10-Q 1 mfc10q6302003.txt U.S. SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] Quarterly Report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended June 30, 2003 [ ] Transition Report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ____________ to _____________ Commission file number: 0-24159 MIDDLEBURG FINANCIAL CORPORATION (Exact Name of Registrant as Specified in its Charter) Virginia 54-1696103 (State or Other Jurisdiction of (I.R.S. Employer Incorporation or Organization) Identification No.) 111 West Washington Street Middleburg, Virginia 20117 (Address of Principal Executive Offices) (Zip Code) (703) 777-6327 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No -------- -------- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes No X -------- -------- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: 1,897,266 shares of common stock, par value $5.00 per share, outstanding as of August 8, 2003 MIDDLEBURG FINANCIAL CORPORATION INDEX
Part I. Financial Information Page No. Item 1. Financial Statements Consolidated Balance Sheets 3 Consolidated Statements of Income 4 Consolidated Statements of Changes in Shareholders' Equity 5 Consolidated Statements of Cash Flows 6 Notes to Consolidated Financial Statements 8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 Item 3. Quantitative and Qualitative Disclosures About Market Risk 18 Item 4. Controls and Procedures 20 Part II. Other Information Item 1. Legal Proceedings 21 Item 2. Change in Securities and Use of Proceeds 21 Item 3. Defaults upon Senior Securities 21 Item 4. Submission of Matters to a Vote of Security Holders 21 Item 5. Other Information 21 Item 6. Exhibits and Reports on Form 8-K 22 Signatures 23
2 PART I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS MIDDLEBURG FINANCIAL CORPORATION Consolidated Balance Sheets (In Thousands, Except Share Data)
(Unaudited) June 30, December 31, 2003 2002 ------------------- ------------------ Assets: Cash and due from banks $ 15,929 $ 8,338 Interest-bearing balances in banks 324 274 Temporary investments: Federal funds sold 6,050 -- Other money market investments 1,281 911 Securities (fair value: June 30, 2003, $170,578, December 31, 2002, $163,957 ) 170,297 163,673 Loans held for sale 20,963 17,489 Loans, net of allowance for loan losses of $2,369 in 2003 and $2,307 in 2002 233,904 209,800 Bank premises and equipment, net 11,649 11,814 Other assets 21,236 12,675 ------------------- ------------------ Total assets $481,633 $424,974 =================== ================== Liabilities and Shareholders' Equity Liabilities: Deposits: Non-interest bearing demand deposits $104,624 $ 90,413 Savings and interest-bearing demand deposits 152,004 138,661 Time deposits 108,539 99,829 ------------------- ------------------ Total deposits $365,167 $328,903 Securities sold under agreements to repurchase 10,827 8,924 Federal Home Loan Bank Advances 13,500 -- Long-term debt 31,420 31,545 Trust preferred capital notes 10,000 10,000 Other liabilities 3,944 4,192 ------------------- ------------------ Total liabilities $434,858 $383,564 ------------------- ------------------ Shareholders' Equity Common stock par value $5.00 per share, authorized 10,000,000 shares; issued and outstanding at June 30, 2003 - 1,897,266 issued and outstanding at December 31, 2002 - 1,852,682 $ 9,486 $ 9,263 Capital surplus 5,427 3,644 Retained earnings 28,334 25,184 Accumulated other comprehensive income 3,528 3,319 ------------------- ------------------ Total shareholders' equity $ 46,775 $ 41,410 ------------------- ------------------ Total liabilities and shareholders' equity $481,633 $424,974 =================== ==================
See Accompanying Notes to Consolidated Financial Statements. 3 MIDDLEBURG FINANCIAL CORPORATION Consolidated Statements of Income (In Thousands, Except Per Share Data)
Unaudited Unaudited ------------------------------------------ For the Six Months For the Quarter Ended June 30, Ended June 30, 2003 2002 2003 2002 -------- -------- -------- -------- Interest Income Interest and fees on loans $ 8,092 $ 8,022 $ 4,068 $ 4,043 Interest on investment securities Taxable 1 2 1 1 Exempt from federal income taxes 103 125 50 59 Interest on securities available for sale Taxable 3,041 2,608 1,531 1,374 Exempt from federal income taxes 776 792 387 393 Dividends 142 140 77 69 Interest on federal funds sold and other 28 47 18 24 -------- -------- -------- -------- Total interest income $ 12,183 $ 11,736 $ 6,132 $ 5,963 Interest expense Interest on deposits $ 1,713 $ 2,169 $ 831 $ 1,069 Interest on long-term debt 854 980 546 544 Interest on short-term borrowings 310 141 47 60 -------- -------- -------- -------- Total interest expense $ 2,877 $ 3,290 $ 1,424 $ 1,673 -------- -------- -------- -------- Net interest income $ 9,306 $ 8,446 $ 4,708 $ 4,290 Provision for loan losses 300 150 225 75 -------- -------- -------- -------- Net interest income after provision for loan losses $ 9,006 $ 8,296 $ 4,483 $ 4,215 -------- -------- -------- -------- Other Income Trust and investment advisory fee income $ 1,688 $ 1,138 $ 842 $ 819 Service charges on deposit accounts 1,181 822 588 471 Net gains (losses) on securities available for sale 441 (47) 146 33 Fees on loans held for resale 900 746 266 403 Commissions on investment sales 645 252 342 112 Equity in earnings of affiliate 764 -- 764 -- Other operating income 37 41 37 10 -------- -------- -------- -------- Total other income $ 5,656 $ 2,952 $ 2,985 $ 1,848 -------- -------- -------- -------- Other Expense Salaries and employee benefits 5,126 4,131 2,486 2,188 Net occupancy expense of premises 1,125 750 546 404 Computer expense 300 230 161 125 Advertising 140 238 78 140 Other operating expenses 1,812 1,491 913 855 -------- -------- -------- -------- Total other expense $ 8,503 $ 6,840 $ 4,184 $ 3,712 -------- -------- -------- -------- Income before income taxes $ 6,159 $ 4,408 $ 3,284 $ 2,351 Income taxes 1,847 1,208 982 665 -------- -------- -------- -------- Net income $ 4,312 $ 3,200 $ 2,302 $ 1,686 ======== ======== ======== ======== Net income per share, basic $ 2.30 $ 1.79 $ 1.22 $ 0.92 Net income per share, diluted $ 2.26 $ 1.74 $ 1.19 $ 0.90 Dividends per share $ 0.62 $ 0.60 $ 0.31 $ 0.30
See Accompanying Notes to Consolidated Financial Statements. MIDDLEBURG FINANCIAL CORPORATION Consolidated Statements of Changes in Shareholders' Equity For the Six Months Ended June 30, 2003 and 2002 (In Thousands) (Unaudited)
Accumulated Other Common Capital Retained Comprehensive Comprehensive Stock Surplus Earnings Income (Loss) Income Total ------------ ---------- ---------------- ----------------- ------------------ ---------- Balances - December 31, 2001 $ 8,761 $ 741 $ 21,084 $ (248) $ 30,338 Comprehensive Income Net income 3,200 $ 3,200 3,200 Issuance of common stock (94,349 shares) 472 2,618 3,090 Other comprehensive income net of tax: Unrealized gains on available for sale securities period (net of tax $620) 1,203 Reclassification adjustment for losses realized in net income (net of tax $16) 31 --------- Other comprehensive income (net of tax $636) 1,234 1,234 1,234 --------- Total comprehensive income $ 4,434 ========= Cash dividends declared (1,088) (1,088) -------- ------- --------- -------- --------- Balances -June 30, 2002 $ 9,233 $ 3,359 $ 23,196 $ 986 $ 36,774 ======== ======= ========= ======== ========= Balances - December 31, 2002 $ 9,263 $ 3,644 $ 25,184 $ 3,319 $ 41,410 Comprehensive Income Net income 4,312 4,312 4,312 Issuance of common stock (44,584 shares) 223 1,783 2,006 Other comprehensive income net of tax: Unrealized holding gains arising during the period (net of tax $258) 500 Reclassification adjustment for gains realized in net income (net of tax $150) (291) --------- Other comprehensive income (net of tax $108) 209 209 209 --------- Total comprehensive income $ 4,521 ========= Cash dividends declared (1,162) (1,162) -------- ------- --------- -------- --------- Balances - June 30, 2003 $ 9,486 $ 5,427 $ 28,334 $ 3,528 $ 46,775 ======== ======= ========= ======== =========
See Accompanying Notes to Consolidated Financial Statements. 5 MIDDLEBURG FINANCIAL CORPORATION Consolidated Statements of Cash Flows (In Thousands) (Unaudited)
For the Six Months Ended ------------------------ June 30, June 30, 2003 2002 -------- -------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 4,312 $ 3,200 Adjustments to reconcile net income to net cash provided by operating activities Provision for loan losses 300 150 Depreciation and amortization 786 512 Equity in earnings of affiliate (764) -- Net (gains) losses on securities available for sale (441) 47 Net (gains) on sales of equipment -- (3) Discount (accretion) and premium amortization on securities, net (42) (46) Originations of loans held for sale (86,145) (47,518) Proceeds from sales of loans held for sale 82,671 47,217 Decrease (increase) in other assets 118 (1,616) (Decrease) increase in other liabilities (386) 1,319 -------- -------- Net cash provided by operating activities $ 409 $ 3,262 -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from maturity, principal paydowns and calls on investment securities $ 814 $ 896 Proceeds from maturity, principal paydowns and calls of securities available for sale 22,307 6,211 Proceeds from sale of securities available for sale 20,825 14,757 Purchase of securities available for sale (49,770) (36,612) Investment in affiliate (6,116) (1,240) Net (increase) in loans (24,404) (16,820) Proceeds from sale of bank premises and equipment 18 20 Purchases of bank premises and equipment (440) (2,712) -------- -------- Net cash (used in) investing activities $(36,766) $(35,500) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Net increase in demand deposits, NOW accounts, and savings accounts $ 27,554 $ 20,252 Net increase in certificates of deposits 8,710 2,668 Net increase in Fed Funds purchased -- 1,100 Proceeds from Federal Home Loan Bank advances 67,820 62,000 Payment on Federal Home Loan Bank advances (54,320) (66,000) Proceeds from long-term debt -- 11,000 Payments on long-term debt (125) (130) Cash dividends paid (1,130) (1,088) Issuance of common stock 6 590 Increase in securities sold under agreements to repurchase 1,903 1,387 -------- -------- Net cash provided by financing activities $ 50,418 $ 31,779 -------- -------- Increase (decrease) in cash and cash equivalents $ 14,061 $ (459) CASH AND CASH EQUIVALENTS Beginning $ 9,523 $ 12,975 ======== ======== Ending $ 23,584 $ 12,516 ======== ========
6 MIDDLEBURG FINANCIAL CORPORATION Consolidated Statements of Cash Flows (continued) (In Thousands) (Unaudited)
For the Six Months Ended ---------------------------------- June 30, June 30, 2003 2002 -------------- ------------- SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash payments for: Interest $2,930 $2,604 Income taxes 842 1,207 SUPPLEMENTAL DISCLOSURES FOR NON-CASH INVESTING AND FINANCING ACTIVITIES Unrealized gain on securities available for sale 317 1,868 Stock issuance for purchase of affiliate 2,000 2,500 Note receivable forgiven in connection with purchase of subsidiary - 1,000 Exercise of option to purchase subsidiary - 1,200
See Accompanying Notes to Consolidated Financial Statements. 7 MIDDLEBURG FINANCIAL CORPORATION Notes to Consolidated Financial Statements For the Six Months Ended June 30, 2003 and 2002 (Unaudited) Note 1. General In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of only normal recurring accruals) necessary to present fairly the financial position as of June 30, 2003 and the results of operations and changes in cash flows for the six months ended June 30, 2003 and 2002. The statements should be read in conjunction with the Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K of Middleburg Financial Corporation (the "Company") for the year ended December 31, 2002 (the "2002 Form 10-K"). The results of operations for the three-month and six-month periods ended June 30, 2003 and 2002 are not necessarily indicative of the results to be expected for the full year. Note 2. Stock-Based Employee Compensation Plan At June 30, 2003, the Company had a stock-based employee compensation plan. The Company accounts for the plan under the recognition and measurement principles of Accounting Principles Board 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 effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
Six Months Ended Three Months Ended June 30, March 31, -------------------------- ------------------------ 2003 2002 2003 2002 ----------- -------------- ----------- ------------ (In Thousands) (In Thousands) Net income, as reported $4,312 $ 1,514 $ 2,302 $ 1,686 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards (77) (31) (44) (56) -------------------------- ------------------------ Pro forma net income $4,235 $ 1,483 $ 2,258 $ 1,630 ========================== ======================== Earnings per share: Basic - as reported $ 2.30 $ 1.79 $ 1.22 $ 0.92 Basic - pro forma 2.26 1.74 1.19 0.89 Diluted - as reported 2.26 1.74 1.19 0.90 Diluted - pro-forma 2.22 1.69 1.17 0.87
8 Note 3. Securities Securities being held to maturity as of June 30, 2003 are summarized as follows:
----------------------------------------------------------- Gross Gross Amortized Unrealized Unrealized Market Cost Gains (Losses) Value ----------------------------------------------------------- (In Thousands) Obligations of states and political subdivisions $ 3,787 $ 281 $ - $ 4,068 Mortgage backed securities 42 - - 42 ---------------- ----------------------------- ------------ $ 3,829 $ 281 $ - $ 4,110 ================ ============================= ============
Securities available for sale as of June 30, 2003 are summarized below:
------------------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Market Cost Gains (Losses) Value ------------------------------------------------------------ (In Thousands) U.S. Treasury securities and obligations of U.S. government corporations and agencies $ 6,838 $ 83 $ - $ 6,921 Corporate securities 3,947 237 (33) 4,151 Obligations of states and political subdivisions 31,185 2,431 - 33,616 Mortgage backed securities 103,903 2,882 (103) 106,682 Other 15,254 213 (369) 15,098 ------------------------------------------------------------ $ 161,127 $ 5,846 $ (505) $166,468 ================ ================ ============= ============
Note 4. Loan Portfolio The consolidated loan portfolio is composed of the following:
------------------------------------ June 30, December 31, 2003 2002 ------------------------------------ (In Thousands) Commercial, financial and agricultural $ 20,435 $ 20,323 Real estate construction 18,778 22,008 Real estate mortgage 184,943 158,035 Installment loans to individuals 12,117 11,741 ------------------ ----------------- Total loans 236,273 212,107 Less: Allowance for loan losses 2,369 2,307 ------------------ ----------------- Loans, net $ 233,904 $ 209,800 ================== =================
The Company had $33,000 in non-performing assets at June 30, 2003. 9 Note 5. Allowance for Loan Losses The following is a summary of transactions in the allowance for loan losses: --------------------------------- June 30, December 31, 2003 2002 --------------------------------- (In Thousands) Balance at January 1 $ 2,307 $ 2,060 Provision charged to operating expense 300 300 Recoveries added to the allowance 9 21 Loan losses charged to the allowance (247) (74) --------------- ---------------- Balance at the end of the period $ 2,369 $ 2,307 =============== ================ Note 6. Earnings Per Share The following table shows the weighted average number of shares used in computing earnings per share and the effect on the weighted average number of shares of potential dilutive common stock. Potential dilutive common stock has no effect on income available to common shareholders.
Six Months Ended Three Months Ended -------------------------------------------------- -------------------------------------------------- June 30, 2003 June 30, 2002 March 31, 2003 March 31, 2002 Per share Per share Per share Per share Shares Amount Shares Amount Shares Amount Shares Amount -------------------------------------------------- -------------------------------------------------- Basic EPS 1,871,526 $ 2.30 1,788,771 $ 1.79 1,890,371 $ 1.22 1,825,056 $ 0.92 =========== ========== ========= ======== Effect of dilutive securities: stock options 37,507 51,068 43,637 51,941 --------- --------- --------- -------- Diluted EPS 1,909,033 $ 2.26 1,839,839 $ 1.74 1,934,008 $ 1.19 1,876,997 $ 0.90 ========= =========== ========= ========= ========= ======== ========= ========
Note 7. Investment in Affiliate On April 15, 2003, the Middleburg Bank (the "Bank"), a wholly owned subsidiary of the Company, acquired 40% of the issued and outstanding membership interest units (the "Acquisition") of Southern Trust Mortgage, LLC ("Southern Trust"). The Bank acquired the membership interest units in equal proportion from the seven members of Southern Trust, all of whom own, in the aggregate, the remaining issued and outstanding units of Southern Trust. Southern Trust is a regional mortgage lender headquartered in Norfolk, Virginia and has offices in Virginia, Maryland, North Carolina, South Carolina and Georgia. The purchase price that the Company and the Bank paid in connection with the Acquisition consisted of approximately $6.0 million in cash and 44,359 shares of the Company's common stock ("Common Stock"). The Company is accounting for its investment in Southern Trust by the equity method of accounting under which the Company's share of the net income of the affiliate is recognized as income in the Company's income statement and added to the investment account, and dividends received from the affiliate are treated as a reduction of the investment account. The investment in affiliate totaling $8.9 million at June 30, 2003 is included in other assets on the consolidated balance sheet. 10 Note 8. Recent Accounting Pronouncements In April 2003, the Financial Accounting Standards Board issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts(collectively referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement is effective for contracts entered into or modified after June 30, 2003, and is not expected to have an impact on the Company's consolidated financial statements. In May 2003, the Financial Accounting Standards Board issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of nonpublic entities. Adoption of the Statement is not expected to have an impact on the Company's consolidated financial statements. 11 Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Critical Accounting Policies The financial condition and results of operations presented in the Consolidated Financial Statements, accompanying Notes to the Consolidated Financial Statements and management's discussion and analysis are, to a large degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change. Presented below is discussion of those accounting policies that management believes are the most important to the portrayal and understanding of the Company's financial condition and results of operations. These critical accounting policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood. See also Note 1 of the Notes to Consolidated Financial Statements in the 2002 Form 10-K. Allowance for Loan Losses The Company monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio. The Company maintains policies and procedures that address the systems of controls over the following areas of maintenance of the allowance: the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan; and the loan grading system. The Company evaluates various loans individually for impairment as required by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 118, Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures. Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management. The evaluations are based upon discounted expected cash flows or collateral valuations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment. If a loan evaluated individually is not impaired, then the loan is assessed for impairment under SFAS No. 5, Accounting for Contingencies, with a group of loans that have similar characteristics. For loans without individual measures of impairment, the Company makes estimates of losses for groups of loans as required by SFAS No. 5. Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type. A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan. The resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including: borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions. The amount of estimated impairment for individually evaluated loans and groups of loans is added together for a total estimate of loans. This estimate of losses is compared to the allowance for loan 12 losses of the Company as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made. If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates. If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses. The Company recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements. Valuation of Derivatives The Company maintains an overall interest rate risk management strategy that incorporates the use of derivative financial instruments. The Company has used derivative financial instruments only for asset/liability management through the hedging of a specific transaction or position, and not for trading or speculative purposes. Management believes that the risk associated with using derivative financial instruments to mitigate interest rate risk sensitivity is minimal and should not have any material unintended impact on the Company's financial condition or results of operations. As of June 30, 2003, the Company had no derivative financial instruments outstanding. Intangibles and Goodwill The Company had approximately $6.7 million in intangible assets and goodwill at June 30, 2003. On April 1, 2002, the Company acquired Gilkison Patterson Investment Advisors, Inc. ("GPIA"), a registered investment advisor. In connection with this investment, a purchase price valuation (using SFAS Nos. 141 and 142 as a guideline) was completed to determine the appropriate allocation to identified intangibles. The valuation concluded that approximately 42% of the purchase price was related to the acquisition of customer relationships with an amortizable life of 15 years. Another 19% of the purchase price was allocated to a non-compete agreement with an amortizable life of 7 years. The remainder of the purchase price has been allocated to goodwill. The purchase price allocation process requires management estimates and judgment as to expectations for the life span of various customer relationships as well as the value that key members of management add to the success of the Company. For example, customer attrition rates were determined based upon assumptions that the past five years may predict the future. If the actual attrition rates, among other assumptions, differed from the estimates and judgments used in the purchase price allocation, the amounts recorded in the financial statements could result in a possible impairment of the intangible assets and goodwill or require an acceleration in the amortization expense. In addition, SFAS No. 142 requires that goodwill be tested annually using a two-step process. The first step is to identify a potential impairment. The second step measures the amount of the impairment loss, if any. Processes and procedures have been identified for the two-step process. When the Company completes its ongoing review of the recoverability of intangible assets and goodwill, factors that are considered important to determining whether an impairment might exist include loss of customers acquired or significant withdrawals of the assets currently under management and/or early retirement or termination of key members of management. Any changes in the key management 13 estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Company's financial condition and results of operations. Financial Summary Net income for the six months ended June 30, 2003 increased 34.8% to $4.3 million or $ 2.26 per diluted share compared to $3.2 million or $1.74 per diluted share for the first six months of 2002. Annualized returns on average assets and equity for the six months ended June 30, 2003 were 1.9 % and 19.0%, respectively, compared to 1.7% and 19.1% for the same period in 2002. Total assets for the Company increased to $481.6 million at June 30, 2003 compared to $425.0 million at December 31, 2002, representing an increase of $56.7 million or 13.3%. Total loans at June 30, 2003 were $233.9 million, an increase of $24.1 million from the December 31, 2002 balance of $209.8 million. Net charge-offs were $238,000 for the six months ended June 30, 2003. Increased net charge offs and the growth in the loan portfolio required an additional $150,000 in provision during the first half of 2003. The allowance for loan losses was $2.4 million or 1.0% of total loans outstanding at June 30, 2003. The Company has developed a strong image advertising campaign that focuses on its commercial lenders. This campaign has built additional awareness within the market. Furthermore, the Company has hired two commercial lenders since January 2003 each of whom have significant experience within the Loudoun County market. These factors have contributed to the strong loan growth during the first and second quarter of 2003. On April 15, 2003, the Bank acquired a 40% interest in Southern Trust. Upon the acquisition of the 40% interest in Southern Trust, the Bank's existing mortgage operation was assumed by Southern Trust. In connection with the Southern Trust investment, the Company entered into two loan participation agreements with Southern Trust. One arrangement is a tri-party agreement among the Company, Southern Trust, and Colonial Bank, Southern Trust's warehouse line lender. The agreement details the arrangements by which the Company purchases 99.0% of selected loans from Colonial Bank. The Company charges Southern Trust a rate equal to the one month LIBOR rate at the time of purchase plus 175 basis points. The rate has a floor of 1.95%. As noted in the tri-party agreement, the Company does not intend to hold the purchased loans more than 30 days, Colonial Bank maintains the note documentation on behalf of the Company, and the Company will engage semi-annual testing to be conducted by third party to validate Colonial Bank procedures. At June 30, 2003, the balance of the Company's participated mortgages held for sale was $20.5 million. The tri-party agreement is capped at $30.0 million. The Company also entered into a construction loan participation agreement with Southern Trust. According to this agreement, the Company can purchase 93% of selected construction loans and draws, up to $20.0 million in outstanding balances and $30.0 million in commitments. The Company will charge Southern Trust an interest rate equal to the prime rate plus 75 basis points on the outstanding participated loans held by the Company. Adjustments in rate related to movements in the prime rate will be made monthly. There were no construction participation loans at June 30, 2003. The investment portfolio increased 4.0% to $170.3 million at June 30, 2003 compared to $163.7 million at December 31, 2002. Deposits increased $36.3 million to $365.2 million at June 30, 2003 from $328.9 million at December 31, 2002. Growth in demand deposits of $14.2 million accounts for the majority of the increase during the first six months of 2003. While the Company has experienced 14 significant growth in the balances within the low cost deposit categories, management believes that a majority of the growth is related to an increase in the number of accounts and relationships with new clients rather than an existing client's decision to shift money from personal investments in stocks. Time deposits decreased $8.7 million since December 31, 2002 to $108.5 million. Securities sold under agreements to repurchase with commercial checking accounts increased $1.9 million from $8.9 million at December 31, 2002 to $10.8 million at June 30, 2003. While the increase in deposits funded the majority of the Company's asset growth for the six months ended June 30, 2003, a need for short term funding materialized during the second quarter of 2003. This need resulted from both an increased demand on the Company's loan portfolio and the implementation of the mortgage loan participation agreement with Southern Trust. Federal Home Loan Bank advances were $13.5 million at June 30, 2003, compared to $0 at December 31, 2002. Shareholders' equity was $46.8 million at June 30, 2003. This amount represents an increase of 13.0% from the December 31, 2002 balance of $41.4 million. The issuance of 44,359 shares stock related to the investment in Southern Trust accounts for much of the increase. The book value per common share was $24.65 at June 30, 2003 and $22.35 at December 31, 2002. Net Interest Income Net interest income is one of the Company's primary sources of earnings and represents the difference between interest and fees earned on earning assets and the interest expense paid on deposits and other interest bearing liabilities. Net interest income totaled $9.3 million for the first six months of 2003 compared to $8.4 million for the same period in 2002, an increase of 10.2%. Average earning assets increased $60.1 million from $346.2 million at June 30, 2002 to $406.3 million at June 30, 2003. The Company continues to obtain a majority of its funding from growth in the low cost deposit categories. Average deposits increased $55.2 million from $283.3 million at June 30, 2002 to $338.5 million at June 30, 2003. Total interest expense decreased to $2.9 million at June 30, 2003 from the $3.3 million balance at June 30, 2002, representing a decrease of 12.6%. Both the strong growth in lower cost deposits and the continued low interest rate environment have contributed to the Company's decreased level in interest expense. The mix of low cost deposits versus time deposits remains balanced at approximately 70% in low cost deposits versus 30% in higher cost time deposits. The net interest margin was 4.79 % for the six months ended June 30, 2003 compared to 5.15% for the same period in 2002. The decline stems from significant prepayments in both the investment and loan portfolio over the past year which have been reinvested in lower yielding assets. Noninterest Income Noninterest income increased 91.6% to $5.7 million for the first six months of 2003 compared to $3.0 million for the same period in 2002. Noninterest income (excluding net gains (losses) on securities available for sale) increased 73.9% to $5.2 million for the first six months of 2003 compared to $3.0 million for the same period in 2002. Commissions and fees from trust and investment advisory activities were $1.7 million for the six month period ended June 30, 2003 compared to $1.1 million for the same period in 2002. Equity in earnings of affiliate, the line item representing the Company's earnings from its 40% investment in Southern Trust, was $764,000 for the period ended June 30, 2003. These earnings comprise 14.7% of total noninterest income at June 30, 2003, and account for 34.5% of the $2.2 million increase in noninterest income. The equity earnings in Southern Trust added $.26 per diluted share for the three months ended June 30, 2003. Southern Trust closed $333 million in loans during the second quarter with only 50% of its production attributable to refinancing volume. Southern Trust also originated and closed $10 million in new construction loans during that same period. As part of the investment in Southern Trust, the Bank's mortgage banking department was transferred to Southern Trust. After April 30, 2003, earnings of the 15 mortgage department will be reported within the equity in earnings from affiliate. As agreed upon with the investment in Southern Trust, the Company will receive 100% of the net income that had been budgeted for the mortgage operation for the year 2003. For the amount that exceeds the 2003 budgeted net income level, the Company will receive its 40% share. Earnings generated by the Middleburg branch of Southern Trust in years subsequent to 2003 will be split according to the Company's ownership percentage of Southern Trust. The Bank's mortgage banking department contributed $.09 per diluted share towards the $.26 per diluted share attributed to Southern Trust above. For the six months ended June 30, 2003, Southern Trust closed $550.4 million in loans. Despite the recent increase in mortgage rates, Southern Trust is on track to produce over $800 million in loans for the third consecutive year. Southern Trust has 15 branch offices in five states. Investment advisory fees provided by GPIA a wholly owned subsidiary acquired on April 1, 2002, totaled $1.0 million for the six months ended June 30, 2003. GPIA, a registered investment advisor, currently manages approximately $600 million in assets. Fiduciary fees, provided by Tredegar Trust Company, increased 1.9% from $637,000 at June 30, 2002 to $648,000 at June 30, 2003. Fiduciary fees are based primarily upon the market value of the accounts under administration. Service charges on deposit accounts increased to $1.2 million at June 30, 2003. That represents an increase of 43.7% from the $822,000 June 30, 2002 balance. The Company continues to benefit from its three years of 20% growth in transactional (checking and money market) accounts. The Company had implemented a daily overdraft charge during the third quarter of 2002. Fees from this charge account for 4.6% of the total service charges on deposit accounts for the six months ended June 30, 2003. The Company also began accounting for the fee income on ATM and VISA check card transactions in gross rather than net of expenses; the result is an increase of $58,000 in service charge income. The related expense is reflected in the noninterest expense section. Investment sales fees increased from $252,000 at June 30, 2002, to $645,000 at June 30, 2003. The addition of two financial consultants to the Investment Sales department contributed to the 155.9% increase in investment sales fees. Fees on loans held for sale is derived from the sale of loans to the secondary market. The Company does not retain servicing on these loans. Upon the Company's investment in Southern Trust, it concluded its own mortgage operations. Noninterest Expense Total noninterest expense includes employee-related costs, occupancy and equipment expense and other overhead. Total noninterest expense increased 24.3% to $8.5 million for the first six months of 2003 compared to $6.8 million for the same period in 2002. Salaries and employee benefits increased by 24.1% when comparing June 30, 2003 to June 30, 2002. Additions to staff to support business development, branching and the formation of a wealth management group have contributed to the increase in salaries and employee benefits. Commissions (included within the salaries and benefits expense) paid to employees for fee related business, such as mortgage originations and investment sales have increased by $266,000 to $668,000 as a result in the increase in sales volume. Net occupancy expense of premises increased $375,000 from $750,000 for the six months ended June 30, 2002 to $1.1 16 million for the six months ended June 30, 2003. The building expansion program affected net occupancy and equipment expense year over year. An operations center opened in late June 2002 and a second full service branch in Leesburg, Virginia opened in July 2002. There were no significant non-recurring expenses in the first half of 2003. Allowance for Loan Losses The allowance for loan losses at June 30, 2003 was $2.4 million compared to $2.2 million at June 30, 2002. The allowance for loan losses was 1.0% of total loans outstanding at June 30, 2003 and 1.04% of total loans outstanding at June 30, 2002. The provision for loan losses was increased to $300,000 for the six months ended June 30, 2003. Increased net charge offs and the growth in the loan portfolio during the first half of 2003 required an additional $150,000 in provision. The provision was $150,000 for the six months ended June 30, 2002. At June 30 , 2003, net loan charge offs totaled $238,000, compared to $8,000 for the same date in 2002. Total loans past due 90 days or more at June 30, 2003 were approximately $2,000. Non-performing loans were .01% of total loans outstanding at June 30, 2003 compared to .06% at June 30, 2002. Management believes that the allowance for loan losses is adequate to cover credit losses inherent in the loan portfolio at June 30, 2003. Loans classified as loss, doubtful, substandard or special mention are adequately reserved for and are not expected to have a material impact beyond what has been reserved. Capital Resources Shareholders' equity at June 30, 2003 and December 31, 2002 was $46.8 million and $41.4 million, respectively. Total common shares outstanding at June 30, 2003 were 1,897,266. At June 30, 2003, the Company's tier 1 and total risk-based capital ratios were 14.5% and 15.7%, respectively, compared to 14.8% and 15.6% at December 31, 2002. The Company's leverage ratio was 9.7% at June 30, 2003 compared to 10.6% at December 31, 2002. The Company's capital structure places it above the regulatory guidelines, which affords the Company the opportunity to take advantage of business opportunities while ensuring that it has the resources to protect against risk inherent in its business. Liquidity Liquidity represents an institution's ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, federal funds sold, short-term investments, securities classified as available for sale as well as loans and securities maturing within one year. As a result of the Company's management of liquid assets and the ability to generate liquidity through liability funding, management believes that the Company maintains overall liquidity sufficient to satisfy its depositors' requirements and meet its customers' credit needs. The Company also maintains additional sources of liquidity through a variety of borrowing arrangements. The Bank maintains federal funds lines with large regional and money-center banking institutions. These available lines total in excess of $5 million, of which none were outstanding at June 30, 2003. Federal funds purchased during the first half of 2003 averaged $460,000 compared to an average of $563,000 during the same period in 2002. At June 30, 2003 and December 31, 2002, the Bank had $10.8 million and $8.9 million, respectively, of outstanding borrowings pursuant to securities sold under agreement to repurchase transactions (Repo Accounts), with maturities of one day. The Repo 17 Accounts are long-term commercial checking accounts with average balances that typically exceed $100,000. The Bank has a credit line in the amount of $56.0 million at the Federal Home Loan Bank of Atlanta. This line may be utilized for short and/or long-term borrowing. The Bank has utilized the credit line for overnight funding throughout the first half of 2003 with an average balance of $2.6 million. At June 30, 2003, cash, interest-bearing deposits with financial institutions, federal funds sold, short-term investments, loans held for sale and securities available for sale were 58.8% of total deposits and liabilities. Forward-Looking Statements Certain information contained in this discussion may include "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are generally identified by phrases such as "the Company expects," "the Company believes" or words of similar import. Such forward-looking statements involve known and unknown risks including, but not limited to, changes in general economic and business conditions, interest rate fluctuations, competition within and from outside the banking industry, new products and services in the banking industry, risk inherent in making loans such as repayment risks and fluctuating collateral values, problems with technology utilized by the Company, changing trends in customer profiles and changes in laws and regulations applicable to the Company. Although the Company believes that its expectations with respect to the forward-looking statements are based upon reliable assumptions within the bounds of its knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market and Interest Rate Risk Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices and equity prices. The Company's primary market risk exposure is interest rate risk, though it should be noted that the assets under management by its trust and investment management subsidiaries for their clients are affected by equity and bond price risk and are not considered in the asset/liability management process. The ongoing monitoring and management of this risk is an important component of the Company's asset/liability management process, which is governed by policies established by its Board of Directors that are reviewed and approved annually. The Board of Directors delegates responsibility for carrying out asset/liability management policies to the Asset/Liability Committee (ALCO) of the Company's banking subsidiary, Middleburg Bank. In this capacity, ALCO develops guidelines and strategies that govern the Company's asset/liability management related activities, based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. Interest rate risk represents the sensitivity of earnings to changes in market interest rates. As interest rates change, the interest income and expense streams associated with the Company's financial instruments also change, affecting net interest income, the primary component of the Company's earnings. ALCO uses the results of a detailed and dynamic simulation model to quantify the estimated 18 exposure of net interest income to sustained interest rate changes. While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also employs additional tools to monitor potential longer-term interest rate risk. The simulation model captures the impact of changing interest rates on the interest income received and interest expense paid on all assets and liabilities reflected on the Company's balance sheet. The simulation model is prepared and updated four times during each year. This sensitivity analysis is compared to ALCO policy limits, which specify a maximum tolerance level for net interest income exposure over a one-year horizon, assuming no balance sheet growth, given both a 100 and 200 basis point (bp) downward shift in interest rates and a 200 basis point upward shift. A parallel and pro rata shift in rates over a 12-month period is assumed. The following reflects the range of the Company's net interest income sensitivity analysis during the six months ended June 30, 2003 as well as the fiscal year of 2002 compared to the 10% Board-approved policy limit. For the Six Months Ended June 30, 2003 Rate Change Estimated Net Interest Income Sensitivity ----------- ----------------------------------------- High Low Average + 200 bp 0.49% 0.34% 0.42% - 100 bp (0.52)% (0.28)% (0.40)% For the Year Ended December 31, 2002 Rate Change Estimated Net Interest Income Sensitivity ----------- ----------------------------------------- High Low Average + 200 bp (2.51%) (1.00%) (1.75%) - 200 bp 2.62% .63% 1.33% Since December 31, 2002, the company's balance sheet has grown by $56.7 million. Both deposit inflows and increased borrowings from the Federal Home Loan Bank have provided the funding for the growth in the loan and securities portfolios. Overall, the Company continues to have minimal interest rate risks to either falling or rising interest rates. The addition to the Company's balance sheet of lesser rate sensitive deposits as well as low duration fixed rate and adjustable rate mortgage backed securities to the investment portfolio has mitigated the Company's liability sensitivity to rising rates. Based upon the first six months of 2003's simulation, the Company could expect an average positive impact to net interest income of $90,000 over the next 12 months if rates rise 200 basis points. If rates were to decline 100 basis points, the Company could expect an average negative impact to net interest income of $94,000 over the next 12 months. At the end of 2002, the Company's interest rate risk model indicated that in a rising rate environment of 200 basis points over a 12 month period net interest income could decrease by 1.75% on average. For the same time period the interest rate risk model indicated that in a declining rate environment of 100 basis points over a 12 month period net interest income could increase by 1.33% on average. While these numbers are subjective based upon the parameters used within the model, management believes the balance sheet is very balanced with little risk to rising rates in the future. The preceding sensitivity analysis does not represent a forecast and should not be relied upon as being indicative of expected operating results. These hypothetical estimates are based upon numerous assumptions, including the nature and timing of interest rate levels such as yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, 19 reinvestment or replacement of asset and liability cashflows. While assumptions are developed based upon current economic and local market conditions, the Company cannot make any assurances about the predictive nature of these assumptions, including how customer preferences or competitor influences might change. Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will also differ due to factors such as prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change, caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in response to or anticipation of changes in interest rates. Item 4. CONTROLS AND PROCEDURES As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company's management, including the Company's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, the Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic filings with the Securities and Exchange Commission. There have been no significant changes in the Company's internal controls or in other factors that could materially affect, or are reasonably likely to materially affect, internal controls subsequent to the date that the Company carried out its evaluation. As disclosed above, on April 15, 2003, the Bank acquired a 40% interest in Southern Trust. During the second quarter of 2003, the Company assisted Southern Trust with an upgrade conversion of its accounting system. The Company continues to monitor the implementation of this system by Southern Trust as part of its evaluation of its disclosure controls and procedures under applicable securities rules and regulations. 20 PART II. OTHER INFORMATION Item 1. Legal Proceedings None Item 2. Change in Securities and Use of Proceeds On April 15, 2003, the Bank acquired 40% of the issued and outstanding membership interest units of Southern Trust. The purchase price that the Company and the Bank paid in connection with the Acquisition included, among other things, the issuance of 44,359 shares of Common Stock, in the aggregate, to the seven members of Southern Trust. The Company relied upon Section 4(2) of the Securities Act for the exemption from registration for this issuance. Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders The Company held its Annual Meeting of Shareholders on Wednesday, April 16, 2003 in Middleburg, Virginia. The shareholders were asked to vote on the election of the directors of the Company. At the Annual Meeting, the votes cast for or withheld for the election of the directors were as follows: NAME FOR WITHHELD ---- --- -------- Howard M. Armfield 1,130,018 100 Joseph L. Boling 1,130,018 100 Childs Frick Burden 1,130,018 100 J. Lynn Cornwell, Jr. 1,130,018 100 William F. Curtis 1,102,692 27,426 Robert C. Gilkison 1,130,018 100 C. Oliver Iselin, III 1,130,018 100 Gary D. LeClair 1,102,692 27,426 Thomas W. Nalls 1,130,018 100 John Sherman 1,129,114 1,004 Millicent W. West 1,130,018 100 Edward T. Wright 1,102,692 27,426 There were no other matters presented to the Company's shareholders during the quarter ended June 30, 2003. Item 5. Other Information None 21 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 31.1 Rule 13a-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a) Certification of Chief Financial Officer 32.1 Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. ss. 1350 (b) Reports on Form 8-K On April 18, 2003, the Company filed a Current Report on Form 8-K dated April 16, 2003 to report, under Items 7 and 12 (under Item 9), and attach as an exhibit and incorporate by reference, a press release that reported the Company's financial results for the quarter ended March 31, 2003. On April 30, 2003, the Company filed a Current Report on Form 8-K dated April 15, 2003 to disclose, under Item 2, the Company's acquisition of an equity interest in Southern Trust. 22 SIGNATURES In accordance with the requirements of the Securities Exchange Act of 1934, as amended, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. MIDDLEBURG FINANCIAL CORPORATION (Registrant) Date: August 14, 2003 /s/ Joseph L. Boling ------------------------------------------ Joseph L. Boling Chairman of the Board & CEO Date: August 14, 2003 /s/ Alice P. Frazier ------------------------------------------ Alice P. Frazier Executive Vice President & CFO Date: August 14, 2003 /s/ Kathleen J. Chappell ------------------------------------------ Kathleen J. Chappell Senior Vice President & Controller (Chief Accounting Officer) 23 EXHIBIT INDEX Number Document 31.1 Rule 13a-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a) Certification of Chief Financial Officer 32.1 Statement of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. ss. 1350