10-Q 1 b400161_10q.txt QUARTERLY REPORT 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 June 30, 2004 OR ( ) 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: O-19065 Sandy Spring Bancorp, Inc. (Exact name of registrant as specified in its charter) Maryland 52-1532952 ------------------------ --------------------------------------- (State of incorporation) (I.R.S. Employer Identification Number) 17801 Georgia Avenue, Olney, Maryland 20832 301-774-6400 ------------------------------------- --------- ------------ (Address of principal office) (Zip Code) (Telephone Number) 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 filing requirements for the past 90 days. YES X NO ------- ------- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES X NO ------- ------- The number of shares of common stock outstanding as of July 20, 2004 is 14,521,700 shares. SANDY SPRING BANCORP, INC. INDEX
PAGE ---------------------------------------------------------------------------------------------------- PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS Consolidated Balance Sheets at June 30, 2004 and December 31, 2003......................................................1 Consolidated Statements of Income for the Six Month Periods Ended June 30, 2004 and 2003..............................................2 Consolidated Statements of Cash Flows for the Six Month Periods Ended June 30, 2004 and 2003 ..............................................4 Consolidated Statements of Changes in Stockholders' Equity for the Six Month Periods Ended June 30, 2004 and 2003...........................................6 Notes to Consolidated Financial Statements...............................................7 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS......................................10 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK .................................................................21 ITEM 4. CONTROLS AND PROCEDURES................................................................21 PART II - OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS, AND ISSUER PURCHASES OF EQUITY SECURITIES.............................................22 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K...................................................... 22 SIGNATURES.................................................................................... 23
PART I - FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS Sandy Spring Bancorp, Inc. and Subsidiaries CONSOLIDATED BALANCE SHEETS
June 30, December 31, (Dollars in thousands, except per share data) 2004 2003 ----------------------------------------------------------------------------------------------------------------------------------- ASSETS Cash and due from banks $41,399 $38,397 Federal funds sold 67,754 10,670 Interest-bearing deposits with banks 736 724 Residential mortgage loans held for sale (at fair value) 12,988 12,209 Investments available-for-sale (at fair value) 569,908 639,460 Investments held-to-maturity -- fair value of $322,896 (2004) and $344,814 (2003) 322,448 337,634 Other equity securities 19,852 21,111 Total loans and leases 1,267,346 1,153,428 Less: allowance for credit losses (14,743) (14,880) ---------------- ---------------- Net loans and leases 1,252,603 1,138,548 Premises and equipment, net 40,498 37,679 Accrued interest receivable 13,025 13,661 Goodwill 7,642 7,642 Other intangible assets 10,473 11,446 Other assets 64,873 65,243 ---------------- ---------------- Total assets $2,424,199 $2,334,424 ================ ================ LIABILITIES Noninterest-bearing deposits $417,400 $368,319 Interest-bearing deposits 1,264,152 1,193,511 ---------------- ---------------- Total deposits 1,681,552 1,561,830 Short-term borrowings 384,436 413,223 Subordinated debentures 35,000 35,000 Other long-term borrowings 114,883 115,158 Accrued interest payable and other liabilities 12,238 15,764 ---------------- ---------------- Total liabilities 2,228,109 2,140,975 STOCKHOLDERS' EQUITY Common stock -- par value $1.00; shares authorized 50,000,000; shares issued and outstanding 14,517,640 (2004) and 14,495,613 (2003) 14,518 14,496 Additional paid in capital 19,511 18,970 Retained earnings 161,459 153,280 Accumulated other comprehensive income 602 6,703 ---------------- ---------------- Total stockholders' equity 196,090 193,449 ---------------- ---------------- Total liabilities and stockholders' equity $2,424,199 $2,334,424 ================ ================
See Notes to Consolidated Financial Statements. 1 Sandy Spring Bancorp, Inc. and Subsidiaries CONSOLIDATED STATEMENTS OF INCOME
Three Months Ended Six Months Ended June 30, June 30, ------------------------------- -------------------------- (In thousands, except per share data) 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------------------------------------ Interest Income: Interest and fees on loans and leases $16,919 $16,252 $33,375 $32,871 Interest on loans held for sale 212 263 350 571 Interest on deposits with banks 2 4 5 7 Interest and dividends on securities: Taxable 5,509 7,880 12,065 16,612 Exempt from federal income taxes 3,515 3,483 7,102 6,951 Interest on federal funds sold 88 109 147 215 ------------------------------- -------------------------- TOTAL INTEREST INCOME 26,245 27,991 53,044 57,227 Interest Expense: Interest on deposits 2,994 3,728 5,724 7,661 Interest on short-term borrowings 3,699 4,497 7,450 9,127 Interest on long-term borrowings 1,690 1,519 3,382 3,029 ------------------------------- -------------------------- TOTAL INTEREST EXPENSE 8,383 9,744 16,556 19,817 ------------------------------- -------------------------- NET INTEREST INCOME 17,862 18,247 36,488 37,410 Provision for Credit Losses 0 0 0 0 ------------------------------- -------------------------- NET INTEREST INCOME AFTER PROVISION 17,862 18,247 FOR CREDIT LOSSES 36,488 37,410 Noninterest Income: Securities gains 109 543 337 551 Service charges on deposit accounts 1,881 2,037 3,749 4,021 Gains on sales of mortgage loans 1,028 1,603 1,797 3,178 Fees on sales of investment products 666 666 1,295 1,187 Trust department income 984 758 1,738 1,478 Insurance agency commissions 1,030 922 2,151 1,941 Income from bank owned life insurance 613 710 1,243 1,319 Income from an early termination of a sublease 0 1,077 0 1,077 Visa check fees 497 494 921 919 Other income 1,433 1,240 2,569 2,136 ------------------------------- -------------------------- TOTAL NONINTEREST INCOME 8,241 10,050 15,800 17,807 Noninterest Expenses: Salaries and employee benefits 10,285 9,514 20,218 18,964 Occupancy expense of premises 1,815 1,533 3,443 3,117 Equipment expenses 1,324 1,099 2,514 2,140 Marketing 482 509 995 963 Outside data services 766 660 1,487 1,305 Amortization of intangible assets 487 664 973 1,329 Other expenses 2,996 2,644 5,295 4,762 ------------------------------- -------------------------- TOTAL NONINTEREST EXPENSES 18,155 16,623 34,925 32,580 ------------------------------- -------------------------- Income Before Income Taxes 7,948 11,674 17,363 22,637 Income Tax Expense 1,555 2,938 3,669 5,573 ------------------------------- -------------------------- NET INCOME $6,393 $8,736 $13,694 $17,064 ================ ============== ==========================
See Notes to Consolidated Financial Statements. 2 Sandy Spring Bancorp, Inc. and Subsidiaries CONSOLIDATED STATEMENTS OF INCOME (Continued)
Three Months Ended Six Months Ended June 30, June 30, ------------------------------- -------------------------- (In thousands, except per share data) 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------------------------------------ Basic Net Income Per Share $0.44 $0.61 $0.94 $1.18 Diluted Net Income Per Share 0.43 0.60 0.93 1.16 Dividends Declared Per Share 0.19 0.18 0.38 0.36
See Notes to Consolidated Financial Statements. 3 Sandy Spring Bancorp, Inc. and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands)
Six Months Ended June 30, ----------------------------------- 2004 2003 -------------------------------------------------------------------------------------------------------------------------- Cash flows from operating activities: Net income $13,694 $17,064 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 3,206 3,051 Provision for credit losses 0 0 Deferred Income Taxes (benefits) (354) 572 Origination of loans held for sale (156,736) (230,952) Proceeds from sales of loans held for sale 157,754 243,549 Gains on sales of loans held for sale (1,797) (3,178) Securities gains (337) (551) Income from early termination of a sublease 0 (1,077) Net decrease in accrued interest receivable 636 53 Net increase in other assets (770) (5,597) Net increase (decrease) in accrued expenses and other liabilities 1,629 (6,154) Other - net 698 811 -------------- --------------- Net cash provided by operating activities 17,623 17,591 Cash flows from investing activities: Net decrease (increase) in interest-bearing deposits with banks (12) 148 Purchases of investments held-to-maturity (22,109) (7,622) Purchases of other equity securities 0 (166) Proceeds from sales of other equity securities 1,259 0 Purchases of investments available-for-sale (316,378) (881,245) Proceeds from sales of investments available-for-sale 166,480 71,760 Proceeds from the sales of other real estate owned 153 0 Proceeds from maturities, calls and principal payments of investments 37,207 95,174 held-to-maturity Proceeds from maturities, calls and principal payments of investments 209,160 732,093 available-for-sale Net increase in loans and leases (113,918) (6,022) Proceeds from an early termination of a sublease 0 750 Expenditures for premises and equipment (5,087) (2,601) -------------- --------------- Net cash provided by (used in) investing activities (43,245) 2,269 Cash flows from financing activities: Net increase in deposits 119,722 97,932 Net decrease in short-term borrowings (29,062) (72,153) Proceeds from long-term borrowings 0 28,500 Common stock purchased and retired (20) (2,999) Proceeds from issuance of common stock 583 455 Dividends paid (5,515) (5,223) -------------- --------------- Net cash provided by financing activities 85,708 46,512 -------------- --------------- Net increase in cash and cash equivalents 60,086 66,372 Cash and cash equivalents at beginning of period 49,067 48,133 -------------- --------------- Cash and cash equivalents at end of period $109,153 $114,505 ============== ===============
4 Sandy Spring Bancorp and Subsidiaries CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
Six Months Ended June 30, ------------------------------------- (Dollars in thousands) 2004 2003 ------------------------------------------------------------------------------------- --------------- ----- --------------- Supplemental Disclosures: Interest payments $16,630 $19,988 Income tax payments 3,909 5,108 Noncash Financing Activities: Transfers from loans to other real estate owned 0 187 Increase in premises and equipment from an early termination of a sublease 0 1,168 Reclassification of borrowings from long-term to short-term 275 30,709
See Notes to Consolidated Financial Statements. 5 Sandy Spring Bancorp, Inc. and Subsidiaries CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
Accum- ulated Other Compre- Total Additional hensive Stock- Common Paid-in Retained Income holders' (Dollars in thousands, except per share data) Stock Capital Earnings (loss) Equity --------------------------------------------- ---- ----------- --- ------------ --- ------------ -- ------------ --- ----------- Balances at January 1, 2004 $14,496 $18,970 $153,280 $6,703 $193,449 Comprehensive income: Net income 13,694 13,694 Other comprehensive loss, net of tax effects and reclassification adjustment (6,101) (6,101) ----------- Total comprehensive income 7,593 Cash dividends - $0.38 per share (5,515) (5,515) Common stock issued pursuant to: Director stock purchase plan- 1,120 shares 1 39 40 Stock option plan - 12,480 shares 13 256 269 Employee stock purchase plan - 8,977 shares 9 265 274 Stock repurchases - 550 shares (1) (19) (20) ----------- ------------ ------------ ------------ ----------- Balances at June 30, 2004 $14,518 $19,511 $161,459 $602 $196,090 =========== ============ ============ ============ =========== Balances at January 1, 2003 $14,536 $21,128 $131,939 $10,421 $178,024 Comprehensive income: Net income 17,064 17,064 Other comprehensive income, net of tax effects and reclassification adjustment 1,304 1,304 ----------- Total comprehensive income 18,368 Cash dividends - $0.36 per share (5,223) (5,223) Common stock issued pursuant to: Stock option plan - 16,123 shares 16 220 236 Employee stock purchase plan - 7,987 shares 8 211 219 Stock repurchases - 95,060 shares (95) (2,904) (2,999) ----------- ------------ ------------ ------------ ----------- Balances at June 30, 2003 $14,465 $18,655 $143,780 $11,725 $188,625 =========== ============ ============ ============ ===========
See Notes to Consolidated Financial Statements. 6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - General The foregoing financial statements are unaudited. In the opinion of Management, all adjustments (comprising only normal recurring accruals) necessary for a fair presentation of the results of the interim periods have been included. These statements should be read in conjunction with the financial statements and accompanying notes included in Sandy Spring Bancorp's 2003 Annual Report to Shareholders. There have been no significant changes to the Company's Accounting Policies as disclosed in the 2003 Annual Report. The results shown in this interim report are not necessarily indicative of results to be expected for the full year 2004. The accounting and reporting policies of Sandy Spring Bancorp (the "Company") conform to accounting principles generally accepted in the United States of America and to general practices within the banking industry. Certain reclassifications have been made to amounts previously reported to conform to current classifications. Consolidation has resulted in the elimination of all significant intercompany accounts and transactions. Cash Flows For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks and federal funds sold (which have original maturities of three months or less). New Accounting Pronouncements In January 2003, the Financial Accounting Standards Board ("FASB") issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which explains identification of variable interest entities and the assessment of whether to consolidate these entities. FIN 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the involved parties. The potential de-consolidation of subsidiary trusts of bank holding companies formed in connection with the issuance of trust preferred securities appears to be an unintended consequence of FIN 46. On December 17, 2003, the FASB revised FIN 46 (FIN 46R) and deferred the effective date of FIN 46 to no later than the end of the first reporting period that ends after March 15, 2004. Accordingly, the Company chose to postpone de-consolidation of the trust preferred securities until March 31, 2004. Prior periods have been restated. The overall effect on the Company's financial position as a result of this deconsolidation was not material. The Company has no significant variable interests in any entities which would require disclosure or consolidation. Note 2 - Stock Option Plan At June 30, 2004, the Company had options outstanding under two stock-based employee compensation plans, the 1992 stock option plan (expired but having outstanding options that may still be exercised) and the 1999 stock option plan. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees", and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effects on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, "Accounting for Stock-Based Compensation", to stock-based employee compensation for the periods indicated. 7
Three Months Ended Six Months Ended June 30, June 30, ---------------------------------------------------------------------- (In thousands, except per share data) 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------------------------ Net income, as reported $ 6,393 $ 8,736 $ 13,694 $ 17,064 Less pro forma stock-based employee compensation expense determined under fair value based method, net of related tax effects (310) (248) (620) (497) -------------------------------------------------------------------- Pro forma net income $ 6,083 $ 8,488 $ 13,074 $ 16,567 ====================================================================== Net income per share: Basic - as reported $ 0.44 $ 0.61 $ 0.94 $ 1.18 Basic - pro forma $ 0.42 $ 0.59 $ 0.90 $ 1.14 Diluted - as reported $ 0.43 $ 0.60 $ 0.93 $ 1.16 Diluted - pro forma $ 0.41 $ 0.58 $ 0.89 $ 1.13
Note 3 - Per Share Data The calculations of net income per common share for the three month and six month periods ended June 30 are as shown in the following table. Basic net income per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding and does not include the impact of any potentially dilutive common stock equivalents. The diluted earnings per share calculation method is derived by dividing net income available to common stockholders by the weighted average number of common shares outstanding adjusted for the dilutive effect of outstanding stock options.
(Dollars and amounts in thousands, except Three Months Ended Six Months Ended Per share data) June 30, June 30, --------------------------------------------------------------- ---------------------------- --- ----------------------------- 2004 2003 2004 2003 ---- ---- ---- ---- Basic: Net income available to common stockholders $6,393 $8,736 $13,694 $17,064 Average common shares outstanding 14,514 14,479 14,510 14,508 Basic net income per share $0.44 $0.61 $0.94 $1.18 ============= ============== ============ ================ Diluted: Net income available to common stockholders $6,393 $8,736 $13,694 $17,064 Average common shares outstanding 14,514 14,479 14,510 14,508 Stock option adjustment 212 197 218 202 ------------- -------------- ------------ ---------------- Average common shares outstanding-diluted 14,726 14,676 14,728 14,710 Diluted net income per share $0.43 $0.60 $0.93 $1.16 ============= ============== ============ ================
Options for 188,768 shares of common stock were not included in computing diluted net income per share for the three and six months ended June 30, 2004 because their effects are antidilutive. Options for 135,147 shares of common stock were not included in computing diluted net income per share for the three months ended June 30, 2003 because their effects were antidilutive. There was no such effect for the six months ended June 30, 2003. Note 4-Pension, Profit Sharing, and Other Employee Benefit Plans Defined Benefit Pension Plan The Company has a qualified, noncontributory, defined benefit pension plan covering substantially all employees. Benefits equal the sum of two parts: (a) the benefit accrued as of December 31, 2000, based on the formula of 1.5% of the highest five year average salary as of that date times years of service as of that date, plus (b) 1.75% of each year's earnings after December 31, 2000 (1.75% of career average earnings). In addition, if the participant's age plus years of service as of January 1, 2001, equal at least 60 and the participant had at least 15 years of service at that date, he or she will receive an additional benefit of 1% of year 2000 earnings for each of the first 10 years of service completed after December 31, 2000. Early retirement is also permitted by the Plan at age 55 after 10 years of service. The Company's funding policy is to contribute at least the minimum amount necessary to keep the plan fully funded. The plan invests primarily in a diversified portfolio of managed fixed income and equity funds. Contributions provide not only for benefits attributed to service to date, but also for the benefit expected to be earned in the coming year. The Company, with input from its actuaries, estimates that the 2004 contribution will be approximately $1.5 million which will maintain the pension plan's fully funded status. 8 Net periodic benefit cost for the three and six month periods ended June 30 includes the following components:
Three months Ended Six months Ended ------------------------------------------------------------------------------------------------------------------- June 30, June 30, (In thousands) 2004 2003 2004 2003 ------------------------------------------------------------------------------------------------------------------- Service cost for benefits earned $395 $285 $790 $569 Interest cost on projected benefit obligation 232 183 464 364 Expected return on plan assets (259) (197) (519) (395) Amortization of prior service cost (16) (15) (31) (31) Recognized net actuarial loss 82 73 164 147 ----- ------ ------ ---- Net periodic benefit cost $434 $329 $868 $654 ===== ===== ===== ====
Cash and Deferred Profit Sharing Plan The Company has a qualified Cash and Deferred Profit Sharing Plan that includes a 401 (k) provision with a Company match. The profit sharing component is non-contributory and covers all employees after ninety days of service. The 401(k) plan provision is voluntary and also covers all employees after ninety days of service. Employees contributing under the 401(k) provision receive a matching contribution up to the first 4% of compensation based on years of service and subject to employee contribution limitations. The Company match includes a vesting schedule with employees becoming 100% vested after four years of service. The Plan permits employees to purchase shares of Sandy Spring Bancorp common stock with their profit sharing allocations, 401 (k) contributions, Company match, and other contributions under the Plan. The Company had expenses related to the qualified Cash and Deferred Profit Sharing Plan of $372,000 and $393,000 for the six month period ended June, 2003 and 2004, respectively and $178,000 and $182,000 for the three month period ended June 30, 2003 and 2004, respectively. The Company also has a performance based compensation benefit which is integrated with the Cash and Deferred Profit Sharing Plan and which provides incentives to employees based on the Company's financial results as measured against key performance indicator goals set by management. The Company had expenses (benefits) related to the performance based compensation benefit of $487,000 and $14,000 for the six months ended June 30, 2003 and 2004, respectively and $43,000 and $(91,000) for the three months ended June 30, 2003 and 2004, respectively. The Company has Supplemental Executive Retirement Agreements (SERAs) with its executive officers, providing for retirement income benefits as well as pre-retirement death benefits. Retirement benefits payable under SERAs, if any, are integrated with other pension plan and Social Security retirement benefits expected to be received by the executives. The Company is accruing the present value of these benefits over the remaining years to the executives' retirement dates. The Company had expenses related to the SERAs of $292,000 and $115,000 for the six months ended June 30, 2003 and 2004, respectively and $152,000 and $119,000 for the three months ended June 30, 2003 and 2004, respectively. The Company has an Executive Health Insurance Plan that provides for payment of defined medical and dental insurance cost and out of pocket expenses for selected executives and their families. Benefits, which are paid during both employment and retirement, are subject to a $6,500 limitation for each executive per year. The Company had expenses related to the Executive Health Insurance Plan of $96,000 and $128,000 for the six months ended June 30, 2003 and 2004, respectively and $64,000 for both the three months ended June 30, 2003 and 2004. 9 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS Sandy Spring Bancorp makes forward-looking statements in this Management's Discussion and Analysis of Financial Condition and Results of Operations that are subject to risks and uncertainties. These forward-looking statements include: statements of goals, intentions, earnings expectations and other expectations; estimates of risks and future costs and benefits; assessments of probable loan and lease losses; assessments of market risk; and statements of the ability to achieve financial and other goals. These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by: management's estimates and projections of future interest rates, market behavior, and other economic conditions; future laws and regulations; and a variety of other matters which, by their nature, are subject to significant uncertainties. Because of these uncertainties, Sandy Spring Bancorp's actual future results may differ materially from those indicated. In addition, the Company's past results of operations do not necessarily indicate its future results. THE COMPANY The Company is the registered bank holding company for Sandy Spring Bank (the "Bank"), headquartered in Olney, Maryland. The Bank operates thirty community offices in Anne Arundel, Frederick, Howard, Montgomery, and Prince George's Counties in Maryland, together with an insurance subsidiary and an equipment leasing company. The Company offers a broad range of financial services to consumers and businesses in this market area. Through June 30, 2004, year-to-date average commercial loans and leases and commercial real estate loans accounted for approximately 42% of the Company's loan and lease portfolio, and year-to-date average consumer and residential real estate loans accounted for approximately 58%. Based upon the most recent data available, consumer deposits account for approximately 75% of total average deposits, while approximately 60% of the Company's revenues are derived from consumer loans, consumer deposits and other retail services. The Company has established a strategy of independence, and intends to establish or acquire additional offices, banking organizations, and nonbanking organizations as appropriate opportunities may arise. CRITICAL ACCOUNTING POLICIES The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America and follow general practices within the industry in which it operates. 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; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. The estimates used in management's assessment of the adequacy of the allowance for credit losses require that management make assumptions about matters that are uncertain at the time of estimation. Differences in these assumptions and differences between the estimated and actual losses could have a material effect. NON-GAAP FINANCIAL MEASURE The Company has for many years used a traditional efficiency ratio that is a non-GAAP financial measure as defined in Commission Regulation G and Item 10 of U.S. Securities and Exchange Commission Regulation S-K. This traditional efficiency ratio is used as a measure of operating expense control and efficiency of operations. Management believes that its traditional ratio better focuses attention on the operating performance of the Company over time than does a GAAP-based ratio, and that it is highly useful in comparing period-to-period operating performance of the Company's core business operations. It is used by management as part of its assessment of its performance in managing noninterest expenses. However, this measure is supplemental, and is not a substitute for an analysis of performance based on GAAP measures. The reader is cautioned that the traditional efficiency ratio used by the Company may not be comparable to GAAP or non-GAAP efficiency ratios reported by other financial institutions. In general, the efficiency ratio measures noninterest expenses as a percentage of net interest income plus total noninterest income. This is a GAAP financial measure. Noninterest expenses used in the calculation of the traditional, non-GAAP efficiency ratio exclude intangible asset amortization. Income for the traditional ratio is increased for the favorable effect of tax-exempt income, and excludes securities gains and losses, which can vary widely from period to period without appreciably affecting operating expenses. The traditional measure is different from the GAAP-based efficiency ratio. The GAAP-based measure is calculated using noninterest expense and income amounts as shown on the face of the Consolidated Statements of Income. The traditional and GAAP-based efficiency ratios are presented and reconciled in Table 1. 10 Table 1 - GAAP based and traditional efficiency ratios
Three Months Ended Six Months Ended -------------------------------------------------------------------------------------------------------------------------- June 30, June 30, -------------------------------------------------------------------------------------------------------------------------- (Dollars in thousands) 2004 2003 2004 2003 -------------------------------------------------------------------------------------------------------------------------- Noninterest expenses-GAAP based $ 18,155 $ 16,623 $ 34,925 $ 32,580 Net interest income plus noninterest income- GAAP based 26,103 28,297 52,288 55,217 Efficiency ratio-GAAP based 69.55% 58.74% 66.79% 59.00% ============ =========== ============= =========== Noninterest expenses-GAAP based $ 18,155 $ 16,623 $ 34,925 $ 32,580 Less non-GAAP adjustment: Amortization of intangible assets 487 664 973 1,329 ------------- ------------ ------------- ----------- Noninterest expenses-traditional ratio 17,668 15,959 33,952 31,251 Net interest income plus noninterest income- GAAP based 26,103 28,297 52,288 55,217 Plus non-GAAP adjustment: Tax-equivalency 1,919 1,809 3,884 3,855 Less non-GAAP adjustments: Securities gains (losses) 109 543 337 551 Income from an early termination of a sublease 0 1,077 0 1,077 ------------- ------------ ------------- ----------- Net interest income plus noninterest Income - traditional ratio 27,913 28,486 55,835 57,444 Efficiency ratio - traditional 63.30% 56.02% 60.81% 54.40% ============= ============ ============= ===========
A. FINANCIAL CONDITION The Company's total assets were $2,424,199,000 at June 30, 2004, compared to $2,334,424,000 at December 31, 2003, increasing $89,775,000 or 4% during the first six months of 2004. Earning assets increased by 4%, to $2,261,032,000 at June 30, 2004, from $2,175,236,000 at December 31, 2003. Total loans and leases, excluding loans held for sale, increased 10% or $113,918,000 during the first six months of 2004, to $1,267,346,000. During this period, all three major loan categories showed increases. These increases occurred in residential real estate loans, which increased by $36,929,000 or 9%, attributable in large part to residential construction loan growth, consumer loans which increased by $41,911,000 or 17%, primarily reflecting higher home equity lines and commercial loans and leases which increased by $35,078,000 or 7%, due predominantly to growth in commercial loans secured by real estate. Residential mortgage loans held for sale increased by $779,000 from December 31, 2003, to $12,988,000 at June 30, 2004. Table 2 - Analysis of Loans and Leases The following table presents the trends in the composition of the loan and lease portfolio at the dates indicated:
(In thousands) June 30, 2004 % December 31, 2003 % ---------------------------------------------------------------------------------------------------------------------- Residential real estate $ 456,558 36% $ 419,629 36% Commercial loans and leases 526,017 42 490,939 43 Consumer 284,771 22 242,860 21 ------------ ----------- ------------- ----------- Total Loans and Leases 1,267,346 100% 1,153,428 100% =========== =========== Less: Allowance for credit losses (14,743) (14,880) ----------- ------------ Net loans and leases $ 1,252,603 $ 1,138,548 =========== ============
11 The total investment portfolio decreased by 9% or $85,997,000 from December 31, 2003, to $912,208,000 at June 30, 2004, as management decreased the amount of leverage on the balance sheet to mitigate interest rate risk in the event of rising rates. The decrease was driven primarily by a decline of $69,552,000 or 11% of available-for-sale securities. The aggregate of federal funds sold and interest-bearing deposits with banks increased by $57,096,000 during the first six months of 2004, reaching $68,490,000 at June 30, 2004. Table 3 - Analysis of Deposits The following table presents the trends in the composition of deposits at the dates indicated:
(In thousands) June 30, 2004 % December 31, 2003 % -------------------------------------------------------------------------------------------------------------------------- Noninterest-bearing deposits $ 417,400 25% $ 368,319 24% Interest-bearing deposits: Demand 230,574 14 224,272 14 Money market savings 362,644 21 376,722 24 Regular savings 230,773 14 187,510 12 Time deposits less than $100,000 269,164 16 269,938 17 Time deposits $100,000 or more 170,997 10 135,069 9 ------------ ------- ----------- ------ Total interest-bearing 1,264,152 75 1,193,511 76 ------------ ------- ----------- ------ Total deposits $ 1,681,552 100% $ 1,561,830 100% ============ ======= =========== ======
Total deposits were $1,681,552,000 at June 30, 2004, increasing $119,722,000 or 8% from $1,561,830,000 at December 31, 2003. First half-year growth rates of 13% were achieved in 2004 for noninterest-bearing demand deposits (up $49,081,000), 23% for interest-bearing regular savings (up $43,263,000), 27% for time deposits of $100,000 or more (up $35,928,000) and 3% for interest-bearing demand deposits (up $6,302,000). Over the same period, decreases of 4% were recorded for money market savings (down $14,078,000) and less than 1% for time deposits of less than $100,000. Total borrowings were $534,319,000 at June 30, 2004, which represented a decrease of $29,062,000 or 5% from December 31, 2003, primarily reflecting a decrease in short-term borrowings as management decreased the leverage in the balance sheet. MARKET RISK AND INTEREST RATE SENSITIVITY OVERVIEW The Company's net income is largely dependent on its net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities mature or reprice on a different basis than interest-earning assets. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net interest income. Net interest income is also affected by changes in the portion of interest-earning assets that are funded by interest-bearing liabilities rather than by other sources of funds, such as noninterest-bearing deposits and stockholders' equity. The Company's Board of Directors has established a comprehensive interest rate risk management policy, which is administered by Management's Asset Liability Management Committee ("ALCO"). The policy establishes limits of risk, which are quantitative measures of the percentage change in net interest income (a measure of net interest income at risk) and the fair value of equityd capital (a measure of economic value of equity ("EVE") at risk) resulting from a hypothetical change in U.S. Treasury interest rates for maturities from one day to thirty years. The Company measures the potential adverse impacts that changing interest rates may have on its short-term earnings, long-term value, and liquidity by employing simulation analysis through the use of computer modeling. The simulation model captures optionality factors such as call features and interest rate caps and floors imbedded in investment and loan portfolio contracts. As with any method of gauging interest rate risk, there are certain shortcomings inherent in the interest rate modeling methodology used by the Company. When interest rates change, actual movements in different categories of interest-earning assets and interest-bearing liabilities, loan prepayments, and withdrawals of time and other deposits, may deviate significantly from assumptions used in the model. Finally, the methodology does not measure or reflect the impact that higher rates may have on adjustable-rate loan customers' ability to service their debts, or the impact of rate changes on demand for loan, lease, and deposit products. 12 The Company prepares a current base case and eight alternative simulations, at least once a quarter, and reports the analysis to the Board of Directors. In addition, more frequent forecasts are produced when interest rates are particularly uncertain or when other business conditions so dictate. If a measure of risk produced by the alternative simulations of the entire balance sheet or of the Company's leverage program violates policy guidelines, ALCO is required to develop a plan to restore the measure of risk to a level that complies with policy limits within two quarters. The Company's interest rate risk management goals are (1) to increase net interest income at a growth rate consistent with the growth rate of total assets and, (2) to minimize fluctuations in net interest margin as a percentage of earning assets. Management attempts to achieve these goals by balancing, within policy limits, the volume of floating-rate liabilities with a similar volume of floating-rate assets; by keeping the average maturity of fixed-rate asset and liability contracts reasonably matched; by maintaining a pool of administered core deposits; and by adjusting pricing rates to market conditions on a continuing basis. The balance sheet is subject to quarterly testing for eight alternative interest rate shock possibilities to indicate the inherent interest rate risk. Average interest rates are shocked by +/- 100, 200, 300, and 400 basis points ("bp"), although the Company may elect not to use particular scenarios that it determines are impractical in a current rate environment. It is management's goal to structure the balance sheet so that net interest earnings at risk over a twelve-month period and the economic value of equity at risk do not exceed policy guidelines at the various interest rate shock levels. The Company augments its quarterly interest rate shock analysis with alternative external interest rate scenarios on a monthly basis. These alternative interest rate scenarios may include non-parallel rate ramp and non-parallel yield curve twists. ANALYSIS OF POSSIBLE OUTCOMES Measures of net interest income at risk produced by simulation analysis are indicators of an institution's short-term performance in alternative rate environments. These measures are typically based upon a relatively brief period, usually one year. They do not necessarily indicate the long-term prospects or economic value of the institution. ESTIMATED CHANGES IN NET INTEREST INCOME
--------------------------------------------------------------------------------------------------- CHANGE IN NET INTEREST INCOME: + 400 BP + 300 BP + 200 BP + 100 BP - 100 BP --------------------------------------------------------------------------------------------------- POLICY LIMIT 30% 25% 20% 15% 15% June 2004 -1.77 -0.70 +1.65 +4.53 -6.70 December 2003 -6.61 -3.80 -2.30 -0.62 -9.17
As shown above, measures of net interest income at risk improved from December 31, 2003 at all interest rate shock levels. Specifically, at the +200bp shock level, the measure moved from -2.30% to +1.65%, well within the policy limit of 20%. Although assumed to be unlikely, our largest exposure is at the -100bp level, with a measure of -6.70% compared to -9.17% at December 31, 2003. This is also well within our prescribed policy limit of 15%. The reduction in the net interest income sensitivity is consistent with management's decision to reduce the duration and size of the investment portfolio during the first six months of 2004 in anticipation of rising interest rates in the future. The measures of equity value at risk indicate the ongoing economic value of the Company by considering the effects of changes in interest rates on all of the Company's cash flows, and discounting the cash flows to estimate the present value of assets and liabilities.. The difference between these discounted values of the assets and liabilities is the economic value of equity, which, in theory, approximates the fair value of the Company's net assets. ESTIMATED CHANGES IN ECONOMIC VALUE OF EQUITY (EVE)
--------------------------------------------------------------------------------------------------------------- DECREASE IN ECONOMIC VALUE OF EQUITY: + 400 BP + 300 BP + 200 BP + 100 BP - 100 BP --------------------------------------------------------------------------------------------------------------- POLICY LIMIT 60% 40% 22.5% 10.0% 12.5% June 2004 -42.65 -32.12 -17.61 -4.15 -2.98 December 2003 -47.83 -34.66 -20.41 -3.98 -10.17
Measures of the economic value of equity (EVE) at risk also improved over year-end 2003 at all interest rate shock levels with the exception of the +100bp. A reduced duration in the investment portfolio is the key contributor to the improved risk position. The economic value of equity exposure at +200bp is now -17.61% compared to -20.41% at year-end 2003, and is well within the policy limit of 22.5%, as are measures at all other shock levels. 13 LIQUIDITY Liquidity is measured using an approach designed to take into account loan and lease payments, maturities, calls and pay-downs of securities, earnings, growth, mortgage banking activities, leverage programs, investment portfolio liquidity, and other factors. Through this approach, implemented by the funds management subcommittee under formal policy guidelines, the Company's liquidity position is measured weekly, looking forward thirty, sixty and ninety days. The measurement is based upon the asset-liability management model's projection of a funds sold or purchased position, along with ratios and trends developed to measure dependence on purchased funds, leverage limitations and core growth. Resulting projections as of June 30, 2004 showed short-term investments exceeding short-term borrowings over the subsequent 90 days by $105,607,000, which increased from $69,038,000 at December 31, 2003. This excess of liquidity over projected requirements for funds indicates that the Company can increase its loans and other earning assets without incurring additional borrowing. The Company also has external sources of funds, which can be drawn upon when required. The main source of external liquidity is a line of credit for $708,215,000 from the Federal Home Loan Bank of Atlanta, of which approximately $360,433,000 was outstanding at June 30, 2004. Other external sources of liquidity available to the Company in the form of lines of credit granted by the Federal Reserve, correspondent banks and other institutions totaled $260,987,000 at June 30, 2004, against which there were outstandings of approximately $25,000,000. Based upon its liquidity analysis, including external sources of liquidity available, management believes the liquidity position is appropriate at June 30, 2004. The following is a schedule of significant commitments at June 30, 2004: (In thousands) Commitments to extend credit: Unused lines of credit (home equity and business) $365,647 Other commitments to extend credit $167,133 Standby letters of credit $ 39,571 -------- $572,351 ======== CAPITAL MANAGEMENT The Company recorded a total risk-based capital ratio of 14.89% at June 30, 2004, compared to 15.51% at December 31, 2003; a tier 1 risk-based capital ratio of 13.93%, compared to 14.34%; and a capital leverage ratio of 8.97%, compared to 8.67%. Capital adequacy, as measured by these ratios, was well above regulatory requirements. Management believes the level of capital at June 30, 2004, is appropriate. Stockholders' equity for June 30, 2004, totaled $196,090,000, representing an increase of $2,641,000 or 1% from $193,449,000 at December 31, 2003. Accumulated other comprehensive income, a component of stockholders' equity comprised of unrealized gains and losses on available-for-sale securities, net of taxes, decreased by 91% or $6,101,000 from December 31, 2003 to $602,000 at June 30, 2004. Internal capital generation (net income less dividends) added $8,179,000 to total stockholders' equity during the first six months of 2004. When internally formed capital is annualized and expressed as a percentage of average total stockholders' equity, the resulting rate was 8% compared to 12% reported for the full-year 2003. External capital formation (equity created through the issuance of stock under the employee stock purchase plan, stock option plan and the director stock purchase plan) totaled $583,000 during the six month period ended June 30, 2004. However, share repurchases amounted to $20,000 from December 31, 2003 through June 30, 2004, for a net increase in stockholders' equity from these sources of $563,000. Dividends for the first six months of the year were $0.38 per share in 2004, compared to $0.36 per share in 2003, for respective dividend payout ratios (dividends declared per share to diluted net income per share) of 41% versus 31%. 14 B. RESULTS OF OPERATIONS - SIX MONTHS ENDED JUNE 30, 2004, AND 2003 Net income for the first six months of the year decreased $3,370,000 or 20% to $13,694,000 in 2004 from $17,064,000 in 2003, representing annualized returns on average equity of 14.03% and 18.91%, respectively. First half-year diluted earnings per share (EPS) were $0.93 in 2004, compared to $1.16 in 2003. The net interest margin decreased by 14 basis points to 3.70% for the six months ended June 30, 2004, from 3.84% for the same period of 2003, as the net interest spread decreased by 13 basis points. These results reflect lower average interest rates in the first half-year of 2004 as more assets repriced down than liabilities during the six months ended June 30, 2004. TABLE 4 - CONSOLIDATED AVERAGE BALANCES, YIELDS AND RATES (Dollars in thousands and tax equivalent)
For the six months ended June 30, 2004 2003 ------------------------------------------------------------------------------ Average Annualized Average Average Annualized Average Balance Interest Yield/Rate Balance Interest Yield/Rate (1) (1) ------------------------------------------------------------------------------ Assets Total loans and leases (2) $ 1,218,625 $67,707 5.56% $1,080,749 $ 67,264 6.22% Total securities 944,038 46,157 4.89 1,049,040 55,287 5.27 Other earning assets 31,486 304 0.97 38,387 443 1.15 ------------- ---------- ---------- --------- TOTAL EARNING ASSETS 2,194,149 114,168 5.20% 2,168,176 122,994 5.67% Nonearning assets 162,627 150,095 ------------- ---------- Total assets $ 2,356,776 $ 2,318,271 ============= =========== Liabilities and Stockholders' Equity Interest-bearing demand deposits $ 227,254 $655 0.29% $ 192,468 $484 0.25% Money market savings deposits 371,988 2,018 0.54 402,550 3,017 0.75 Regular savings deposits 202,253 719 0.36 163,187 530 0.32 Time deposits 420,101 8,119 1.93 443,508 11,417 2.57 ------------- ----------- ----------- --------- Total interest-bearing deposits 1,221,596 11,511 0.94 1,201,713 15,448 1.29 Short-term borrowings 391,907 14,744 3.76 477,097 18,275 3.83 Long-term borrowings 150,000 6,727 4.48 121,607 6,058 4.98 ------------- ----------- ----------- --------- Total interest-bearing liabilities 1,763,503 32,982 1.87 1,800,417 39,781 2.21 ------ ------ Noninterest-bearing demand deposits 376,361 311,097 Other noninterest-bearing liabilities 20,673 24,830 Stockholders' equity 196,239 181,927 ------------- ----------- Total liabilities and stockholders' equity $ 2,356,776 $2,318,271 ============= =========== Net interest spread 3.33% 3.46% ============ ============= Net interest margin (3) 3.70% 3.84% ============ ============= Ratio of average earning assets to Average interest-bearing liabilities 124.42% 120.43% ============= ============
(1) Interest income includes the effects of taxable-equivalent adjustments (reduced by the nondeductible portion of interest expense) using the appropriate federal income tax rate of 35% and, where applicable, the marginal state income tax rate of 7.00% (or a combined marginal federal and state rate of 39.55%), to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable-equivalent adjustment amounts utilized in the above table (on an annual basis) to compute yields were $7,810,000 and $7,774,000 for the six months ended June 30, 2004 and 2003, respectively. (2) Non-accrual loans are included in the average balances. (3) Net interest margin = annualized net interest income on a tax-equivalent basis divided By total interest-earning assets. 15 NET INTEREST INCOME Net interest income for the first six months of the year was $36,488,000 in 2004, a decrease of 2% from $37,410,000 in 2003, due to lower interest rates on loans and investment securities and lower investment securities balances, offset in part by the effects of loan growth, reduced interest rates on deposits and borrowings, and lower borrowing balances. Non-GAAP tax-equivalent net interest income, which takes into account the benefit of tax advantaged investment securities, also decreased by 2%, to $40,372,000 in 2004 from $41,265,000 in 2003. The effects of average balances, yields and rates are presented in table 4. For the first six months, total interest income decreased by $4,183,000 or 7% in 2004, compared to 2003. On a non-GAAP tax-equivalent basis, interest income also decreased by 7%. Average earning assets rose by 1% over the prior period, to $2,194,149,000 from $2,168,176,000, while the average yield earned on those assets decreased by 47 basis points to 5.20%. Comparing the first six months of 2004 versus 2003, average total loans and leases grew by 13% to $1,218,625,000 (56% of average earning assets, versus 50% a year ago), while recording a 66 basis point decline in average yield to 5.56%. Average residential real estate loans increased by 21% (reflecting increases in both mortgage and construction lending); average consumer loans increased by 13% (attributable primarily to home equity line growth); and, average commercial loans and leases grew by 6% (due to increases in commercial mortgages and other commercial loans and leases, partially offset by a decline in construction loans). Over the same period, average total securities decreased by 10% to $944,038,000 (43% of average earning assets, versus 48% a year ago), while the average yield earned on those assets also decreased, by 38 basis points to 4.89%. Interest expense for the first six months of the year decreased by $3,261,000 or 16% in 2004, compared to 2003. Average total interest-bearing liabilities decreased by 2% over the prior year period, while the average rate paid on these funds also decreased, by 34 basis points to 1.87%. As shown in Table 4, money market savings deposits, time deposits and short and long-term borrowings recorded declines in average rate. These declines were partially offset by slight increases in the rates paid on interest-bearing demand deposits and regular savings deposits. CREDIT RISK MANAGEMENT The Company's loan and lease portfolio (the "credit portfolio") is subject to varying degrees of credit risk. Credit risk is mitigated through portfolio diversification, limiting exposure to any single customer, industry or collateral type. The Company maintains an allowance for credit losses (the "allowance") to absorb losses inherent in the loan and lease portfolio. The allowance is based on careful, continuous review and evaluation of the loan and lease portfolio, along with ongoing, quarterly assessments of the probable losses inherent in that portfolio, and, to a lesser extent, in unused commitments to provide financing. The allowance represents an estimation made pursuant to Statement of Financial Accounting Standards ("SFAS") No. 5, "Accounting for Contingencies," or SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." The adequacy of the allowance is determined through careful and continuous evaluation of the credit portfolio, and involves consideration of a number of factors, as outlined below, to establish a prudent level. Determination of the allowance is inherently subjective and requires significant estimates, including estimated losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends, which may be susceptible to significant change. Loans and leases deemed uncollectible are charged against the allowance, while recoveries are credited to the allowance. Management adjusts the level of the allowance through the provision for credit losses, which is recorded as a current period operating expense. The Company's systematic methodology for assessing the appropriateness of the allowance includes: (1) the formula allowance reflecting historical losses, as adjusted, by credit category and (2) the specific allowance for risk-rated credits on an individual or portfolio basis. The formula allowance that is based upon historical loss factors, as adjusted, establishes allowances for the major loan and lease categories based upon adjusted historical loss experience over the prior eight quarters, weighted so that losses in the most recent quarters have the greatest effect. The factors used to adjust the historical loss experience address various risk characteristics of the Company's loan and lease portfolio including (1) trends in delinquencies and other non-performing loans, (2) changes in the risk profile related to large loans in the portfolio, (3) changes in the categories of loans comprising the loan portfolio, (4) concentrations of loans to specific industry segments, (5) changes in economic conditions on both a local and national level, (6) changes in the Company's credit administration and loan and lease portfolio management processes and (7) quality of the Company's credit risk identification processes. The specific allowance is used to allocate an allowance for internally risk rated commercial loans where significant conditions or circumstances indicate that a loss may be imminent. Analysis resulting in specific allowances, including those on loans identified for evaluation of impairment, includes consideration of the borrower's overall financial condition, resources and payment record, support available from financial guarantors and the sufficiency of collateral. These factors are combined to estimate the probability and severity of inherent losses. Then a specific allowance is established based on the Company's calculation of the potential loss embedded in the individual loan. Allowances are also established by application of credit risk factors to other internally risk rated loans, individual consumer and residential loans and commercial leases having reached nonaccrual or 90-day past due status, and unfunded commitments. Each risk rating category is assigned a credit risk factor based on management's estimate of the associated risk, complexity, and size of the individual loans within the category. Additional allowances may also be established in special circumstances involving a particular group of credits or portfolio within a risk category when management becomes aware that losses incurred may exceed those determined by application of the risk factor alone. 16 The amount of the allowance is reviewed monthly by the senior loan committee, and reviewed and approved by the Board of Directors quarterly. There were no provisions for credit losses in the first six months of 2004 or 2003. The Company experienced net charge-offs during the first six months of 2004 and 2003 of $137,000 and $3,000, respectively. Management believes that the allowance is adequate. However, its determination requires significant judgment, and estimates of probable losses inherent in the credit portfolio can vary significantly from the amounts actually observed. While management uses available information to recognize probable losses, future additions to the allowance may be necessary based on changes in the credits comprising the portfolio and changes in the financial condition of borrowers, such as may result from changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, and independent consultants engaged by the Sandy Spring Bank, periodically review the credit portfolio and the allowance. Such review may result in additional provisions based on these third-party judgments of information available at the time of each examination. During the first six months of 2004, there were no changes in estimation methods or assumptions that affected the allowance methodology. The allowance for credit losses was 1.16% of total loans and leases at June 30, 2004 and 1.29% at December 31, 2003. The allowance decreased during the first six months of 2004 by $137,000 (the amount of net charge-offs for the period), from $14,880,000 at December 31, 2003, to $14,743,000 at June 30, 2004. The stability of the allowance reflects the required reserve computed by the allowance methodology at June 30, 2004, compared to December 31, 2003. In spite of loan growth, the required reserve declined due to a decrease in internally risk-rated commercial loans and management's analysis of improving economic trends. Nonperforming loans and leases increased by $135,000 to $2,990,000 from December 31, 2003 to June 30, 2004, while nonperforming assets increased by $58,000 to $2,990,000. Expressed as a percentage of total assets, nonperforming assets decreased to 0.12% at June 30, 2004 from 0.13% at December 31, 2003. The allowance for credit losses represented 493% of nonperforming loans and leases at June 30, 2004, compared to coverage of 521% at December 31, 2003. Significant variation in this coverage ratio may occur from period to period because the amount of nonperforming loans and leases depends largely on the condition of a small number of individual credits and borrowers relative to the total loan and lease portfolio. Other real estate owned was $0 at June 30, 2004, and $77,000 at December 31, 2003. The balance of impaired loans and leases was $856,000 at June 30, 2004, with specific reserves against those loans of $278,000, compared to $336,000 at December 31, 2003, with specific reserves of $120,000. 17 Table 5 -- Analysis of Credit Risk (Dollars in thousands) Activity in the allowance for credit losses is shown below:
Six Months Ended Twelve Months Ended June 30, 2004 December 31, 2003 -------------------------------------------------------------------------------------------------------- Balance, January 1 $14,880 $15,036 Provision for credit losses 0 0 Loan charge-offs: Residential real estate (21) (148) Commercial loans and leases (74) (122) Consumer (117) (87) ------------ -------------- Total charge-offs (212) (357) Loan recoveries: Residential real estate 25 126 Commercial loans and leases 45 63 Consumer 5 12 -------------- -------------- Total recoveries 75 201 -------------- -------------- Net charge-offs (137) (156) -------------- -------------- Balance, period end $14,743 $14,880 ============== ============== Net charge-offs to average loans and leases (annual basis) (0.02)% (0.01)% Allowance to total loans and leases 1.16% 1.29% The following table presents nonperforming assets at the dates indicated: June 30, December 31, 2004 2003 --------------------------------------------------------------------------------------------------- Non-accrual loans and leases $674 $522 Loans and leases 90 days past due 2,316 2,333 -------------- -------------- Total nonperforming loans and leases* 2,990 2,855 Other real estate owned 0 77 -------------- -------------- Total nonperforming assets $2,990 $2,932 ============== ============== Nonperforming assets to total assets 0.12% 0.13% ----------------------------------------------------------------------------------------------------
* Those performing credits considered potential problem credits (which the Company classifies as substandard), as defined and identified by management, amounted to approximately $6,732,000 at June 30, 2004, compared to $16,793,000 at December 31, 2003. Although these are credits where known information about the borrowers' possible credit problems causes management to have doubts as to their ability to comply with the present repayment terms, which could result in their reclassification as nonperforming credits in the future, most are well collateralized and are not believed to present significant risk of loss. 18 NONINTEREST INCOME AND EXPENSES Total noninterest income was $15,800,000 for the six-month period ended June 30, 2004, an 11% or $2,007,000 decrease from the same period of 2003. This decline was mainly the result of decreases in gains on sales of mortgage loans (down $1,381,000 or 43%), reflecting lower levels of mortgage banking activity, securities gains (down $214,000 or 39%) and nonrecurring income of $1,077,000 recorded in 2003 from the early termination of a sublease. Partially offsetting these decreases were increases in trust department income (up $260,000 or 18%), insurance agency commissions (up $210,000 or 11%) and fees on sales of investment products (up $108,000 or 9%), reflecting management's desire to both increase and diversify its sources of noninterest income. Also, other income increased $433,000 or 20%, due primarily to increases in gains on sales of other real estate owned and gains on sales of SBA loans. Total noninterest expenses were $34,925,000 for the six-month period ended June 30, 2004, a 7% or $2,345,000 increase from the first half-year of 2003. The Company incurs additional costs in order to enter new markets, provide new services, and support the growth of the Company. Management controls its operating expenses, however, with the goal of maximizing profitability over time. Most of the rise in noninterest expenses during the first half-year of 2004 occurred in salaries and employee benefits (up $1,254,000 or 7%), attributable to a larger staff and merit increases, occupancy expenses (up $326,000 or 10%) which increased due to an expanded branch network and the opening of a new operations center, equipment expenses (up $374,000 or 17%) and other expenses (up $533,000 or 11%) which increased mainly as the result of an increase in professional fees. The Company opened a new branch in June 2003 and another in August 2003. Average full-time equivalent employees increased to 602 during the first six months of 2004, from 558 during the like period in 2003, an 8% increase. The ratio of net income per average full-time-equivalent employee after completion of the first six months of the year was $23,000 in 2004 and $31,000 in 2003 (which includes after-tax income from an early termination of a sublease). INCOME TAXES The effective tax rate decreased to 21.1% for the six-month period ended June 30, 2004, from 24.6% for the prior year period. This decline was primarily due to an increase in tax-advantaged investment interest income as a percentage of total income before taxes. C. RESULTS OF OPERATIONS - SECOND QUARTER 2004 AND 2003 Second quarter net income of $6,393,000 ($0.43 per share-diluted) in 2004 was $2,343,000 or 27% below net income of $8,736,000 ($0.60 per share-diluted) shown for the same quarter of 2003. Annualized returns on average equity for these periods were 13.07% in 2004 versus 19.04% in 2003. Second quarter net interest income was $17,862,000 in 2004, a decrease of 2% from $18,247,000 in 2003, reflecting a 16 basis point decline in net interest margin partially offset by a 2% higher volume of average earning assets. Non-GAAP tax-equivalent net interest income, which takes into account the benefit of tax advantaged investment securities, decreased by 2%. There were no second quarter provisions for credit losses in 2004 or 2003. Net charge-offs of $132,000 were recorded for the three-month period ended June 30, 2004, compared to net recoveries of $10,000 for the three-month period ended June 30, 2003. Second quarter noninterest income was $8,241,000 in 2004, representing an 18% or $1,809,000 decrease from the same period of 2003. This decrease was mainly the result of decreases in gains on sales of mortgage loans (down $575,000 or 36%), securities gains (down $434,000 or 80%) and service charges on deposit accounts (down $156,000 or 8%). In addition, noninterest income for the first six months of 2003 included nonrecurring income of $1,077,000 from the early termination of a sublease. Partially offsetting this decrease, were increases in trust department income (up $226,000 or 30%), insurance agency commissions (up $108,000 or 12%) and other income (up $193,000 or 16%). Second quarter noninterest expenses increased 9% or $1,532,000 to $18,155,000 in 2004 from $16,623,000 in 2003. This increase was mainly the result of increases in salaries and employee benefits (up $771,000 or 8%), occupancy expense (up $282,000 or 18%), equipment expenses (up $225,000 or 20%) and other expenses (up $352,000 or 13%). The second quarter effective tax rate decreased to 19.6%, from the 25.2% recorded in the second quarter of 2003. This decrease was primarily due to an increase in tax-advantaged investment interest income as a percentage of total income before taxes. 19 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK See "Financial Condition - Market Risk and Interest Rate Sensitivity" in Management's Discussion and Analysis of Financial Condition and Results of Operations, above, which is incorporated herein by reference. Management has determined that no additional disclosures are necessary to assess changes in information about market risk that have occurred since December 31, 2003. ITEM 4. CONTROLS AND PROCEDURES The Company's management, under the supervision and with the participation of the Company's Chief Executive Officer and Chief Financial Officer, evaluated as of the last day of the period covered by this report, the effectiveness of the design and operation of the Company's disclosure controls and procedures, as defined in Rule 13a-15 under the Securities Exchange Act of 1934. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures were adequate. There were no significant changes in the Company's internal controls over financial reporting (as defined in Rule 13a-15 under the Securities Act of 1934) during the quarter ended June 30, 2004, that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 20 PART II - OTHER INFORMATION Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS, AND ISSUER PURCHASES OF EQUITY SECURITIES The following table provides information on the Company's purchases of its common stock during the six months ended June 30, 2004.
Issuer Purchases of Equity Securities (1) ----------------------------------------------------------------------------------------------------------------------------- (c) Total Number of (d) Maximum Number Shares Purchased as that May Yet Be Part of Publicly Purchased Under the (a) Total Number of (b) Average Price Paid Announced Plans or Plans or Programs Period Shares Purchased per Share Programs (2)(3) ----------------------------------------------------------------------------------------------------------------------------- January 2004 0 NA 0 670,904 February 2004 0 NA 0 670,904 March 2004 550 $36.05 550 670,354 April 2004 0 NA 0 670,354 May 2004 0 NA 0 670,354 June 2004 0 NA 0 670,354 -----------------------------------------------------------------------------------------------------------------------------
(1) Includes purchases of the Company's stock made by or on behalf of the Company or any affiliated purchasers of the Company as defined in Securities and Exchange Commission Rule 10b-18. (2) On March 26, 2003, the Company publicly announced a stock repurchase program that permits the repurchase of up to 5%, or 726,804 shares, of its outstanding common stock. The current program replaced a similar plan that expired on March 31, 2003. Repurchases under the program may be made on the open market and in privately negotiated transactions from time to time until March 31, 2005, or earlier termination of the program by the Board. The repurchases are made in connection with shares expected to be issued under the Company's stock option and benefit plans, as well as for other corporate purposes. In 2003, a total of 55,900 shares were repurchased under the current program and 49,560 shares were purchased under the previous program. (3) Indicates the number of shares remaining under the plan at the end of the indicated month. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Company's annual shareholders' meeting held on April 21, 2004, the shareholders of the Company elected five directors by the following vote: Nominee For Against Withheld -------------------------------------------------------------------------------- Solomon Graham 11,031,193 136,709 0 Gilbert L. Hardesty 11,029,619 138,283 0 Charles F. Mess 10,808,218 359,684 0 Lewis R. Schumann 10,944,219 223,680 0 W. Drew Stabler 11,078,435 89,464 0 There were no solicitations in opposition to management's nominees and all such nominees were elected. All five director-nominees were incumbent directors previously elected by the shareholders to three-year terms. Directors continuing in office are Susan D. Goff, Robert L. Mitchell, Robert L. Orndorff, Jr., David E. Rippeon, John Chirtea, Hunter R. Hollar, and Craig A. Ruppert. 21 Also at the annual meeting, the shareholders ratified the appointment of McGladrey & Pullen, LLP, as the independent auditors for 2004 by the following vote: Broker For Against Witheld Non Votes --------------------------------------------------------------- 10,898,728 73,671 195,500 3,000 Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. Exhibit 31(a) and (b) Rule 13a-14(a) / 15d-14(a) Certifications Exhibit 32 (a) and (b) 18 U.S.C. Section 1350 Certifications (b) Reports on Form 8-K. On April 15, 2004, the Company furnished, under Item 9 and Item 12, its news release including results of operations and financial condition and related information concerning non-GAAP financial measures for March 31, 2004, and the quarter then ended. On July 15, 2004, the Company furnished, under Item 9 and Item 12, its news release including results of operations and financial condition and related information concerning non-GAAP financial measures for June 30, 2004, and the quarter then ended. 22 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this quarterly report to be signed on its behalf by the undersigned, thereunto duly authorized. SANDY SPRING BANCORP, INC. (Registrant) By: /S/ HUNTER R. HOLLAR -------------------------------------- Hunter R. Hollar President and Chief Executive Officer Date: August 4, 2004 By: /S/ JAMES H. LANGMEAD --------------------------------------- James H. Langmead Executive Vice President and Chief Financial Officer Date: August 4, 2004 23