Peoples Bancorp of North Carolina - 10-Q quarterly report FY

 The following is an analysis of the allowance for loan losses for the nine months ended September 30, 2006 and 2005:

Management's discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of Peoples Bancorp of North Carolina, Inc. Peoples Bancorp is the parent company of Peoples Bank (the “Bank”) and a registered bank holding company operating under the supervision of the Federal Reserve Board. The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander Mecklenburg, Iredell and Union counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).

Our business consists principally of attracting deposits from the general public and investing these funds in loans secured by commercial real estate, secured and unsecured commercial and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System, inflation, interest rates, market and monetary fluctuations. Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered. Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that local employers may be required to eliminate employment positions of borrowers, and small businesses and other commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating its allowance for loan losses, and changes in these economic conditions could result in increases or decreases to the provision for loan losses.

Our business emphasis has been to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We believe that we can be more effective in servicing our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability of our senior management team.

The Federal Reserve has increased the Federal Funds Rate a total of 3.00% since December 31, 2004 with the rate set at 5.25% as of September 30, 2006. These increases had a positive impact on third quarter earnings and should continue to have a positive impact on the Bank’s net interest income in the future periods. The positive impact from the increase in the Federal Funds Rate has been partially offset by the decrease in earnings realized on interest rate contracts, including both interest rate swaps and interest rate floors, utilized by the Company. The swaps were put in place during the time that the Federal Funds Rate approached 1.00% and helped to offset the decline in income experienced in 2003 and 2004 because of the reductions in the Federal Funds Rate that the Federal Reserve implemented from January 2001 to June 2003. Additional information regarding the Company’s interest rate contacts is provided below in the section entitled “Asset Liability and Interest Rate Risk Management.”

The Company currently qualifies as a non-accelerated filer in accordance with Rule 12b-2 of the Securities Exchange Act of 1934. Therefore, the Company is not currently subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (“SOX 404”). The Company will qualify as an accelerated filer and be required to comply with SOX 404 effective December 31, 2006. The Company will incur additional consulting and audit expenses in becoming compliant and continuing to comply with SOX 404. Management does not expect expenses related to SOX 404 to have a material impact on the Company’s financial statements.

The Bank opened a new Banco de la Gente office in Union County, in Monroe, North Carolina in June 2006 in a continuing effort to serve the Latino community. The Bank also plans to open a new traditional banking office in Iredell County, in Mooresville, North Carolina during the first six months of 2007. Management expects to continue to open at

 

The consolidated financial statements include the financial statements of Peoples Bancorp of North Carolina, Inc. and its wholly owned subsidiary, Peoples Bank, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc. and Real Estate Advisory Services, Inc. (collectively called the “Company”). All significant intercompany balances and transactions have been eliminated in consolidation.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance. The following is a summary of some of the more subjective and complex accounting policies of the Company. A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2006 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 4, 2006 Annual Meeting of Shareholders. The following is a summary of the more subjective and complex accounting policies of the Company.

Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability. The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses. The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability. In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements. Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques. The Company’s internal models generally involve present value of cash flow techniques. The various techniques are discussed in greater detail elsewhere in management’s discussion and analysis and the notes to the consolidated financial statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards. These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities.” For a more complete discussion of policies, see the notes to the consolidated financial statements.

In September 2006, the FASB ratified the conclusions reached by the Emerging Issues Task Force (EITF) on EITF 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements.” This issue will require companies to recognize an obligation for either the present value of the entire promised death benefit or the annual “cost of insurance” required to keep the policy in force during the post-retirement years. This will be effective for fiscal years beginning after December 15, 2007. Management is currently evaluating the effect of the proposal on the Company’s results of operations and financial condition, as the Bank has split-dollar policies in place in its BOLI.

In June 2006, FASB issued Financial Interpretation No. 48 (“FIN 48”) Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements and prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. This interpretation will be effective for the Company beginning in January of 2007. The Company is in the process of assessing the impact of this interpretation on its financial position and results of operations.

Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with generally accepted accounting principles. Actual results could differ from those estimates.

 

 

The annualized return on average assets was 1.21% for the three months ended September 30, 2006 compared to 1.02% for the same period in 2005, and annualized return on average shareholders' equity was 15.75% for the three months ended September 30, 2006 compared to 13.44% for the same period in 2005.

Net earnings for the nine months ended September 30, 2006 were $7.3 million, or $1.92 basic net earnings per share and $1.87 diluted net earnings per share. Net earnings from recurring operations for the nine months ended September 30, 2006 were $7.6 million, or $2.00 basic net income per share and $1.95 diluted net income per share, representing a 57% increase over net earnings from recurring operations of $4.8 million, or $1.27 basic net income per share and $1.25 diluted net income per share, for the same period one year ago. The increase in net earnings for the nine-month period ended September 30, 2006 is primarily attributable to growth in interest-earning assets, which contributed to increases in net interest income and non-interest income. In addition the Company had a decrease in the provision for loan losses. The increases in net interest income and non-interest income and the decrease in the provision for loan losses were partially offset by an increase in non-interest expense.

The annualized return on average assets was 1.27% for the nine months ended September 30, 2006 compared to 0.90% for the same period in 2005, and annualized return on average shareholders’ equity was 16.08% for the nine months ended September 30, 2006 compared to 11.55% for the same period in 2005.

Interest income increased $3.4 million or 30% for the three months ended September 30, 2006 compared with the same period in 2005. The increase was due to an increase in the average yield received on loans resulting from Federal Reserve interest rate increases combined with an increase in the average outstanding balance of loans and investment securities available-for-sale. The average yield earned on loans, including fees, was 8.67% for the three months ended September 30, 2006 as compared to 7.25% for the same period of 2005. During the quarter ended September 30, 2006, average loans increased $52.9 million to $608.6 million from $555.7 million for the three months ended September 30, 2005. During the quarter ended September 30, 2006, average investment securities available-for-sale increased $11.2 million to $119.3 million from $108.1 million for the three months ended September 30, 2005.

Interest expense increased $2.3 million or 57% for the three months ended September 30, 2006 compared with the same period in 2005. The increase in interest expense was due to an increase in the cost of funds to 4.00% for the three months ended September 30, 2006 from 2.78% for the same period in 2005, combined with an increase in volume of interest-bearing liabilities. The increase in the cost of funds is primarily attributable to increases in the average rate paid on interest-bearing deposits. The average rate paid on interest-bearing checking and savings accounts was 1.89% for the three months ended September 30, 2006 as compared to 1.37% for the same period of 2005. The average rate paid on certificates of deposits was 4.40% for the three months ended September 30, 2006 compared to 3.17% for the same period one year ago.

Net interest income for the nine-month period ended September 30, 2006 was $25.1 million, an increase of 24% over net interest income of $20.3 million for the nine months ended September 30, 2005. This increase is attributable to an increase in interest income due to increases in the prime rate combined with increases in the average outstanding balances of loans and investment securities available-for-sale.

Interest income increased $10.3 million or 33% to $41.6 million for the nine months ended September 30, 2006 compared to $31.3 million for the same period in 2005. The increase was primarily due to an increase in the average yield received on loans resulting from Federal Reserve interest rate increases combined with an increase in the average

 

Interest expense increased 50% to $16.5 million for the nine months ended September 30, 2006 compared to $11.0 million for the corresponding period in 2005. The increase in interest expense was due to an increase in the cost of funds to 3.65% for the nine months ended September 30, 2006 from 2.64% for the same period in 2005. The increase in the cost of funds is primarily attributable to increases in the average rate paid on interest-bearing deposits. The average rate paid on interest-bearing checking and savings accounts was 1.69% for the nine months ended September 30, 2006 as compared to 1.36% for the same period in 2005. The average rate paid on certificates of deposits was 4.09% for the nine months ended September 30, 2006 from 2.91% for the same period one year ago.

Total non-interest income was $6.0 million for the nine months ended September 30, 2006, a 14% increase over the $5.3 million for the same period in 2005. This increase is primarily due to an increase in fee income and other miscellaneous income resulting from activity in new branches opened in 2004, 2005 and 2006. Service charges were $2.9 million for the nine months ended September 30, 2006, a 6% increase over the same period in 2005. This increase is primarily due to an increase of $92,000 in account maintenance income. Other service charges and fees increased 40% to $1.2 million for the nine months ended September 30, 2006 when compared to the same period one year ago. This increase is primarily attributable to an increase of $184,000 in check cashing fee income and an increase of $58,000 in miscellaneous fee income. Mortgage banking income increased 5% to $356,000 for the nine months ended September 30, 2006 when compared to the same period in 2005. Miscellaneous income increased 35% to $1.6 million for the nine months ended September 30, 2006. This increase in miscellaneous income was partially attributable to an increase of $154,000 in debit card fee income primarily associated with increased card usage due to an increased number of demand accounts, income amounting to $118,000 distributed by a SBIC investment owned by the Bank and a $69,000 increase in income from the Bank’s Real Estate Advisory Services, Inc. subsidiary. These increases were partially offset by a $337,000 loss on sale of securities, which reflects management’s efforts to reposition the Bank’s investment portfolio in order to reduce exposure to a decrease in interest rates. Recurring non-interest income amounted to $6.3 million and $5.4 million for the nine months ended September 30, 2006 and 2005, respectively. Net non-recurring losses on the disposition of assets totaled $311,000 for the nine months ended September 30, 2006 and included the $337,000 loss on the sale of securities partially offset by a $26,000 gain on the disposition of assets.

 

 

Total non-interest expense was $17.8 million for the nine months ended September 30, 2006, an increase of 12% over the same period in 2005. Salary and employee benefits totaled $9.9 million for the nine months ended September 30, 2006, an increase of 9% over the same period in 2005. The increase in salary and employee benefits is primarily due to normal salary increases and increased incentive expense. Occupancy expense increased 3% to $3.1 million for the nine months ended September 30, 2006. Other non-interest expense increased 26% to $4.9 million for the nine months ended September 30, 2006 as compared to the same period in 2005. The increase in other non-interest expense is attributable to an increase of $178,000 in consulting expense due to Sarbanes-Oxley related expense, an increase of $296,000 in amortization of the issuance costs of the trust preferred securities issued in 2001 that management intends to call on December 31, 2006 and an increase of $165,000 in debit card expense. The Company also had non-recurring expense of $178,000 from a prepayment fee associated with the early termination of a $5.0 million Federal Home Loan Bank advance during the first quarter of 2006. Recurring non-interest expense increased 11% to $17.6 million for the nine months ended September 30, 2006, as compared to $15.9 million for the same period last year.

The Company reported income taxes of $4.1 million and $2.5 million for the nine months ended September 30, 2006 and 2005, respectively. This represented effective tax rates of 36% and 35% for the respective periods.

An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan losses is prepared by the Bank’s credit administration personnel and presented to the Bank’s Board of Directors on a regular basis. The allowance is the total of specific reserves allocated to significant individual loans plus a general reserve. After individual loans with specific allocations have been deducted, the general reserve is calculated by applying general reserve percentages to the nine risk grades within the portfolio. Loans are categorized as one of nine risk grades based on

 

The following table presents the percentage of loans assigned to each risk grade along with the general reserve percentage applied to loans in each risk grade at September 30, 2006 and December 31, 2005.

 

 

At September 30, 2006 there were no relationships exceeding $1.0 million in the Watch risk grade, one relationship which totaled $1.4 million in the Substandard risk grade and one relationship which totaled $3.1 million in the Low Substandard risk grade. These customers continue to meet payment requirements. These relationships would not become non-performing assets unless they are unable to meet those payment requirements.

An allowance for loan losses is also established, as necessary, for individual loans considered to be impaired in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 114. A loan is considered impaired when, based on current information and events, it is probable that all amounts due according to the contractual terms of the loan will not be collected. Impaired loans are measured based on the present value of expected future cash flows, discounted at the loan’s effective interest rate, or at the loan’s observable market price, or the fair value of collateral if the loan is collateral dependent. At September 30, 2006 and December 31, 2005, the recorded investment in loans that were considered to be impaired under SFAS No. 114 was approximately $3.1 million and $3.5 million, respectively, with related allowance for loan losses of approximately $362,000 and $478,000, respectively.

The allowance for loan losses totaled $8.1 million at September 30, 2006 and $7.4 million at December 31, 2005, which represented 1.30% of total loans outstanding at September 30, 2006 and 1.31% of total loans outstanding as of December 31, 2005.

The Bank’s allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance for loan losses and the size of the allowance for loan losses compared to a group of peer banks identified by the regulators. During their routine examinations of banks, the FDIC and the North Carolina Commissioner of Banks may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

While it is the Bank's policy to charge off in the current period loans for which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise. After review of all relevant matters affecting loan collectability, management believes that the allowance for loan losses is appropriate.

The Company grants loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg County. Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market. Non-real estate loans also can be affected by local economic conditions. At September 30, 2006, approximately 5% of the Company’s portfolio was not secured by any type of collateral. Unsecured loans generally involve higher credit risk than secured loans and, in the event of customer default, the Company has a higher exposure to

 

Total non-performing loans, which include non-accrual loans and loans ninety days past due and still accruing, were $3.1 million and $4.4 million at September 30, 2006 and December 31, 2005, respectively. The ratio of non-performing loans to total loans was 0.50% at September 30, 2006, as compared to 0.79% at December 31, 2005.

Securities sold under agreements to repurchase amounted to $8.6 million and $981,000 as of September 30, 2006 and December 31, 2005, respectively.

The trust preferred securities issued by PEBK Trust accrue and pay quarterly distributions based on the liquidation value of $50,000 per capital security at a floating rate of prime plus 50 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust has funds with which to make the distributions and other payments. The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.

These trust preferred securities are mandatorily redeemable upon maturity of the debentures on December 31, 2031, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust, in whole or in part, on or after December 31, 2006. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest. Management intends to call these trust preferred securities on December 31, 2006. In June 2006, as a result of management’s decision to call these securities, the amortization of the related issuance cost was revised so it will be fully

 

In June 2006 the Company formed a second wholly owned Delaware statutory trust, PEBK Capital Trust II (“PEBK Trust II”), which issued $20.0 million of guaranteed preferred beneficial interests in the Company’s junior subordinated deferrable interest debentures. All of the common securities of PEBK Trust II are owned by the Company. The proceeds from the issuance of the common securities and the trust preferred securities were used by PEBK Trust II to purchase $20.6 million of junior subordinated debentures of the Company, which pay a floating rate equal to three month LIBOR plus 163 basis points. The proceeds received by the Company from the sale of the junior subordinated debentures are intended to be used to repay the trust preferred securities issued by PEBK Trust in December 2001 and for general purposes. The debentures represent the sole asset of PEBK Trust II. PEBK Trust II is not included in the consolidated financial statements.

The trust preferred securities issued by PEBK Trust II accrue and pay quarterly at a floating rate of three month LIBOR plus 163 basis points. The Company has guaranteed distributions and other payments due on the trust preferred securities to the extent PEBK Trust II has funds with which to make the distributions and other payments. The net combined effect of all the documents entered into in connection with the trust preferred securities is that the Company is liable to make the distributions and other payments required on the trust preferred securities.

These trust preferred securities are mandatorily redeemable upon maturity of the debentures on June 28, 2036, or upon earlier redemption as provided in the indenture. The Company has the right to redeem the debentures purchased by PEBK Trust II, in whole or in part, on or after September 15, 2011. As specified in the indenture, if the debentures are redeemed prior to maturity, the redemption price will be the principal amount and any accrued but unpaid interest.

Management expects to call the PEBK Trust securities and issued the new PEBK Trust II securities in an effort to reduce interest expense. Based on interest rates in effect at September 30, 2006, the rate on the PEBK Trust securities was 8.75%, while the interest rate on the PEBK Trust II securities was 7.02%.

 

 

 

The Company settled two previously outstanding interest rate swap agreements during 2005. The first swap, with a notional amount of $25.0 million and maturing in April 2006 was sold for a loss of $318,000. The second swap with a notional amount of $30.0 million and maturing in September 2006 was sold for a loss of $552,000. The losses realized upon settlement were recognized over the original term of the agreements and during the nine-month period, ended September 30, 2006, losses of approximately $386,000 were recognized.

At September 30, 2006, the Bank had a significant amount of deposits in amounts greater than $100,000, including brokered deposits of $54.8 million, which mature over the next year. The balance and cost of these deposits are more susceptible to changes in the interest rate environment than other deposits.

The Bank had a line of credit with the FHLB equal to 20% of the Bank’s total assets, with an outstanding balance of $78.8 million at September 30, 2006. The remaining availability at FHLB was $52.6 million at September 30, 2006. The Bank also had the ability to borrow up to $26.0 million for the purchase of overnight federal funds from three correspondent financial institutions as of September 30, 2006.

The liquidity ratio for the Bank, which is defined as net cash, interest bearing deposits with banks, federal funds sold, certain investment securities and certain FHLB advances available under the line of credit, as a percentage of net deposits (adjusted for deposit runoff projections) and short-term liabilities was 33.09% at September 30, 2006 and 36.81% at December 31, 2005. The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy is 20%.

 

 

The Company enters into derivative contracts to manage various financial risks. A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate. Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date. Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk. Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management”.

Since implementation of a stock repurchase plan implemented in November 2005, which expires in November 2006, the Company has repurchased $425,000, or 17,500 shares of its common stock.

Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 4.0% or greater. Tier 1 capital is generally defined as shareholders' equity and Trust Preferred Securities less all intangible assets and goodwill. The Company’s Tier 1 capital ratio was 11.93% and 11.02% at September 30, 2006 and December 31, 2005, respectively. Total risk-based capital is defined as Tier 1 capital plus supplementary capital. Supplementary capital, or Tier 2 capital, consists of the Company's allowance for loan losses, not exceeding 1.25% of the Company's risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets. The Company’s total risk-based capital ratio was 15.06% and 12.19% at September 30, 2006 and December 31, 2005, respectively. In addition to the Tier 1 and total risk-based capital requirements, financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater. The Company’s Tier 1 leverage capital ratio was 10.79% and 9.84% at September 30, 2006 and December 31, 2005, respectively.

The Bank’s Tier 1 risk-based capital ratio was 10.42% and 10.46% at September 30, 2006 and December 31, 2005, respectively. The total risk-based capital ratio for the Bank was 11.61% and 11.64% at September 30, 2006 and December 31, 2005, respectively. The Bank’s Tier 1 leverage capital ratio was 9.41% and 9.33% at September 30, 2006 and December 31, 2005, respectively.

A bank is considered to be "well capitalized" if it has a total risk-based capital ratio of 10.0 % or greater, a Tier 1 risk-based capital ratio of 6.0% or greater, and has a leverage ratio of 5.0% or greater. Based upon these guidelines, the Bank was considered to be "well capitalized" at September 30, 2006.