Quarterly Report

U.S. Securities and Exchange Commission
Washington, D.C. 20549

Form 10-Q

For the quarterly period ended March 31, 2003

For the transition period ended

Commission File Number 000-33227

Southern Community Financial Corporation

Registrant’s telephone number, including area code (336) 768-8500

Securities Registered Pursuant to Section 12(g) of the Exchange Act:
Common Stock, No Par Value

7.25% Cumulative Convertible Trust Preferred Securities

7.25% Convertible Junior Subordinated Debentures

Guarantee with respect to 7.25% Convertible Trust Preferred Securities

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 o

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

As of May 2, 2003, (the most recent practicable date), the registrant had outstanding 8,791,683 shares of Common Stock, no par value.

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Part I. FINANCIAL INFORMATION

Item 1 — Financial Statements

SOUTHERN COMMUNITY FINANCIAL CORPORATION
CONSOLIDATED BALANCE SHEETS

*     Derived from audited financial statements

See accompanying notes.

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SOUTHERN COMMUNITY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

See accompanying notes.

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SOUTHERN COMMUNITY FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

See accompanying notes.

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SOUTHERN COMMUNITY FINANCIAL CORPORATION

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY (Unaudited)

See accompanying notes.

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SOUTHERN COMMUNITY FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

See accompanying notes.

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SOUTHERN COMMUNITY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements

Note 1 — Basis of Presentation

The consolidated financial statements include the accounts of Southern Community Financial Corporation and its wholly-owned subsidiaries, Southern Community Capital Trust I, a trust for the convertible preferred securities, and Southern Community Bank and Trust and its wholly-owned subsidiaries, Southeastern Acceptance Corporation, a consumer finance company, and VCS Management, L.L.C., the managing general partner for Venture Capital Solutions L.P., a Small Business Investment Company. All intercompany transactions and balances have been eliminated in consolidation. In management’s opinion, the financial information, which is unaudited, reflects all adjustments (consisting solely of normal recurring adjustments) necessary for a fair presentation of the financial information as of and for the three month periods ended March 31, 2003 and 2002, in conformity with accounting principles generally accepted in the United States of America.

The preparation of financial statements requires management to make estimates and assumptions that affect reported amounts of assets and liabilities at the date of the financial statements, as well as the amounts of income and expense during the reporting period. Actual results could differ from those estimates. Operating results for the three month period ended March 31, 2003 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2003.

The organization and business of Southern Community Financial Corporation (the “Company”), accounting policies followed by the Company and other relevant information are contained in the notes to the consolidated financial statements filed as part of the Company’s 2002 annual report on Form 10-K. This quarterly report should be read in conjunction with such annual report.

Note 2 — Per Share Data

Basic and diluted net income per share are computed based on the weighted average number of shares outstanding during each period after retroactively adjusting for a 5% stock dividend distributed October 15, 2002. Diluted net income per share reflects the potential dilution that could occur if stock options were exercised or convertible trust-preferred securities were converted, resulting in the issuance of common stock that then shared in the net income of the Company.

Basic and diluted net income per share have been computed based upon net income as presented in the accompanying consolidated statements of operations divided by the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:

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SOUTHERN COMMUNITY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements

Note 2 — Per Share Data (Continued)

For the three months ended March 31, 2003 net income for determining diluted earnings per share was $1,146 thousand, after adjusting for the $199 thousand after tax effect of the expense associated with the dilutive convertible preferred securities. For the three months ended March 31, 2003 and 2002, there were 115,193, and 109,594 options, respectively, that were antidilutive since the exercise price exceeded the average market price for the period. For the three months ended March 31, 2002, there were 2,088,975 of antidilutive shares related to the convertible trust preferred securities. These antidilutive common stock equivalents have been omitted from the calculation of diluted earnings per share for their respective periods.

Note 3 — Stock Compensation Plans

Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation , encourages all entities to adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also allows an entity to continue to measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. Stock options issued under the Company’s stock option plans have no intrinsic value at the grant date and, under Opinion No. 25, no compensation cost is recognized for them. The Company has elected to continue with the accounting methodology in Opinion No. 25. Presented below are the pro forma disclosures of net income and earnings per share and other disclosures as if the fair value based method of accounting had been applied.

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SOUTHERN COMMUNITY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements

Note 4 — Loans

Following is a summary of loans at each of the balance sheet dates presented:

An analysis of the allowance for loan losses is as follows:

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SOUTHERN COMMUNITY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements

Note 5 — Non-Interest Income and Other Non-Interest Expenses

The major components of non-interest income are as follows:

The major components of other non-interest expense are as follows:

Note 6 – Guarantees

The Company has issued guarantees under standby letters of credit, which require the Company to fund the guarantee in part or in entirety, in the event the customer fails to perform under an obligating agreement. These standby letters of credit typically have terms ranging from 12 to 60 months.

The maximum amount of the Company’s guarantees under these standby letters of credit along with the carrying amount of the liability under these guarantees are as follows (in thousands):

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SOUTHERN COMMUNITY FINANCIAL CORPORATION
Notes to Consolidated Financial Statements

Note 7 — Recent Accounting Pronouncements

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (Statement 146). This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). A liability for a cost associated with an exit or disposal activity shall be recognized and measured initially at its fair value in the period in which the liability is incurred, except for certain qualifying employee termination benefits. The adoption of Statement 146 by the Company on January 1, 2003 had no significant impact to the consolidated financial statements.

In January 2003, the FASB issued FASB Interpretation No. (FIN) 46, Consolidation of Variable Interest Entities. This interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the interpretation. FIN 46 applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003. For public enterprises with a variable interests in a variable interest entity created before February 1, 2003, FIN 46 applies no later than the beginning of the first interim or annual period beginning after June 15, 2003. The Company is in the process of determining the impact of FIN 46 on its consolidated financial statements.

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

This Quarterly Report on Form 10-Q may contain certain forward-looking statements consisting of estimates with respect to our financial condition, results of operations and business that are subject to various factors which could cause actual results to differ materially from these estimates. These factors include, but are not limited to, general economic conditions, changes in interest rates, deposit flows, loan demand, real estate values, and competition; changes in accounting principles, policies, or guidelines; changes in legislation or regulation; and other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services.

Effective October 1, 2001, Southern Community Bank and Trust became a wholly owned subsidiary of Southern Community Financial Corporation. Southern Community Financial Corporation has no material assets other than those of the bank. Southern Community Bank and Trust (the “bank”) was incorporated November 14, 1996 and began banking operations on November 18, 1996. The bank is engaged in general commercial and retail banking in the Piedmont area of North Carolina, principally Forsyth, Guilford and Yadkin Counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation and on February 2, 2002 the bank became a member of the Federal Reserve System. The bank undergoes periodic examinations by those regulatory authorities.

Financial Condition at March 31, 2003 and December 31, 2002

During the three-month period ending March 31, 2003, total assets increased by $1.8 million, or .3%, to $614.1 million. Deposit growth coupled with cash flow from the securities portfolio and federal funds sold supported loan growth as well as maturing short-term borrowings. Deposits grew $12.8 million, or 2.8% during the quarter, with time and demand deposits increasing 3.8% and 11.9%, respectively. Loans increased $21.0 million or 5.0% during the quarter.

Consistent with prior periods, a substantial portion of our asset growth resulted from strong loan demand. At March 31, 2003, loans totaled $442.9 million, an increase of $21.0 million or 5.0% during the three months. Commercial mortgage loans experienced the greatest growth, increasing by $20.9 million, or 15.1%. In addition, construction lending generated $4.5 million, or 7.0%, growth during the quarter. Offsetting this growth was a moderate decrease among our loans collateralized with residential mortgages, which decreased $2.9 million, or 2.5%, and consumer loans which were $1.0 million or 3.5% below year-end balances.

Our total liquid assets, defined as cash and due from banks, federal funds sold and investment securities, decreased by $19.6 million during the three months, to $149.8 million at March 31, 2003 versus $169.4 million at the beginning of the period. Our composition of liquid assets has shifted as call options on agency securities held in the investment portfolio were exercised by the issuer, and the proceeds were reinvested into the loan portfolio. In addition, our investment in federal funds sold decreased from $11.1 million at December 31, 2002 to $605,000 at March 31, 2003 to support growth in both our loan portfolio and to a lesser extent, our held-to-maturity investment portfolio.

Customer deposits continue to be our primary funding source. At March 31, 2003, deposits totaled $462.0 million, an increase of $12.8 million or 2.8% from year-end 2002. We decreased our short-term borrowings through pay-downs on repurchase agreements in the amount of $12.3 million. We have maintained our level of long-term debt at $55.0 million, which was increased in prior periods to take advantage of lower interest rates being offered by the Federal Home Loan Bank of Atlanta. We will utilize various funding sources, as necessary, to support balance sheet management and growth. However, we believe that as our branch network grows and matures, the volume of core deposits will become a relatively larger portion of our funding mix, which should contribute to a reduction in our overall funding cost. Demand deposits increased $5.0 million from year-end and totaled $46.9 million as of March 31, 2003 comprising 10.2% of total deposits, an increase from $41.9 million or 9.3% of total deposits at December 31, 2002.

Our capital position remains strong, with all of our regulatory capital ratios at levels that make us “well capitalized” under federal bank regulatory capital guidelines. At March 31, 2003, our stockholders’ equity totaled $48.3 million, an increase of $750,000 from the December 31, 2002 balance. The increase is the result of retained net income from operations during the period of $947,000, net of decreases in unrealized gains on investment securities available-for-sale and cash flow hedges in the amounts of $195,000 and $2,000, net of tax, respectively.

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Results of Operations for the Three Months Ended March 31, 2003 and 2002

Net Income. Our net income for the three months ended March 31, 2003 was $947,000, an increase of $393,000 from the same three-month period in 2002. Net income per share was $.11 basic and $.10 diluted for the three months ended March 31, 2003, as compared with $.06 basic and diluted for the same period in 2002. We have continued to experience strong growth, with total assets averaging $601.3 million during the current three-month period as compared to $509.1 million in the prior period, an increase of $92.1 million or 18.1%. Our interest rate spread and net yield on average interest-earning assets increased 52 basis points and 44 basis points, respectively. Our net interest income grew 34.5%, from $3.6 million for the three-month period ending March 2002 to $4.8 million for the current quarter. Net income was also supported by a $408,000 increase in non-interest income. These improvements were partially offset by a 27.8% increase in non-interest expenses. Our expense growth included the costs of new facilities, additional personnel costs, and other infrastructure associated with expansion of our business. While these expenses represent investments in building our franchise, they initially hinder our earnings.

Net Interest Income. During the three months ended March 31, 2003, our net interest income increased by $1.2 million or 34.5% over the first quarter 2002 results to $4.8 million. Net-interest income benefited from strong growth in average earning assets, coupled with a reduction in cost on interest-bearing liabilities which offset lower asset yields caused by the decline in interest rates from period to period. The rates earned on a significant portion of our loan portfolio adjust immediately when index rates, such as prime, change. Conversely, most of our interest-bearing liabilities, including certificates of deposit and borrowings, have rates fixed. As a result, interest rate reductions generally result in an immediate drop in our interest income on loans, with a delayed impact on interest expense because reductions in interest costs will only occur upon renewals of certificates of deposit or borrowings. Because rates stabilized at a lower level during 2002, downward repricings of our interest-bearing liabilities have been larger than our downward repricings of our interest-earning assets. Average total interest-earning assets increased $85.2 million, or 17.8%, during the three months ended March 31, 2003 as compared to the same period in 2002. Our average yields on total interest-earning assets for the same periods decreased by 37 basis points from 6.38% to 6.01%. Our average total interest-bearing liabilities increased by $77.9 million, or 18.0%. Our average cost of total interest-bearing liabilities decreased by 89 basis points from 3.69% to 2.80%. For the three months ended March 31, 2003, our net interest spread was 3.21% and our net interest margin was 3.48%. For the three months ended March 31, 2002, our net interest spread was 2.69% and our net interest margin was 3.04%.

On May 1, 2003, the bank terminated one of the two interest rate swap contracts held at quarter-end for $1.0 million, which included $59,000 of accrued interest receivable. The swap had a notional value of $25 million and under the contract we received a fixed rate of interest and paid a rate based on daily average Prime. Unwinding this transaction resulted in a gain of $951,000, which will be amortized over a twenty-six month period, the remaining life of the swap contact, and will contribute approximately $36,500 to interest income on a monthly basis.

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Average Yield/Cost Analysis

The following table contains information relating to the Company’s average balance sheet and reflects the average yield on assets and cost of liabilities for the periods indicated. Such annualized yields and costs are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented. The average loan portfolio balances include non-accrual loans.