10-Q 1 mainbody.htm SFSC 10Q SEPT 30, 2003 SFSC 10Q Sept 30, 2003

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


Form 10-Q

x
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2003
 
or
o
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 1-018166

 
STATE FINANCIAL SERVICES CORPORATION
(Exact name of registrant as specified in its charter)


WISCONSIN
(State or other jurisdiction of incorporation or organization)
39-1489983
(I.R.S. Employer identification No.)


815 NORTH WATER STREET, MILWAUKEE, WISCONSIN 53202-3526
(Address and Zip Code of principal executive offices)



(414) 425-1600
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No

Indicate by check mark whether the registrant is an accelerated filer (as defined by Rule 12b-2 of the Exchange Act). Yes X No

As of November 12 , 2003 , there were 7,051,709 shares of Registrant's $0.10 Par Value Common Stock outstanding.

 
 
     
 
 
 
FORM 10-Q
 
     
 
STATE FINANCIAL SERVICES CORPORATION
 
 
INDEX
 
 
PART I - FINANCIAL INFORMATION
 
 
 
Page No.
Item 1.
Financial Statements (Unaudited)
 
 
Consolidated Statements of Financial Condition as of September 30, 2003 and December 31, 2002 (audited)
3
 
Consolidated Statements of Income for the Three Months ended September 30, 2003 and 2002
4
 
Consolidated Statements of Income for the Nine Months ended September 30, 2003 and 2002
5
 
Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2003 and 2002
6
 
Notes to Consolidated Financial Statements
7
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
9
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
18
Item 4.
Controls and Procedures
18
 
PART II - OTHER INFORMATION
 
Item 1.
Legal Proceedings
19
Item 2.
Exhibits and Reports on Form 8-K
19
Item 4.
Submission of Matters to a Vote of Security Holders
19
Signatures
 
20
Exhibits
 
Exhibit Index
 
     
 
Part I.     Financial Information
Item 1.  Financial Statements

STATE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES
Consolidated Statements of Financial Condition
 
  
September 30,
2003
(unaudited)
December 31,
2002
(audited)
   
 
 
ASSETS
   
 
    
 
  
Cash and due from banks
 
$
41,723,339
 
$
56,767,916
 
Interest-bearing bank balances
   
5,281,647
   
2,040,592
 
Federal funds sold
   
2,620,958
   
8,708,297
 
Cash and cash equivalents
   
49,625,944
   
67,516,805
 
Investment securities
   
 
    
 
  
Available-for-sale (at fair value)
   
396,035,172
   
422,081,645
 
Held-to-maturity (fair value of $1,145,240 – September 30, 2003 and $1,551,666 - December 31, 2002)
   
1,116,110
   
1,505,269
 
Loans (net of allowance for loan losses of $10,365,329 – September 30, 2003 and $8,805,000 –December 31, 2002)
   
771,686,974
   
703,968,455
 
Loans held for sale
   
4,810,691
   
31,750,135
 
Premises and equipment
   
26,930,721
   
27,789,893
 
Accrued interest receivable
   
5,417,204
   
7,789,746
 
Goodwill
   
27,465,062
   
27,465,062
 
Bank owned life insurance
   
20,804,533
   
20,258,388
 
Other assets
   
11,355,067
   
6,698,985
 
   
 
 
TOTAL ASSETS
 
$
1,315,247,478
 
$
1,316,824,383
 
   
 
 
 
    
 
    
 
  
LIABILITIES AND SHAREHOLDERS' EQUITY
   
 
    
 
  
Deposits:
   
 
    
 
  
Demand
   
158,373,425
   
163,036,430
 
Savings
   
231,053,465
   
228,312,579
 
Money market
   
212,107,261
   
221,142,347
 
Time deposits in excess of $100,000
   
94,043,137
   
88,001,266
 
Other time deposits
   
211,204,069
   
240,381,060
 
   
 
 
TOTAL DEPOSITS
   
906,781,357
   
940,873,682
 
 
    
 
    
 
  
Federal Home Loan Bank advances
   
77,400,000
   
92,400,000
 
Notes payable
   
16,100,000
   
15,700,000
 
Trust preferred securities
   
15,000,000
   
15,000,000
 
Securities sold under agreements to repurchase
   
177,817,658
   
126,636,913
 
Federal funds purchased
   
3,500,000
   
10,000,000
 
Accrued expenses and other liabilities
   
6,876,938
   
9,089,417
 
Accrued interest payable
   
1,783,710
   
2,191,711
 
   
 
 
TOTAL LIABILITIES
   
1,205,259,663
   
1,211,891,723
 
 
    
 
    
 
  
Shareholders' Equity:
   
 
    
 
  
Preferred stock, $1 par value; authorized--100,000 shares;
issued and outstanding—none
   
--
   
--
 
Common stock, $0.10 par value; authorized--25,000,000 shares; issued 9,491,182 shares in 2003 and 9,406,321 shares in 2002, outstanding 7,026,842 shares in 2003 and 6,946,981 shares in 2002
   
949,118
   
940,632
 
Additional paid in capital
   
84,239,823
   
83,157,808
 
Retained earnings
   
60,697,618
   
54,288,325
 
Accumulated other comprehensive income
   
3,951,656
   
6,518,045
 
Unearned shares held by ESOP
   
(3,946,310
)
 
(4,160,060
)
Treasury Stock – 2,464,340 shares in 2003 and 2,459,340 in 2002
   
(35,904,090
)
 
(35,812,090
)
   
 
 
TOTAL SHAREHOLDERS' EQUITY
   
109,987,815
   
104,932,660
 
   
 
 
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
 
$
1,315,247,478
 
$
1,316,824,383
 
   
 
 
See notes to unaudited consolidated financial statements.
 
 
     
 
 
STATE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income (Unaudited)

 
  
Three Months Ended September 30,
   
 
  
2003
2002
   
 
 
INTEREST INCOME:
   
 
    
 
  
Loans
 
$
11,427,984
 
$
11,606,922
 
Investment securities:
   
 
    
 
  
Taxable
   
3,293,913
   
4,739,741
 
Tax-exempt
   
553,689
   
669,844
 
Federal funds sold and other short-term investments
   
38,714
   
217,803
 
   
 
 
TOTAL INTEREST INCOME
   
15,314,300
   
17,234,310
 
 
    
 
    
 
  
INTEREST EXPENSE:
   
 
    
 
  
Deposits
   
3,003,273
   
4,550,169
 
Notes payable and other borrowings
   
1,623,110
   
1,377,236
 
   
 
 
TOTAL INTEREST EXPENSE
   
4,626,383
   
5,927,405
 
   
 
 
NET INTEREST INCOME
   
10,687,917
   
11,306,905
 
 
    
 
    
 
  
Provision for loan losses
   
600,000
   
1,050,000
 
   
 
 
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES
   
10,087,917
   
10,256,905
 
 
    
 
    
 
  
OTHER INCOME:
   
 
    
 
  
Service charges on deposit accounts
   
741,877
   
665,705
 
ATM and merchant service fees
   
406,395
   
785,314
 
Security commissions and management fees
   
131,986
   
136,002
 
Investment securities gains, net
   
187,210
   
(24,085
)
Gain on sale of loans
   
1,406,750
   
734,588
 
Bank owned life insurance
   
236,388
   
33,334
 
Mortgage origination fees
   
129,698
   
59,375
 
Gain on sale or fixed assets
   
723
   
670,390
 
Other
   
343,973
   
312,511
 
   
 
 
TOTAL OTHER INCOME
   
3,585,000
   
3,373,134
 
 
    
 
    
 
  
OTHER EXPENSES:
   
 
    
 
  
Salaries and employee benefits
   
4,918,055
   
4,688,880
 
Net occupancy expense
   
663,356
   
677,256
 
Equipment rentals, depreciation and maintenance
   
982,621
   
972,029
 
Data processing
   
505,097
   
519,490
 
Legal and professional
   
398,603
   
232,848
 
ATM and merchant services
   
219,837
   
580,375
 
Advertising
   
224,738
   
300,036
 
Delivery & postage
   
274,779
   
252,901
 
Other
   
958,647
   
1,263,736
 
   
 
 
TOTAL OTHER EXPENSES
   
9,145,733
   
9,487,551
 
 
    
 
    
 
  
INCOME BEFORE INCOME TAXES
   
4,527,184
   
4,142,488
 
Income tax expense
   
1,406,104
   
1,266,501
 
   
 
 
NET INCOME
 
$
3,121,080
 
$
2,875,987
 
   
 
 
 
    
 
    
 
  
Basic earnings per common share
 
$
0.47
 
$
0.39
 
Diluted earnings per common share
   
0.46
   
0.39
 
Dividends per common share
   
0.13
   
0.12
 


See notes to unaudited consolidated financial statements.
 
 
     
 
 
STATE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income (Unaudited)
 
 
  
Nine Months Ended September 30,
   
 
  
2003
2002
   
 
 
INTEREST INCOME:
   
 
    
 
  
Loans
 
$
35,092,350
 
$
35,944,970
 
Investment securities:
   
 
    
 
  
Taxable
   
10,327,351
   
12,985,373
 
Tax-exempt
   
1,739,515
   
2,022,021
 
Federal funds sold and other short-term investments
   
100,780
   
449,631
 
   
 
 
TOTAL INTEREST INCOME
   
47,259,996
   
51,401,995
 
 
    
 
    
 
  
INTEREST EXPENSE:
   
 
    
 
  
Deposits
   
9,415,102
   
13,481,217
 
Notes payable and other borrowings
   
5,291,821
   
3,974,958
 
   
 
 
TOTAL INTEREST EXPENSE
   
14,706,923
   
17,456,175
 
   
 
 
NET INTEREST INCOME
   
32,553,073
   
33,945,820
 
 
    
 
    
 
  
Provision for loan losses
   
2,025,000
   
1,950,000
 
   
 
 
NET INTEREST INCOME AFTER
PROVISION FOR LOAN LOSSES
   
30,528,073
   
31,995,820
 
 
    
 
    
 
  
OTHER INCOME:
   
 
    
 
  
Service charges on deposit accounts
   
2,121,757
   
1,955,313
 
ATM and merchant service fees
   
1,857,241
   
2,313,301
 
Security commissions and management fees
   
327,297
   
377,009
 
Investment securities gains, net
   
322,680
   
465,035
 
Gain on sale of loans
   
4,053,950
   
1,789,309
 
Gain on sale of merchant processing
   
1,300,000
   
0
 
Bank owned life insurance
   
1,044,476
   
33,334
 
Mortgage origination fees
   
395,312
   
141,392
 
Gain on sale of fixed assets
   
37,372
   
702,391
 
Other
   
979,375
   
1,017,957
 
   
 
 
TOTAL OTHER INCOME
   
12,439,460
   
8,795,041
 
 
    
 
    
 
  
OTHER EXPENSES:
   
 
    
 
  
Salaries and employee benefits
   
15,058,052
   
13,581,828
 
Net occupancy expense
   
2,052,527
   
2,082,879
 
Equipment rentals, depreciation and maintenance
   
2,939,402
   
2,877,682
 
Data processing
   
1,424,830
   
1,558,832
 
Legal and professional
   
1,212,789
   
1,424,241
 
ATM and merchant services
   
1,185,273
   
1,635,466
 
Advertising
   
842,655
   
904,243
 
Delivery & postage
   
825,656
   
783,589
 
Provision for merchant chargebacks
   
300,000
   
0
 
Merchant processing exit fee
   
150,000
   
0
 
Efficiency consulting expense
   
570,000
   
0
 
Severance charges
   
180,114
   
0
 
Other
   
3,540,606
   
3,949,442
 
   
 
 
TOTAL OTHER EXPENSES
   
30,281,904
   
28,798,202
 
INCOME BEFORE INCOME TAXES
   
12,685,629
   
11,992,659
 
Income tax expense
   
3,675,750
   
3,699,904
 
   
 
 
NET INCOME
 
$
9,009,879
 
$
8,292,755
 
   
 
 
Basic earnings per common share
 
$
1.35
 
$
1.12
 
Diluted earnings per common share
   
1.33
   
1.11
 
Dividends per common share
   
0.39
   
0.36
 
 
See notes to unaudited consolidated financial statements.
 
 
     
 
 
STATE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows (Unaudited)
 
 
  
Nine Months Ended
September 30,
 
  
2003
2002
OPERATING ACTIVITIES
   
 
    
 
  
Net income
 
$
9,009,879
 
$
8,292,755
 
Adjustments to reconcile net income to net cash provided by operating activities:
   
 
    
 
  
Provision for loan losses
   
2,025,000
   
1,950,000
 
Depreciation
   
2,114,838
   
2,109,294
 
Amortization of premiums and accretion of discounts on investment securities
   
934,318
   
1,943,476
 
Income from bank owned life insurance
   
(546,145
)
 
0
 
Decrease (increase) in accrued interest receivable
   
2,372,542
   
(1,117,566
)
Decrease in accrued interest payable
   
(408,001
)
 
(532,180
)
Realized investment securities gains
   
(322,680
)
 
(465,035
)
Other
   
(5,546,485
)
 
897,341
 
   
 
 
NET CASH PROVIDED BY OPERATING ACTIVITIES
   
9,633,266
   
13,078,085
 
INVESTING ACTIVITIES
   
 
    
 
  
Proceeds from maturities or principal payments of investment securities held-to-maturity
   
390,000
   
350,500
 
Purchases of securities available-for-sale
   
(698,147,945
)
 
(317,030,268
)
Proceeds from maturities and sales of investment securities available-for-sale
   
719,693,474
   
159,069,068
 
Net (increase) decrease in loans
   
(42,804,075
)
 
65,910,793
 
Purchase of bank owned life insurance
   
0
   
(20,000,000
)
Net purchases of premises and equipment
   
(1,255,666
)
 
(1,393,533
)
NET CASH USED IN INVESTING ACTIVITIES
   
(22,124,212
)
 
(113,093,440
)
FINANCING ACTIVITIES
   
 
    
 
  
Net (decrease) increase in deposits
   
(34,092,325
)
 
36,760,592
 
Repayment of notes payable
   
(10,710,000
)
 
0
 
Proceeds of notes payable
   
11,110,000
   
2,167,224
 
Increase in securities sold under agreements to repurchase
   
51,180,745
   
70,015,328
 
Decrease in Federal Home Loan Bank advances
   
(15,000,000
)
 
(20,200,000
)
Decrease in guaranteed ESOP obligation
   
213,750
   
0
 
Cash dividends
   
(2,600,586
)
 
(2,656,842
)
Repayments of federal funds purchased
   
(6,500,000
)
 
0
 
Purchase of treasury stock
   
(92,000
)
 
(1,946,871
)
Proceeds from exercise of stock options and restricted stock awards
   
1,090,501
   
92,002
 
   
 
 
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
   
(5,399,915
)
 
84,231,433
 
   
 
 
DECREASE IN CASH AND CASH EQUIVALENTS
   
(17,890,861
)
 
(15,783,922
)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD
   
67,516,805
   
94,549,518
 
   
 
 
CASH AND CASH EQUIVALENTS AT END OF PERIOD
 
$
49,625,944
 
$
78,765,596
 
   
 
 
Supplemental information:
   
 
    
 
  
Interest paid
 
$
15,114,924
 
$
17,988,355
 
Income taxes paid
   
3,318,092
   
4,416,836
 
Conversion of mortgage loans into fixed rate securities
   
0
   
101,567,223
 

See notes to unaudited consolidated financial statements.
 
 
     
 
 
STATE FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
September 30, 2003

NOTE A—BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements include the accounts of State Financial Services Corporation (the "Company" or "State") and its subsidiaries. All significant intercompany balances and transactions have been eliminated. The unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles for complete financial statements have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Interim operating results are not necessarily indicative of the results that may be expected for the year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2002.

NOTE B—ACCOUNTING CHANGES

FIN No. 46 – Consolidation of Variable Interest Entities

In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN No. 46). The objective of this interpretation is to provide guidance on how to identify a variable interest entity (VIE) and determine when the assets, liabilities, non-controlling interest, and results of operations of a VIE need to be included in a company’s consolidated financial statements. Because the Company does not have interest in any VIEs, the Company does not expect the adoption of FIN No. 46 to have a material impact on its results of operations, financial position, or liquidity.

 
FASB Statement No. 150

In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". This Statement establishes standards for classifying and measuring as liabilities certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. Statement 150 represents a change in practice in the accounting for a number of financial instruments, including mandatorily redeemable equity instruments and certain equity derivatives that frequently are used in connection with share repurchase programs. The provisions of this statement are not expected to have a material impact on the Corporation’s consolidated financial statements.


NOTE C—EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income by the weighted-average common shares outstanding during the period less unearned ESOP shares. Diluted earnings per share is computed by dividing net income by the weighted-average common shares outstanding during the period less unallocated ESOP shares plus the assumed conversion of all potentially dilutive securities. The denominators for the earnings per share amounts are as follows:
 
   

Three months ended

 

    Nine months ended

  
   
 
 
     
Sept. 30,
2003 
    
Sept. 30,
2002 
    
Sept. 30,
2003 
    
Sept. 30,
2002 
  
   
 
 
 
 
Basic:
   
 
    
 
    
 
    
 
  
Weighted-average number of shares outstanding
   
7,014,434
   
7,677,618
   
6,978,545
   
7,745,788
 
Less: weighted-average number of unearned ESOP shares
   
(322,599
)
 
(349,184
)
 
(322,599
)
 
(349,184
)
   
 
 
 
 
Denominator for basic earnings per share
   
6,691,835
   
7,328,434
   
6,655,946
   
7,396,604
 
   
 
 
 
 
Fully diluted:
   
 
    
 
    
 
    
 
  
Denominator for basic earnings per share
   
6,691,835
   
7,328,434
   
6,655,946
   
7,396,604
 
Add: assumed conversion of stock options using treasury stock method
   
147,066
   
69,725
   
121,357
   
61,750
 
   
 
 
 
 
Denominator for fully diluted earnings per share
   
6,838,901
   
7,398,159
   
6,777,303
   
7,458,354
 
   
 
 
 
 
 
     
 
 
NOTE D—COMPREHENSIVE INCOME

Comprehensive income is the total of reported net income and all other revenues, expenses, gains and losses that under generally accepted accounting principles are not included in reported net income but are instead reflected directly in shareholders’ equity.
 
 
  
Three months ended
Nine months ended
   
 
 
  
     
Sept. 30,
2003 
    
Sept. 30,
2002 
    
Sept. 30,
2003 
    
Sept. 30,
2002 
  
   
 
 
 
 
Net Income
 
$
3,121,080
 
$
2,875,987
 
$
9,009,879
 
$
8,292,755
 
Other comprehensive income:
   
 
    
 
    
 
    
 
  
Change in unrealized securities gains (losses), net of tax
   
(1,842,117
)
 
821,455
   
(2,370,232
)
 
4,761,840
 
Reclassification adjustment for realized gains (losses) included in net income, net of tax
   
(113,805
)
 
14,641
   
(196,157
)
 
(282,695
)
   
 
 
 
 
Total comprehensive income
 
$
1,165,158
 
$
3,712,083
 
$
6,443,490
 
$
12,771,900
 
   
 
 
 
 

NOTE E—STOCK REPURCHASE PROGRAM

In December 2002, the Company completed its Dutch Auction tender offer, purchasing and retiring 716,000 shares of the Company’s Common Stock at $16.50 per share.

On April 28, 2003, the Company’s Board of Directors authorized the repurchase of up to 5%, or approximately 348,000 shares, of the Company’s Common Stock. As of November 12, 2003 no shares have been repurchased.

NOTE F — STOCK-BASED COMPENSATION

The Company follows Accounting Principles Board Opinion No. 25 under which no compensation expense is recorded when the exercise price of the Company’s employee stock options equals the market price of the underlying stock on the date of grant. The Company’s pro forma information regarding net income and net income per share has been determined as if these options had been accounted for since January 1, 1995, in accordance with the fair value method of Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation" (FAS No. 123).

The Black-Scholes option valuation model is commonly used in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Since the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimates, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

In determining compensation expense in accordance with FAS No. 123, the fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for the three and nine months ended September 30, 2003 and September 30, 2002 .
 
 
 
  
Three months ended
Nine months ended
   
 		  
 		  
   

Sept. 30, 2003 

 

Sept. 30, 2002 

 

Sept. 30, 2003 

 
Sept. 30, 2002 
  
  
 
 
 
 
Expected life of options
   
6.75 years
   
6.75 years
   
6.75 years
   
6.75 years
 
Risk-free interest rate
   
3.60
%
 
3.33
%
 
3.60
%
 
3.33
%
Expected dividend yield
   
2.20
%
 
2.60
%
 
2.20
%
 
3.00
%
Expected volatility factor
   
26.90
%
 
15.77
%
 
26.90
%
 
15.77
%

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period, which is three years. Options issued in the prior year vested in six months. The Company’s pro forma information is as follows:

 
  
Three months ended
Nine months ended
   
 		  
 		  
(Thousands, except per share data)
 

Sept. 30, 2003 

 

Sept. 30, 2002 

 
Sept. 30, 2003 

 

Sept. 30, 2002 

  
  
 
 
 
 
Net income, as reported
 
$
3,121
 
$
2,876
 
$
9,010
 
$
8,293
 
Pro forma compensation expense in accordance with SFAS No. 123, net of tax
   
(53
)
 
(99
)
 
(137
)
 
(231
)
 
 
 
 
 
Pro forma net income
 
$
3,068
 
$
2,777
 
$
8,873
 
$
8,062
 
  
 
 
 
 
Net income per common share, as reported:
   
 
    
 
    
 
    
 
  
Basic
 
$
0.47
 
$
0.39
 
$
1.35
 
$
1.12
 
Diluted
 
$
0.46
 
$
0.39
 
$
1.33
 
$
1.11
 
 
    
 
    
 
    
 
    
 
  
Pro forma net income per common share:
   
 
    
 
    
 
    
 
  
Basic
 
$
0.46
 
$
0.38
 
$
1.33
 
$
1.09
 
Diluted
 
$
0.45
 
$
0.38
 
$
1.31
 
$
1.08
 

The pro forma disclosures include only the effect of options granted subsequent to January 1, 1995. Accordingly, the effects of applying the FAS No. 123 pro forma disclosures to future periods may not be indicative of future effects.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Application of Critical Accounting Policies

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the consolidated financial statements.

All significant accounting policies are presented in Note 1 to the consolidated financial statements in the Company’s 2002 Annual Report on Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the consolidated financial statements and how those values are determined.

Management has determined that its accounting policies with respect to the allowance for loan losses is the accounting area requiring subjective or complex judgments that is most important to the Company’s financial position and results of operations, and therefore, is its only critical accounting policy. The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated statement of condition. Note 1 to the consolidated financial statements in the Company’s 2002 Annual Report on Form 10-K describes the methodology used to determine the allowance for loan losses. In addition, a discussion of the factors driving changes in the amount of the allowance for loan losses is included in the Allowance for Loan Losses and Net Charge-offs set forth below.

Changes in Financial Condition

At September 30, 2003 and December 31, 2002, total assets were $1.3 billion. During the first three quarters of 2003, significant uses of funds consisted of a $34.1 million decrease in total deposits, $15.0 million in repayment of Federal Home Loan Bank ("FHLB") borrowings, $42.8 million increase in loans receivable, $6.5 million in repayment of federal funds purchased, $2.6 million in payment of cash dividends, and $1.3 million in purchases of premises and equipment. Funding sources for the first three quarters of 2003 came from a $9.6 million increase in net cash provided by operating activities, $21.9 million net decrease in investment securities, $51.2 million increase in securities sold under agreement to repurchase, $1.1 million in proceeds from the exercise of stock options, $0.4 million net increase in notes payable, and $0.2 million decrease in guarantee ESOP obligation.

Asset Quality

At September 30, 2003, non-performing assets were $16.4 million, an increase of $3.4 million from December 31, 2002 primarily due to an increase of $4.9 million in other real estate owned offset by a $1.5 million decrease in non-accrual loans. The increase in other real estate owned was due to one commercial property, which the Company has contracted to sell at a price to fully cover the $5.1 million included in non-performing assets. If all contingencies are satisfied, the transaction is expected to close in the fourth quarter of 2003. Total non-performing assets as a percentage of total assets were 1.24% at September 30, 2003 and 0.98% at December 31, 2002. As a percentage of total loans outstanding, the level of non-performing loans was 1.40% at September 30, 2003 compared to 1.69% at December 31, 2002. This percentage decrease was due to the decrease in non-performing loans.

When, in the opinion of management, serious doubt exists as to the collectibility of a loan, the loan is placed on non-accrual status. In all cases, however, when a loan reaches 90 days delinquent on the payment of principal or interest the loan is placed on non-accrual status. At the time a loan is classified as non-accrual, interest credited to income in the current year is reversed and interest income accrued in the prior year is charged to the allowance for loan losses. The following table summarizes non-performing assets on the dates indicated (dollars in thousands).

 
  
Sep. 30
2003
Jun. 30
2003
Mar. 31
2003
Dec. 31
2002
Sep. 30
2002
   
 
 
 
 
 
Non-accrual loans
 
$
10,993
 
$
10,731
 
$
13,649
 
$
12,558
 
$
13,548
 
Accruing loans past due 90 days or more
   
0
   
0
   
0
   
0
   
0
 
Restructured loans
   
0
   
0
   
0
   
0
   
0
 
   
 
 
 
 
 
Total non-performing and restructured loans
   
10,993
   
10,731
   
13,649
   
12,558
   
13,548
 
Other real estate owned
   
5,381
   
371
   
346
   
452
   
253
 
   
 
 
 
 
 
Total non-performing assets
 
$
16,374
 
$
11,102
 
$
13,995
 
$
13,010
 
$
13,801
 
   
 
 
 
 
 
Ratios:
   
 
    
 
    
 
    
 
    
 
  
Non-performing loans to total loans
   
1.40
%
 
1.34
%
 
1.78
%
 
1.69
%
 
1.97
%
Allowance to total loans
   
1.32
   
1.23
   
1.22
   
1.18
   
1.25
 
Allowance to non-performing loans
   
94.29
   
91.50
   
68.18
   
70.11
   
63.15
 
Non-performing assets to total assets
   
1.24
   
0.84
   
1.08
   
0.98
   
1.08
 
   
 
 
 
 
 

Allowance for Loan Losses and Net Charge-offs

Management maintains the allowance for loan losses (the "Allowance") at a level considered adequate to provide for probable loan losses. The Allowance is increased by provisions charged to earnings and is reduced by charge-offs, net of recoveries. At September 30, 2003, the Allowance was $10.4 million, an increase of $1.6 million from the balance at December 31, 2002. The Allowance was increased primarily due to the increased number of commercial loans, which are generally higher risk, particularly during a weak economic period. As of September 30, 2003 commercial and commercial real estate loans made up 73% of the total loan portfolio, compared to 64% as of December 31, 2002. As the commercial loan portfolio has grown in size, the complexity of the commercial relationship has also increased.

As a percentage of total loans outstanding, the Allowance was 1.32% at September 30, 2003 compared to 1.18% at December 31, 2002. The determination of Allowance adequacy is based upon on-going evaluations of the Company’s loan portfolio conducted by the Internal Loan Review function of its banking subsidiary, State Financial Bank, N.A. (the "Bank"), and reviewed by management. These evaluations consider a variety of factors, including, but not limited to, general economic conditions, loan portfolio size, type, and composition, previous loss experience, the borrowers’ financial condition, collateral adequacy, and the level of non-performing loans. Based upon its analyses, management considered the Allowance adequate to recognize the risk inherent in the loan portfolio at September 30, 2003.

The following table sets forth an analysis of the Allowance for loan losses for the periods indicated (dollars in thousands):
 
 
  
Nine months
ended
Sept. 30, 2003
Year ended
Dec. 31, 2002
   
 
 
Balance at beginning of period
 
$
8,805
 
$
7,900
 
Charge-offs:
   
 
    
 
  
Commercial
   
169
   
1,425
 
Real estate mortgage
   
170
   
35
 
Installment
   
318
   
523
 
Other
   
13
   
15
 
Total charge-offs
   
670
   
1,998
 
Recoveries:
   
 
    
 
  
Commercial
   
121
   
390
 
Real estate mortgage
   
15
   
0
 
Installment
   
67
   
107
 
Other
   
2
   
6
 
Total recoveries
   
205
   
503
 
   
 
 
Net charge-offs
   
465
   
1,495
 
Additions charged to operations
   
2,025
   
2,400
 
   
 
 
Balance at end of period
 
$
10,365
 
$
8,805
 
   
 
 
Ratios:
   
 
    
 
  
Net charge-offs to average loans outstanding 1
   
0.08
%
 
0.22
%
Net charge-offs to total allowance 1
   
6.00
   
16.98
 
Allowance to period end loans outstanding
   
1.32
   
1.18
 
  
 
 
1.Annualized.


Results of Operations-Comparison of the Three-Month Periods Ended September 30, 2003 and September 30, 2002.

General

For the quarter ended September 30, 2003, the Company reported net income of $3.1 million and net income per share on a fully diluted basis of $0.46, compared to net income of $2.9 million and net income per share on a fully diluted basis of $0.39 reported for the quarter ended September 30, 2002. The increase in earnings per share was mainly due to fewer shares being outstanding due to the stock repurchases effected since the second quarter of 2002.

Net Interest Income

The following table sets forth average balances, related interest income and expenses, and effective interest yields and rates for the three-month periods ended September 30, 2003 and September 30, 2002 (dollars in thousands):

 
  
Three months ended
September 30, 2003
Three months ended
September 30, 2002
   
 
  
Average Balance
 
Interest
Yield/
Rate 4
Average Balance
 
Interest
Yield/
Rate 4
   
 
ASSETS
   
 
    
 
    
 
    
 
    
 
    
 
  
Interest-earning assets:
   
 
    
 
    
 
    
 
    
 
    
 
  
Loans 123
 
$
780,713
 
$
11,438
   
5.81
%
$
658,363
 
$
11,626
   
7.01
%
Taxable investment securities
   
361,133
   
3,277
   
3.60
%
 
356,523
   
4,705
   
5.24
%
Tax-exempt investment securities 3
   
58,444
   
852
   
5.78
%
 
65,372
   
1,015
   
6.16
%
Other short-term investments
   
0
   
0
   
0.00
%
 
1,799
   
10
   
2.19
%
Interest-earnings deposits
   
6,463
   
17
   
1.06
%
 
1,819
   
25
   
5.47
%
Federal funds sold
   
17,673
   
39
   
0.87
%
 
52,895
   
218
   
1.63
%
   
 
 
 
 
 
 
Total interest-earning assets
   
1,224,426
   
15,623
   
5.06
%
 
1,136,771
   
17,599
   
6.14
%
Non-interest-earnings assets:
   
 
    
 
    
 
    
 
    
 
    
 
  
Cash and due from banks
   
47,845
   
 
    
 
    
42,547
   
 
    
 
  
Premises and equipment, net
   
27,255
   
 
    
 
    
28,184
   
 
    
 
  
Other assets
   
62,758
   
 
    
 
    
43,373
   
 
    
 
  
Less: Allowance for loan losses
   
(10,126
)
 
 
    
 
    
(8,893
)
 
 
    
 
  
   
             
             
TOTAL
 
$
1,352,158
   
 
    
 
  
$
1,241,982
   
 
    
 
  
   
             
             
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
 
    
 
    
 
    
 
    
 
  
Interest-bearing liabilities:
   
 
    
 
    
 
    
 
    
 
    
 
  
Now accounts
 
$
103,685
 
$
51
   
0.20
%
$
103,082
 
$
127
   
0.49
%
Money market accounts
   
216,469
   
504
   
0.92
%
 
214,162
   
770
   
1.43
%
Savings deposits
   
130,124
   
131
   
0.40
%
 
124,620
   
300
   
0.95
%
Time deposits
   
309,263
   
2,140
   
2.75
%
 
372,068
   
3,353
   
3.58
%
Notes payable
   
33,587
   
303
   
3.58
%
 
17,638
   
146
   
3.28
%
FHLB borrowings
   
77,400
   
785
   
4.02
%
 
47,500
   
624
   
5.21
%
Federal funds purchased
   
1,402
   
5
   
1.41
%
 
0
   
0
   
0.00
%
Securities sold under agreement to repurchase
   
 
202,983
   
 
708
   
 
1.38
%
 
 
87,784
   
 
607
   
 
2.74
%
   
 
 
 
 
 
 
Total interest-bearing liabilities
   
1,074,913
   
4,627
   
1.71
%
 
966,854
   
5,927
   
2.43
%
Non-interest-bearings liabilities:
   
 
    
 
    
 
    
 
    
 
    
 
  
Demand deposits
   
160,441
   
 
    
 
    
151,715
   
 
    
 
  
Other
   
7,717
   
 
    
 
    
9,297
   
 
    
 
  
   
             
             
Total liabilities
   
1,243,071
   
 
    
 
    
1,127,866
   
 
    
 
  
   
             
             
Stockholders’ equity
   
109,087
   
 
    
 
    
114,116
   
 
    
 
  
   
             
             
TOTAL
 
$
1,352,158
   
 
    
 
  
$
1,241,982
   
 
    
 
  
   
             
             
Net interest earning and interest rate spread
   
 
    
 
$10,996
   
3.35
%
 
 
    
 
$11,672
   
3.71
%
         
 
       
 
 
Net yield on interest-earning assets
   
 
    
 
    
3.56
%
 
 
    
 
    
4.07
%
               
             
 


1     For the purposes of these computations, non-accrual loans are included in the daily average loan amounts outstanding.
2     Interest earned on loans includes loan fees (which are not material in amount) and interest income that has been received from borrowers whose loans were removed from non-accrual during the period indicated.
3    Taxable-equivalent adjustments are made in calculating interest income and yields using a 35% rate for all years presented. The related adjustments were $308 thousand and $365 thousand for September 30, 2003 and September 30, 2002, respectively. The Company believes this disclosure of tax-exempt interest is more meaningful to the reader because these results are more comparable to other banks due to the impact that tax-exempt holdings have on net interest margin.
4    Annualized.
 
 
     
 
 
For the quarter ended September 30, 2003, the Company reported taxable-equivalent net interest income of $11.0 million, a decrease of $0.7 million, or 5.8%, from the $11.7 million reported for the quarter ended September 30, 2002. This modest decrease reflects the Company’s interest rate risk management policy, which is designed to minimize the impact of interest rate changes on net interest income. The taxable-equivalent yield on interest-earning assets (net interest margin) decreased to 3.56% in the third quarter of 2003 from 4.07% in the third quarter of 2002.

The Company’s taxable-equivalent total interest income decreased $2.0 million for the quarter ended September 30, 2003 compared to the same period of 2002 due to the lower interest rate environment. Average loans outstanding increased by $122.4 million, or 18.6%, in the third quarter of 2003 over the third quarter of 2002. For the quarter ended September 30, 2003, the taxable-equivalent yield on interest-earning assets was 5.06% compared to 6.14% for the quarter ended September 30, 2002. The third quarter 2003 loan yield was 5.81% compared to 7.01% in the third quarter of 2002. The Company also experienced declines in the yields earned on its investment securities. For the quarter ended September 30, 2003, the yield earned on taxable investment securities decreased to 3.60% from 5.24% for the quarter ended September 30, 2002. The taxable equivalent yields earned on tax-exempt investment securities decreased to 5.78% for the quarter ended September 30, 2003 from 6.16% for the quarter ended September 30, 2002. The decline in these yields for the third quarter of 2003 compared to the third quarter of 2002 is the result of matured or repaid securities replaced by lower yielding securities in a lower interest rate environment.
 
  The Company’s funding costs were also impacted by the lower interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities decreased to 1.71% for the third quarter of 2003 from 2.43% for the third quarter of 2002. The Company uses wholesale funding sources, such as the FHLB, to balance the timing differences between its various business funding sources and to support loan origination. In the third quarter of 2003, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 29.3% of the Company’s interest-bearing liabilities compared to 15.8% in the third quarter 2002 due to loan growth exceeding deposit growth in the period.

Provision for Loan Losses

The provision for loan losses was $600 thousand in the third quarter of 2003 compared to $1,050 thousand in the third quarter of 2002. The provision is adjusted to reflect loan growth and management’s assessment of asset quality and risk inherent in the loan portfolio. This loan growth has been primarily centered in the commercial and commercial real estate loan categories, which are generally considered higher risk than other types of loans.

Other Income

Total other income increased $212 thousand in the third quarter of 2003 over the third quarter of 2002. The increase was the result of increases in service charges on deposit accounts, investment securities gains, gains on sale of residential mortgage loans, bank owned life insurance, mortgage origination fees, and other income. These increases were offset by decreases in automated teller machine (ATM) and merchant services, security commissions and management fees, and gain on sale of fixed assets. Service charges on deposit accounts increased $76 thousand due to increased fees on business accounts. Investment security gains increased $211 thousand. Gains on sale of residential mortgage loans increased $672 thousand and mortgage origination fees increased $70 thousand, both due to increased refinancing activity on residential mortgages. Bank owned life insurance increased $203 thousand due to a full quarter of income earned for the third quarter of 2003 compared to only a half a month of earned income for the third quarter of 2002. Other income increased $31 thousand. ATM and merchant services decreased $379 thousand mainly due to the sale of the merchant credit card processing business during the second quarter of 2003. Security commission and management fees decreased $4 thousand. Gain on sale of fixed assets decreased $670 thousand in the third quarter of 2003 compared to the third quarter of 2002 due to the sale of non-bank related real estate in the third quarter of 2002.

Other Expenses

Other expenses decreased $342 thousand in the third quarter of 2003 over the third quarter of 2002. The decrease was due to decreases in net occupancy and equipment expense, data processing, ATM and merchant services, advertising, and other expense. These decreases were offset by increases in personnel costs, legal and professional fees, and delivery and postage. Personnel costs increased $229 thousand mainly due to increased sales commissions as a result of the increased volume of refinancing activity on residential mortgages. Net occupancy and equipment expense decreased $3 thousand and data processing decreased $14 thousand. Legal and professional expense increased $166 thousand and other expense decreased $305 thousand, both due to reallocation of expenses. ATM and merchant services decreased $361 thousand mainly due to the sale of the merchant credit card processing business during the second quarter of 2003. Advertising decreased $75 thousand due to a more efficient use of marketing funds and delivery and postage increased $22 thousand.
Income Taxes

Income tax expense for the quarter ended September 30, 2003 was $1.4 million and was $1.3 million for the quarter ended September 30, 2002. The effective tax rate was 31.1% for the third quarter of 2003 compared to an effective rate of 30.1% for the third quarter of 2002. The increase was due to a larger portion of tax-exempt revenue in 2002 compared to 2003.

Results of Operations-Comparison of the Nine-Month Periods Ended September 30, 2003 and September 30, 2002.

General

For the nine months ended September 30, 2003, the Company reported a net income of $9.0 million and net income per share on a fully diluted basis of $1.33, compared to net income of $8.3 million and net income per share on a fully diluted basis of $1.11 reported for the nine months ended September 30, 2002. The increase in net income was mainly due to increased non-interest income including bank owned life insurance and gain on sale of mortgage loans. The increase in earnings per share was mainly due to fewer shares being outstanding due to the stock repurchases effected since the second quarter of 2002.

 
     
 
 
Net Interest Income

The following table sets forth average balances, related interest income and expenses, and effective interest yields and rates for the nine-month periods ended September 30, 2003 and September 30, 2002 (dollars in thousands):


 
  
Nine months ended
September 30, 2003
Nine months ended
September 30, 2002
   
 
  
Average
Balance
Interest
Yield/
Rate
Average
Balance
Interest
Yield/
Rate
   
 
ASSETS
   
 
    
 
    
 
    
 
    
 
    
 
  
Interest-earning assets:
   
 
    
 
    
 
    
 
    
 
    
 
  
Loans
 
$
768,380
 
$
35,131
   
6.11
%
$
672,447
 
$
36,003
   
7.16
%
Taxable investment securities
   
354,916
   
10,291
   
3.88
%
 
322,594
   
12,905
   
5.35
%
Tax-exempt investment securities
   
61,332
   
2,676
   
5.83
%
 
63,130
   
3,064
   
6.49
%
Other short-term investments
   
0
   
0
   
0.00
%
 
652
   
10
   
2.03
%
Interest-earning deposits
   
2,401
   
37
   
2.04
%
 
1,349
   
70
   
6.94
%
Federal funds sold
   
13,629
   
101
   
0.99
%
 
37,314
   
450
   
1.61
%
   
 
 
 
 
 
 
Total interest-earning assets
   
1,200,658
   
48,236
   
5.37
%
 
1,097,486
   
52,502
   
6.40
%
Non-interest-earning assets:
   
 
    
 
    
 
    
 
    
 
    
 
  
Cash and due from banks
   
39,303
   
 
    
 
    
43,267
   
 
    
 
  
Premises and equipment, net
   
27,524
   
 
    
 
    
28,396
   
 
    
 
  
Other assets
   
61,594
   
 
    
 
    
42,209
   
 
    
 
  
Less: Allowance for loan losses
   
(9,554
)
 
 
    
 
    
(8,399
)
 
 
    
 
  
   
             
             
TOTAL
 
$
1,319,525
   
 
    
 
  
$
1,202,959
   
 
    
 
  
   
             
             
LIABILITIES AND STOCKHOLDERS’ EQUITY                                      
Interest-bearing liabilities:
   
 
    
 
    
 
    
 
    
 
    
 
  
Now accounts
 
$
111,466
 
$
276
   
0.33
%
$
98,404
 
$
356
   
0.48
%
Money market accounts
   
214,285
   
1,744
   
1.09
%
 
222,661
   
2,446
   
1.47
%
Savings deposits
   
128,645
   
492
   
0.51
%
 
124,636
   
885
   
0.95
%
Time deposits
   
317,270
   
6,904
   
2.91
%
 
343,845
   
9,794
   
3.81
%
Notes payable
   
30,403
   
850
   
3.74
%
 
17,930
   
445
   
3.32
%
FHLB borrowings
   
77,583
   
2,354
   
4.06
%
 
51,050
   
1,960
   
5.13
%
Federal funds purchased
   
1,491
   
18
   
1.61
%
 
55
   
1
   
2.43
%
Securities sold under agreement
to repurchase
   
163,246
   
2,070
   
1.70
%
 
78,527
   
1,569
   
2.67
%
Total interest-bearing liabilities
   
1,044,389
   
14,708
   
1.88
%
 
937,108
   
17,456
   
2.49
%
Non-interest-bearing liabilities:
   
 
    
 
    
 
    
 
    
 
    
 
  
Demand deposits
   
157,944
   
 
    
 
    
146,038
   
 
    
 
  
Other
   
9,029
   
 
    
 
    
8,405
   
 
    
 
  
   
             
             
Total liabilities
   
1,211,362
   
 
    
 
    
1,091,551
   
 
    
 
  
   
             
             
Stockholders’ equity
   
108,163
   
 
    
 
    
111,408
   
 
    
 
  
   
             
             
TOTAL
 
$
1,319,525
   
 
    
 
  
$
1,202,959
   
 
    
 
  
   
             
             
Net interest earning and interest rate spread         $

 33,528

    
3.49
%       $
35,046
   

 3.91

%
         
 
       
 		  
 		  
Net yield on interest-earning assets                 
3.73
%              
4.27
%
               
 		              
 		  
 

1    For the purposes of these computations, non-accrual loans are included in the daily average loan amounts outstanding.
2    Interest earned on loans includes loan fees (which are not material in amount) and interest income that has been received from borrowers whose loans were removed from non-accrual during the period indicated.
3    Taxable-equivalent adjustments are made in calculating interest income and yields using a 35% rate for all years presented. The related adjustments were $975 thousand and $1,100 thousand for September 30, 2003 and September 30, 2002, respectively. The Company believes this disclosure of tax-exempt interest is more meaningful to the reader because these results are more comparable to other banks due to the impact that tax-exempt holdings have on net interest margin.
4    Annualized.

 
     
 
 
For the nine months ended September 30, 2003, the Company reported taxable-equivalent net interest income of $33.5 million, a decrease of $1.5 million, or 0.4%, from the $35.0 million reported for the nine months ended September 30, 2002. This modest decrease reflects the Company’s interest rate risk management policy, which is designed to minimize the impact of interest rate changes on net interest income. The taxable-equivalent yield on interest-earning assets (net interest margin) decreased to 3.73% in the first three quarters of 2003 from 4.27% in the first three quarters of 2002.

The Company’s taxable-equivalent total interest income decreased $4.3 million for the nine months ended September 30, 2003 compared to the same period of 2002 due to the lower interest rate environment. Average loans outstanding increased $95.9 million, or 14.3%, in the first three quarters of 2003 over the first three quarters of 2002. For the nine months ended September 30, 2003, the taxable-equivalent yield on interest-earning assets was 5.37% compared to 6.40% for the nine months ended September 30, 2002. The first three quarters of 2003 loan yield was 6.11% compared to 7.16% in the first three quarters of 2002. The Company also experienced declines in the yields earned on its investment securities. For the nine months ended September 30, 2003, the yield earned on taxable investment securities decreased to 3.88% from 5.35% for the nine months ended September 30, 2002. The taxable equivalent yields earned on tax-exempt investment securities decreased to 5.83% for the nine months ended September 30, 2003 from 6.49% for the nine months ended September 30, 2002. The decline in these yields for the nine months ended September 30, 2003 compared to the nine months ended September 30, 2002 is the result of matured or repaid securities replaced by lower yielding securities in a lower interest rate environment.

The Company’s funding costs were also impacted by the lower interest rate environment prevalent over the preceding twelve months. The cost of interest-bearing liabilities decreased to 1.88% for the first three quarters of 2003 from 2.49% for the first three quarters of 2002. The Company uses wholesale funding sources, such as the FHLB, to balance the timing differences between its various business funding sources and to support loan origination. In the first three quarters of 2003, notes payable, FHLB borrowings, federal funds purchased, and securities sold under agreements to repurchase comprised 26.1% of the Company’s interest-bearing liabilities compared to 15.7% in the first three quarters of 2002 due to loan growth exceeding deposit growth in the period.

Provision for Loan Losses

The provision for loan losses was $2.0 million in the first three quarters of 2003 and 2002. The provision is adjusted to reflect loan growth and management’s assessment of asset quality and risk inherent in the loan portfolio. This loan growth has been primarily centered in the commercial and commercial real estate loan categories, which are generally considered higher risk than other types of loans.

Other Income

Total other income increased $3.6 million in the first three quarters of 2003 over the first three quarters of 2002. The increase was the result of increases in service charges on deposit accounts, gain on sale of residential mortgage loans, gain on sale of merchant processing, bank owned life insurance, and mortgage origination fees. These increases were offset by decreases in ATM and merchant services, security commissions and management fees, investment securities gains, and gain on sale of fixed assets, and other income. Service charges on deposit accounts increased $166 thousand due to increased fees on business accounts. Gains on sale of residential mortgage loans increased $2.3 million and mortgage origination fees increased $254 thousand. Both due to increased refinancing activity on residential mortgages. The sale of the Company’s merchant credit card processing business resulted in a gain of $1.3 million. Bank owned life insurance increased $1.0 million due to a full nine months of income earned in 2003 compared to a half a month of income earned in 2002. ATM and merchant services decreased $456 thousand mainly due to the sale of the merchant credit card processing business during the second quarter of 2003. Security commission and management fees decreased $50 thousand, investment security gains decreased $142 thousand, and other income decreased $39 thousand. Gain on sale of fixed assets decreased $665 thousand due to the sale of non-bank related real estate sold in the third quarter of 2002.

Other Expenses

Other expenses increased $1.5 million in the first three quarters of 2003 over the first three quarters of 2002. The increase was due to increases in personnel costs, net occupancy and equipment expense, delivery and postage, provision for merchant chargebacks, merchant processing exit fee, efficiency consulting expense, and severance charges. These increases were offset by decreases in, data processing, legal and professional fees, ATM and merchant services, advertising, and other expense. Personnel costs increased $1.5 million mainly due to increased sales commissions as a result of the increased volume of refinancing activity on residential mortgages. Net occupancy and equipment expense increased $31 thousand, data processing decreased $134 thousand, and legal and professional expense decreased $211 thousand. ATM and merchant services decreased $450 thousand mainly due to the sale of the merchant credit card processing business during the second quarter of 2003. Advertising decreased $62 thousand, and delivery and postage increased $42 thousand. Provision for merchant chargebacks of $300 thousand and merchant processing contract exit fee of $150 thousand were recorded as a result of the sale of its merchant credit card processing business. The Company is in the process of improving efficiency and recorded a charge of $570 thousand for efficiency consulting expense and $180 thousand for severance of management personnel. Other expense decreased $409 thousand.

Income Taxes

Income tax expense for the nine months ended September 30, 2003 and 2002 was $3.7 million. The effective tax rate was 29.0% for the first three quarters of 2003 compared to an effective rate of 30.9% for the same period in 2002. The decrease in the tax rate is due to a higher tax-exempt income as a percentage of total income.

Liquidity

The primary functions of asset/liability management are to assure adequate liquidity and maintain an appropriate balance between interest-earning assets and interest-bearing liabilities. Liquidity management involves the ability to meet the cash flow requirements of depositors and borrowers. Liquid assets (including cash deposits with banks, short-term investments, interest-earning deposits, and federal funds sold) are maintained primarily to meet customers’ current needs. The Company had liquid assets of $49.6 million and $67.5 million at September 30, 2003 and December 31, 2002, respectively.

Capital Resources

There are certain regulatory requirements that affect the Company's level of capital. The following table sets forth these requirements and the Company's capital levels and ratios at September 30, 2003 (dollars in thousands):

 
  
 
 
Actual
Regulatory
Minimum
Requirement )
Regulatory
Well-capitalized
Requirement
   
 
  
Amount
Percent
Amount
Percent
Amount
Percent
   
 
 
 
 
 
 
Tier 1 leverage
 
$
93,430
   
7.1
%
$
52,912
   
4.0
%
$
66,140
   
5.0
%
Tier 1 risk-based capital
 
$
93,430
   
9.7
%
$
38,448
   
4.0
%
$
57,673
   
6.0
%
Risk-based capital
 
$
103,795
   
10.8
%
$
76,897
   
8.0
%
$
96,121
   
10.0
%

The Company is pursuing a policy of continued asset growth, which requires the maintenance of appropriate ratios of capital to assets. The existing capital levels allow for additional asset growth without further capital infusion. It is the Company's plan to maintain its capital position at or in excess of the "well-capitalized" definition. The Company seeks to obtain additional capital growth through earnings retention and a consistent dividend policy.

Derivative Financial Instruments and Hedging Activities

Interest rate risk, the exposure of the Company’s net interest income and net fair value of its assets and liabilities, to adverse movements in interest rates, is a significant market risk exposure that can have a material effect on the Company’s financial position, results of operations and cash flows. The Company has policies to ensure that neither earnings nor fair value at risk exceed established guidelines and assesses these risks by continually identifying and monitoring changes in interest rates that may adversely impact expected future earnings and fair values.

The Company has designed strategies to confine these risks within the established limits and identify appropriate risk/reward trade-offs in the financial structure of its balance sheet. These strategies include the use of interest rate swap agreements to manage fluctuations in cash flows or fair values resulting from interest rate risk.

The Company designated the current interest swap outstanding as a fair value hedge of an existing loan that qualifies for "short-cut" treatment.    Accordingly, the Company does not anticipate ineffectiveness arising from differences between the fair value of the loan and the fair value of the swap.

The following table summarizes the Company’s fair value hedges at September 30, 2003 (dollars in thousands):
 

Hedged Item
Hedging Instrument
Notional Amount
Fair Value
Remaining Term (Years)
Fixed Rate Loan
Receive Variable Swap
$4,031
$4,120
9.25

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Refer to the Company’s annual report on Form 10-K for the year ended December 31, 2002 for a complete discussion of the Company’s market risk. There have been no material changes to the market risk information included in the Company’s 2002 annual report on Form 10-K.

Item 4. Controls and Procedures

The Company’s management, with participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (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 Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective in recording, processing, summarizing, and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act. There have not been any 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 fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 
     
 
 
Forward Looking Statements

The Company intends certain matters discussed in this Report to be "forward-looking statements" intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. These forward-looking statements can generally be identified as such because the statements will include words such as "believes," "anticipates," "expects," or words of similar meaning. Similarly, statements that describe future plans, objectives, outlooks, targets or goals are also forward-looking statements. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this Report. Factors that could cause such a variance include, but are not limited to, adequacy of the Company’s loan loss reserve, changes in interest rates, local market competition, customer loan and deposit preferences, governmental regulations, and other general economic conditions. Shareholders, potential investors, and other readers are urged to consider these factors in evaluating the forward-looking statements and cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements included in this Report are only made of the date of this Report, and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

Part II.  Other Information

Item 1. Legal Proceedings

From time to time, the Company and the Bank, are party to legal proceedings arising out of their general lending activities and other operations. Currently there are no material proceedings.

Item 2. Exhibits and Reports on Form 8-K
 
(a)     Exhibits


 

(b)    Reports on Form 8-K
 
    The Company filed a Current Report on Form 8-K, dated July 15, 2003, furnishing under Item 12 the Company’s press release dated July 15, 2003, with respect to financial results for the quarter ended June 30, 2003.

Item 4.  Submission of Matters to Vote of Security Holders

None

 
     
 
 
SIGNATURES


Pursuant to the requirement 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.

     
  STATE FINANCIAL SERVICES CORPORATION
 
 		  
 		  (Registrant)
 
Date: November 12, 2003

  

 By: /s/ Michael J. Falbo
  Michael J. Falbo
  President and Chief Executive Officer

   
 
 		  
 
Date: November 12, 2003 By: /s/  Daniel L. Westrope
  Daniel L. Westrope
  Senior Vice President and
  Chief Financial Officer


 
 
 
     
 
 

STATE FINANCIAL SERVICES CORPORATION
EXHIBIT INDEX TO FORM 10-Q
For The Quarter Ended September 30, 2003


Exhibit Number

31.1  Certification by the Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.

31.2  Certification by the Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) under the Securities Exchange Act of 1934.

32.1    Certification of Periodic Financial Report by the Chief Executive Officer and Chief Financial Officer pursuant to U.S.C. Section 1350.