|  **U. S. SECURITIES AND  EXCHANGE COMMISSION  WASHINGTON,  D.C. 20549**   
**FORM 10-Q**  
 
(X)QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT OF 1934      For the quarterly period ended March 31, 2003
(  ) TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934   
  For the transition period from __________ to  __________ 
Commission  file number  0-26016
**PALMETTO  BANCSHARES, INC.**(Exact name of  registrant as specified in its charter) 
**South Carolina  (State or  other jurisdiction of incorporation or organization)**
**74-2235055  (IRS Employer Identification No.)**       
**301 Hillcrest  Drive, Laurens, South Carolina  (Address of  principal executive offices)**
**29360  (Zip Code)**  
    
**(864) 984-4551  (Registrant's  telephone number)**
**palmettobank.com  (Registrant's web site)**            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 X    No __                Indicate  the number of shares outstanding of each of the issuer's classes of common  stock, as of the latest  practicable date.Class Outstanding at May 2, 2003 Common stock, $5.00 par value 6,349,109 
 

 

 

**PALMETTO BANCSHARES, INC.****Table of Contents**      Page No.**PART I.  FINANCIAL INFORMATION**3Item 1.Financial Statements3Item 2.
Management's Discussion and Analysis    of Financial Condition    and      Results of Operations11Item 3.Quantitative and Qualitative Disclosures about Market Risk27Item 4.Controls and Procedures29**PART II.  OTHER INFORMATION**30Item 1.Legal Proceedings30Item 2.Changes in Securities and Use of Proceeds30   Item 3.Defaults Upon Senior Securities30  Item 4.Submission of Matters to a Vote of Security Holders30Item 5.Other Information30Item 6.Exhibits and Reports on Form 8-K30**SIGNATURES**31**CERTIFICATIONS PURSUANT TO 15 U.S.C. SECTION    7241**32
 

 

 

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**PART 1. FINANCIAL INFORMATION**

**Item 1. Financial Statements**

**PALMETTO BANCSHARES, INC. ****Consolidated Balance Sheets****(in thousands, except share data)****March 31,****December 31,****2003****2002****2002**(unaudited)ASSETSCash and due from banks $        32,953            36,079                32,608 Federal funds sold           14,479            22,280 5,485 Federal Home Loan Bank (FHLB) stock, at cost             1,868              1,733 1,733       Investment securities available for sale at fair value         113,138          104,873 115,108 Loans held for sale 11,093   13,363  11,851                        Loans  646,628 555,660 625,542      Less allowance for loan losses            (6,771)            (5,744)(6,402)                Loans, net          639,857          549,916              619,140 Premises and equipment, net           19,805            19,522 19,715 Accrued interest receivable             4,114              4,740 4,146 Other assets           15,792            12,014 15,206                Total assets $      853,099          764,520              824,992 LIABILITIES AND SHAREHOLDERS' EQUITYLiabilitiesDeposits     Noninterest-bearing  $      116,615          101,945              114,573      Interest-bearing          622,144          565,695 607,418                 Total deposits          738,759          667,640 721,991       Securities sold under agreements to repurchase           16,261            16,798 12,831 Commercial paper (Master notes)           16,965            13,154 14,839 Other liabilities           11,358              6,225 7,810                Total liabilities          783,343          703,817 757,471 Shareholders' equity      Common stock - par value $5.00 per share;  authorized 10,000,000           shares; issued and outstanding 6,329,909, 6,291,578 and 6,324,659          at March 31, 2003 and 2002 and December 31, 2002, respectively.           31,650            31,458 31,623 Capital surplus                   89                    29                        50 Retained earnings           36,314            29,148 34,173       Accumulated other comprehensive income, net of tax             1,703                    68 1,675                Total shareholders' equity            69,756            60,703 67,521                    Total liabilities and shareholders' equity  $      853,099          764,520              824,992 
      See accompanying notes to consolidated interim financial statements.
 

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**PALMETTO BANCSHARES, INC. ****Consolidated Statements of Income**
**(in thousands, except share data)** 
        **For the three months ended       March 31,**  **2003****2002**
(unaudited)Interest incomeInterest and fees on loans $      10,722           10,528 Interest and dividends on investment securities available for sale     U.S. Treasury and U.S. Government agencies                415                311      State and municipal                382                635      Mortgage-backed securities                209                131 Interest on federal funds sold                 35                  58 Dividends on FHLB stock                 23                  26            Total interest income          11,786           11,689 Interest expenseInterest on deposits, including retail repurchase agreements            2,804             3,308 Interest on federal funds purchased                   4                     1 Interest on commercial paper (Master notes)                 23                  34            Total interest expense             2,831             3,343                 Net interest income             8,955             8,346 Provision for loan losses               900                900                Net interest income after provision for loan losses            8,055             7,446 Noninterest incomeService charges on deposit accounts            2,004             1,825 Fees for trust and brokerage services               637                612 Gains on sales of mortgage loans               339                225 Gains on sales of investment securities                 95                140  Other 
398  
569           Total noninterest income             3,473             3,371 Noninterest expense               Salaries and other personnel   
3,670  
3,679 Net occupancy               567                548 Furniture and equipment               813                635 FDIC assessment                 39                  28 Postage and supplies               396                382 Marketing and advertising               184                255 Telephone               184                193 Cardholder processing               136                141 Sales finance losses                 11                  24  Other  
1,228  
1,288           Total noninterest expense             7,228 7,173                 Income before income taxes             4,300             3,644 Income tax provision            1,398             1,189                Net income  $        2,902             2,455 Share Data:Net income - Basic $           0.46               0.39 Net income - Diluted              0.45               0.38 Book value            11.02               9.65 Weighted average common shares outstanding - Basic    6,326,698     6,287,279 Weighted average common shares outstanding - Diluted    6,482,699     6,473,816 
See accompanying notes to consolidated interim financial statements.
 

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**PALMETTO BANCSHARES, INC. **** Consolidated Statements of Changes in Shareholders' Equity and Comprehensive Income ****(in thousands, except share data) (unaudited)**AccumulatedShares ofothercommonCommonCapitalRetainedcomprehensivestockstocksurplusearningsincome, netTotalBalance at December 31, 2001 6,283,623  $   31,418                26          27,386                            238          59,068 Net income            2,455             2,455       Other comprehensive income, net of tax:           Unrealized holding gains (losses) arising during period, net          of tax effect of $53                            (84)           Less:  reclassification adjustment for gains included                in net income, net of tax effect of $54                            (86)           Net unrealized gains (losses) on securities             (170)Comprehensive income            2,285       Cash dividend declared and paid ($.11 per share)             (693)             (693)Stock option activity         7,955 40                  3                  43 Balance at March 31, 2002 6,291,578  $   31,458                29          29,148                               68          60,703 Balance at December 31, 2002 6,324,659  $   31,623                50          34,173                         1,675          67,521 Net income            2,902             2,902       Other comprehensive income, net of tax:           Unrealized holding gains arising during period, net          of tax effect of $54                              86            Less:  reclassification adjustment for gains included                in net income, net of tax effect of $37                            (58)           Net unrealized gains on securities                 28 Comprehensive income            2,930       Cash dividend declared and paid ($.12 per share)             (761)             (761)Stock option activity5,250 27                39                  66 Balance at March 31, 2003 6,329,909  $   31,650                89          36,314                         1,703          69,756 
See accompanying notes to consolidated interim financial statements.

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**PALMETTO BANCSHARES, INC.**
**Consolidated Statements of Cash Flows **
**(in thousands) **
**For the three months       ended March 31,  **
**2003**
**2002**
(unaudited)      Cash flows from operating activitiesNet income $       2,902           2,455 Adjustments to reconcile net income to net cash           provided by (used in) operating activities                Depreciation and amortization              249              588                Gain on sale of investment securities               (95)            (140)               Provision for loan losses              900              900                Origination of loans held for sale       (36,773)      (27,184)               Sale of loans held for sale         37,870 24,100                Gain on sale of loans             (339)(225)               Change in accrued interest receivable 32 207                Change in other assets (21)(219)               Change in other liabilities, net 3,531 1,809                      Net cash provided by operating activities 8,256 2,291       Cash flows from investing activities      Purchase of investment securities available for sale      (15,327)      (37,130)      Proceeds from maturities of investment securities available for sale          4,335           4,841       Proceeds from sale of investment securities available for sale          9,114         20,779 Principal paydowns on mortgage-backed securities available for sale          3,744           1,451       Purchase of Federal Home Loan Bank stock            (135)                 -         Net increase in loans outstanding      (21,750)         (4,043)      Purchases of premises and equipment, net            (527)            (774)                Net cash used in investing activities       (20,546)      (14,876)      Cash flows from financing activities      Net increase in deposit accounts16,768         22,340       Net increase in securities sold under agreements to repurchase3,430           1,485       Net increase in commercial paper2,126           2,078       Proceeds from issuance of common stock                66                 43 Dividends paid            (761)            (693)                     Net cash provided by financing activities 21,629         25,253       Net increase in cash and cash equivalents9,339 12,668       Cash and cash equivalents at beginning of the period38,093         45,691       Cash and cash equivalents at end of the period $     47,432         58,359       Supplemental Information      Cash paid during the period for:Interest expense $       2,926           3,573 Income taxes962              698       Supplemental schedule of non-cash investing and financing transactions      Change in unrealized gain on investment securities available for sale, pre-tax  $            45             (276)      Loans transferred to other real estate owned133           1,506 Loans charged -off588              868 
      See accompanying notes to consolidated interim financial statements.
 

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**PALMETTO BANCSHARES, INC.Notes To Consolidated Interim Financial Statements**

 

1.       GENERAL

Principles of Consolidation and Nature of OperationsThe foregoing unaudited consolidated financial statements include accountsof the Palmetto Bancshares, Inc. (defined collectively with its subsidiaries asthe "Company"), its wholly owned subsidiary, The Palmetto Bank (the "Bank"), andPalmetto Capital, Inc., the Bank's wholly owned subsidiary. The Bank provides afull range of banking services including, but not limited to, taking depositsand making loans. Palmetto Capital offers the brokerage of stocks, bonds, mutualfunds and unit investment trusts. Palmetto Capital also offers advisory servicesand variable rate annuities. The Company's primary market area is the upstate ofSouth Carolina. 

In management's opinion, all significant intercompany accounts andtransactions have been eliminated, and all adjustments necessary for a fairpresentation of the results for interim periods presented have been included. Any such adjustments are of a normal and recurring nature. The Company operatesas one business segment. Assets held by the Company or its subsidiary in afiduciary or agency capacity for customers are not included in the consolidatedfinancial statements as such items do not represent assets of the Company or itssubsidiary.

Basis of PresentationThe unaudited consolidated interim financial statements are presented inaccordance with the instructions for Form 10-Q.  Accordingly, certaininformation and footnotes required by generally accepted accounting principlesfor complete financial statements are not included herein.  The interimstatements should be read in conjunction with the financial statements andfootnotes thereto included in the Company's Annual Report on Form 10-K for theyear ended December 31, 2002. 

Summary of Significant Accounting PoliciesThe significant accounting policies used by the Company for interimreporting are consistent with the accounting policies followed for annualfinancial reporting as described in Note 1 to the Company's Annual Report onForm 10-K for the year ended December 31, 2002.  There have been no changesin these policies subsequent to the year ended December 31, 2002.

Accounting Estimates and AssumptionsThe accounting and reporting policies of the Company conform to accountingprinciples generally accepted in the United States of America and to generalpractices within the banking industry. In preparing the consolidated financialstatements, management is required to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities as of the dates of the consolidated balance sheets forthe periods presented. In addition, they affect the reporting amounts of incomeand expense during the reporting period as of the dates of the consolidatedstatements of income for the periods presented. Actual results could differ fromthese estimates and assumptions.  As such, the results of operations forthe three months ended March 31, 2003 are not necessarily indicative of theresults of operations that may be expected in future periods.

Risks and UncertaintiesIn the normal course of its business the Company encounters two significanttypes of risk: economic and regulatory. There are three main components ofeconomic risk: interest rate risk, credit risk and market risk. The Company issubject to interest rate risk to the degree that its interest-bearingliabilities mature or reprice at different speeds, or on different bases, thanits interest-earning assets. Credit risk is the risk of default on the Company'sloan portfolio that results from borrowers' inability or unwillingness to makecontractually required payments. Market risk reflects changes in the value ofcollateral underlying loans, the valuation of real estate held by the Companyand the valuation of mortgage loans held for sale, investments andmortgage-backed securities available for sale and mortgage servicing rights. 

 

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The Company is subject to the regulations of various government agencies.These regulations can and do change significantly from period to period. TheCompany also undergoes periodic examinations by the regulatory agencies, whichmay subject it to further changes with respect to asset valuations, amounts ofrequired loss allowances and operating restrictions resulting from theregulators' judgments based on information available to them at the time oftheir examinations.

ReclassificationsCertain amounts previously presented in the consolidated financialstatements for prior periods have been reclassified to conform to currentclassifications. All such reclassifications had no effect on the prior years'net income or shareholders' equity as previously reported.

2.       PER SHARE INFORMATION

Basic and diluted earnings per share have been computed based on net incomein the accompanying consolidated statements of income divided by the weightedaverage common shares outstanding or assumed to be outstanding as summarizedbelow:
 For the three      months ended March 31,
           2003
             2002BASICAverage common shares outstanding      (denominator)         6,326,698         6,287,279DILUTEDAverage common shares outstanding 6,326,698  6,287,279Dilutive potential common shares         156,001        186,537Average diluted shares outstanding      (denominator)        6,482,699        6,473,816
At March 31, 2003 there were no option shares that were excluded from thecalculation of diluted earnings because the exercise price was greater than theaverage market price of the common shares as of that date, based on informationavailable to the Company at that time.

3.       INTANGIBLE ASSETS

In July 2001, the FASB issued SFAS No. 141, "Business Combinations" and SFASNo. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 required that allbusiness combinations initiated after June 30, 2001 be accounted for using thepurchase method. Also under SFAS No. 141, identified intangible assets acquiredin a purchase business combination must be separately valued and recognized onthe balance sheet if they meet certain requirements. Under SFAS No. 142,goodwill and identified intangible assets with indefinite useful lives are notsubject to amortization but are to be tested for impairment on an annual basis.The Company adopted SFAS No. 141 and the provisions of SFAS No. 142 relating tonon-amortization and amortization of intangible assets on July 1, 2001.

Effective January 1, 2002, the Company adopted SFAS No. 142 which requiregoodwill and intangible assets with indefinite useful lives no longer beamortized but instead tested for impairment at least annually in accordance withthe provisions of SFAS No. 142. Goodwill and intangible assets with indefiniteuseful lives acquired in purchase business combinations completed before July 1,2001 were subject to amortization through December 31, 2001, at which timeamortization ceased. Intangible assets with estimable useful lives are amortizedover their respective estimable useful lives to their estimable residual valuesand reviewed for impairment in accordance with SFAS No. 144, "Accounting for theImpairment or Disposal of Long-Lived Assets." SFAS No. 141 required the Companyto evaluate its existing intangible assets that were acquired in prior purchasebusiness combinations and make any necessary reclassifications in order toconform with the new criteria in SFAS No. 141 in terms of recognition of finiteand infinite useful lives intangibles. Upon adoption of SFAS No. 142, theCompany reassessed the useful lives and residual values of all intangible assetsacquired.

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In connection with SFAS No. 142's transitional goodwill impairmentevaluation, the statement requires the Company to perform an assessment ofwhether there was an indication that goodwill was impaired as of the date ofadoption. The Company then had six months from the date of adoption to determinethe fair value of each reporting unit and compare it to the reporting unit'scarrying amount. The Company completed its analysis of the fair value of itsreporting units with goodwill by June 30, 2002 and was not required to providefor any transitional impairment losses.

In accordance with SFAS No. 142, the Company plans to review impairmentannually and make adjustments as necessary to the carrying amount of goodwill.

The table set forth below illustrates the activity of intangible assets withfinite lives, which are comprised of customer list intangibles, presented in"other assets" in the consolidated balance sheets, and the related amortization,presented in "other noninterest expense" in the consolidated statements ofincome, for the years noted (in thousands).

  For the three months ended      March 31,    2003  2002          Balance, at      beginning of year   $   608 727        Amortization       34     30          Balance, at      end of year             $   574        697
The table set forth below illustrates the activity of intangible assets withinfinite lives, presented in "other assets" in the consolidated balance sheets,and the related amortization, presented in "other noninterest expense" in theconsolidated statements of income, for the years noted (in thousands).
        For the three      months ended March 31,      2003   2002              Balance, at beginning of year$ 3,6913,691              Amortization--- ---             Balance, at end of year        $ 3,691                            3,691 
            

The intangibles of one past acquisition were not differentiated betweenindefinite and definite useful lives prior to the issuance of FASB No. 141 andNo. 142 although the information to do so was available. Upon the adoption ofthese statements, indefinite useful life intangibles were segregated from thetotal balance as permitted by the pronouncements. The preceding tables have beenadjusted to reflect this change.

The Company estimates amortization expense related to intangibles with finitelives in fiscal years 2003 through 2009 ranging from $144 thousand to $33thousand.

4.      MORTGAGE SERVICING RIGHTS

Capitalized mortgage servicing rights ("MSRs") totaled $2.1 million, $2.1million and $1.8 million at March 31, 2003, December 31, 2002, and March 31,2002, respectively. Amortization expense for MSRs totaled $420 thousand and $196thousand for the three months ended March 31, 2003 and 2002, respectively.Amortization expense for MSRs for the twelve months ended December 31, 2002totaled $946 thousand. Amortization expense is based on current informationregarding loan payments and prepayments. Amortization expense could change infuture periods based on changes in the volume of prepayments and otherenvironmental factors. Prepayments could increase as a result of any furtherdecline in market interest rates, leading to an increase in amortizationexpense.  The impairment adjustments to MSRs for the three months endedMarch 31, 2003 and 2002 were $46 thousand and $37 thousand, respectively. Theimpairment adjustment to MSRs for the twelve months ended December 31, 2002totaled $44 thousand. A valuation allowance for impairment totaling $159thousand was required at March 31, 2003, increasing from a valuation allowanceof $105 thousand required at March 31, 2002. The valuation allowance forimpairment required at December 31, 2002 totaled $113 thousand.

 

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5.      STOCK-BASED COMPENSATION

At March 31, 2003, the Company had a stock-based compensation plan which wasdescribed more fully in Note 12 of the Notes To Consolidated FinancialStatements included in the Company's Annual Report on Form 10-K for the yearended December 31, 2002. The Company accounts for this plan under therecognition and measurement principles of Accounting Principles Board ("APB")Opinion No. 25, "Accounting for Stock Issued to Employees," and relatedInterpretations. The Company's employees as well as directors participate in thestock awards plan providing both with an opportunity to increase their equityinterests in the Company based on the attainment of specific performancecriteria for the Company. No stock-based compensation cost is reflected in netincome, as all stock options granted under these plans had an exercise priceequal to the fair market value of the underlying common stock on the date ofgrant. The table set forth below illustrates the effect on net income andearnings per share if the Company had applied the fair value recognitionprovisions of SFAS No. 123, "Accounting for Stock-Based Compensation," tostock-based compensation (in thousands, except share data).
                For the three months ended March 31,2003                                2002       Net income, as reported$  2,902  2,455Deduct: Total stock-based employee and      director     compensation expense      determined under    fair value based methods      for all awards,    net of related tax effects              27                 42Pro forma net income        $ 2,875          2,413Earnings per share    Basic - as reported$     .46     .39    Basic - pro forma            .45            .38    Diluted - as reported      .45     .38    Diluted - pro forma            .44            .37
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**Item 2.  Management's Discussion and Analysis of Financial Conditionand Results of Operations**

The following discussion and analysis is presented to assist in understandingthe financial condition and results of operations of Palmetto Bancshares, Inc.(defined collectively with its subsidiaries as the "Company").  Thisdiscussion should be read in conjunction with the consolidated financialstatements and related notes and other financial data appearing in this reportas well as the Annual Report of Palmetto Bancshares, Inc. on Form 10-K for theyear ended December 31, 2002.  Results of operations for the three monthperiod ended March 31, 2003 are not necessarily indicative of results that maybe attained for any other period.  Percentage calculations contained hereinhave been calculated based upon actual, not rounded, results.

The holding company was organized in 1982 under the laws of South Carolina.Through its wholly-owned subsidiary, The Palmetto Bank (the "Bank"), and theBank's wholly-owned subsidiary, Palmetto Capital, Inc. ("Palmetto Capital"), theCompany engages in the general banking business in the upstate South Carolinamarket of Laurens, Greenville, Spartanburg, Greenwood, Anderson, Cherokee,Abbeville, and Oconee counties (the "Upstate").  The Bank was organized andchartered under South Carolina law in 1906. 

The Bank performs a full range of banking activities, including such servicesas checking, savings, money market, and other time deposits of various types ofconsumer and commercial depositors; loans for business, real estate, andpersonal uses; safe deposit box rental and various electronic funds transferservices.  The Bank also offers both individual and commercial trustservices through an active trust department.  Palmetto Capital is abrokerage subsidiary of the Bank, which offers customers stocks, treasury andmunicipal bonds, mutual funds and insurance annuities, as well as college andretirement planning. 

FORWARD LOOKING STATEMENTS

This report contains certain forward-looking statements (as defined in thePrivate Securities Litigation Reform Act of 1995) to assist in the understandingof anticipated future operating and financial performance, growth opportunities,growth rates, and other similar forecasts and statements of expectations. Theseforward-looking statements reflect current views, but are based on assumptionsand are subject to risks, uncertainties, and other factors, which may causeactual results to differ materially from those in such statements. These factorsinclude, but are not limited to, the following:
- risks from changes in economic, monetary policy and industry conditions;
- changes in interest rates, deposit rates, the net interest margin and  funding sources;
- market risk and inflation;
- risks inherent in making loans including repayment risks and value of  collateral;
- loan growth, 
- the adequacy of the allowance for loan losses and the assessment of  problem loans;
- the ability of the Company to meet its contractual obligations;
- fluctuations in consumer spending;
- competition in the banking industry and demand for our products and  services;
- dependence on senior management;
- technological changes;
- ability to increase market share;
- expense projections;
- risks associated with income taxes, including the potential for adverse  adjustments; 
- changes in accounting policies and practices;
- costs and effects of litigation; and
- recently-enacted or proposed legislation.    

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Should one or more of these risks or uncertainties materialize, or shouldunderlying assumptions prove incorrect, actual results may vary materially fromthose expected or projected. Such forward-looking statements speak only as ofthe date on which such statements are made. We undertake no obligation to updateany forward looking statement to reflect events or circumstances after the dateon which such statement is made to reflect the occurrence of unanticipatedevents. In addition, certain statements in future filings by the Company withthe Securities Exchange Commission, in press releases and in oral and writtenstatements made by or with the approval of the Company, which are not statementsof historical fact, constitute forward-looking statements.

SIGNIFICANT ACCOUNTING POLICIES

The Company considers its policies regarding its allowance for loan losses(the "Allowance") to be its most critical accounting policy due to thesignificant degree of management judgment exercised in relation to thisestimate. The Company has developed policies and procedures for assessing theadequacy of the Allowance recognizing that this process requires a number ofassumptions and estimates with respect to its loan portfolio. The adequacy ofthe Allowance is analyzed on a monthly basis using its internal analysis model.For purposes of this analysis, adequacy is defined as a level sufficient toabsorb probable losses in the portfolio. An allowance model is used that takesinto account factors including the composition of the loan portfolio includingrisk grade classifications (based on an internally developed grading system),historical asset quality trends including, but not limited to, previous lossexperience ratios, and reviews of specific high risk sectors of the portfolio.Loans are graded at inception and are reviewed on a periodic basis to ensurethat assigned risk grades are proper based on the definition of suchclassification. The value of underlying collateral is also considered duringsuch analysis.  These assessments may be impacted in future periods bychanges in economic conditions, the impact of regulatory examinations, and thediscovery of information with respect to borrowers, which is not known tomanagement at the time of the issuance of the consolidated financial statements.

 

 

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BALANCE SHEET REVIEW

Overview

Total assets increased by $28.1 million, or 3.4%, at March 31, 2003 ascompared to December 31, 2002 and increased by $88.6 million, or 11.6%, at March31, 2003 as compared to March 31, 2002. Liquid assets, which include cash,federal funds sold, and investments available for sale, increased by $7.5million, or 4.8%, at March 31, 2003 from December 31, 2002 and decreased by $2.5million or 1.5% at March 31, 2003 from March 31, 2002. Total liabilitiesincreased $25.9 million, or 3.4%, at March 31, 2003 from December 31, 2002 andincreased $79.5 million, or 11.3%, at March 31, 2003 from March 31, 2002. Totalshareholders' equity increased $2.2 million, or 3.3%, at March 31, 2003 fromDecember 31, 2002 and reported a $9.1 million increase, or 14.9%, at March 31,2003 from March 31, 2002.

Securities

At March 31, 2003, the Company's investment portfolio totaled $115.0 millioncompared to $116.8 million and $106.6 million at December 31, 2002 and March 31,2002, respectively.  This represents a decrease of 1.6% from December 31,2002 and a 7.9% increase from March 31, 2002. The composition of the investmentportfolio at March 31, 2003 follows: agencies 28%, municipalities 30%,treasuries 9%, and mortgage-backed securities and other securities 33%. 

During the first three months of 2003, the Bank purchased $15.3 million ofinvestment securities (available for sale), $13.4 million of the investmentportfolio matured or was sold resulting in a gain of $95 thousand, and $3.7million was paid down on mortgage backed securities held for sale.  TheMarch 31, 2003 securities balance included $45 thousand in pre-tax unrealizedgains in the portfolio.

During the first three months of 2002, the Bank purchased $37.1 million ofinvestment securities (available for sale), $25.6 million of the investmentportfolio matured or was sold resulting in a gain of $140 thousand, and $1.5million was paid down on mortgage backed securities held for sale. The March 31,2002 securities balance included $277 thousand in pre-tax unrealized losses inthe portfolio. 

Loans

At March 31, 2003, the Company had total loans outstanding, including heldfor investment loans net of related allowance and held for sale mortgage loans,of $651.0 million, which equaled 84% of total deposits, including securitiessold under agreements to repurchase and commercial paper, and 76% of totalassets.  Loans are the largest category of earning assets and generallyproduce higher yields than other earning assets. The loan portfolio consistsprincipally of commercial loans, commercial real estate loans, consumer loans,sales finance loans, and mortgage loans. 

Mortgage loans held for sale were $11.1 million at March 31, 2003 compared to$11.9 million and $13.4 million at December 31, 2002 and March 31, 2002,respectively.  This represents a decrease of 6.4% from December 31, 2002and a decrease of 17% from March 31, 2002.  As a result of the favorableinterest rate environment for mortgage loans and refinances, the Bank originatedapproximately $43.8 million in mortgage loans during the first three months of2003, with substantially all being sold during the same period. 

Loans, net of unearned income, excluding those mortgage loans held for sale,were $646.6 million at March 31, 2003 compared to $625.5 million and $555.7million at December 31, 2002 and March 31, 2002, respectively. This representsincreases of 3.4% from December 31, 2002 and an increase of 16.4% from March 31,2002. 

 

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See "Credit Quality" for additional discussion of loan portfolio performance. 

Allowance for Loan Losses 

The adequacy of the allowance is analyzed on a monthly basis.  Forpurposes of this analysis, adequacy is defined as a level sufficient to absorbprobable losses in the portfolio. The Bank uses an allowance model that takesinto account loan risk grades, delinquency trends, and charge-off ratios as wellas loan growth. Assessing the adequacy of the allowance requires considerablejudgment. Management's judgments are based on numerous assumptions about currentevents, which we believe to be reasonable.  The allowance is subject toexamination and adequacy testing by regulatory agencies.  

The allowance for loan losses totaled $6.8 million at March 31, 2003 comparedto $6.4 million and $5.7 million at December 31, 2002 and March 31, 2002,respectively.  This represents an increase of 5.8% from December 31, 2002and 17.9% from March 31, 2002.  Table 1 summarizes the changes in theallowance. 
Table 1Summary of Loan Loss and      Recovery Experience(dollars in thousands)                   
      At and for the      three months       ended March 31,
At and for the       year ended             2003  2002  December 31, 2002                      Allowance at beginning of period              $6,4025,6585,658Net charge-offs:       Loans charged-off    588                      868              3,770       Less: loans recovered57 54 226531                          814              3,544 Additions to reserves through provision900                9004,288 Allowance at end of period$6,771            5,744$6,402Average loans excluding mortgage       loans held for sale                 $630,452556,606577,949Loans, net of unearned, excluding mortgage             loans held for sale                          646,628555,660625,542Net charge-offs as a % of average loans       excluding mortgage loans held for             sale (annualized, where applicable)0.34%0.590.61Allowance as a % of loans, net of unearned,             excluding mortgage loans held for sale,  1.05        1.031.02
 

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The allowance for loan losses as a percentage of loans excluding mortgageloans held for sale increased to 1.05% at March 31, 2003 from 1.02% and 1.03% atDecember 31, 2002 and March 31, 2002, respectively. During mid-1999 managementnoted deterioration in the performance of the sales finance portfolio resultingin increased charge-offs in 1999 and 2000. In the years since the discovery ofthe deterioration in the portfolio and these heightened charge-offs, charge-offlevels have declined.  In 2001 net charged-off loans declined $970 thousandfrom 2000.  2002 net charged-off loans declined $282 thousand from 2001.Annualized (where applicable) net charge-offs as a percentage of average loansexcluding mortgage loans held for sale have declined from .59% at March 31, 2002to .34% at March 31, 2003.  Additionally, it was noted that growth withinthe sales finance portfolio has been relatively unchanged with a balance of $15.2 million at March 31, 2003, $14.7 million at December 31, 2002 and $14.5million at March 31, 2002. 

Net charge-offs for the three months ended March 31, 2003 totaled $531thousand a decline from $814 thousand for the three months ended March 31, 2002. The majority of the decline in net charge-offs over these periods was the resultof a decline of $107 thousand in the commercial and industrial loan category aswell as a decline in the installment loan category (excluding credit cards) of$207 thousand.  Comparing the same periods, net charge-offs within theloans secured by real estate and credit card portfolios remained relativelyunchanged.

See "Credit Quality" for additional discussion of factors contributing to theallowance for loan losses.  

Other Assets

At March 31, 2003, other assets totaled $15.8 million compared to $15.2million and $12.0 million at December 31, 2002 and March 31, 2002, respectively. This represents an increase of 3.9% from December 31, 2002 and 31.4% from March31, 2002.

At March 31, 2003 major components of other assets included the TravelersExpress reserve (described below) totaling $1.9 million, net mortgage servicingrights which totaled $2.0 million, pension plan assets totaling $2.5 million,other real estate owned totaling $2.5 million, and $4.3 million of intangibleassets.  

At December 31, 2002 major components of other assets included the TravelersExpress reserve totaling $1.9 million, net mortgage servicing rights whichtotaled $2.0 million, pension plan assets totaling $2.4 million, other realestate owned totaling $2.5 million, and $4.3 million of intangible assets. 

At March 31, 2002 large components contributing to the balance of $12.0million of other assets included net mortgage servicing rights totaling $1.7million, pension plan assets totaling $1.8 million, other real estate ownedtotaling $1.6 million, and $4.3 million of intangible assets.

In August 2002, the Bank established a reserve account with TravelersExpress, its third party official check vendor.  In the past, TravelersExpress has paid checks and the Bank remitted the forwarded balance thefollowing day which resulted in payment of one day's interest to TravelersExpress on the forwarded monies.  Establishing this reserve account haseliminated the need for forwarded monies and therefore the interest payments toTravelers Express.

The recent favorable interest rate environment as well as the addition ofmortgage loan originators has contributed to the increase in the loan portfolioat March 31, 2003 from December 31, 2002 as well as March 31, 2002.  Asnoted in the "Loans" section above, originations of mortgage loans held for salethus far in 2003 have totaled $43.8 million.  Since loans are typicallysold servicing retained, the increase in loans originated results in increasedadditions to the mortgage servicing rights portfolio.  Amortization andimpairment of the rights as well as loan payoffs offset these additions. 

 

15

 

Due to the low volume of properties within the other real estate ownedportfolio, the foreclosure of new property or the sale of an existing propertycan cause the balance to fluctuate greatly on a monthly basis.  During thefirst three months of 2002, three relationships were added to the portfoliototaling $1.5 million while two properties were sold totaling $69 thousand. At March 31, 2002, there were 7 relationships within the portfolio totaling $1.6million.  At December 31, 2002 the other real estate owned portfoliocontained 12 relationships totaling $2.5 million.  From December 31, 2002to March 31, 2003, only three additional relationships were added to theportfolio totaling $133 thousand and only two properties were sold totaling $54thousand bringing the portfolio total to $2.5 million at March 31, 2003. 

As noted above in the "Allowance for Loan Losses" section, during mid-1999management noted deterioration in the performance of the sales financeportfolio. In the periods following these findings, charge-offs increased andcollateral was repossessed, in some cases, in conjunction with a portion ofthese sales finance loans. Since this discovery and the related charge-offs, theBank has begun to experience a decrease in charge-offs (in part related to thisportfolio).  In addition, the balance of repossessed automobiles has begunto decline.  Resulting from the review of the loans within the portfolio,repossessed automobiles have declined from $564 thousand at March 31, 2002 to$181 thousand at December 31, 2002 and to $98 thousand at March 31, 2003.Additionally growth within the sales finance loan portfolio has been relativelystable over this time frame.

See Note 3 of Notes To Consolidated Interim Financial Statements containedherein for a summary of intangible assets.

Deposits

At March 31, 2003, deposits totaled $738.8 million compared to $722.0 millionand $667.6 million at December 31, 2002 and March 31, 2002, respectively. This represents an increase of 2.3% from December 31, 2002 and 10.7% from March31, 2002.  Deposits remain the Bank's primary source of funds for loans andinvestments.  Deposits provided funding for 101% and 102% of averageearning assets for the three month periods ended March 31, 2003 and 2002,respectively.  Deposit pricing remains very competitive. The composition ofthe deposit portfolio at March 31, 2003 follows: time deposits 44%,interest-bearing demand deposits 34%, noninterest-bearing deposits 16%, andsavings 6%.  

Borrowed Funds

At March 31, 2003, total securities sold under agreement to repurchasetotaled $16.3 million compared to $12.8 million and $16.8 million at December31, 2002 and March 31, 2002, respectively. This represents an increase of 26.7%from December 31, 2002 and a decrease of 3.2% from March 31, 2002.

At March 31, 2003, total commercial paper totaled $17.0 million compared to$14.8 million and $13.2 million at December 31, 2002 and March 31, 2002,respectively.  This represents an increase of 14.3% from December 31, 2002and 29% from March 31, 2002.

Other Liabilities

At March 31, 2003, other liabilities totaled $11.4 million compared to $7.8million and $6.2 million at December 31, 2002 and March 21, 2002, respectively. This represents an increase of 45.4% from December 31, 2002 and 82.5% from March31, 2002.

The increase in other liabilities at March 31, 2003 compared to December 31,2002 of $3.5 million is the result of fluctuations in several accounts with themajority of the change accumulated within three accounts.  Accrued incometaxes increased approximately $437 thousand at March 31, 

 

16

 

 

2003 compared to December 31, 2002 based on the timing of tax payments over the two periods. The mortgage servicing loans in process account increased$4.7 million at March 31, 2003 from December 31, 2002 constituting the majorityof the increase in this category.  When mortgage loans are funded, fundsare recorded in this account until all information is received for loan systementry.  Once all items have been received, the loan is booked on the loansystem simultaneously transferring the funds from this clearing account to theproper loan account.  Due to the high volume of mortgage loans originatedover the past 24 months, the time it takes for the loan documents to be receivedand entered into the loan system has increased, thereby increasing the balanceof this account.  These increases were offset, for the most part, by adecrease in accrued expenses at March 31, 2003 from December 31, 2002. This decrease is mainly due to incentive payments during January 2003 related to2002 performance.  At December 31, 2002, $1.4 million was accrued for theseincentive payments.  Incentive accruals at March 31, 2003 related to 2003performance totaled $239 thousand.  

The increase in other liabilities at March 31, 2003 compared to March 31,2002 of $5.1 million results from the fluctuations in several accounts with themajority of the change accumulated within two accounts. Taxes relating to theunrealized gain on available for sale securities increased approximately $1.0million due to an increase in the unrealized gain on available for salesecurities at March 31, 2003 from March 31, 2002. Also, mortgage servicing loansin process account that increased $3.9 million at March 31, 2003 from March 31,2002, which constituted the majority of the increase in this category. Once allitems have been received, the loan is booked on the loan system simultaneouslytransferring the funds from this clearing account to the proper loan account. Due to the high volume of mortgage loans originated over the past 24 months, thetime it takes for the loan documents to be received and entered into the loansystem has increased, thereby increasing the balance of this account.

Capital Resources and Dividends

Shareholders' equity totaled $69.8 million, $67.5 million, and $60.7 millionat March 31, 2003, December 31, 2002, and March 31, 2002, respectively. Shareholders' equity as a percentage of total assets was 8.18% at March 31, 2003and December 31, 2002 and 7.94% at March 31, 2002.   Increases inshareholders' equity resulted from retention of earnings, unrealized gains inthe available for sale security portfolio, and stock option exercises offset bydividends paid.  

Book value per share was $11.02 at March 31, 2003 compared to $10.73 and$9.65 at December 31, 2002 and March 31, 2002, respectively.  

As of March 31, 2003, the Company and the Bank were in compliance with eachof the applicable regulatory capital requirements and met or exceeded the"well-capitalized" regulatory guidelines.  Table 2 sets forth variouscapital ratios for the Company and the Bank.  The Company and the Bank aresubject to certain regulatory restrictions on the amount of dividends they arepermitted to pay.  At December 31, 2002, the Bank had $2.7 million ofexcess capital available for payment of dividends and still be considered"well-capitalized" related to the total risk based capital ratio.

 

17

 

Table 2Capital Ratios

**As of      3/31/03**
**Adequately      Capitalized      Requirement**** **
**Well-Capitalized       Requirement**Company:                         Total Risk-based Capital
 

10.53%
 

8.00%
 

10.00%   Tier 1 Risk-based Capital
 

9.50
 

4.00
 

6.00   Tier 1 Leverage Ratio
 

7.59
 

4.00
 

5.00Bank:
 

 
 

    Total Risk-based Capital
 

10.41%
 

8.00%
 

10.00%   Tier 1 Risk-based Capital
 

9.38
 

4.00
 

6.00   Tier 1 Leverage Ratio
 

7.49
 

4.00
 

5.00
 

For a complete discussion of capital matters see related topics in theCompany's Annual Report on Form 10-K for the year ended December 31, 2002.

Off-Balance Sheet Arrangements

The Company's off-balance sheet arrangements, which principally includelending commitments, are described below. At March 31, 2003, December 31, 2002and March 31, 2002, the Company had no interests in non-consolidated specialpurpose entities. Neither the Company nor the Bank is involved in otheroff-balance sheet contractual relationships, unconsolidated related entitiesthat have off-balance sheet arrangements or transactions that could result inliquidity needs or other commitments or significantly impact earnings.

Lending commitments include loan commitments, standby letters of credit, andunused credit card lines. These instruments are not recorded in the consolidatedbalance sheet until funds are advanced under the commitments. The Companyprovides these lending commitments to customers in the normal course ofbusiness. The Company applies essentially the same credit policies and standardsas it does in the lending process when making these commitments. 

For commercial customers, loan commitments generally take the form ofrevolving credit arrangements to finance customer's working capitalrequirements. For retail customers, loan commitments are generally lines ofcredit secured by residential property. Unused credit card lines are generallyused for short-term borrowings. At March 31, 2003, these commitments totaled$111.7 million. 

Standby letters of credit represent an obligation of the Company to a thirdparty contingent upon the failure of Company's customer to perform under theterms of an underlying contract with the third party or obligates the Company toguarantee or stand as surety for the benefit of the third party.  Theunderlying contract may entail either financial or nonfinancial obligations andmay involve such things as the customer's delivery of merchandise, completion ofa construction contract, release of a lien,

 

18

 

 

or repayment of an obligation.  Under the terms of a standby letter ofcredit, generally, drafts will be drawn only when the underlying event fails tooccur as intended.  The Company can seek recovery of the amounts paid fromthe borrower; however, standby letters of credit are generally notcollateralized. In recent months the Company has reflected in its policyregarding such commitments that collateral is encouraged with exceptionsrequiring approvals. Commitments under standby letters of credit are usually forone year or less.  At March 31, 2003, the Company has recorded no liabilityfor the current carrying amount of the obligation to perform as a guarantor andno contingent liability is considered necessary, as such amounts are notconsidered material.  The maximum potential amount of undiscounted futurepayments related to standby letters of credit at March 31, 2003 was $1.8million.  Past experience indicates that many of these standby letters ofcredit will expire unused. However, through its various sources of liquidity,the Company believes that it has the necessary resources to meet theseobligations should the need arise.  Additionally, current fair value ofsuch guarantees are deemed immaterial at March 31, 2003.

The table set forth below represents the Bank's issued commitments to extendcredit and unused credit card lines at March 31, 2003 (in thousands).
     Home equity loans  $   19,117     Credit cards      36,475     Commercial real estate      development      25,189     Other unused lines of credit      30,959     Total unused commitment and      unused credit card lines        $ 111,740
Generally, unused loan commitments are at adjustable rates that fluctuatewith prime rate or are at fixed rates that approximate market rates. The currentamounts of these commitments approximate their fair value. 

Obligations under noncancelable operating lease agreements totaled $4.2million at March 31, 2003. These obligations are payable over several years. 

Liquidity

Liquidity management ensures that adequate funds are available to meetdeposit withdrawals, fund loan and capital expenditure commitments, maintainreserve requirements, pay operating expenses, provide funds for dividends, andmanage operations on an ongoing basis.  Funds are primarily provided by theBank through customer deposits, principal and interest payments on loans, loansales, securities available for sale, maturities of securities, and earnings.

Proper liquidity management is crucial to ensure that the Company is able totake advantage of new opportunities as well as meet the demands of itscustomers.  In this process, we focus on assets and liabilities and on themanner in which they combine to provide adequate liquidity to meet our needs.

Investment securities are an important tool to our liquidity management. Securities classified as available for sale may be sold in response to changesin interest rates, liquidity needs, and/or significant prepayment risk.

Net cash provided by operations and deposits from customers have been theprimary sources of liquidity for the Company.  Liquidity is also enhancedby the ability to acquire new deposits through the Bank's established branchnetwork of 30 branches in South Carolina. 

The Bank has access to borrowings from the FHLB and maintains short-termlines of credit. At March 31, 2003, the Bank had approximately $84 million ofunused borrowing capacity from the FHLB. The Bank has pledged assets to be usedas collateral if the Bank takes advantage of the FHLB line of credit.  AtMarch 31, 2003, the Bank had unused short-term lines of credit totalingapproximately $37 million (which are withdrawable at the lender's option).Management believes that these sources are adequate to meet its liquidity needsand to maintain the liquidity ratio within policy guidelines.

 

19

 

The Company has certain cash needs including general operating expenses andthe payment of dividends and interest on borrowings.  The Company currentlyhas no long-term debt outstanding and has declared and paid cash dividendstotaling $0.12 per share in the three month period ended March 31, 2003. Although there can be no guarantee that additional dividends will be paid in2003, the Company plans to continue its quarterly dividend payments. 

In the normal course of business, to meet the financial needs of itscustomers, the Company, principally through the Bank, enters into agreement toextend credit. For amounts and types of such agreements at March 31, 2003, see"Off-Balance Sheet Arrangements." Increased demand for funds under theseagreements would reduce the Company's liquidity and could require additionalsources of liquidity. 

Credit Quality

A willingness to take credit risk is inherent in the decision to grantcredit. Prudent risk-taking requires a credit risk management system based onsound policies and control processes that ensure compliance with those policies.Adherence to underwriting standards is managed through a multi-layered creditapproval process and review of loans approved by lenders. Through loan review,reviews of exception reports, and ongoing analysis of asset quality trends,compliance with loan monitoring policies is managed. 

Table 3 presents information pertaining to nonperforming assets.
Table 3 Nonperforming Loans and Assets       (dollars in thousands)  
March 31, 
December 31,           2003  2002  2002             Nonaccrual loans $   3,578 2,7582,500   Total nonperforming loans  3,5782,7582,500   Other real estate owned 2,5481,6072,468 Repossessed automobiles   98             564 181           Total nonperforming assets $6,2244,9295,149                                                                             Loans past due 90 days and still accruing (1) $    187  327  233 Total nonperforming loans as a percentage of loans (2).55
%.50.40                    Total nonperforming assets as a percentage  of loans,      other real estate owned, and repossessed automobiles (2).96 .88.82   Allowance for loan losses as a  percentage of      nonperforming loans1.89x2.082.56         (1) Substantially all of these loans are credit card      loans. (2) Calculated using loans, net of unearned, excluding      mortgage loans held for sale. 
Similar to other parts of the country, the markets served by the Company areexperiencing a moderately slowing economy with higher bankruptcy filings andhigher delinquency rates.  Until the economy improves, credit qualityindicators will remain volatile. While current economic data seems to besignaling improvement, the outlook remains uncertain. Management believes,however, that loss exposure in its loan portfolio is identified, adequatelyreserved in a timely manner, and closely monitored to ensure that changes arepromptly addressed in its analysis of allowance adequacy. Accordingly,management believes the allowance as of March 31, 2003 is adequate, based on itsassessment of probable losses, and available facts and circumstances thenprevailing. 

 

20

 

Other real estate owned increased $941 thousand at March 31, 2003 from March31, 2002.  This increase is attributed to several properties acquired insettlement of loans that have not yet been sold due to market conditions.Additionally, nonaccrual loans have increased $1.1 million over the same timeframe. In the past more flexibility was given for borrowers to make paymentswhen they became delinquent. In recent times, which have reflected a moderatelyslowing economy with higher bankruptcy filings and higher delinquency rates, theCompany has been applying more strict collection policies to such loans. The Company believes in most of these nonaccrual loan cases, collateral issufficient to cover any potential losses.  As a result, the Company hasadvanced loans to nonaccrual status, ceasing negotiations that typically tookplace in the past, if such loan meets the Company's definition, as a step towardforeclosure, if future conditions deem necessary.  

Although the Company has seen an increase in both nonaccrual loans and otherreal estate owned at March 31, 2003 from March 31, 2002, management believes theallowance as of March 31, 2003 is adequate, based on its assessment of probablelosses, and available facts and circumstances then prevailing.  Managementbelieves that the current loan portfolio has stronger credit quality over theportfolio of March 31, 2002.  This has been achieved through the earlyidentification of problem loans (which could now be in nonaccrual status or inthe other real estate owned portfolio) which have required higher provisionssince deemed "problem" as such loans would have when not deemed problem. Therefore, the increase of nonaccrual loans and other real estate owned wouldnot necessarily indicate a need for increased provision.  The installment loancategory, which includes sales finance loans, has also seen improvements relatedto credit quality of remaining loans over the past 12 months.  Thisimproved credit quality within the installment portfolio has resulted in theCompany no longer needing additional reserves within the Allowance model tocover the additional inherent losses in this portfolio.

 

 

 

21

 

EARNINGS REVIEW

COMPARISON OF THE RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002

Overview

Net income for the three months ended March 31, 2003 totaled $2.9 million, up18.2% compared with $2.5 million for the first quarter of 2002. Earnings perdiluted share for the first quarter 2003 were $0.45, an 18.4% increase from$0.38 per diluted share in the first quarter 2002. Earnings per basic share forthe first quarter 2003 were $0.46, a 17.9% increase from $0.39 per basic sharein the first quarter 2002. 

Average common shares outstanding on a diluted basis were 6,482,699 in thefirst quarter 2003, up 0.14% from 6,473,816 for first quarter 2002. Averagecommon shares outstanding on a basic basis were 6,326,698 in the first quarter2003, up slightly from 6,287,279 in the first quarter 2002. 

Net interest income for the three months ended March 31, 2003 and 2002 was$9.0 million and $8.3 million, respectively, an increase of 7.3%. Noninterest income for the three months ended March 31, 2003 totaled $3.5million, up 3.0% compared with $3.4 million for the first quarter 2002.Noninterest expense for the three months ended March 31, 2003 increased $55thousand from the three month period ended March 31, 2002.

Net Interest Income

Net interest income is the difference between gross interest and fees onearning assets, primarily loans and investment securities and interest paid ondeposits and other interest-earning liabilities. The net interest marginmeasures how effectively a company manages the difference between the yield onearning assets and the rate paid on funds to support those assets. Fullytax-equivalent net interest income adjusts the yield for assets earning taxexempt income to a comparable yield on a taxable basis.  Table 4 presentsaverage balance sheets and a net interest income analysis on a tax-equivalentbasis for the three months ended March 31, 2003 and 2002.

Fully tax-equivalent net interest income for the first quarter of 2003increased $484 thousand, or 5.6%, to $9.1 million from $8.7 million in the firstquarter of 2002. The fully tax-equivalent net interest margin decreased to 4.83%in the first quarter of 2003 from 5.12% in the first quarter of 2002. 

Average earning assets grew $82.8 million, or 12.1%, to $768.1 million in thefirst quarter of 2003 from $685.3 million in the first quarter of 2002,primarily from the growth of loans and investment securities. Average loans were$642.5 million during the first quarter of 2003 compared with $565.6 millionduring the first quarter of 2002. Average investment securities, including theaverage net unrealized securities gains, increased from $103.4 million in thefirst quarter of 2002 to $111.9 million in the first quarter of 2003. 

Average earning deposits increased from $551.1 million during the firstquarter of 2002 to $610.9 million during the first quarter of 2003. Averageother interest-earning liabilities increased to $34.1 million in the firstquarter of 2003 from $29.9 million during the first quarter of 2002. 

 

 

22
Table 4      Comparative Average Balance - Yields and Costs(dollars in thousands)
**For the three months ended March 31,** 
**2003**
**2002** 
**Average      Balance**
**Income/      Expense**
**Yield/      Rate**
**Average/      Balance**
**Income/      Expense**
**Yield/      Rate**ASSETSEarnings assetsFederal funds sold $   11,559  $          35      1.23 % $   14,295  $          58      1.65 %Federal Home Loan Bank stock and deposits        2,128              23      4.38         2,031              26      5.19 Nontaxable investment securities (2) (3)      34,357            569      6.71       54,751            948      7.02 Taxable investment securities (2)      77,590            625      3.27       48,631            442      3.69 Loans, net of unearned (1)    642,458       10,722      6.77     565,614       10,528      7.55      Total earning assets    768,092       11,974      6.32     685,322       12,002      7.10 Nonearning assetsCash and due from banks      29,564       29,837 Allowance for loan losses       (6,540)       (5,707)Premises and equipment, net      19,779       19,418 Accrued interest        4,109         4,728 Other assets      15,777       11,259      Total nonearning assets      62,689       59,535            Total assets $  830,781  $  744,857       LIABILITIES AND SHAREHOLDERS' EQUITYLiabilities Earning liabilitiesDemand deposits $  240,097  $        304      0.51 % $  226,531  $        440      0.79 %Savings      39,277              39      0.40       35,336              66      0.76 Time    331,553         2,440      2.98     289,241         2,761      3.87      Total earning deposits    610,927         2,783      1.85     551,108         3,267      2.40 Other earning liabilities      34,073              48      0.57       29,927              76      1.03      Total earning liabilities    645,000         2,831      1.78     581,035         3,343      2.33 Nonearning liabilitiesNonearning deposits    107,944       98,070 Other nonearnings liabilities        8,640         4,774      Total nonearning liabilities    116,584     102,844      Total liabilities    761,584     683,879 Shareholders' equity      69,197       60,978      Total liabilities and shareholders' equity $  830,781  $  744,857 NET INTEREST MARGIN (FTE) $     9,143      4.83 % $     8,659      5.12 %Tax-equivalent adjustment (3) $        188  $        313 
 
(1)Nonaccrual loans are included in average balances for yield computations.  The effect of foregone interest incomeas a result of loans on nonaccrual was not considered in the above analysis.  All loans and deposits are domestic.(2)      The average balances for investment securities include the unrealized gain or loss recorded for available for sale securities.(3)      The tax-equivalent adjustment to net interest income adjusts the yield for assets earning tax-exempt income      to a comparable yield on a taxable basis.  Yields on nontaxable securities are stated on a fully taxable equivalent      basis, assuming the effective rate for the respective period.  The adjustments made to convert nontaxable investments to a fully      taxable equivalent basis were $188 and $313 for the 2003 and 2002 periods, respectively.  
23

The underlying factor for the changes in the yields and rates on earningassets and costing liabilities has been the action of the Federal Reserve OpenMarket Committee during the past 27 months. From January 2001 through the end ofMarch 2003, the Federal Reserve cut interest rates 5.25%.  Variable rateloans repriced immediately following changes in interest rates by the FederalReserve. During the first quarter of 2003 as compared to the first quarter of2002, the net interest margin improved, primarily from repricing certificates ofdeposits at lower rates which was only partially offset by the decreasing yieldsof the loan and securities portfolios which was a direct result of the interestrate environment.   The weighted average yield of the loan portfoliodecreased from 7.55% for first quarter 2002 to 6.77% for first quarter 2003. Theweighted average yield of the securities portfolio decreased from 5.45% forfirst quarter 2002 to 4.33% for first quarter 2003.   As the Companyreduced its interest rates during the year, the decline in the funding sourcerate outpaced the decline in the earning asset yield. 

Provision for Loan Losses

The provision for loan losses was $900 thousand for the first quarter of both2003 and 2002. The provision is adjusted each month to reflect loan volumegrowth and allow for loan charge‐offs, recoveries and other factors which impactManagement's assessment of the adequacy of the allowance for loan losses. Management's objective is to maintain the allowance for loan losses at anadequate level to cover probable losses in the portfolio.  Additions to theallowance for loan losses are based on Management's evaluation of the loanportfolio under current economic conditions, past loan loss experience, and suchother factors, which in Management's judgment deserve recognition in estimatingloan losses. 

During mid-1999 Management noted deterioration in the performance of thesales finance portfolio that resulted in increased charge-offs during 1999 and2000. This portfolio was a contributor to the increase in the provision duringrecent years as a result of higher charge-offs. However, annualized firstquarter net charge-offs as a percentage of average loans excluding mortgageloans held for sale have begun to decline and were .34% for the quarter endedMarch 31, 2003 compared to .59% for the quarter ended March 31, 2002.  Thisdecline in charge-offs effects historical charge-off ratios which are factorswithin the Company's allowance model. See "Allowance for Loan Losses" fordiscussion of such factors and their effects on the allowance for loan lossesand the provision for loan losses.

While Management uses the best information available to make evaluations,future adjustments to the allowance in the form of provisions through the incomestatement may be necessary if economic conditions differ substantially from theassumptions used in making the evaluation.  The allowance for loan lossesis subject to periodic evaluation by various regulatory authorities and may besubject to adjustment, based upon information that is available to them at thetime of their examination.

NonInterest Income and Expense

Noninterest income for the first quarter of 2003 increased $102 thousand, or3.0%, to $3.5 million from $3.4 million in the first quarter of 2002. Noninterest expense for the first quarter of 2003 increased $55 thousand, or..8%, to $7.2 million at the end of the first quarter of 2003.

Contributing to the increase in noninterest income for the three months endedMarch 31, 2003 from the same period ended 2002 were increases in service changeson deposit accounts totaling $179 thousand and gain on sales of mortgage loanstotaling $114 thousand.  The increase in gains on sales of loans in thefirst three months of 2003 and higher levels of gains in recent previousquarters are attributable to the increased originations and refinances ofmortgage loans resulting from low mortgage loan interest rates.  Shouldinterest rates increase the level of originations and refinances of mortgageloans may decline which may result in gains on sales of mortgage loans beinglower than recent results.  Offsetting these increases were declines ingain on sale of investment securities totaling $45 thousand and othernoninterest income of $171 thousand.  The main component of the decline inother noninterest income was the increase in mortgage servicing rightsamortization (income contra) during the first three months of 2003 from the sameperiod of 2002.  Due to the increased prepayment speeds attributable tocurrent market interest rates, amortization expense on servicing rightsincreased $224 thousand in the quarter ended March 31, 2003 from the quarterended March 31, 2002.  Additionally, the Company recorded an impairmentreserve against the carrying value of servicing rights during the 2003 quarterof $46 thousand, an increase of $9 thousand from the first quarter 2002impairment of $37 thousand.

 

24

 

 

The slight increase within noninterest expense for the three months endedMarch 31, 2003 from the three months ended March 31, 2002 was the result offluctuations in several accounts with the majority of the change accumulatedwithin one financial statement line item, furniture and equipment expense, whichincreased $178 thousand for the three months ended March 31, 2003 from the sameperiod ended March 31, 2002. The increase in furniture and equipment expense isdue to additional expense related to new item processing hardware, software, andthe related installations the first payment of which was made in July 2002. Alsocontributing to this increase was the opening of the Travelers Rest and Senecabranches during the first quarter of 2002.  As a result, these branches maynot have experienced a full three months of furniture and equipment expense,depending on the opening date, for the period ended 2002 as they did in 2003.

Income Taxes

Income tax expense attributable to income from continuing operationsincreased to $1.4 million for the first quarter of 2003 from $1.2 million forthe first quarter of 2002. The effective income tax rate was 33% for the firstquarter of both 2003 and 2002. 

 

 

 

25

 

ACCOUNTING AND REPORTING MATTERS

In November 2002, the FASB issued FASB Interpretation ("FIN") No. 45,"Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others." This Interpretation elaborates on the disclosures to bemade by a guarantor in its interim and annual financial statements about itsobligations under certain guarantees that it has issued. It also clarifies thata guarantor is required to recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee. This Interpretation does not prescribe a specific approach forsubsequently measuring the guarantor's recognized liability over the term of therelated guarantee. This Interpretation also incorporates, without change, theguidance in FASB Interpretation No. 34, "Disclosure of Indirect Guarantees ifIndebtedness of Others," which is being superseded. FIN No. 45 requires that theinitial recognition and initial measurement provisions of the Interpretation beapplied on a prospective basis to guarantees issued or modified after December31, 2002. Disclosure requirements of the Interpretation are effective forfinancial statements of interim or annual periods ending after December 15,2002. The Company adopted this Interpretation effective December 31, 2002 andhas included the required disclosures within this Quarterly Report on Form 10-Qfor the quarter ended March 31, 2003.

In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-BasedCompensation- Transition and Disclosure-an amendment of FASB Statement No. 123." ThisStatement amends FASB Statement No. 123, "Accounting for Stock-BasedCompensation," to provide alternative methods of transition for a voluntarychange to the fair value based method of accounting for stock-based employeecompensation. In addition, this statement amends the disclosure requirements ofStatement 123 to require prominent disclosures in both annual and interimfinancial statements about the method of accounting for stock-based employeecompensation and the effect of the method used on reported results. The Companyadopted this standard effective December 31, 2002 and has included the requireddisclosures in this Quarterly Report on Form 10-Q for the quarter ended March31, 2003. As of March 31, 2003, the Company has not elected the fair valuetreatment of stock-based compensation. Therefore, the adoption of this standardhad no impact on the financial position or the results of operations of theCompany.

Other accounting standards that have been issued or proposed by the FASB orother standards-setting bodies that do not require adoption until a future dateare not expected to have a material impact on the financial position or theresults of operations of the Company upon adoption.

****

 

 

 

26

 

**Item 3.  Quantitative and Qualitative Disclosures about Market Risk**

Market risk is the risk of loss from adverse changes in market prices andrates.  The Company's market risk arises principally from interest raterisk inherent in its lending, deposit, borrowing and investing activities. Management actively monitors and manages its inherent rate risk exposure.Although the Company manages other risks, such as credit quality and liquidityrisk, in the normal course of business, management considers interest rate riskto be its most significant market risk. This risk could potentially have thelargest material effect on the Company's financial condition and results ofoperations.  Other types of market risks, such as foreign currency exchangerate risk and commodity price risk, do not arise in the normal course of theCompany's business activities.

The Company's profitability is affected by fluctuations in interest rates. Management's goal is to maintain a reasonable balance between exposure tointerest rate fluctuations and earnings.  A sudden and substantial increaseor decrease in interest rates may adversely impact the Company's earnings to theextent that the interest rates on interest-earning assets and interest-bearingliabilities do not change at the same speed, to the same extent or on the samebasis.  The Company monitors the impact of changes in interest rates on itsnet interest income using several tools.

At March 31, 2003, Management believes that there have been no significantchanges in market risk as disclosed in the Company's Annual Report on Form 10-Kfor the year ended December 31, 2002.

The Bank's goal is to minimize interest rate risk between interest-bearingassets and liabilities at various maturities through its Asset-LiabilityManagement ("ALM").  ALM involves managing the mix and pricing of assetsand liabilities in the face of uncertain interest rates and an uncertaineconomic outlook.  It seeks to achieve steady growth of net interest incomewith an acceptable amount of interest rate risk and sufficient liquidity. The process provides a framework for determining, in conjunction with the profitplanning process, which elements of the Company's profitability factors can becontrolled by Management.  Understanding the current position andimplications of past decisions is necessary in providing direction for thefuture financial Management of the Company.  The Company uses anasset-liability model to determine the appropriate strategy for currentconditions.

Interest sensitivity management is part of the asset-liability managementprocess.  Interest sensitivity gap ("GAP") is the difference between totalrate sensitive assets and rate sensitive liabilities in a given time period. The Company's rate sensitive assets are those repricing within one year andthose maturing within one year.  Rate sensitive liabilities include insuredmoney market accounts, savings accounts, interest-bearing transaction accounts,time deposits and borrowings.  The profitability of the Company isinfluenced significantly by Management's ability to manage the relationshipbetween rate sensitive assets and liabilities.

The following table is a summary of the Company's one year gap (dollars inthousands):

 
 
March 31, 2003     Interest-earning assets maturing or repricing within one    year                          $ 351,782 
Interest-bearing liabilities maturing or repricing within    one year                          $ 328,862 Cumulative gap      $   22,920 Gap as a percentage of total assets                                           2.69 
%
The above analysis does not take in to account any prepayments on mortgages,consumer or other loans, or securities.  All maturities are stated incontractual terms.  The Company's current GAP analysis reflects that inperiods of increasing or decreasing interest rates, rate sensitive assets willreprice slower than rate sensitive liabilities. The Company's GAP analysis alsoshows that at the interest repricing of one year, the Company's net interestmargin would be adversely impacted by an increase in market interest rates. Thisanalysis, however, does not take into account the dynamics of the marketplace. GAP is a static measurement that assumes that if the prime rate increases by1.00%, all assets and liabilities that are due to reprice will increase by 1.00%at the next opportunity. 

 

27

 

 

Because the Company's Management feels that GAP analysis is a staticmeasurement, it manages its interest income through its asset/liabilitystrategies that focus on a net interest income model based on Management'sprojections.  The Company has a targeted net interest income range of plusor minus twenty percent based on a 3.00% change over twelve months.  The asset/liability committee meets weekly to address interest pricing issues,and this model is reviewed monthly.  Management will continue to monitorits liability sensitive position in times of increasing interest rates, whichmight adversely affect its net interest margin.  

 

 

 

28

 

**Item 4.  Controls and Procedures**

Under the supervision and with the participation of our management, includingthe Chief Executive Officer and Chief Accounting Officer, we have evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures within 90 days of the filing date of this quarterly report, and,based on their evaluation, our Chief Executive Officer and Chief AccountingOfficer have concluded that these controls and procedures are effective. Therewere no significant changes in our internal controls or in other factors thatcould significantly affect these controls subsequent to the date of theirevaluation. 

Disclosure controls and procedures are our controls and other procedures thatare designed to ensure that information required to be disclosed by us in thereports that we file or submit under the Exchange Act is recorded, processed,summarized and reported, within the time periods specified in the Securities andExchange Commission's rules and forms.  Disclosure controls and proceduresinclude, without limitation, controls and procedures designed to ensure thatinformation required to be disclosed by us in the reports that we file or submitunder the Exchange Act is accumulated and communicated to our management,including our Chief Executive Officer and Chief Accounting Officer, asappropriate to allow timely decisions regarding required disclosure. 

 

 

 

29

 

**PART II.  OTHER INFORMATION**

**Item 1.  Legal Proceedings**

The Company is currently subject to various legal proceedings and claims thathave arisen in the ordinary course of its business. In the opinion of managementbased on consultation with external legal counsel, any reasonably foreseeableoutcome of such current litigation would not materially affect the Company'sconsolidated financial position or results of operations.

**Item 2.  Changes in Securities and Use of Proceeds**

None

**Item 3.  Defaults Upon Senior Securities**

None

**Item 4.  Submission of Matters to a Vote of Securities Holders**

None

**Item 5.  Other Information**

None

**Item 6.  Exhibits and Reports on Form 8‐K**

(a)  Exhibits

None

(b)  Reports on Form 8-K

On April 17, 2003, the Company filed a Form 8-K announcing the earningsrelease dated April 10, 2003, which included selected financial data for thequarter ended March 31, 2003 and for select other previously reported periods. 

On April 25, 2003, the Company filed a Form 8-K announcing the mailing of itsquarterly earnings overview to shareholders dated April 19, 2003, which includedselected financial data for the quarter ended March 31, 2003 and for selectother previously reported periods.  

 

 

 

30

 

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

PALMETTO BANCSHARES, INC.

By:

/s/      L. Leon Patterson                           L. Leon Patterson Chairman and Chief Executive Officer

/s/      Paul W. Stringer                                 Paul W. Stringer President and Chief Operating Officer(Chief Accounting Officer)

Date:   May 15, 2003

31

 

CERTIFICATION OF CHIEF EXECUTIVE OFFICER OF PALMETTOBANCSHARES, INC. PURSUANT TO 15 U.S.C. SECTION 7241

I, L. Leon Patterson, hereby certify that:  

1.      I have reviewed this quarterly report on Form 10-Q of Palmetto Bancshares, Inc.;

2.      Based on my knowledge, this quarterly report does not contain any untruestatement of a material fact or omit to state a material fact necessary to makethe statements made, in light of the circumstances under which such statementswere made, not misleading with respect to the period covered by this quarterlyreport;

3.      Based on my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

4.      The registrant's other certifying officers and I are responsible forestablishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-14 and 15d-14) for the registrant and have: 

(a) designed such disclosure controls and proceduresto ensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this quarterly report is being prepared;

(b) evaluated the effectiveness of the registrant'sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this quarterly report ("Evaluation Date"); and

(c) presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date; 

5.      The registrant's other certifying officers and I have disclosed, based on ourmost recent evaluation, to the registrant's auditors and the audit committee ofregistrant's board of directors (or persons fulfilling the equivalentfunctions): 

(a) all significant deficiencies in the design oroperation of internal controls which could adversely affect the registrant'sability to record, process, summarize and report financial data and haveidentified for the registrant's auditors any material weaknesses in internalcontrols; and 

(b) any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant'sinternal controls; and

6.      The registrant's other certifying officers and I have indicated in thisquarterly report whether or not there were significant changes in internalcontrols or in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

By:

/s/      L. Leon Patterson                          L. Leon PattersonChairman and Chief Executive OfficerDate: May 15, 2003

32

 

CERTIFICATION OF CHIEF ACCOUNTING OFFICER OF PALMETTOBANCSHARES, INC. PURSUANT TO 15 U.S.C. SECTION 7241

I, Paul W. Stringer, hereby certify that:  

 

1.      I have reviewed this quarterly report on Form 10-Q of Palmetto Bancshares, Inc.;

2.      Based on my knowledge, this quarterly report does not contain any untruestatement of a material fact or omit to state a material fact necessary to makethe statements made, in light of the circumstances under which such statementswere made, not misleading with respect to the period covered by this quarterlyreport;

3.      Based on my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

4.      The registrant's other certifying officers and I are responsible forestablishing and maintaining disclosure controls and procedures (as defined inExchange Act Rules 13a-14 and 15d-14) for the registrant and have: 

(a) designed such disclosure controls and proceduresto ensure that material information relating to the registrant, including itsconsolidated subsidiaries, is made known to us by others within those entities,particularly during the period in which this quarterly report is being prepared;

(b) evaluated the effectiveness of the registrant'sdisclosure controls and procedures as of a date within 90 days prior to thefiling date of this quarterly report ("Evaluation Date"); and

(c) presented in this quarterly report ourconclusions about the effectiveness of the disclosure controls and proceduresbased on our evaluation as of the Evaluation Date; 

5.      The registrant's other certifying officers and I have disclosed, based on ourmost recent evaluation, to the registrant's auditors and the audit committee ofregistrant's board of directors (or persons fulfilling the equivalentfunctions): 

(a) all significant deficiencies in the design oroperation of internal controls which could adversely affect the registrant'sability to record, process, summarize and report financial data and haveidentified for the registrant's auditors any material weaknesses in internalcontrols; and 

(b) any fraud, whether or not material, that involvesmanagement or other employees who have a significant role in the registrant'sinternal controls; and

6.      The registrant's other certifying officers and I have indicated in thisquarterly report whether or not there were significant changes in internalcontrols or in other factors that could significantly affect internal controlssubsequent to the date of our most recent evaluation, including any correctiveactions with regard to significant deficiencies and material weaknesses.

 

By:

/s/      Paul W. Stringer                                     Paul W. StringerPresident and Chief Operating Officer (Chief Accounting Officer)Date: May 15, 2003

 

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