10-Q 1 form10q-62162_cap.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 |X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 2004 |_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From ____________ to ____________ Commission File Number 0-30062 CAPITAL BANK CORPORATION (Exact name of registrant as specified in its charter) North Carolina 56-2101930 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 4901 Glenwood Avenue Raleigh, North Carolina 27612 (Address of Principal executive offices) (Zip Code) Registrant's telephone number, including area code: (919) 645-6400 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. |X| Yes |_| No Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). |X| Yes |_| No As of August 3, 2004, there were 6,587,068 shares outstanding of the registrant's common stock, no par value. Capital Bank Corporation CONTENTS
Page No. PART I - FINANCIAL INFORMATION Item 1. Financial Statements Condensed consolidated statements of financial condition at June 30, 2004 (Unaudited) and December 31, 2003 1 Condensed consolidated statements of income for the three months ended June 30, 2004 and 2003 (Unaudited) 2 Condensed consolidated statements of income for the six months ended June 30, 2004 and 2003 (Unaudited) 3 Condensed consolidated statements of changes in shareholders' equity for the six months ended June 30, 2004 and 2003 (Unaudited) 4 Condensed consolidated statements of comprehensive income (loss) for the three and six months ended June 30, 2004 and 2003 (Unaudited) 5 Condensed consolidated statements of cash flows for the six months ended June 30, 2004 and 2003 (Unaudited) 6 - 7 Notes to condensed consolidated financial statements 8 - 13 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13 - 29 Item 3. Quantitative and Qualitative Disclosures About Market Risk 29 Item 4. Controls and Procedures 29 - 30 PART II - OTHER INFORMATION Item 1. Legal Proceedings 30 Item 2. Changes in Securities and Use of Proceeds 30 Item 3. Defaults Upon Senior Securities 30 Item 4. Submission of Matters to a Vote of Security Holders 30 - 31 Item 5. Other Information 31 Item 6. Exhibits and Reports on Form 8-K 31 - 32 Signatures 33
CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION June 30, 2004 and December 31, 2003
June 30, December 31, 2004 2003 --------------------------------------------------------------------------------------- (Dollars in thousands) (Unaudited) ASSETS Cash and due from banks: Interest earning $ 2,091 $ 569 Noninterest earning 26,729 21,839 Federal funds sold 6,497 3,202 Investment securities - available for sale, at fair value 150,340 165,913 Loans-net of unearned income and deferred fees 657,537 625,945 Allowance for loan losses (11,417) (11,613) --------- --------- Net loans 646,120 614,332 --------- --------- Premises and equipment, net 14,968 14,190 Bank owned life insurance 9,754 9,429 Deposit premium and goodwill, net 14,404 14,530 Deferred tax assets 7,668 6,492 Other assets 7,183 7,238 --------- --------- Total assets $ 885,754 $ 857,734 ========= ========= LIABILITIES Deposits: Demand, noninterest bearing $ 62,726 $ 58,350 Savings and interest bearing demand deposits 214,452 200,452 Time deposits 394,618 370,817 --------- --------- Total deposits 671,796 629,619 --------- --------- Repurchase agreements 8,828 11,014 Borrowings 102,456 114,591 Subordinated debentures 20,620 20,620 Other liabilities 9,439 8,967 --------- --------- Total liabilities 813,139 784,811 --------- --------- SHAREHOLDERS' EQUITY Common stock, no par value; 20,000,000 shares authorized; 6,586,216 and 6,541,495 issued and outstanding as of June 30, 2004 and December 31, 2003, respectively 67,825 67,381 Retained earnings 6,778 5,165 Accumulated other comprehensive income (1,988) 377 --------- --------- Total shareholders' equity 72,615 72,923 --------- --------- Total liabilities and shareholders' equity $ 885,754 $ 857,734 ========= =========
See Notes to Condensed Consolidated Financial Statements -1- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF INCOME Three Months Ended June 30, 2004 and 2003
2004 2003 ------------------------------------------------------------------------------------------ (In thousands except per share data) (Unaudited) Interest income: Loans and loan fees $ 8,572 $ 8,723 Investment securities 1,552 1,356 Federal funds and other interest income 39 56 ----------- ----------- Total interest income 10,163 10,135 ----------- ----------- Interest expense: Deposits 2,913 3,074 Borrowings and repurchase agreements 1,019 1,089 ----------- ----------- Total interest expense 3,932 4,163 ----------- ----------- Net interest income 6,231 5,972 Provision for loan losses 297 2,696 ----------- ----------- Net interest income after provision for loan losses 5,934 3,276 ----------- ----------- Noninterest income: Deposit service charges and other fees 768 746 Mortgage origination fees and related gains 365 1,297 Investment securities gains, net -- 191 Other noninterest income 411 505 ----------- ----------- Total noninterest income 1,544 2,739 ----------- ----------- Noninterest expenses: Salaries and employee benefits 3,061 3,236 Occupancy 582 528 Furniture and equipment 474 361 Data processing 301 309 Advertising 222 189 Amortization of deposit premium 61 80 Other expenses 1,369 1,074 ----------- ----------- Total noninterest expenses 6,070 5,777 ----------- ----------- Income before income tax expense 1,408 238 Income tax expense (benefit) 517 (47) ----------- ----------- Net income $ 891 $ 285 =========== =========== Earnings per share - basic $ 0.13 $ 0.04 =========== =========== Earnings per share - diluted $ 0.13 $ 0.04 =========== =========== Weighted average shares Basic 6,708,742 6,684,327 =========== =========== Fully diluted 6,883,157 6,872,728 =========== ===========
See Notes to Condensed Consolidated Financial Statements -2- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF INCOME Six Months Ended June 30, 2004 and 2003
2004 2003 ---------------------------------------------------------------------------------------- (In thousands except per share data) (Unaudited) Interest income: Loans and loan fees $ 17,043 $ 17,201 Investment securities 3,270 2,984 Federal funds and other interest income 81 127 ---------- ---------- Total interest income 20,394 20,312 ---------- ---------- Interest expense: Deposits 5,775 6,230 Borrowings and repurchase agreements 2,119 2,175 ---------- ---------- Total interest expense 7,894 8,405 ---------- ---------- Net interest income 12,500 11,907 Provision for loan losses 413 3,296 ---------- ---------- Net interest income after provision for loan losses 12,087 8,611 ---------- ---------- Noninterest income: Deposit service charges and other fees 1,495 1,402 Mortgage origination fees and related gains 702 2,503 Investment securities gains, net 13 442 Other noninterest income 935 997 ---------- ---------- Total noninterest income 3,145 5,344 ---------- ---------- Noninterest expenses: Salaries and employee benefits 5,903 6,664 Occupancy 1,154 1,060 Furniture and equipment 839 729 Data processing 623 588 Advertising 424 380 Amortization of deposit premium 126 154 Other expenses 2,638 2,150 ---------- ---------- Total noninterest expenses 11,707 11,725 ---------- ---------- Income before income tax expense 3,525 2,230 Income tax expense 1,254 664 ---------- ---------- Net income $ 2,271 $ 1,566 ========== ========== Earnings per share - basic $ 0.34 $ 0.23 ========== ========== Earnings per share - diluted $ 0.33 $ 0.23 ========== ========== Weighted average shares Basic 6,698,844 6,706,791 ========== ========== Fully diluted 6,884,862 6,888,502 ========== ==========
See Notes to Condensed Consolidated Financial Statements -3- Capital Bank Corporation Consolidated Statements of Changes in Shareholders' Equity For the Six Months Ended June 30, 2004 and 2003
(Dollars in thousands) Shares of Other Common Common Comp. Retained Stock Stock Income Earnings Total ---------- ---------- ---------- ---------- ---------- Balance at January 1, 2003 6,595,784 $ 68,697 $ 1,293 $ 5,481 $ 75,471 Repurchase of outstanding common stock (132,500) (1,938) -- -- (1,938) Issuance of common stock for compensation 2,373 24 24 Reissuance of common stock for options exercised 54,657 425 -- -- 425 Net income -- -- -- 1,566 1,566 Other comprehensive income -- -- 254 -- 254 Cash dividends -- -- -- (658) (658) ---------- ---------- ---------- ---------- ---------- Balance at June 30, 2003 6,520,314 $ 67,208 $ 1,547 $ 6,389 $ 75,144 ========== ========== ========== ========== ========== Balance at January 1, 2004 6,541,495 $ 67,381 $ 377 $ 5,165 $ 72,923 Issuance of common stock for options exercised 44,721 444 -- -- 444 Net income -- -- -- 2,271 2,271 Other comprehensive income -- -- (2,365) -- (2,365) Cash dividends -- -- -- (658) (658) ---------- ---------- ---------- ---------- ---------- Balance at June 30, 2004 6,586,216 $ 67,825 $ (1,988) $ 6,778 $ 72,615 ========== ========== ========== ========== ==========
The accompanying notes are an integral part of these consolidated financial statements. -4- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) Three and Six Months Ended June 30, 2004 and 2003
2004 2003 ----------------------------------------------------------------------------------------- (In thousands) (Unaudited) Three month period ended June 30, 2004 and 2003: Net income $ 891 $ 285 Reclassification of gains recognized in net income -- (191) Unrealized gains (losses) on securities available for sale (5,677) 750 Income tax benefit (expense) 2,189 (216) -------- -------- Comprehensive income (loss) $ (2,597) $ 628 ======== ======== Six month period ended June 30, 2004 and 2003: Net income $ 2,271 $ 1,566 Reclassification of gains recognized in net income (13) (442) Unrealized gains (losses) on securities available for sale (3,825) 880 Income tax benefit (expense) 1,473 (184) -------- -------- Comprehensive income (loss) $ (94) $ 1,820 ======== ========
See Notes to Condensed Consolidated Financial Statements -5- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Six Months Ended June 30, 2004 and 2003
2004 2003 ------------------------------------------------------------------------------------- (In thousands) (Unaudited) Cash Flows From Operating Activities Net income $ 2,271 $ 1,566 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Amortization of deposit premium 126 154 Depreciation 744 751 Investment securities gains, net (13) (442) Change in loans held for sale (787) (10,239) Amortization of premiums on securities, net 407 1,042 Deferred income tax expense 309 59 Provision for loan losses 413 3,296 Changes in assets and liabilities: Accrued interest receivable and other assets 129 (51) Accrued interest payable and other liabilities 472 (798) Other operating activities, net 69 (3) -------- -------- Net cash provided by (used in) operating activities 4,140 (4,665) -------- -------- Cash Flows From Investing Activities Loan originations, net of principal repayments (31,813) (38,149) Additions to premises and equipment (2,236) (742) Net (purchase) sale of Federal Home Loan Bank stock 603 (682) Purchase of securities available for sale (27,424) (67,720) Purchase of bank owned life insurance -- (6,000) Proceeds from sales of property and equipment 645 -- Proceeds from maturities of securities available for sale 22,137 45,722 Proceeds from sales of securities available for sale 16,013 15,858 Other investing activities, net -- (30) -------- -------- Net cash used in investing activities (22,075) (51,743) -------- -------- Cash Flows From Financing Activities Net increase in deposits 42,177 39,293 Net increase (decrease) in repurchase agreements (2,186) 2,672 Net increase (decrease) in borrowings (12,135) 16,867 Proceeds from subordinated debentures, net of issuance costs -- 9,700 Cash dividends paid (658) (664) Issuance of common stock for options 444 425 Issuance of common stock for compensation -- 24 Purchase of common stock -- (1,938) -------- -------- Net cash provided by financing activities 27,642 66,379 -------- --------
(continued on next page) See Notes to Condensed Consolidated Financial Statements -6- CAPITAL BANK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Six Months Ended June 30, 2004 and 2003 2004 2003 -------------------------------------------------------------------------------- (In thousands) (Unaudited) Net change in cash and cash equivalents 9,707 9,971 Cash and cash equivalents: Beginning 25,610 51,533 -------- -------- Ending $ 35,317 $ 61,504 ======== ======== Supplemental Disclosure of Cash Flow Information Transfer from loans to real estate acquired through foreclosure $ 399 $ 240 ======== ======== Dividends payable $ 328 $ 326 ======== ======== Cash paid for: Income taxes $ 384 $ 1,008 ======== ======== Interest $ 7,777 $ 8,555 ======== ======== See Notes to Condensed Consolidated Financial Statements -7- Notes to the Condensed Consolidated Financial Statements 1. Significant Accounting Policies and Interim Reporting The accompanying unaudited condensed consolidated financial statements include the accounts of Capital Bank Corporation (the "Company") and its wholly owned subsidiaries, Capital Bank (the "Bank") and Capital Bank Investment Services, Inc. ("CBIS"). In addition, the Company has interest in two trusts, Capital Bank Statutory Trust I and II (hereinafter collectively referred to as the "Trusts"). The Trusts have not been consolidated with the financial statements of the Company. The interim financial statements have been prepared in accordance with generally accepted accounting principles. They do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and therefore should be read in conjunction with the audited financial statements and accompanying footnotes in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. In the opinion of management, all adjustments necessary for a fair presentation of the financial position and results of operations for the periods presented have been included and all significant intercompany transactions have been eliminated in consolidation. The results of operations for the six month period ended June 30, 2004 are not necessarily indicative of the results of operations that may be expected for the year ended December 31, 2004. The balance sheet at December 31, 2003 has been derived from the Company's audited consolidated financial statements. The accounting policies followed are as set forth in Note 1 of the Notes to Financial Statements in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. 2. Comprehensive Income Comprehensive income includes net income and all other changes to the Company's equity, with the exception of transactions with shareholders ("other comprehensive income"). The Company's only components of other comprehensive income relate to unrealized gains and losses on securities available for sale, net of the applicable income tax effect. The Company's comprehensive income and information concerning the Company's other comprehensive income items for the three and six month periods ended June 30, 2004 and 2003 are as shown in the Company's Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2004 and 2003 (unaudited). 3. Earnings Per Share The Company is required to report both basic and diluted earnings per share ("EPS"). Basic EPS excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted EPS assumes the conversion, exercise or issuance of all potential common stock instruments, such as stock options, unless the effect is to reduce a loss or increase earnings per share. For the Company, EPS is adjusted for outstanding stock options using the treasury stock method in order to compute diluted EPS. The following tables provide a computation and reconciliation of basic and diluted EPS for the three and six month periods ended June 30, 2004 and 2003. -8-
2004 2003 ------------------------ (Dollars in thousands) (Unaudited) Three month periods ended June 30, 2004 and 2003: Income available to shareholders - basic and diluted $ 891 $ 285 ========== ========== Shares used in the computation of earnings per share: Weighted average number of shares outstanding - basic 6,708,742 6,684,327 Incremental shares from assumed exercise of stock options 174,415 188,401 ---------- ---------- Weighted average number of shares outstanding - diluted 6,883,157 6,872,728 ========== ========== Six month periods ended June 30, 2004 and 2003: Income available to shareholders - basic and diluted $ 2,271 $ 1,566 ========== ========== Shares used in the computation of earnings per share: Weighted average number of shares outstanding - basic 6,698,844 6,706,791 Incremental shares from assumed exercise of stock options 186,018 181,711 ---------- ---------- Weighted average number of shares outstanding - diluted 6,884,862 6,888,502 ========== ==========
Options to purchase approximately 643,000 shares of common stock were used in the diluted calculation. An aggregate of 7,000 options were not included in the diluted calculation because the option price exceeded the average fair market value of the associated common shares of stock. 4. Stock Based Compensation The Company has a stock option plan under which options to purchase Company common stock may be granted periodically to certain employees. Grants of options are made by the Board of Directors or its Compensation Committee. All grants must be at no less than fair market value on the date of grant, must be exercised no later than 10 years from the date of grant, and may be subject to some vesting provisions. The Company accounts for its stock options under the provisions of APB Opinion No. 25 ("APB 25"), Accounting for Stock Issued to Employees. However, under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 123 ("FAS 123"), Accounting for Stock-Based Compensation, the Company is required to disclose the pro forma effects on net income as if it had recorded compensation based on the fair value of options granted. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with certain assumptions. Option pricing models require the use of highly subjective assumptions, including expected stock price volatility, which if changed can materially affect fair value estimates. Accordingly, the model does not necessarily provide a reliable single measure of the fair value of the Company's stock options. Under SFAS No. 148 ("FAS 148"), Accounting for Stock-Based Compensation--Transition and Disclosure, companies are required to disclose for each period for which an income statement is presented an accounting policy footnote that includes (i) the method of accounting for stock options; (ii) total stock compensation cost that is recognized in the income statement and would -9- have been recognized had FAS 123 been adopted for recognition purposes as of its effective date; and (iii) pro forma net income and earnings per share (where applicable) that would have been reported had FAS 123 been adopted for recognition purposes as of its effective date. These disclosures are required to be made in annual financial statements and in quarterly information provided to shareholders without regard to whether the entity has adopted FAS 123 for recognition purposes. The Company granted 8,000 options to purchase its shares of common stock at a weighted average price of $16.33 during the first six months of 2004. For the three and six month periods ended March 30, 2004 and 2003, the following table summarizes the net income and stock-based compensation expense, as reported, compared to pro forma amounts had the fair value method been applied:
2004 2003 ----------------------- (Dollars in thousands) (Unaudited) Three month periods ended June 30, 2004 and 2003: Net income, as reported $ 891 $ 285 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (39) (45) ----------------------- Pro forma net income $ 852 $ 240 ======================= Earnings per share: Basic - as reported $ 0.13 $ 0.04 Basic - pro forma $ 0.13 $ 0.04 Diluted - as reported $ 0.13 $ 0.04 Diluted - pro forma $ 0.13 $ 0.04 Six month periods ended June 30, 2004 and 2003: Net income, as reported $ 2,271 $ 1,566 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (81) (93) ----------------------- Pro forma net income $ 2,190 $ 1,473 ======================= Earnings per share: Basic - as reported $ 0.34 $ 0.23 Basic - pro forma $ 0.33 $ 0.23 Diluted - as reported $ 0.33 $ 0.22 Diluted - pro forma $ 0.32 $ 0.22
-10- 5. Investment Securities The following table shows the gross unrealized losses and fair value of Company's investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category at June 30, 2004: ----------------------- (Dollars in thousands) (Unaudited) Gross Unrealized Description of security Fair Value Losses ---------- ---------- Direct obligations of U.S. government agencies $ 34,383 $ 1,113 Municipal bonds 24,470 69 Federal agency mortgage-backed securities 86,398 2,054 FHLB stock 5,089 -- ----------------------- $ 150,340 $ 3,236 ======================= Government Agency Obligations. The unrealized losses on the Company's investments in direct obligations of U.S. government agencies were the result of interest rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price materially less than the amortized cost of the investment. Because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at June 30, 2004. Federal Agency Mortgage-Backed Securities. The unrealized losses on the Company's investment in agency mortgage-backed securities issued by FNMA, FHLMC, and GNMA were caused by interest rate increases. The Company purchased most of these investments at either a discount or a premium relative to their face amount, and the contractual cash flows of each is guaranteed by the issuer organization. Accordingly, it is expected that the securities would not be settled at a price materially less than the amortized cost of the Company's investment. Because the decline in market value is attributable to changes in interest rates and not credit quality and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at June 30, 2004. -11- 6. Loans The composition of the loan portfolio by loan classification at June 30, 2004 and December 31, 2003 is as follows: June 30, December 31, (Dollars in thousands) 2004 2003 ---------- ------------ Commercial $ 509,068 $ 474,104 Consumer 41,500 42,929 Home equity lines 59,724 58,430 Residential mortgages 47,232 50,437 ---------- ---------- 657,524 625,900 Less deferred loan fees (costs), net 13 45 ---------- ---------- $ 657,537 $ 625,945 ========== ========== Loans held for sale, primarily from mortgage banking activities, as of June 30, 2004 and December 31, 2003 were $5.6 million and $4.8 million, respectively, and were included in the residential mortgage category. 7. New Pronouncements Revenue Recognition In December 2003, the SEC issued Staff Accounting Bulletin No. 104 ("SAB 104"), Revenue Recognition, which supercedes Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial Statements." The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, which was superceded as a result of the issuance of Emerging Issues Task Force 00-21 ("EITF 00-21"), Accounting for Revenue Arrangements with Multiple Deliverables. SAB 104 also incorporated certain sections of the SEC's "Revenue Recognition in Financial Statements--Frequently Asked Questions and Answers" document. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104. The adoption of SAB 104 did not have a material impact on our consolidated financial position, results of operations or cash flows. Post Retirement Benefits In December 2003, the FASB revised SFAS No. 132, Employer's Disclosures about Pensions and Other Post-retirement Benefits. The revised standard requires new disclosures in addition to those required by the original standard about the assets, obligations, cash flows and net periodic benefit cost of defined benefit pension plans and other defined benefit post-retirement plans. As revised, SFAS No. 132R, is effective for financial statements with fiscal years ending after December 15, 2003. The interim-period disclosures required by this standard are effective for interim periods beginning after December 15, 2003. However, disclosure of the estimated future benefit payments is effective for fiscal years ending after June 14, 2004. The adoption of this SFAS did not have a material impact on our results of operations or financial condition. -12- Investments In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on the remaining portions of EITF 003-01, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, effective for the first fiscal year or interim period beginning after June 15, 2004. EITF 003-01 provides new disclosure requirements for other-than-temporary impairments on debt and equity investments. Investors are required to disclose quantitative information about: (i) the aggregate amount of unrealized losses, and (ii) the aggregate related fair values of investments with unrealized losses, segregated into time periods during which the investment has been in an unrealized loss position of less than 12 months and greater than 12 months. In addition, investors are required to disclose the qualitative information that supports their conclusion that the impairments noted in the qualitative disclosure are not other-than-temporary. The adoption of this EITF is not expected to have a material impact on our results of operations or financial condition. Loan Commitments In March 2004, the Securities and Exchange Commission issued Staff Accounting Bulletin (SAB) No. 105, Application of Accounting Principles to Loan Commitments. SAB 105 requires that the fair value measurement of mortgage loan commitments, which are derivatives, exclude any expected future cash flows related to the customer relationship or servicing rights. The guidance in SAB 105 must be applied to mortgage loan commitments entered into after March 31, 2004. The impact on the Company is not material given the declines in mortgage banking volume but could be in the future. The impact is primarily the timing of when gains should be recognized in the financial statements. Purchased Loans In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position (SOP) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, which addresses the accounting for differences between contractual cash flows and expected cash flows for loans acquired in a transfer when those differences are attributable at least in part to a decline in credit quality. The scope of SOP 03-3 includes loans where there is evidence of deterioration in credit quality since origination, and includes loans acquired individually, in pools or as part of a business combination. Under SOP 03-3, the difference between expected cash flows and the purchase price is accreted as an adjustment to yield over the life. The Company does not expect its application to have a material impact on our consolidated financial position or results of operations. Item 2 Management's Discussion and Analysis Of Financial Condition and Results of Operations The following discussion presents an overview of the unaudited financial statements for the three and six month period ended June 30, 2004 and 2003 for Capital Bank Corporation (the "Company") and its wholly owned subsidiaries. This discussion and analysis is intended to provide pertinent information concerning financial position, results of operations, liquidity, and capital resources for the periods covered. It should be read in conjunction with the unaudited financial statements and related footnotes contained in Part I, Item 1 of this report. Information set forth below contains various forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), which statements represent the -13- Company's judgment concerning the future and are subject to risks and uncertainties that could cause the Company's actual operating results to differ materially. Such forward-looking statements can be identified by the use of forward-looking terminology, such as "may", "will", "expect", "anticipate", "estimate", "believe", or "continue", or the negative thereof or other variations thereof or comparable terminology. The Company cautions that such forward-looking statements are further qualified by important factors that could cause the Company's actual operating results to differ materially from those in the forward-looking statements, as well as the factors set forth in this discussion and analysis, and the Company's periodic reports and other filings with the Securities and Exchange Commission. Risk Factors You should consider the following material risk factors carefully before deciding to invest in Capital Bank Corporation securities. If any of the events described below occur, the Company's business, financial condition, or results of operations could be materially adversely affected. In that event, the trading price of the Company's common stock may decline, in which case the value of your investment may decline as well. Our Results Are Impacted by the Economic Conditions of Our Principal Operating Regions Our operations are concentrated throughout Central and Western North Carolina. As a result of this geographic concentration, our results may correlate to the economic conditions in these areas. Deterioration in economic conditions in any of these market areas, particularly in the industries on which these geographic areas depend, may adversely affect the quality of our loan portfolio and the demand for our products and services, and accordingly, our results of operations. We Are Exposed to Risks in Connection with the Loans We Make A significant source of risk for us arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. We have underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for loan losses, that we believe are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying our loan portfolio. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect our results of operations. We Compete With Larger Companies for Business The banking and financial services business in our market areas continues to be a competitive field and is becoming more competitive as a result of: o Changes in regulations; o Changes in technology and product delivery systems; and o The accelerating pace of consolidation among financial services providers. We may not be able to compete effectively in our markets, and our results of operations could be adversely affected by the nature or pace of change in competition. We compete for loans, deposits and customers with various bank and nonbank financial services providers, many of which have substantially greater resources including higher total assets and capitalization, greater access to capital markets and offering a broader array of financial services. -14- Our Trading Volume Has Been Low Compared With Larger Banks The trading volume in the Company's common stock on the NASDAQ National Market has been comparable to other similarly-sized banks. Nevertheless, this trading is relatively low when compared with more seasoned companies listed on the NASDAQ National Market or other consolidated reporting systems or stock exchanges. Thus, the market in the Company's common stock may be limited in scope relative to other companies. We Depend Heavily on Our Key Management Personnel The Company's success depends in part on its ability to retain key executives and to attract and retain additional qualified management personnel who have experience both in sophisticated banking matters and in operating a small to mid-size bank. Competition for such personnel is strong in the banking industry and we may not be successful in attracting or retaining the personnel we require. We expect to effectively compete in this area by offering financial packages that include incentive-based compensation and the opportunity to join in the rewarding work of building a growing bank. Technological Advances Impact Our Business The banking industry is undergoing technological changes with frequent introductions of new technology-driven products and services. In addition to improving customer services, the effective use of technology increases efficiency and enables financial institutions to reduce costs. The Company's future success will depend, in part, on our ability to address the needs of our customers by using technology to provide products and services that will satisfy customer demands for convenience as well as to create additional efficiencies in our operations. Many of our competitors have substantially greater resources than we do to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or successfully market such products and services to our customers. Government Regulations May Prevent or Impair Our Ability to Pay Dividends, Engage in Acquisitions or Operate in Other Ways Current and future legislation and the policies established by federal and state regulatory authorities will affect our operations. We are subject to supervision and periodic examination by the Federal Deposit Insurance Corporation and the North Carolina State Banking Commission. Banking regulations, designed primarily for the protection of depositors, may limit our growth and the return to you, our investors, by restricting certain of our activities, such as: o The payment of dividends to our shareholders; o Possible mergers with or acquisitions of or by other institutions; o Our desired investments; o Loans and interest rates on loans; o Interest rates paid on our deposits; o The possible expansion of our branch offices; and/or o Our ability to provide securities or trust services. We also are subject to capitalization guidelines set forth in federal legislation, and could be subject to enforcement actions to the extent that we are found by regulatory examiners to be undercapitalized. We cannot predict what changes, if any, will be made to existing federal and state legislation and regulations or the effect that such changes may have on our future business and earnings prospects. The cost of compliance with regulatory requirements including those imposed by the Securities and Exchange Commission may adversely affect our ability to operate profitably. -15- There Are Potential Risks Associated With Future Acquisitions and Expansions We intend to continue to explore expanding our branch system through selective acquisitions of existing banks or bank branches in the Research Triangle area and other North Carolina markets. We cannot say with any certainty that we will be able to consummate, or if consummated, successfully integrate, future acquisitions, or that we will not incur disruptions or unexpected expenses in integrating such acquisitions. In the ordinary course of business, we evaluate potential acquisitions that would bolster our ability to cater to the small business, individual and residential lending markets in North Carolina. In attempting to make such acquisitions, we anticipate competing with other financial institutions, many of which have greater financial and operational resources. In addition, since the consideration for an acquired bank or branch may involve cash, notes or the issuance of shares of common stock, existing shareholders could experience dilution in the value of their shares of the Company's common stock in connection with such acquisitions. Any given acquisition, if and when consummated, may adversely affect our results of operations or overall financial condition. In addition, we may expand our branch network through de novo branches in existing or new markets. These de novo branches will have expenses in excess of revenues for varying periods after opening which could decrease the Company's reported earnings. Overview Capital Bank Corporation is a financial holding company incorporated under the laws of the state of North Carolina on August 10, 1998. The Company's primary function is to serve as the holding company for its wholly-owned subsidiaries, Capital Bank (the "Bank") and Capital Bank Investment Services, Inc. ("CBIS"). In addition, the Company has interest in two trusts, Capital Bank Statutory Trust I and II (hereinafter collectively referred to as the "Trusts"). The Trusts have not been consolidated with the financial statements of the Company. The Bank was incorporated under the laws of the State of North Carolina on May 30, 1997, and commenced operations as a state-chartered banking corporation on June 20, 1997. The Bank is not a member of the Federal Reserve System and has no subsidiaries. CBIS was incorporated under the laws of the State of North Carolina on January 3, 2001 and commenced operations as a full service investment company on March 1, 2001. In the third quarter of 2003, the Company discontinued the operations of CBIS. Capital Bank is a community bank engaged in the general commercial banking business in Wake, Chatham, Northampton, Granville, Warren, Alamance, Lee, Buncombe, Guilford and Catawba Counties of North Carolina. Wake County has a diversified economic base, comprised primarily of services, retail trade, government and manufacturing and includes the City of Raleigh, the state capital. Lee, Northampton, Granville, Warren and Chatham counties are significant centers for various industries, including agriculture, manufacturing, lumber and tobacco. Alamance and Guilford counties have an diversified economic base, comprised primarily of manufacturing, agriculture, retail and wholesale trade, government, services and utilities. Catawba County, which includes Hickory, is a regional center for manufacturing and wholesale trade. The economic base of Buncombe County is comprised primarily of services, medical, tourism and manufacturing industries and includes the city of Asheville. The Bank offers a full range of banking services, including the following: checking accounts; -16- savings accounts; NOW accounts; money market accounts; certificates of deposit; loans for real estate, construction, businesses, agriculture, personal uses, home improvement and automobiles; home equity lines of credit; consumer loans; individual retirement accounts; safe deposit boxes; bank money orders; internet banking; electronic funds transfer services including wire transfers; traveler's checks; various investments; and free notary services to all Bank customers. In addition, the Bank provides automated teller machine access to its customers for cash withdrawals through nationwide ATM networks. At present, the Bank does not provide the services of a trust department. Beginning in the third quarter of 2004, the Bank plans to offer non-insured investment products and services through a business relationship with a leading Raleigh, North Carolina based broker-dealer. The Bank anticipates hiring four - six predominately commission compensated investment representatives during the remainder of 2004 to offer these products and services to its customers. The Trusts were formed for the sole purpose of issuing trust preferred securities. The proceeds from such issuances were loaned to the Company in exchange for the Debentures, which are the sole assets of the Trust. A portion of the proceeds from the issuance of the Debentures were used by the Company to repurchase shares of Company common stock. The Company's obligation under the Debentures constitutes a full and unconditional guarantee by the Company of the Trust's obligations under the trust preferred securities. The Trusts have no operations other than those that are incidental to the issuance of the trust preferred securities. Executive Summary As discussed in more detail within this Management's Discussion and Analysis, the following is a brief summary of certain of our significant quarterly results: o The Company recorded an increase in net income for the second quarter 2004 compared to the same period in the prior year. Profit for the quarter was $891,000 or $.13 per fully diluted share compared to $285,000 or $.04 per fully diluted share in the second quarter of 2003. For the six months ended June 30, 2004, net income was $2,271,000 or $.33 per fully diluted share compared to $1,566,000 or $.23 per fully diluted share for the first six months of 2003. o The provision for loan losses was $297,000 and $2,696,000 for the quarters ended June 30, 2004 and 2003, respectively. For the six months ended June 30, 2004, the provision for loan losses was $413,000 compared to $3,296,000 for the same period of 2003. Net charge-offs for the six months ended June 30, 2004 were $609,000 or .19% of average loans compared to $3,232,000 or 1.04% of average loans for the six months ended June 30, 2003. The significant declines in the provision expense and net charge-offs are the result of credit issues reported during the second quarter of 2003. o Net interest income increased from 2003 levels for both the quarter and the six months ended June 30, 2004, increasing by $259,000 and $593,000, respectively. The Company's net interest margin increased compared to second quarter 2003 by 10 basis points to 3.14% in second quarter of 2004. For the six months ended June 30, 2004 and 2003, the net interest margin was 3.17% and 3.07%, respectively. -17- o Mortgage production, a large component of noninterest income, was impacted by industry wide lower origination volumes caused by higher mortgage interest rates. The Company's noninterest income for both the three months and six months ended June 30, 2004 declined compared to the comparable periods of 2003, largely due to declines in mortgage income and securities gains realized in 2003. Noninterest income was $1,544,000 for the second quarter of 2004 and $3,145,000 for the six months ended June 30, 2004 versus $2,739,000 and $5,344,000 for the comparable periods of 2003. o Noninterest expense was $6,070,000 for the three months and $11,707,000 for the six months ended June 2004 compared to $5,777,000 and $11,725,000, respectively, for the same periods of 2003. Personnel expense, the largest component of noninterest expense, declined in both periods as a result of declines in commissions on mortgage production offset by increased salary expense from newly hired associates. Financial Condition Total consolidated assets of the Company at June 30, 2004 were $885.8 million compared to $857.7 million at December 31, 2003, an increase of $28.0 million, or 3%. This increase was due to strong internal growth primarily due to a successful certificate of deposit campaign during the first quarter and annualized loan growth in excess of 10% on the asset side of the balance sheet. On June 30, 2004, loans, including loans held for sale of $5.6 million, were $657.5 million, up $31.6 million, or 5%, compared to December 31, 2003. Loan growth increased in part due to the addition of new commercial lenders in the Company's higher growth regions and the decision to expand the Company's market around those high growth areas. At June 30, 2004, investment securities were $150.3 million, down $15.6 million from December 31, 2003. Due to the current fixed income market conditions, the Company made a decision to not reinvest the principal cash flows from its investment portfolio in certain interest rate environments. Federal funds sold were $6.5 million, up $3.3 million from December 31, 2003. As the Company increased its cash position due to the significant amount of funds brought in as a result of the deposit campaign, most of that cash was invested in Federal Funds after repaying short-term borrowings rather than being invested in long term securities. As loan demand increases, the Company intends to use these short term investments to fund additional loans. Earning assets represented 92.18% of total assets as of June 30, 2004. The allowance for loan losses as of June 30, 2004 was $11.4 million and represented approximately 1.74% of total loans. The allowance for loan losses decreased $196,000 or 2% from the December 31, 2003 balance of $11.6 million due to the overall improvement in loan quality in the portfolio. Management believes that the amount of the allowance is adequate to absorb probable losses inherent in the current loan portfolio. See "Asset Quality" for additional discussion. Deposits as of June 30, 2004 were $671.8 million, an increase of $42.2 million or 7% from December 31, 2003, primarily as a result of strong internal growth fueled by a successful certificate of deposit campaign run during the first quarter and a demand deposit account campaign started in the latter part of the second quarter. During the first six months of this year, the Company experienced an increase of $23.8 million, or 6%, in certificates of deposit compared to December 31, 2003. This movement was largely attributable to a promotion running from January to March, 2004. At June 30, 2004, certificates of deposit represented 58.74% of total deposits compared to 58.90% at December 31, 2003. At the same time, noninterest bearing demand deposit accounts increased to $62.7 million at June 30, 2004, an increase of $4.4 million, -18- or 7%, from $58.4 million at December 31, 2003. The Company currently has a focus on gathering these types of accounts and, beginning in the second quarter, the Bank began an advertising and promotional campaign designed to attract more of these deposits. Savings, interest bearing demand deposit, and money market accounts increased to $214.5 million at June 30, 2004, an increase of $14.0 million, or 7%, from $200.5 million at December 31, 2003. Borrowings decreased by $12.1 million, or 11%, to $102.5 million at June 30, 2004 from $114.6 million as of December 31, 2003. The Company used some of the funds received from the deposit campaign to pay off all of its short-term borrowings during the first quarter. Total consolidated shareholders' equity was $72.6 million as of June 30, 2004, a decrease of $310,000 from December 31, 2003. The decrease can be attributed to a $2.4 million decrease in accumulated other comprehensive income, reflecting a decline in the fair value of the investment portfolio. This decline is partially offset by an increase in retained earnings of $1.6 million, reflecting the net income during the six month period ended June 30, 2004 less dividends paid during that same time. See Part I - Financial Information - Item 1. - Financial Statements - Consolidated Statements of Changes in Shareholders' Equity for additional information. Results of Operations Three month period ended June 30, 2004 For the three month period ended June 30, 2004, the Company reported net income of $891,000, or $0.13 per diluted share, compared to income of $285,000, or $0.04 per diluted share, for the same three month period ended June 30, 2003. Net interest income increased 4%, or $259,000 from $6.0 million for the three month period ended June 30, 2003, to $6.2 million for the same period in 2004. The rise in net interest income is primarily the result of a $13.8 million increase in average earning assets due to internal growth funded in part by a $9.7 million increase in average noninterest bearing deposits. The net interest margin on a fully taxable equivalent basis increased 10 basis points year-over-year to 3.14% for the three months ended June 30, 2004 from 3.04% for the same time period for 2003. The increase in the net interest margin can be largely attributed to a decrease in the rate paid on interest-bearing liabilities and the benefit from noninterest bearing liabilities. The Company's balance sheet remains asset-sensitive and, as a result, its interest earning assets reprice quicker than its interest bearing liabilities after interest rate movements. We believe this should help to increase our margin even more in the third quarter in light of the Federal Reserve Open Market Committee's ("FOMC") decision to increase the benchmark federal funds rate 25 basis points on June 30th of 2004. The Bank increased its prime rate June 30, 2004 by 25 basis points in response to the FOMC rate increase to 4.25%. The following table reflects the Company's effective yield on earning assets and cost of funds. Yields and costs are computed by dividing income or expense for the year by the respective daily average asset or liability balance. -19- Average Balances, Interest Earned or Paid, and Interest Yields/Rates Three Months Ended June 30, 2004 and 2003 (Tax Equivalent Basis - Dollars in Thousands) (1)
2004 2003 ------------------------------------------------------------------------------- Average Amount Average Average Amount Average Balance Earned Rate Balance Earned Rate ------------------------------------------------------------------------------- Assets Loans receivable: (2) Commercial $ 504,802 $ 6,496 5.18% $ 473,008 $ 6,407 5.42% Consumer 39,491 667 6.79% 50,729 849 6.69% Home equity 60,195 724 4.84% 46,850 640 5.46% Residential mortgages 47,586 685 5.79% 64,234 827 5.15% ----------------------------------------------------------------------------- Total loans 652,074 8,572 5.29% 634,821 8,723 5.50% Investment securities (3) 154,244 1,720 4.48% 151,134 1,511 4.00% Federal funds sold and other interest on short term investments 12,531 39 1.25% 19,099 56 1.17% ----------------------------------------------------------------------------- Total interest earning assets 818,849 $ 10,331 5.07% 805,054 $ 10,290 5.11% ====================== ====================== Cash and due from banks 18,812 21,222 Other assets 51,813 48,995 Reserve for loan losses (11,391) (10,097) --------- --------- Total assets $ 878,083 $ 865,174 ========= ========= Liabilities and Equity Savings deposits $ 17,785 $ 11 0.25% $ 20,004 $ 23 0.46% Interest-bearing demand deposits 187,029 522 1.12% 182,544 536 1.17% Time deposits 401,755 2,380 2.38% 396,051 2,515 2.54% ----------------------------------------------------------------------------- Total interest bearing deposits 606,569 2,913 1.93% 598,599 3,074 2.05% Borrowed funds 97,698 796 3.28% 112,114 1,037 3.70% Trust preferred debt 20,620 214 4.17% 4,437 26 2.34% Repurchase agreements 9,563 9 0.38% 15,625 26 0.67% ----------------------------------------------------------------------------- Total interest-bearing liabilities 734,450 $ 3,932 2.15% 730,775 $ 4,163 2.28% ====================== ====================== Non-interest bearing deposits 60,293 50,639 Other liabilities 9,039 8,033 --------- --------- Total liabilities 803,782 789,447 Shareholders' equity 74,301 75,727 --------- --------- Total liabilities and equity $ 878,083 $ 865,174 ========= ========= Net interest spread (4) 2.92% 2.83% Tax equivalent adjustment $ 168 $ 155 Net interest income and net interest margin (5) $ 6,399 3.14% $ 6,127 3.04%
(1) The taxable equivalent basis is computed using a blended federal and state rate of approximately 38%. (2) Loans receivable include nonaccrual loans for which accrual of interest has not been recorded. (3) The average balance for investment securities exclude the effect of their mark-to-market adjustment, if any. (4) Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. (5) Net interest margin represents the net interest income divided by average interest-earning assets. -20- Yields on commercial loans and equity loans declined 24 basis points and 62 basis points, respectively, from the second quarter of 2003 to the same period in 2004. Lower yields in 2004 reflect the 25 basis point decline in the prime rate charged by the Bank between those two periods. In July, 2003, the FOMC dropped the benchmark federal funds rate by 25 basis points to 4.00%, where it remained until June 30, 2004. In addition, yields earned by the Company have declined somewhat as the Bank has moved toward making more variable rate loans rather than fixed rate loans in light of the projected future additional increases in the federal funds rate. Variable rate loans made up approximately 70% of the total loan portfolio at June 30, 2004 compared to 69% in the prior year. The yield on investment securities increased from 4.00% in the second quarter of 2003 to 4.48% in the same period of 2004. The investment yield in 2003 was negatively affected by higher premium amortizations on mortgage backed securities ("MBS") as the average expected lives of the MBS portfolio was shortened due to significant refinancing of the underlying mortgage loans in the low mortgage rate environment of that time. The rate paid on certificates of deposit decreased from 2.54% to 2.38%, a 16 basis point drop, as new certificates were opened at lower rates as interest rates were declining. The rate on borrowings dropped year over year from 3.70% to 3.28%. In July of 2003, the Bank entered into interest rate swap agreements on $25.0 million of the outstanding Federal Home Loan Bank advances to swap fixed rate borrowings to a variable rate. The net effect of the swaps has been to reduce the interest and, accordingly, the effective rate paid on those advances. For the three month period ended June 30, 2004, the provision for loan losses was $297,000 compared to $2.7 million for the same period in 2003, a decrease of $2.4 million. The high provision recorded in 2003 is primarily the result of one significant commercial loan relationship originated by the former High Street Bank, acquired by the Company in the fourth quarter of 2002, that was charged off during the three month period ended June 30, 2003. This relationship, comprised of three commercial loans, totaled approximately $2.5 million and resulted in an after tax impact on the Condensed Consolidated Statements of Income for the three and six month periods ended June 30, 2003 of approximately $1.3 million. In 2004, the provision declined due to an overall improvement in credit quality in the Company's loan portfolio and a reduction in charge offs during the period, which dropped to $101,000 in 2004 from $3.2 million recorded in the same period of 2003. At June 30, 2004, the allowance for loan losses was 1.74% of total loans. See "Asset Quality" for further discussion. Noninterest income for the three month period ended June 30, 2004, was $1.5 million compared to $2.7 million for the same period in 2003, a decrease of $1.2 million or 44%. The decrease was primarily attributable to a substantial drop in fee income recorded by the Bank's mortgage department as a result of industry-wide decreased mortgage refinance business caused by increases in mortgage loan interest rates. For the same reason, mortgage origination fees fell 72% to $354,000 in the second quarter of 2004 from the $1.3 million earned in the three month period ended June 30, 2003. In addition, during the second quarter of 2003, the Company recorded securities gains of $191,000, compared to no sales of investment securities during the same period of 2004. -21- NSF fees increased to $509,000 during the three months ended June 30, 2004 from $466,000 during the same period in 2003, primarily as a result of the growth in the number of deposit accounts on which these fees are charged. Other categories that improved include ATM fees, which increased 13% from $77,000 in the three month period ended June 30, 2003 to $87,000 in the three month period ended June 30, 2004, and other noninterest income, which includes fees earned by the government lending department Noninterest expense for the three month period ended June 30, 2004 was $6.1 million compared to $5.8 million for the corresponding period in 2003. Salaries and employee benefits, representing the largest noninterest expense category, decreased to $3.1 million for the three month period ended June 30, 2004, from $3.2 million for the same period in 2003. This decrease reflects a drop in commissions paid to the mortgage originators as a result of the decline in business in that area. Commissions decreased from $632,000 in the second quarter of 2003 to $192,000 for the same period in 2004, a drop of $440,000, or 70%. This decline was partially offset by increased salary levels in other areas, including the Mortgage Origination department, as the Company moves to build the infrastructure needed to ensure success in that line of business going forward. It remains management's intention to maintain adequate staffing levels to meet customer needs and keep pace with expected growth. As of June 30, 2004, the Company had 216 full-time equivalent employees compared to 230 for the same date in 2003 and 190 at December 31, 2003. Occupancy costs, the second largest component of noninterest expenses, increased 10%, or $54,000, to $582,000 for the three month period ended June 30, 2004 from $528,000 for the same period in 2003. This increase is primarily the result of an increased number of locations as the Company has expanded its branch market into Greensboro, North Carolina and will open new locations in Wake Forest, North Carolina and an additional branch in the Asheville, North Carolina area during the third quarter. In addition, the Company has moved its operations to a new facility to centralize the operations and credit administration functions. Furniture and equipment increased from $361,000 in the three months ended June 30, 2003 to $474,000 for the same period in 2004, an increase of $113,000 or 31%. This increase reflects upgrades to the information technology area of the Company to better position it for future growth. Other expenses increased from $1.1 million for the three month period ended June 30, 2003 to $1.4 million for the same period in 2004. Largest components of changes in other expenses for the second quarter of 2004 include telephone and data line expense, which increased from $75,000 in 200 to $139,000 in 2004, primarily due to the cost of additional bandwidth required for the data lines to handle the increased network traffic as the Company continues to expand. Travel and entertainment increased year-over-year from $51,000 in 2003 to $118,000 in 2004 as the footprint of the organization expanded and travel between locations increased. Franchise taxes increased $16,000 to $46,000 from $30,000 in the comparable prior year due to the increase in the net capital of the Company on which the franchise tax is assessed. The Company recorded an income tax expense of $517,000 during the three month period ended June 30, 2004 compared to a benefit of $47,000 during the same period in 2003. The benefit recorded during the second quarter of 2003 was primarily the result of the decline in taxable income due to the significant loan losses recorded during the period. At June 30, 2004, the Company had net deferred tax assets of $7.7 million resulting from timing differences associated -22- primarily with the deductibility of certain expenses reflected on the financial statements and the mark-to-market of unrealized security losses. Six month period ended June 30, 2004 For the six month period ended June 30, 2004, the Company's net income was $2.3 million, or $0.33 per diluted share, compared to income of $1.6 million, or $0.23 per diluted share, for the same three month period ended June 30, 2003. Net interest income increased 5%, or $593,000 from $11.9 million for the six month period ended June 30, 2003, to $12.5 million for the same period in 2004. The rise in net interest income is primarily the result of a $15.7 million increase in average earning assets due to internal growth funded in part by a $9.5 million increase in average noninterest bearing deposits. The net interest margin on a fully taxable equivalent basis increased 10 basis points year-over-year to 3.17% for the six months ended June 30, 2004 from 3.07% for the same time period for 2003. Similar to the three month period described above, the increase in the net interest margin can be largely attributed to a decrease in the rate paid on interest-bearing liabilities, which declined as a percent of total interest-bearing liabilities from 2.34% in 2003 to 2.16% for the same period in 2004. In addition, the Company received a benefit from growth of $8.7 million in noninterest bearing liabilities. The following table reflects the Company's effective yield on earning assets and cost of funds. Yields and costs are computed by dividing income or expense for the year by the respective daily average asset or liability balance. -23- Average Balances, Interest Earned or Paid, and Interest Yields/Rates Six Months Ended June 30, 2004 and 2003 (Tax Equivalent Basis - Dollars in Thousands) (1)
2004 2003 ------------------------------------------------------------------------------ Average Amount Average Average Amount Average Balance Earned Rate Balance Earned Rate ------------------------------------------------------------------------------ Assets Loans receivable: (2) Commercial $ 493,823 $ 12,840 5.21% $ 458,648 $ 12,297 5.38% Consumer 39,320 1,330 6.78% 50,208 1,700 6.79% Home equity 59,747 1,446 4.85% 46,140 1,274 5.54% Residential mortgages 47,779 1,427 5.99% 66,656 1,930 5.81% ----------------------------------------------------------------------------- Total loans 640,669 17,043 5.33% 621,652 17,201 5.55% Investment securities (3) 158,267 3,606 4.57% 153,396 3,275 4.28% Federal funds sold and other interest on short term investments 13,689 81 1.19% 21,874 127 1.16% ----------------------------------------------------------------------------- Total interest earning assets 812,625 $ 20,730 5.12% 796,922 $ 20,603 5.18% ====================== ====================== Cash and due from banks 21,417 21,026 Other assets 51,789 46,118 Reserve for loan losses (11,553) (9,858) --------- --------- Total assets $ 874,278 $ 854,208 ========= ========= Liabilities and Equity Savings deposits $ 17,536 $ 22 0.25% $ 19,774 $ 45 0.46% Interest-bearing demand deposits 185,629 1,015 1.10% 181,153 1,059 1.17% Time deposits 394,676 4,738 2.41% 392,715 5,126 2.62% ----------------------------------------------------------------------------- Total interest bearing deposits 597,841 5,775 1.94% 593,642 6,230 2.10% Borrowed funds 104,229 1,665 3.20% 109,920 2,100 3.83% Trust preferred debt 20,620 430 4.18% 2,218 26 2.35% Repurchase agreements 10,373 24 0.46% 14,300 49 0.69% ----------------------------------------------------------------------------- Total interest-bearing liabilities 733,063 $ 7,894 2.16% 720,080 $ 8,405 2.34% ====================== ====================== Non-interest bearing deposits 58,106 48,579 Other liabilities 8,719 9,560 --------- --------- Total liabilities 799,888 778,219 Shareholders' equity 74,390 75,989 --------- --------- Total liabilities and equity $ 874,278 $ 854,208 ========= ========= Net interest spread (4) 2.96% 2.84% Tax equivalent adjustment $ 336 $ 291 Net interest income and net interest margin (5) $ 12,836 3.17% $ 12,198 3.07%
(1) The taxable equivalent basis is computed using a blended federal and state rate of approximately 38%. (2) Loans receivable include nonaccrual loans for which accrual of interest has not been recorded. (3) The average balance for investment securities exclude the effect of their mark-to-market adjustment, if any. (4) Net interest spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. (5) Net interest margin represents the net interest income divided by average interest-earning assets. -24- For the six month period ended June 30, 2004, the provision for loan losses was $413,000 compared to $3.3 million for the same period in 2003, a decrease of $2.8 million. The provision in 2003 was adversely affected by the significant charge-offs during that period as previously described. See "Asset Quality" for further discussion. Noninterest income for the six month period ended June 30, 2004, was $3.1 million compared to $5.3 million for the same period in 2003, a decrease of 41%. Similar to the previous discussion for the three month period ended June 30, 2004, the decrease was primarily attributable to a substantial drop in fee income recorded by the Bank's mortgage department as a result of industry-wide decreased mortgage refinance business caused by increases in mortgage loan interest rates. Mortgage origination fees fell 72% to $702,000 in the second quarter of 2004 from the $2.5 million earned in the six month period ended June 30, 2003. Securities gains also fell 97% during the period from $442,000 during the first six months of 2003 to $13,000 during the same period of 2004. NSF fees increased to $983,000 during the six months ended June 30, 2004 from $876,000 during the same period in 2003, primarily as a result of the growth in the number of deposit accounts on which these fees are charged. Other categories that improved include ATM fees, which increased 14% from $140,000 in the six month period ended June 30, 2003 to $159,000 in the six month period ended June 30, 2004, and other noninterest income, which includes fees earned by the government lending department. One other component of the year-over-year increase in other noninterest income is a $108,000 gain on sale of repossessed property recorded in first quarter of 2004. Noninterest expense for the six month periods ended June 30, 2004 and 2003 were $11.7 million during each period. Salaries and employee benefits, representing the largest noninterest expense category, decreased to $5.9 million for the six month period ended June 30, 2004 from $6.7 million for the same period in 2003. This decrease reflects a significant drop in commissions paid to the mortgage originators as a result of the decline in business in that area. Commissions decreased from $1.2 million in the second quarter of 2003 to $352,000 for the same period in 2004, a drop of $827,000 or 71%. Occupancy costs, the second largest component of noninterest expenses, increased 9%, or $94,000 to $1.2 million for the six month period ended June 30, 2004 from $1.1 million for the same period in 2003. This increase is primarily the result of one time costs incurred to move the operations and credit administration functions to a new facility to consolidate operations and locations during the first quarter and due to an increased number of locations as the Company has expanded its branch market as previously described. Other expenses increased from $2.2 million for the six month period ended June 30, 2003 to $2.6 million for the same period in 2004. Largest components of other expenses for the period in 2004 includes audit and accounting fees, which increased from $90,000 in 2003 to $186,000 in 2004, primarily a result of additional services required for the Federal Deposit Insurance Corporation Improvement Act ("FDICIA") as a result of the Bank having reached over $500 million in assets as of January 1, 2003. As explained previously, travel and entertainment increased year-over-year from $110,000 in 2003 to $207,000 in 2004 as the footprint of the organization expanded and travel between locations increased. Although management expects noninterest expense to -25- increase on an absolute basis as the Company continues its growth, these expenses as a percentage of asset size and operating revenue are anticipated to decrease over time. The Company recorded an income tax expense of $1.3 million during the six month period ended June 30, 2004 compared to an expense of $664,000 during the same period in 2003. Asset Quality Determining the allowance for loan losses is based on a number of factors. At the origination of each commercial loan, management assesses the relative risk of the loan and assigns a corresponding risk grade. To ascertain that the credit quality is maintained after the loan is booked, the Bank has a procedure whereby a loan review officer does an annual review of all loans over a certain threshold, all unsecured loans over a certain loan amount, a sampling of loans within a lender's authority, and a sampling of the entire loan pool. Loans are reviewed for credit quality, sufficiency of credit and collateral documentation, proper loan approval, covenant, policy and procedure adherence, and continuing accuracy of the loan grade. This officer reports directly to the Chief Credit Officer and will report on a sampling of loans each month to the Board of Directors' Loan Committee. On an as needed basis, the Bank will hire an outside third party firm to do a review of loans to ensure quality standards and accurate risk assessment. The Company calculates the amount of allowance needed to cover the probable losses in the portfolio by applying a reserve percentage to each risk grade. Consumer loans and mortgages are not risk graded but a percentage is reserved for these loans based on historical losses. The reserve percentages have been developed based on historical losses and industry trends. In addition to this quantitative analysis, a qualitative assessment of the general economic trends, portfolio concentration and the trend of delinquencies are taken into consideration. The allowance is adjusted accordingly to an amount that management believes will be adequate to absorb probable losses on existing loans that may become uncollectible. The allowance for loan losses is established through a provision for loan losses charged to expense. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. Based on this allowance calculation, management charged operations in the amount of $413,000 for the six month period ended June 30, 2004 to provide for probable losses related to uncollectible loans. Loan loss reserves were 1.74% and 1.86% of gross loans, respectively, as of June 30, 2004 and December 31, 2003. The following table presents an analysis of changes in the allowance for loan losses for the three and six month periods ended June 30, 2004 and 2003: -26-
Three Months Six Months Ended June 30, Ended June 30, 2004 2003 2004 2003 -------- -------- -------- -------- (Dollars in thousands) Allowance for loan losses, beginning of period $ 11,221 $ 9,919 $ 11,613 $ 9,390 Net charge-offs: Loans charged off: Commercial 14 3,262 461 3,325 Consumer 134 80 319 155 Mortgage 70 1 70 39 -------- -------- -------- -------- Total charge-offs 218 3,343 850 3,519 -------- -------- -------- -------- Recoveries of loans previously charged off: Commercial 33 172 87 276 Consumer 58 10 62 11 Mortgage 26 -- 92 -- -------- -------- -------- -------- Total recoveries 117 182 241 287 -------- -------- -------- -------- Total net charge-offs 101 3,161 609 3,232 -------- -------- -------- -------- Loss provisions charged to operations 297 2,696 413 3,296 -------- -------- -------- -------- Allowance for loan losses, end of period $ 11,417 $ 9,454 $ 11,417 $ 9,454 ======== ======== ======== ======== Net charge-offs to average loans during the period (annualized) 0.06% 1.99% 0.19% 1.04% Allowance as a percent of gross loans 1.74% 1.46%
The following table presents an analysis of nonperforming assets as of June 30, 2004 and 2003 and December 31, 2003: June 30, 2004 December 31, 2004 2003 2003 --------- --------- ------------ (Dollars in thousands) Nonperforming assets: Nonaccrual loans: Commercial real estate $ 3,085 $ 864 $ 3,376 Construction 580 298 1,444 Commercial 655 517 390 Consumer 561 270 529 Mortgage 1,837 1,637 2,271 --------- --------- --------- Total nonaccrual loans 6,718 3,586 8,010 Foreclosed property held 412 745 978 --------- --------- --------- Total nonperforming assets $ 7,130 $ 4,331 $ 8,988 ========= ========= ========= Nonperforming loans to total loans 1.02% 0.56% 1.44% Nonperforming assets to total assets 0.80% 0.48% 1.05% Allowance coverage of nonperforming loans 170% 264% 145% Overall credit quality improved during the quarter, despite a modest increase in nonperforming loans. We project the resolution of several significant nonperforming loans during the second -27- half of 2004 with minimal loss, if any. The Company has experienced improvements in both classified and watch list loans during the second quarter and the six months ended June 30, 2004. On June 30, 2004, nonperforming assets were $7.1 million, a $1.9 million decrease from the balance at December 31, 2003. Nonperforming assets, which includes nonperforming loans and foreclosed property, decreased both on an absolute basis and as a percentage of total assets between those periods. A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. Loans deemed to be impaired at June 30, 2004 and December 31, 2003 amounted to $2.9 million and $3.0 million, respectively. Average impaired loans during the second quarter of 2004 were $3.0 million. The Bank uses several factors in determining if a loan is impaired. The internal asset classification procedures include a review of significant loans and lending relationships by both management and third party credit review firms and includes the accumulation of related data. This data includes loan payment status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income or loss, etc. It is possible that these factors and management's evaluation of the adequacy of the allowance for loan losses will change. Foreclosed property decreased to $412,000 at June 30, 2004 from $745,000 million at June 31, 2003. The Company is actively marketing all of its foreclosed property. All nonperforming assets, including nonperforming loans and foreclosed assets, are recorded at the lower of cost or market. Liquidity and Capital Resources The Company's liquidity management involves planning to meet the Company's anticipated funding needs at a reasonable cost. Liquidity management is guided by policies formulated by the Company's senior management and the Asset/Liability Management Committee of the Company's Board of Directors. The Company had $35.3 million in its most liquid assets, cash and cash equivalents, as of June 30, 2004. The Company's principal sources of funds are loan repayments, deposits, Federal Home Loan Bank borrowings and capital. Core deposits (total deposits less certificates of deposits in the amount of $100,000 or more), one of the most stable sources of liquidity, together with equity capital, funded 69.92% of total assets at June 30, 2004. In addition, the Company has the ability to take advantage of various other funding programs available from the Federal Home Loan Bank of Atlanta, as well as access to funding through various brokered deposit programs. In the late part of the third quarter of 2004, the Company expects to close on the sale of three branches to two other North Carolina financial institutions. The cash requirements of this sale call for the Bank to pay approximately $25.0 million to the other parties to cover the net liabilities assumed by those companies, primarily deposits, in excess of the net assets sold, primarily loans. -28- In order to fund the sale, the Company expects to issue fixed rate brokered certificates of deposit and will evaluate whether to enter into interest rate swaps to effectively convert some of those brokered deposits to a floating rate. The management of equity is a critical aspect of capital management in any business. The determination of the appropriate amount of equity is affected by a wide number of factors. The primary factor for a regulated financial institution is the amount of capital needed to meet regulatory requirements, although other factors, such as the "risk equity" the business requires and balance sheet leverage, also will affect the determination. During the second quarter of 2004, the Board of Directors approved a stock repurchase plan authorizing the repurchase of up to 50,000 shares of the Company's stock. The principal purpose of the stock repurchase program is to manage the equity capital relative to the growth of the Company, to offset the dilutive effect of employee equity-based compensation and to enhance long term shareholder value. The repurchase program will be affected through regular open-market purchases. Management currently has no immediate intent to repurchase shares but instead, plans to monitor and evaluate the capital level on an ongoing basis. To be categorized as well capitalized, the Company and the Bank must maintain minimum amounts and ratios. The Company's actual capital amounts and ratios as of June 30, 2004 and the minimum requirements are presented in the following table.
Minimum Requirements To Be Actual Well Capitalized --------------------- --------------------- (Dollars in thousands) Amount Ratio Amount Ratio -------- --------- -------- --------- Capital Bank Corporation Total Capital (to Risk Weighted Assets) $ 86,684 11.78% $ 73,578 10.00% Tier I Capital (to Risk Weighted Assets) 76,612 10.41% 44,147 6.00% Tier I Capital (to Average Assets) 76,612 8.90% 43,047 5.00% Capital Bank Total Capital (to Risk Weighted Assets) $ 83,622 11.38% $ 73,505 10.00% Tier I Capital (to Risk Weighted Assets) 74,406 10.12% 44,103 6.00% Tier I Capital (to Average Assets) 74,406 8.62% 43,134 5.00%
Shareholders' equity was $72.6 million or $11.03 per share at June 30, 2004. Management believes this level of shareholders' equity provides adequate capital to support the Company's growth and to maintain a well capitalized position. Item 3 Quantitative and Qualitative Disclosures About Market Risk The Company has not experienced any material change in the risk of its portfolio of interest earning assets and interest bearing liabilities from December 31, 2003 to June 30, 2004. Item 4 Controls and Procedures As required by paragraph (b) of Rule 13a-15 under the Exchange Act, the Company's management, with the participation of the Chief Executive Officer and the Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as -29- such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and the Chief Financial Officer provide that, as of the end of the period covered by this report, the Company's disclosure controls and procedures are effective, in that they provide reasonable assurance that the information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the United States Securities and Exchange Commission's rules and forms. There have been no changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. Part II - Other Information Item 1 Legal Proceedings There are no material pending legal proceedings to which the Company is a party or to which any of its property is subject. In addition, the Company is not aware of any threatened litigation, unasserted claims or assessments that could have a material adverse effect on the Company's business, operating results or condition. Item 2 Changes in Securities and Use of Proceeds None Item 3 Defaults Upon Senior Securities None Item 4 Submission of Matters to a Vote of Security Holders On June 24, 2004, the annual meeting of shareholders of the Company was held to consider and vote upon two issues: (i) the election of Class I, II and III directors and (ii) the ratification of the appointment of PricewaterhouseCoopers LLP as the Company's independent auditors for the fiscal year ended December 31, 2004. Each item considered was approved by the shareholders. Of the 6,571,626 shares eligible to vote, 5,854,626 were voted as shown on the following tables: -30- For Withheld Total ------------------------------------- Class I Directors: Charles F. Atkins 5,757,668 96,958 5,854,626 B. Grant Yarber 5,706,714 147,912 5,854,626 Oscar A. Keller, Jr. 5,749,721 104,905 5,854,626 James D. Moser, Jr. 5,756,543 98,083 5,854,626 Don W. Perry 5,757,428 97,198 5,854,626 Class II Directors: John F. Grimes, III 5,755,199 99,427 5,854,626 J. Rex Thomas 5,755,895 98,731 5,854,626 Class III Directors: George R. Perkins, III 5,754,846 99,780 5,854,626 Vote concerning the ratification of the appointment of PricewaterhouseCoopers LLP as the independent auditors for the fiscal year ended December 31, 2004: For Against Abstain Total ----------------------------------------- 5,833,676 6,845 14,105 5,854,626 Item 5 Other Information None Item 6 Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 4.1 In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting long-term debt of the registrant have been omitted but will be furnished to the Commission upon request. Exhibit 10.1 Change of Control agreement dated July 2, 2004 between Karen H. Priester and Capital Bank Corporation Exhibit 31.1 Certification of B. Grant Yarber pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 Certification of Richard W. Edwards pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 32.1 Certification of B. Grant Yarber pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes- Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed -31- herewith for purposes of liability under the Securities Exchange Act of 1934, as amended or the Securities Act of 1933, as amended, as the case may be.] Exhibit 32.2 Certification of Richard W. Edwards pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes- Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended or the Securities Act of 1933, as amended, as the case may be.] (b) Reports on Form 8-K On April 22, 2004, the Company furnished a Current Report on Form 8-K attaching a press release announcing the appointment of Richard W. Edwards as Chief Financial Officer and also reporting financial results for the quarterly period ended March 31, 2004, which included selected financial data for the quarter ended March 31, 2004 and for other selected periods. Information furnished in the Form 8-K referenced in the prior sentence is not deemed to be filed with the SEC. On April 26, 2004, the Company filed a Current Report on Form 8-K attaching a press release announcing the appointment of B. Grant Yarber as Chief Executive Officer. On July 20, 2004, the Company furnished a Current Report on Form 8-K attaching a press release reporting financial results for the quarterly period ended June 30, 2004, which included selected financial data for the quarter ended June 30, 2004 and for other selected periods. Information furnished in the Form 8-K referenced in the prior sentence is not deemed to be filed with the SEC. -32- Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CAPITAL BANK CORPORATION Date: August 3, 2004 By: /s/ Richard W. Edwards -------------------------- Richard W. Edwards Chief Financial Officer -33- Exhibit Index Exhibit 4.1 In accordance with Item 601(b)(4)(iii)(A) of Regulation S-K, certain instruments respecting long-term debt of the registrant have been omitted but will be furnished to the Commission upon request. Exhibit 10.1 Employment agreement dated July 2, 2004 between Karen H. Priester and Capital Bank Corporation Exhibit 31.1 Certification of B. Grant Yarber pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 31.2 Certification of Richard W. Edwards pursuant to Rule 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Exhibit 32.1 Certification of B. Grant Yarber pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] Exhibit 32.2 Certification of Richard W. Edwards pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.] -34-