollars in thousands) As of December 31, 2004 Total Risk-Based Capital (to Risk-Weighted Assets) $ 62,804 17.12% 29,346 8.00% 36,682 10.00% Tier 1 Capital (to Risk-Weighted Assets) 59,775 16.30% 14,673 4.00% 22,010 6.00% Tier 1 Capital (to Adjusted Total Assets) 59,775 11.95% 20,011 4.00% 25,014 5.00% Tangible Capital (to Adjusted Total Assets) 59,775 11.95% 7,504 1.50% 15,008 3.00% As of December 31, 2003 Total Risk-Based Capital (to Risk-Weighted Assets) $ 64,415 18.38% 28,037 8.00% 35,046 10.00% Tier 1 Capital (to Risk-Weighted Assets) 61,389 17.52% 14,019 4.00% 21,028 6.00% Tier 1 Capital (to Adjusted Total Assets) 61,389 12.65% 19,409 4.00% 24,261 5.00% Tangible Capital (to Adjusted Total Assets) 61,389 12.65% 7,278 1.50% 14,556 3.00%
On May 23, 2002, the MHC approved a Plan of Conversion and Reorganization. As a result of the Conversion, the Bank established a memo liquidation account in an amount equal to its equity at the time of the Conversion of approximately $44 million for the benefit of eligible account holders and supplemental eligible account holders who continue to maintain their accounts at the Bank after the Conversion. In the event of a complete liquidation of the Bank, each eligible account holder and supplemental eligible account holder will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held. As a result, stockholders' equity is substantially restricted at December 31, 2004 and 2003. 60 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 12 - EMPLOYEE BENEFIT PLANS The Bank provides supplemental benefits to substantially all employees through a 401(k) savings plan. Eligible participants may contribute up to 75% of eligible compensation, with the Bank providing matching contributions of 50% of employee contributions up to 6% of eligible compensation. The plan also provides for discretionary employer contributions. During 2004, 2003 and 2002, no discretionary employer contributions were made to the 401(k) plan. Total expense relating to this plan was $104,591 for the year ended December 31, 2004, $106,973 for the year ended December 31, 2003, and $93,032 for the year ended December 31, 2002. The Bank also maintains nonqualified deferred compensation and/or supplemental retirement plans for certain of its directors and executive officers. The Bank also adopted nonqualified deferred compensation plans for key employees and directors of Citizens Bank, a wholly-owned subsidiary of Innes Street Financial Corporation, which was acquired by the Company on December 31, 2001. The deferred assets related to these plans are maintained in rabbi trusts, which are included in Other Assets of the Company. The assets are accounted for at market value in accordance with SFAS Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, with the resulting gains or losses in value recorded in income. The corresponding change in fair value of the deferred compensation obligation is recorded as compensation expense. Total expense for the all of the plans was $505,822 for the year ended December 31, 2004, $737,483 for the year ended December 31, 2003, and $312,182 for the year ended December 31, 2002. 2003 Recognition and Retention Plan ("2003 RRP") - Pursuant to resolutions of the Board of Directors of Citizens South Banking Corporation adopted on August 18, 2003, and the subsequent approval by the stockholders of the Company on October 23, 2003, the Company has adopted and implemented the Citizens South Banking Corporation 2003 Recognition and Retention Plan with a total of 210,398 shares. On November 3, 2003, awards of 196,560 shares of restricted stock were made under the 2003 RRP. All shares vest over a seven-year period commencing on the date of the award, at the rate of 30% on November 3, 2003, 10% on January 2, 2004, 10% on November 3, 2005, and 10% per year on November 3 of each year thereafter. The fair market value of the restricted stock at the time of the grant was $15.04 per share. During 2004, 25,962 shares vested, no additional shares were granted, and no shares were forfeited. At December 31, 2004, there remain 13,838 restricted shares unissued and available for grants under the 2003 RRP. 1999 Stock Option Plan - On April 12, 1999, the Company's shareholders approved the Citizens South Bank 1999 Stock Option Plan that provided the issuance of 211,335 options for directors and officers to purchase the Company's common stock. Pursuant to the mutual holding company conversion and reorganization completed on September 30, 2002, each share of the $1.00 par value common stock of Citizens South Banking Corporation (the former Federal corporation) was exchanged for 2.1408 shares of $0.01 par value common stock of the Citizens South Banking Corporation (the new Delaware Corporation), which preserved the previous shareholders' interest in Citizens South Banking Corporation. Thus, the options for 211,335 shares of common stock in the 1999 Stock Option Plan were exchanged for options for 452,425 shares, with the exercise prices of previously granted options adjusted according to the same ratio. During 2004, there were no options granted, 5,234 reload options issued, 16,965 shares were exercised, and 1,071 shares were forfeited under the 1999 Stock Option Plan. Of the 16,965 shares exercised, 4,281 were exercised for cash and 12,684 were exercised by the exchange of stock and reload provisions of the plan. At December 31, 2004, there remain 1,612 options unissued and available for grants under the 1999 Stock Option Plan. 61 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 12 - EMPLOYEE BENEFIT PLANS (CONTINUED) 2003 Stock Option Plan - Pursuant to resolutions of the Board of Directors of Citizens South Banking Corporation adopted on August 18, 2003, and the subsequent approval by the stockholders of the Company on October 23, 2003, the Company has adopted and implemented the Citizens South Banking Corporation 2003 Stock Option Plan with a total of 525,995 options available for award. On November 3, 2003, the following awards of stock options were made under the 2003 Stock Option Plan: Non-statutory options of 157,020 shares at $15.04 to directors and advisory board members, vesting over a five-year period at 20% per year, commencing on the initial date of the optionee's board service to the Bank or its predecessor, Gaston Federal Bank (excluding service to the former Citizens Bank, Inc.); incentive options of 360,000 shares at $15.04 to employees, vesting over a five-year period at 20% per year, commencing on the initial date of the optionee's employment with the Bank or its predecessor, Gaston Federal Bank (excluding service to the former Citizens Bank, Inc.). During 2004, there were 7,500 incentive options granted at the market price of the stock on the date of grant to an employee, vesting over a five-year period at 20% per year, commencing on the date of the grant, no reload options were issued, no options were exercised, and 12,500 options were forfeited. At December 31, 2004, there remain 13,975options unissued and available for grants under the 2003 Stock Option Plan. The following is a summary of stock option activity and related information for the years ended December 31, 2004, 2003 and 2002.
Year Ended December 31, 2004 Year Ended December 31, 2003 Year Ended December 31, 2002 ------------------------------- ------------------------------- ------------------------------- Weighted Avg. Weighted Avg. Weighted Avg. Options Exercise Price Options Exercise Price Options Exercise Price -------------- -------------- -------------- -------------- -------------- -------------- Outstanding- Beginning of period 810,953 $ 12.45 380,401 $ 5.72 410,482 $ 5.63 Granted 12,734 12.95 598,803 14.81 26,759 7.73 Exercised (16,965) 5.61 (168,251) 5.61 (51,488) 5.61 Forfeited (13,571) 14.30 - - (5,352) 9.78 -------------- -------------- -------------- -------------- -------------- -------------- Outstanding-end of period 793,151 $ 12.58 810,953 $ 12.45 380,401 $ 5.72 ============== ============== ============== ============== ============== ============== Exercisable-end of period 708,495 $ 12.43 690,795 $ 12.27 294,451 $ 5.63 ============== ============== ============== ============== ============== ============== Weighted average fair value of options granted during the period $ 3.90 $ 3.69 $ 1.60 ============== ============== ==============
Exercise prices for options outstanding as of December 31, 2004 ranged from $5.14 to $15.06. Exercise prices for options outstanding as of December 31, 2003 ranged from $5.14 to $15.06. The weighted average remaining contractual life of those options is approximately six years at December 31, 2004, and four years at December 31, 2003. 62 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 12 - EMPLOYEE BENEFIT PLANS (CONTINUED) Employee Stock Ownership Plan - The Bank established an Employee Stock Ownership Plan (ESOP) in 1998. The ESOP is a tax-qualified retirement plan designed to invest primarily in the Company's common stock. All full-time employees of the Bank who have completed one year of service with the Bank are eligible to participate in the ESOP. The ESOP utilized funds borrowed from the Company totaling $1,690,680, to purchase approximately 8%, or 169,068 shares of the Company's common stock issued in the 1998 Conversion. The ESOP utilized funds borrowed from the Company totaling $1,051,980 to purchase 105,198 additional shares of the Company's common stock issued in the 2002 Conversion. The loans to the ESOP will be primarily repaid with contributions from the Bank to the ESOP over a period not to exceed 15 years for each loan. Under the terms of the ESOP, the Bank makes contributions to the ESOP sufficient to cover all payments of principal and interest as they become due. The 1998 loan had an outstanding balance of $901,695 with an interest rate of 5.25% and $1,014,406 with an interest rate of 4.00% at December 31, 2004 and 2003, respectively. The interest rate on the loan is based on the Bank's prime rate. The 2002 loan had an outstanding balance of $841,584 with an interest rate of 5.25% and $911,716 with an interest rate of 4.00% at December 31, 2004 and 2003, respectively. Shares purchased with the loan proceeds are held in a suspense account by the trustee of the plan for future allocation among participants as the loan is repaid. Contributions to the ESOP and shares released from the suspense account are allocated among participants on the basis of compensation as described in the plan. The number of shares released to participants will be determined based upon the percentage of principal and interest payments made during the year divided by the total remaining principal and interest payments including the current year's payment. Participants will vest in the shares allocated to their respective accounts over a period not to exceed 5 years. Any forfeited shares are allocated to the then remaining participants in the same proportion as contributions. As of December 31, 2004, 153,997 shares have been allocated to participants and 248,341 shares remain unallocated. The fair value of the unallocated shares was $3,543,826 at December 31, 2004. The Company recognizes compensation expense attributable to the ESOP ratably over the fiscal year based upon the estimated number of ESOP shares to be allocated each December 31st. The Company recognized $223,231, $219,333, and $145,305, as compensation expense in the years ended December 31, 2004, December 31, 2003 and December 31, 2002, respectively. The trustee for the ESOP must vote all allocated shares held in the ESOP trust in accordance with the instructions of the participants. Unallocated shares held by the ESOP trust are voted by the trustee in a manner calculated to most accurately reflect the results of the allocated ESOP shares voted, subject to the requirements of the Employee Retirement Income Security Act of 1974, as amended (ERISA). NOTE 13 - FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. The estimates are significantly affected by the assumptions used, including discount rates and estimates of future cash flows. These estimates may differ substantially from amounts that could be realized in an immediate sale or settlement of the instrument. 63 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 13 - FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED) Fair value approximates book value for the following financial instruments due to their short-term nature: cash and due from banks, interest-earning bank balances, and advances from customers for taxes and insurance. Fair value for investment securities and mortgage-backed and related securities are based on quoted market prices. If a quoted market price is not available, fair value is estimated using market prices for similar securities. Fair value for variable rate loans that reprice frequently is based on the carrying value reduced by an estimate of credit losses inherent in the portfolio. Fair value for all other loans is estimated by discounting their future cash flows using interest rates currently being offered for loans of comparable terms and credit quality. Fair value for demand deposit accounts and interest-bearing accounts with no fixed maturity is equal to the carrying value. Certificate of deposit fair values are estimated by discounting cash flows from expected maturities using interest rates currently being offered for similar instruments. The carrying amount of repurchase agreements approximates fair value due to the short-term nature of the agreements. Fair value for the advances from the Federal Home Loan Bank Board is based on discounted cash flows using current interest rates. At December 31, 2004 and 2003, the Company had outstanding unfunded commitments to extend credit offered in the normal course of business. Fair values of these commitments are based on fees currently charged for similar instruments. At December 31, 2004 and 2003, the carrying amounts and fair values of these off-balance sheet financial instruments were immaterial. The Company has used management's best estimates of fair values of financial instruments based on the above assumptions. This presentation does not include certain financial instruments, nonfinancial instruments or certain intangible assets such as customer relationships, deposit base intangibles, or goodwill. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. The estimated fair values of financial instruments as of December 31 were as follows:
2004 2003 --------------------------------- --------------------------------- Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value --------------- --------------- --------------- --------------- Financial assets Cash and due from banks $ 5,799,611 $ 5,799,611 $ 5,374,150 $ 5,374,150 Interest-earning bank balances 5,790,650 5,790,650 2,840,035 2,840,035 Investments and mortgage- backed securities 133,576,857 133,576,857 145,401,283 145,401,283 Loans 314,126,978 315,148,762 295,026,346 297,407,462 Financial liabilities Deposits 374,744,428 366,115,439 342,445,676 349,743,577 Repurchase agreements 771,538 771,538 681,394 681,394 Advances from FHLB 55,000,000 55,467,576 58,300,000 59,928,212
64 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 14 - EARNINGS PER SHARE Earnings per share has been determined under the provisions of SFAS No. 128, Earnings Per Share. Basic earnings per share is computed by dividing net income applicable to common stock by the weighted average number of common shares outstanding during the period, without considering any dilutive items. Diluted earnings per share is computed by dividing net income applicable to common stock by the weighted average number of common shares and common stock equivalents for items that are dilutive, net of shares assumed to be repurchased using the treasury stock method. Common stock equivalents arise from the assumed conversion of outstanding stock options. The only potential stock of the Company as defined in SFAS No. 128, are stock options granted to various directors and officers of the Bank and unvested RRP shares. The following is a summary of the computation of basic and diluted earnings per share:
Year Ended Year Ended Year Ended December 31, December 31, December 31, 2004 2003 2002 -------------- -------------- -------------- Net income $ 2,955,421 $ 3,390,566 $ 4,507,934 Weighted average outstanding shares 7,611,022 8,623,838 8,767,982 Basic earnings per share $ 0.39 $ 0.39 $ 0.51 Weighted average outstanding shares 7,611,022 8,623,838 8,767,982 Dilutive effect of stock options 101,648 138,707 102,072 -------------- -------------- -------------- Weighted average diluted shares 7,712,670 8,762,545 8,870,054 Diluted earnings per share $ 0.38 $ 0.39 $ 0.51
In conjunction with the 2002 Conversion, as described in Note 1. of the Notes to Consolidated Financial Statements, the Company had 9,062,727 shares on common stock issued and outstanding on September 30, 2002. In March 2003, the Company's Board of Directors announced the authorization to repurchase of up to 343,027 shares of outstanding common stock. The Company repurchased 342,200 shares of stock at an average price of $13.66 under this authority in October 2003. During October 2003 the Company's Board of Directors announced the authorization to repurchase up to 879,900 shares, or 10% of the outstanding common stock. The Company repurchased 877,235 shares of stock at an average price of $13.80 under this authority by May 2004. During May 2004, the Company's Board of Directors authorized the repurchase of up to 815,000 shares, or 10% of the outstanding common stock. As of December 31, 2004, the Company had repurchased 726,000 shares of stock at an average price of $13.02 under this authorization and had 89,000 shares remaining. As of December 31, 2004, a total of 1,945,435 shares, or 21.5% of the outstanding shares of common stock, have been repurchased under these plans at an average price of $13.48 per share. 65 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 15 - PARENT-ONLY FINANCIAL INFORMATION The earnings of the Bank are recognized by Citizens South Banking Corporation using the equity method of accounting. Accordingly, undistributed earnings of the Bank are recorded as increases in the Company's investment in the Bank. The following are the condensed financial statements of the Company as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002. Condensed Statements of Financial Condition December 31, December 31, 2004 2003 ------------- ------------- Assets Cash and cash equivalents $ 2,687,014 $ 15,190,646 Investment in securities available-for-sale 2,476,936 3,095,237 Investment in subsidiary 66,828,552 69,044,166 Other assets 431,654 362,656 ------------- ------------- Total assets $ 72,424,156 $ 87,692,705 ============= ============= Liabilities and Stockholders' Equity Liabilities $ 29,899 $ 23,797 Stockholders' equity 72,394,257 87,668,908 ------------- ------------- Total liabilities and stockholders' equity $ 72,424,156 $ 87,692,705 ============= ============= Condensed Statements of Operations
Year Ended Year Ended Year Ended December 31, December 31, December 31, 2004 2003 2002 ------------- ------------- ------------- Interest income $ 238,212 $ 474,295 $ 255,815 Interest expense - - (26,865) Other noninterest income 163,800 10,177 81,592 Other noninterest expenses (631,667) (980,671) (94,346) ------------- ------------- ------------- Income before income taxes and undistributed earnings from subsidiaries (229,655) (496,199) 216,196 Income taxes 96,000 204,995 (83,162) ------------- ------------- ------------- Income before undistributed earnings from subsidiaries (133,655) (291,204) 133,034 Equity in undistributed earnings of subsidiaries 3,089,076 3,681,770 4,374,900 ------------- ------------- ------------- Net income $ 2,955,421 $ 3,390,566 $ 4,507,934 ============= ============= =============
66 CITIZENS SOUTH BANKING CORPORATION Notes to Consolidated Financial Statements (Continued) NOTE 15 - PARENT-ONLY FINANCIAL INFORMATION (CONTINUED) Condensed Statements of Cash Flows
Year Ended Year Ended Year Ended December 31, December 31, December 31, 2004 2003 2002 ------------- ------------- ------------- Operating activities Net income $ 2,955,421 $ 3,390,566 $ 4,507,934 Adjustments to reconcile net income to net Cash provided by operating activities (Gain) on sale of investments (163,800) - (81,592) Equity in undistributed (earnings) of Subsidiaries (3,089,076) (3,681,770) (4,374,900) Allocation of shares to ESOP 282,995 287,717 273,998 Vesting of shares issued for the RRP 281,025 974,848 - (Increase) in other operating subsidiaries (21,514) (14,772) (48,551) (Decrease) increase in other operating liabilities 6,102 (309,536) 84,972 ------------- ------------- ------------- Net cash provided by operating activities 251,153 647,053 361,861 Investing activities Proceeds from the sale of investments 1,008,000 - - Purchase of investments available-for-sale (347,282) (2,000,000) (94,117) ------------- ------------- ------------- Net cash used in investing activities 660,718 (2,000,000) (94,117) Financing activities Issuance of additional common stock 1,315 - 50,133,555 Repurchase of common stock (16,403,258) (9,801,707) - Contributed capital to bank subsidiary - - (23,124,633) Dividends received from bank subsidiary 5,000,000 - - Exercise of options - 149,793 - Dividends to stockholders (2,013,560) (2,136,607) (873,719) ------------- ------------- ------------- Net cash (used in) provided by financing activities (13,415,503) (11,788,521) 26,135,203 Net increase (decrease) in cash and cash equivalents (12,503,632) (13,141,468) 26,402,947 Cash and cash equivalents, beginning of period 15,190,646 28,332,114 1,929,167 ------------- ------------- ------------- Cash and cash equivalents, end of period $ 2,687,014 $ 15,190,646 $ 28,332,114 ============= ============= =============
67 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the Company's disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC's rules and forms. There has been no change in the Company's internal control over financial reporting identified in connection with the quarterly evaluation that occurred during the Company's last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. MANAGEMENT'S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Management of Citizens South Banking Corporation (the "Company") is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. The Company's internal control over financial reporting is 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. The Company's internal control over financial reporting includes those policies and procedures that: . pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; . provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that material receipts and expenditures of the Company are being made only in accordance with the authorizations of management and directors of the Company; and . 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 of the Company. 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. Management assessed the effectiveness of the Company's internal control over financial reporting as of December 31, 2004. In making this assessment, management 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 and those criteria, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2004. The Company's independent registered public accounting firm has issued an attestation report on management's assessment of the Company's internal control over financial reporting. That report is presented on the following page of this report. 68 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors Citizens South Banking Corporation We have audited management's assessment, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting, that Citizens South Banking Corporation and subsidiaries (the "Company") maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material aspects. 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 accounting principles generally accepted in the United States of America. 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 accounting principles generally accepted in the United States of America, 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 the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by COSO. Also in our opinion, the Company maintained, in all material aspects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of condition of the Company as of December 31, 2004 and 2003 and the related consolidated statements of operations, comprehensive income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2004 and our report dated March 3, 2005 expressed an unqualified opinion on these consolidated financial statements. /s/ Cherry, Bekaert & Holland, L.L.P. Gastonia, North Carolina March 3, 2005 69 ITEM 9B. OTHER INFORMATION None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The "Proposal I - Election of Directors" section of the Registrant's Definitive Proxy Statement dated April 4, 2005, (the "Proxy Statement") as filed pursuant to Section 14 of the Securities Exchange Act of 1034 in connection with the 2004 Annual Meeting of Shareholders is incorporated herein by reference. In addition, the Item 1. "Executive Officers of the Registrant" section of the Proxy Statement is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The "Proposal I - Election of Directors" section of the Registrant's Proxy Statement is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The "Proposal I - Election of Directors" section of the Registrant's Proxy Statement is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The "Proposal I - Election of Directors" section of the Registrant's Proxy Statement is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The "Principal Accountant's Fees and Services" section of this Registrant's Proxy Statement is incorporated herein by reference. 70 ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K A. Index of Exhibits 3.1 Certificate of Incorporation of Citizens South Banking Corporation (incorporated herein by reference to the Registration Statement on Form S-1 (File No. 333-91498), originally filed with the Commission on June 28, 2002 3.2 Bylaws of Citizens South Banking Corporation (incorporated herein by reference to the Registration Statement on Form S-1 (File No. 333-91498), originally filed with the Commission on June 28, 2002 4 Form of Common Stock Certificate of Citizens South Banking Corporation (incorporated herein by reference to the Registration Statement on Form S-1 (File No. 333-91498), originally filed with the Commission on June 28, 2002 10.1 Employment Agreement with Kim S. Price dated May 17, 2004 10.2 Deferred Compensation and Income Continuation Agreement (incorporated by reference to the Registration Statement on Form SB-2 (File No. 333-42951), originally filed with the Commission on December 22, 1997 10.3 Employee Stock Ownership Plan (incorporated by reference to the Registration Statement on Form SB-2 (File No. 333-42951), originally filed with the Commission on December 22, 1997 10.4 Supplemental Executive Retirement Plan (incorporated by reference to the Registration Statement on Form SB-2 (File No. 333-42951), originally filed with the Commission on December 22, 1997 10.5 Severance Agreement with Gary F. Hoskins dated May 17, 2004 10.6 Severance Agreement with Paul L. Teem, Jr. dated May 17, 2004 10.7 Severance Agreement with Michael R. Maguire dated May 17, 2004 10.8 Severance Agreement with Daniel M. Boyd, IV dated May 17, 2004 10.9 Severance Agreement with V. Burton Brinson, Jr. dated May 17, 2004 10.10 Salary Continuation Agreement with Kim S. Price dated January 1, 2004 10.11 Salary Continuation Agreement with Gary F. Hoskins dated January 1, 2004 10.12 Salary Continuation Agreement with Paul L. Teem, Jr. dated January 1, 2004 10.13 Salary Continuation Agreement with Michael R. Maguire dated January 1, 2004 10.14 Salary Continuation Agreement with Daniel M. Boyd, IV dated January 1, 2004 10.15 Salary Continuation Agreement with V. Burton Brinson, Jr. dated January 1, 2004 10.16 Endorsement Split Dollar Agreement with Kim S. Price dated January 1, 2004 71 10.17 Endorsement Split Dollar Agreement with Gary F. Hoskins dated January 1, 2004 10.18 Endorsement Split Dollar Agreement with Paul L. Teem, Jr. dated January 1, 2004 10.19 Endorsement Split Dollar Agreement with Michael R. Maguire dated January 1, 2004 10.20 Endorsement Split Dollar Agreement with Daniel M. Boyd, IV dated January 1, 2004 10.21 Endorsement Split Dollar Agreement with V. Burton Brinson, Jr. dated January 1, 2004 10.22 Amended Deferred Compensation and Income Continuation Agreement with David W. Hoyle, Sr. dated March 15, 2004 10.23 Amended Deferred Compensation and Income Continuation Agreement with Ben R. Rudisill, II dated March 15, 2004 10.24 Amended Deferred Compensation and Income Continuation Agreement with James J. Fuller dated March 15, 2004 10.25 Amended Deferred Compensation and Income Continuation Agreement with Charles D. Massey dated March 15, 2004 10.26 Amended Director Retirement Agreement with David W. Hoyle, Sr. dated March 15, 2004 10.27 Amended Director Retirement Agreement with Ben R. Rudisill, II dated March 15, 2004 10.28 Amended Director Retirement Agreement with James J. Fuller dated March 15, 2004 10.29 Amended Director Retirement Agreement with Charles D. Massey dated March 15, 2004 10.30 Amended Director Retirement Agreement with Eugene R. Matthews, II dated March 15, 2004 14 Code of Ethics Policy (incorporated herein by reference to the "Proposal I - Election of Directors" section of the Registrant's Proxy Statement dated April 4, 2005 21 Subsidiaries of Registrant (incorporated herein by reference to the Registration Statement on Form S-1 (File No. 333-91498), originally filed with the Commission on June 28, 2002 23 Consent of Cherry, Bekaert & Holland, L.L.P. 24 Power of Attorney (set forth on signature page) 31 Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32 Statement of Chief Executive Officer and Chief Financial Officer furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 72 SIGNATURES Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Citizens South Banking Corporation Date: March 10, 2005 By: /s/ Kim S. Price -------------------------------- Kim S. Price President and Chief Executive Officer Pursuant to the requirements of the Securities Exchange 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. By: /s/ Kim S. Price By: /s/ Gary F. Hoskins ------------------------------- -------------------------------- Kim S. Price Gary F. Hoskins President, Chief Executive Executive Vice President, Officer and Director (Principal Treasurer and Chief Financial Executive Officer) Officer (Principal Financial and Accounting Officer) Date: March 10, 2005 Date: March 10, 2005 By: /s/ David W. Hoyle By: /s/ Ben R. Rudisill, II ------------------------------- -------------------------------- David W. Hoyle Ben R. Rudisill, II Chairman Vice Chairman Date: March 10, 2005 Date: March 10, 2005 By: /s/ Eugene R. Matthews, II By: /s/ Charles D. Massey ------------------------------- -------------------------------- Eugene R. Matthews, II Charles D. Massey Director Director Date: March 10, 2005 Date: March 10, 2005 By: /s/ James J. Fuller ------------------------------- James J. Fuller Director Date: March 10, 2005 73