Quarterly Report

 

 

U.S. Securities and Exchange Commission

Washington, D.C. 20549

Form 10-Q

þ Quarterly Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the quarterly period ended June 30, 2005

o Transition Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934

For the transition period ended                                          

Commission File Number 000-33227

Southern Community Financial Corporation

(Exact name of registrant as specified in its charter)

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

7.95% Cumulative Trust Preferred Securities
7.95% Junior Subordinated Debentures
Guarantee with respect to 7.95% Cumulative 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 þ No o

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

As of July 31, 2005, (the most recent practicable date), the registrant had outstanding 17,837,150 shares of Common Stock, no par value.

 

 

				Page No.
Part I.		FINANCIAL INFORMATION
Item 1 -		Financial Statements (Unaudited)
		Consolidated Balance Sheets June 30, 2005 and December 31, 2004			3
		Consolidated Statements of Operations Three Months and Six Months Ended June 30, 2005 and 2004			4
		Consolidated Statements of Comprehensive Income Three Months and Six Months Ended June 30, 2005 and 2004			5
		Consolidated Statement of Stockholders’ Equity Six Months Ended June 30, 2005			6
		Consolidated Statements of Cash Flows Six Months Ended June 30, 2005 and 2004			7
		Notes to Consolidated Financial Statements			8
Item 2 -		Management’s Discussion and Analysis of Financial Condition and Results of Operations			13
Item 3 -		Quantitative and Qualitative Disclosures about Market Risk			19
Item 4 -		Controls and Procedures			19
Part II.		Other Information
Item 2 -		Unregistered Sales of Equity Securities and Use of Proceeds			20
Item 5 -		Submission of Matters to a Vote of Security Holders			20
Item 6 -		Exhibits			20

Part I. FINANCIAL INFORMATION

See accompanying notes.

See accompanying notes.

See accompanying notes.

See accompanying notes.

Southern Community Financial Corporation

Note 2 — Net Income Per Share

Basic and diluted net income per share are computed based on the weighted average number of shares outstanding during each period. 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. The convertible trust preferred securities were converted or redeemed during the quarter ended March 31, 2004.

Basic and diluted net income per share have been computed based upon the weighted average number of common shares outstanding or assumed to be outstanding as summarized below:

For the three and six month periods ending June 30, 2005 and 2004, no adjustment was made for the after tax effect of the expense associated with the dilutive convertible preferred securities which were converted or redeemed during the first quarter of 2004. Due to the conversion, the after tax effect of the expense associated with the dilutive convertible preferred securities adjustment was nominal, as less than one thousand dollars in interest expense was paid on redeemed shares.

For the six months ended June 30, 2005 and 2004, there were 495,482 and 17,200 stock options, respectively, that were antidilutive since the exercise price exceeded the average market price for the period.

Note 3 — Business Combination

In August 2004, the company acquired certain assets of two residential mortgage offices from J.R. Davidson Inc., dba Davidson Mortgage in Cornelius, North Carolina in exchange for cash. Davidson Mortgage, formed in 1997, is a mortgage banking company with two offices located in Cornelius, North Carolina and Lexington, South Carolina. Davidson’s primary focus is on conventional conforming and jumbo loan products. The results of Davidson Mortgage’s operations are reflected in the company’s consolidated financial statements from the date of acquisition. The pro forma impact of the Davidson Mortgage acquisition is not material.

Note 4 — Stock Compensation Plans

The Company accounts for stock option awards under the intrinsic value method prescribed in Accounting Principles Board (APB) No. 25, “Accounting for Stock Issued to Employees” which generally results in the recognition of no compensation expense because the exercise price of the stock options equals or exceeds the fair market value of the underlying stock on the grant date. The pro forma impact of accounting for those awards at fair value is disclosed below.

During the first quarter 2005, the Company vested all unvested stock options. As a result of this decision 623,725 non-vested options were accelerated from their established vesting over a 5 year period from date of grant to being fully vested. At the date the decision was made to accelerate the vesting, some of the options had exercise prices below market value. In accordance with the provisions of APB No. 25, compensation expense of $70,000 ($45,000 net of tax effect) has been recognized in the six months ended June 30, 2005 to reflect the effects of the accelerated vesting. The Company applied certain assumptions in the determination of the expense recognized during the period which were based on historical employee attrition rates.

The decision to accelerate the vesting of these options, which the Company believes to be in the best interest of our stockholders, was made primarily to reduce non-cash compensation expenses that would have been recorded in future periods following our application of SFAS No. 123(R). Because we accelerated these options, we expect to reduce our non-cash compensation expense related to these options by approximately $1.6 million (pre-tax) between the first quarter of 2006 and 2009, based on estimated value calculations using the Black-Scholes methodology. During the second quarter of 2005 the Company granted employee stock options to purchase 31,000 shares, which were exercisable upon grant, and options to purchase 10,000 shares to advisory board members which vest over a five year period.

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

The following is a summary of nonperforming assets at the periods presented:

Note 5 — Loans (Continued)

During the first quarter of 2005, management completed an extensive review of the allowance for loan losses related to the loan portfolio acquired in the first quarter of 2004 in connection with The Community Bank acquisition. This review was completed during the one year allocation period, and as a result, management determined the allowance for loan losses as recorded in the preliminary purchase price allocation should be adjusted downward. A purchase price allocation adjustment of $491,000 was recorded as a reduction of the allowance for loan losses and a reduction of goodwill.

As of June 30, 2005 the Company had recorded investment in loans considered impaired in accordance with SFAS No. 114 of $4.0 million with a corresponding valuation allowance of $1.4 million.

Note 6 — 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 7 – Common Stock Repurchase Program

In March 2005, the Company announced a plan to repurchase up to 300,000 shares of its common stock. Purchases may be made from time to time when the Company believes it is advantageous to do so, considering such factors as the current market price and anticipated liquidity and capital needs. During the second quarter of 2005, the Company repurchased 140,000 shares at an average price of $9.08 per share.

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.

Summary of the Second Quarter

The Company ended the period with total assets of $1.3 billion, an increase of $61.8 million or 5.0% on a linked quarter basis. During the quarter the Company experienced strong loan demand as net loans grew $35.9 million or 4.5% to end the period at $833.5 million. The growth in earning assets and higher interest rates combined to produce an increase in interest income of $1.2 million, or 7.9% from the first quarter. However, funding costs also increased, compressing our net interest margin 7 basis points to 3.20% from 3.27% for the quarter ended June 30, 2005. Despite the challenges presented in this flatter yield curve environment, we were able to increase net interest income by $150,000 to $9.2 million in the second quarter. While the Company may gain some benefit in the near-term from an increase in the Prime rate, we attempt to manage its balance sheet to minimize exposure to interest rate changes. The increased net interest income combined with improvements in non-interest income and reductions in non-interest expense to produce net income of $2.1 million, an increase of $470 thousand or 29% on a linked quarter basis, and an increase of $113 thousand, or 5.8% over the second quarter of 2004.

In March 2005, the Company announced a plan to repurchase up to 300,000 shares of stock. Through June 30, 2005, the Company has repurchased 140,000 shares at an average price of $9.08 per share. In addition, on July 28, 2005, the Company’s announced that its Board of Directors declared a quarterly cash dividend of $0.03 per share on the Corporation’s common stock. This is the Company’s second consecutive quarterly dividend, following our former practice of annual cash dividends.

Financial Condition at June 30, 2005 and December 31, 2004

During the six-month period ending June 30, 2005, total assets increased by $83.3 million, or 6.8%, to $1.3 billion. The investment and loan portfolios increased by $15.9 million and $49.7 million, respectively. Asset growth was supported by wholesale borrowings coupled with strong deposit growth. Deposits increased $24.6 million, or 2.9% during the period, with demand deposits increasing $14.2 million or 14.5%.

At June 30, 2005, loans totaled $845.8 million, an increase of $49.7 million or 6.2% during the six months. Commercial mortgage loans, which total $295.0 million or 34.9% of gross loans, continue to comprise the largest segment of the portfolio. Loans secured by residential mortgages and the commercial and industrial portfolio represent 28.3% and 17.1% of gross loans, respectively. Construction lending experienced the most growth during the period, increasing $36.0 million to end the quarter at $138.3 million and 16.4% of the consolidated loan portfolio.

Our total liquid assets, defined as cash and due from banks, federal funds sold and investment securities, increased by $29.9 million during the six months, to $360.7 million at June 30, 2005 versus $330.8 million at the beginning of the period. Increases in the securities portfolio accounted for $15.9 million of the increase in liquid assets.

We utilize various funding sources, as necessary, to support balance sheet management and growth. Asset growth during the period was funded primarily by increases in deposits and wholesale borrowings. Customer deposits continue to be our primary funding source. At June 30, 2005, deposits totaled $869.8 million, an increase of $24.6 million or 2.9% from year-end 2004. Non-maturity deposits accounted for all of the deposit growth during the period, increasing $25.3 million. Borrowings during the period rose $57.0 million or 24.4% to $290.1 million.

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 June 30, 2005, our stockholders’ equity totaled $135.8 million, a decrease of $1.1 million from the December 31, 2004 balance. The decrease is primarily the result of $2.7 million of cash dividends declared and paid during the period, coupled with a $1.5 million net decrease in the fair market value of

available-for-sale securities, and $1.3 million of capital that was utilized to repurchase 140,000 shares of the Company’s outstanding stock.

Results of Operations for the Three Months Ended June 30, 2005 and 2004

Net Income. Our net income for the three months ended June 30, 2005 was $2.1 million, an increase of $113 thousand from the same three-month period in 2004. Net income per share was $.12 basic and $.11 diluted for the three months ended June 30, 2005, as compared with $.11 basic and $.11 diluted for the same period in 2004. With strong internal growth, our level of average earning assets has increased $108.2 million or 10.4% to $1.2 billion from $1.0 billion for the second quarter 2004. Our interest rate spread and net yield on average interest-earning assets declined 23 basis points and 13 basis points, respectively. Our net interest income grew 6.3%, from $8.6 million for the three-month period ending June 2004 to $9.2 million for the current quarter. Net income was also supported by a $74,000 or 4.2% increase in non-interest income. These improvements were partially offset by a 9.2% 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 June 30, 2005, our net interest income increased by $545 thousand or 6.3% over the second quarter 2004 results to $9.2 million. Net interest income benefited from strong growth in average earning assets, coupled with increased yields on the loan portfolio due to interest rate hikes by the Federal Reserve. Due to strong loan demand our level of average earning assets has increased $108.2 million or 10.4% to $1.2 billion from $1.0 billion for the second quarter 2004. The rates earned on a significant portion of our loan portfolio adjust immediately when index rates, such as prime, change. As a result, interest rate increases generally result in an immediate increase in our interest income on loans. Between June 2004 and June 2005 the Federal Reserve increased the targeted Federal funds rate by 225 basis points causing an equal increase in the prime rate. However, the flattening of the yield curve has hampered fixed rate loan and investment portfolio yields from keeping pace with the increase in short-term interest rates. Our average yield on interest-earning assets in the second quarter of 2005 increased 70 basis points above that of the second quarter 2004 to 5.76%. However, our funding costs for the second quarter of 2005 increased 92 basis points to 2.88% from 1.95% for the same three-month period one year ago. This rise is due primarily to increased costs of wholesale borrowings and certificates of deposits being issued or renewed at higher rates. Average interest bearing liabilities increased $97.4 million or 10.5% to $1.0 billion from $927.5 million for the second quarter 2004. As a result of funding costs increases outpacing the rise in earning asset yields our net interest spread and net interest margin were negatively impacted. For the three months ended June 30, 2005, our net interest spread was 2.88% and our net interest margin was 3.20%. For the three months ended June 30, 2004, our net interest spread was 3.10% and our net interest margin was 3.32%.

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 annualized 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.

Provision for Loan Losses. Our provision for loan losses for the three months ended June 30, 2005 was $475,000 representing a decrease of $242,000 from the $717,000 provision we made for the three months ended June 30, 2004. In evaluating the allowance for loan losses, we consider factors that include growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors. During the three months ended June 30, 2005 net loan charge-offs totaled $243,000, down from $275,000 of net charge-offs during the three months ended June 30, 2004. On an annualized basis, our percentage of net loan charge-offs to average loans outstanding was .12% and .16% for the three months ended June 30, 2005 and 2004, respectively. The dollar amount of non-performing assets increased to $7.3 million from $3.3 million at December 31, 2004 and $3.0 million at June 30, 2004, and as a percentage of total assets the ratio increased from 0.25% of total assets at June 2004 to 0.56% at June 2005. The increase in non-performing assets from December 31, 2004 was primarily the result of loans in two relationships, for which specific reserves had been established in 2004, being placed on nonaccrual status in the first quarter of 2005. The allowance for loan losses at June 30, 2005 represented 1.46% of loans outstanding, compared with 1.57% at December 31, 2004 and 1.70% at June 30, 2004. The provision for loan losses and the allowance as a percentage of loans outstanding have declined as a result of trends in the economy and the loan portfolio, and continued strong credit quality. We believe that the Company’s allowance is adequate to absorb probable losses inherent in our loan portfolio.

Non-Interest Income. For the three months ended June 30, 2005, non-interest income increased by $74,000 or 4.2% to $1.9 million from $1.8 million for the same period in the prior year. The increase for the three months ended June 30, 2005 was due primarily to increased services charges and fees on deposit accounts with a larger deposit base and fees generated from mortgage originations due to the lower long-term interest rate environment. We expect a continued positive trend in service charge fee income in the future as we continue to expand our branch network and deposit base. In addition, as Salem Capital Partners’ portfolio matures, we anticipate some fluctuation in our non-interest income as gains and losses on their investments are recognized.

Non-Interest Expense . We strive to maintain non-interest expenses at levels that we believe are appropriate given the nature of our operations and the investments in personnel and facilities that have been necessary to support and service our growth. From 1998 forward through the current three-month period, we have consistently maintained our ratio of non-interest expenses to average total assets below 3.0%. Because of our growth we have consistently seen increases in every major component of our non-interest expenses. For the three months ended June 30, 2005, our non-interest expense increased $617,000 or 9.2% over the same period in 2004. Salaries and employee benefit expense increased $356,000 or 10.1%. This increase reflects the addition of personnel to support our expanding business and, to a lesser degree, normal salary increases. Occupancy and equipment expense increased $332,000, or 31.9% due to additional infrastructure to support in-house processing. Other expenses decreased $71,000 or 3.3% to $2.1 million. Due to our strong asset growth, our ratio of non-interest expenses, on an annualized basis, to average total assets decreased slightly to 2.32% as compared with 2.33% for the same three months in 2004.

Provision for Income Taxes. Our provision for income taxes, as a percentage of income before income taxes, was 35.8% and 34.3%, respectively, for the three months ended June 30, 2005 and 2004.

Results of Operations for the Six Months Ended June 30, 2005 and 2004

Net Income. Our net income for the six months ended June 30, 2005 was $3.7 million, an increase of $27,000 from the same six-month period in 2004. Net income per share was $.21 basic and $.20 diluted for the six months ended June 30, 2005, as compared with $.22 basic and $.21 diluted for the same period in 2004. With strong internal growth our level of average earning assets has increased $106.9 million or 10.4% to $1.1 billion from $1.0 billion for the first six months of 2004. Our interest rate spread and net yield on average interest-earning assets decreased 19 basis points and 12 basis points, respectively. Our net interest income grew 6.7%, from $17.1 million for the six-month period ending June 2004 to $18.2 million for the current period. Net income was also supported by a $291,000 or 8.8% increase in non-interest income. These improvements were offset by a 13.1% increase in non-interest expenses. Our expense growth included the costs of new infrastructure and facilities associated with bringing item and core processing in-house and the continued expansion of our business, additional personnel costs, and as well as other unusual expenses incurred during the first quarter. These unusual expenses included costs related to retirement plans for the departure of two members of management, expensing of stock options and additional professional services expense associated with the evaluation and testing of controls over financial reporting as required under Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”).

Net Interest Income. During the six months ended June 30, 2005, our net interest income totaled $18.2 million, an increase of $1.1 million or 6.7% over the $17.1 million for the same six-month period in 2003. Net interest income benefited from strong growth in average earning assets, coupled with increased yields on the loan portfolio due to interest rate hikes by the Federal Reserve. Due to strong loan demand our level of average earning assets has increased $106.9 million or 10.4% to $1.1 billion from $1.0 billion for the six-months ended June 2004. The rates earned on a significant portion of our loan portfolio adjust immediately when index rates, such as prime, change. As a result, interest rate increases generally result in an immediate increase in our interest income on loans. Between June 2004 and June 2005 the Federal Reserve increased the targeted Federal funds rate by 225 basis points causing an equal increase in the prime rate. However, the flattening of the yield curve has hampered fixed rate loan and investment portfolio yields from keeping pace with the increase in short-term interest rates. Our average yield on interest-earning assets in the first six months of 2005 increased 57 basis points above that of the first half of 2004 to 5.66%. However, our funding costs for the same six month period of 2005 increased 76 basis points to 2.73% from 1.97% for the same six-month period one year ago. This rise is due primarily to increased costs of wholesale borrowings and certificates of deposits being issued or renewed at higher rates. Average interest bearing liabilities increased $95.6 million or 10.5% to $1.0 billion from $913.4 million for the six-month period ending June 2004. As a result of funding costs increases outpacing the rise in earning asset yields our net interest spread and net interest margin were negatively impacted. For the six months ended June 30, 2005, our net interest spread was 2.93% and our net interest margin was 3.23%. For the six months ended June 30, 2004, our net interest spread was 3.12% and our net interest margin was 3.35%.

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.