**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10 - Q**

** **

**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)**

**OF THE SECURITIES EXCHANGEACT OF 1934**

** **

**For the quarterly period ended September 30,2005**

 

**Commission File Number 000-51548**

 

**STATENATIONAL BANCSHARES, INC.**

(Exact name of registrantas specified in its charter)

 
| **Texas**                        | ** ** | **75-2641879**                        |
|----------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)  |       |                                  |

 

**4500 Mercantile Plaza Drive**

**Suite 300**

**Fort Worth, Texas 76137**

(Address of principalexecutive offices, including zip code)

 

**(817) 547-1150**

(Registrant’s telephonenumber, including area code)

 

Indicate by check markwhether the registrant: (i) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (ii) has been subject to such filing requirements forthe past 90 days.

Yes o No ý

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act.)

Yes o No ý

 

Indicate by check mark whether the registrant is a shell company(as defined in Rule 12b-2 of the Exchange Act.)

Yes o No ý

 

The number of sharesoutstanding of the issuer’s Common Stock as of November 10, 2005 was11,971,107shares.

 

 

----

 

**STATE NATIONAL BANCSHARES, INC.**

 

INDEX

 
| **PART I -**  | **FINANCIAL INFORMATION**                                                                   | ** ** |
|--------------------|---------------------------------------------------------------------------------------------|------------|
| ** **         | ** **                                                                                  | ** ** |
| ITEM 1.            | FINANCIAL STATEMENTS                                                                        |       |
| ITEM 2.            | MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |       |
| ITEM 3.            | QUANTITATIVE AND QUALITATIVE  DISCLOSURES ABOUT MARKET RISK                                 |       |
| ITEM 4.            | CONTROLS AND PROCEDURES                                                                     |       |
|               |                                                                                        |       |
| **PART II -** | **OTHER INFORMATION**                                                                       | ** ** |
| ** **         | ** **                                                                                  | ** ** |
| ITEM 1.            | LEGAL PROCEEDINGS                                                                           |       |
| ITEM 2.            | UNREGISTERED SALES OF EQUITY  SECURITIES AND USE OF PROCEEDS                                |       |
| ITEM 3.            | DEFAULTS UPON SENIOR  SECURITIES                                                            |       |
| ITEM 4.            | SUBMISSION OF MATTERS TO A  VOTE OF SECURITY HOLDERS                                        |       |
| ITEM 5.            | OTHER INFORMATION                                                                           |       |
| ITEM 6.            | EXHIBITS                                                                                    |       |

 

i

----

 

# **PART I- FINANCIAL INFORMATION**

# ** **

## **ITEM1.  Financial Statements**

## ** **

**STATE NATIONAL BANCSHARES, INC.AND SUBSIDIARIES**

 

**Consolidated Balance Sheets**

**September 30, 2005 and December 31,2004**

(In thousands, except numberof shares)

(Unaudited)

 
| ** **                                                                                                                                                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                  | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| **Assets:**                                                                                                                                                 |       |                   |       |                  |       |
| Cash and due from banks                                                                                                                                     |       | $                      | 64,658     |                  | $          | 54,892 |   |
| Federal funds sold                                                                                                                                          |       | 60,900                 |       | 19,100                |       |
| Interest-bearing  deposits in other banks                                                                                                                   |       | 16,525                 |       | 15,475                |       |
| Total cash and cash equivalents                                                                                                                             |       | 142,083                |       | 89,467                |       |
| Securities available-for-sale, at fair value (amortized cost of $117,993, and  $150,547 at September 30, 2005 and December 31, 2004 respectively) |       | 116,958                |       | 151,008               |       |
| Federal Reserve Bank  stock and other investments, at cost                                                                                                  |       | 7,941                  |       | 8,306                 |       |
| Loans held-for-sale                                                                                                                                         |       | 6,761                  |       | 8,382                 |       |
| Loans:                                                                                                                                                      |       |                   |       |                  |       |
| Loans held for investment, net of unearned income                                                                                                           |       | 966,561                |       | 937,784               |       |
| Allowance for loan losses                                                                                                                                   |       | (11,620                | )          | (11,383               | )          |
| Net loans held for investment                                                                                                                               |       | 954,941                |       | 926,401               |       |
| Premises and equipment,  net                                                                                                                                |       | 35,583                 |       | 33,915                |       |
| Goodwill                                                                                                                                                    |       | 70,818                 |       | 70,818                |       |
| Other intangible  assets, net                                                                                                                               |       | 13,015                 |       | 15,486                |       |
| Accrued interest  receivable                                                                                                                                |       | 6,766                  |       | 6,773                 |       |
| Other real estate and  repossessed assets                                                                                                                   |       | 1,851                  |       | 1,952                 |       |
| Bank owned life  insurance                                                                                                                                  |       | 36,286                 |       | 35,324                |       |
| Other assets                                                                                                                                                |       | 4,006                  |       | 2,548                 |       |
| **Total assets**                                                                                                                                            |       | $                      | 1,397,009  |                  | $          | 1,350,380 |   |
| **Liabilities and shareholders’ equity:**                                                                                                              |       |                   |       |                  |       |
| Deposits:                                                                                                                                                   |       |                   |       |                  |       |
| Noninterest-bearing demand deposits                                                                                                                         |       | $                      | 428,795    |                  | $          | 390,159 |   |
| Interest-bearing demand deposits                                                                                                                            |       | 441,275                |       | 450,351               |       |
| Interest-bearing time deposits                                                                                                                              |       | 280,706                |       | 285,884               |       |
| Total deposits                                                                                                                                              |       | 1,150,776              |       | 1,126,394             |       |
| Federal funds purchased  and securities sold under agreement to repurchase                                                                                  |       | 27,470                 |       | 18,530                |       |
| Accrued interest  payable                                                                                                                                   |       | 1,202                  |       | 835                   |       |
| Other liabilities                                                                                                                                           |       | 8,416                  |       | 5,362                 |       |
| Junior subordinated  debentures                                                                                                                             |       | 47,000                 |       | 47,000                |       |
| Notes payable                                                                                                                                               |       | 810                    |       | 899                   |       |
| Total liabilities                                                                                                                                           |       | 1,235,674              |       | 1,199,020             |       |
| **Shareholders’ equity:**                                                                                                                              |       |                   |       |                  |       |
| Common stock, $1.00 par value; authorized  shares-40,000,000; issued shares-11,971,107 at September 30, 2005 and  10,054,582 in 2004                   |       | 11,971                 |       | 10,055                |       |
| Additional paid-in  capital                                                                                                                                 |       | 177,012                |       | 133,519               |       |
| Retained earnings                                                                                                                                           |       | 19,157                 |       | 7,482                 |       |
| Accumulated other  comprehensive (loss) income                                                                                                              |       | (677                   | )          | 304                   |       |
| Subscription receivable                                                                                                                                     |       | (46,128                | )          | —                |       |
| **Total shareholders’ equity**                                                                                                                         |       | 161,335                |       | 151,360               |       |
| **Total liabilities and shareholders’ equity**                                                                                                         |       | $                      | 1,397,009  |                  | $          | 1,350,380 |   |

 

See Accompanying Notes to Consolidated Financial Statements.

 

1

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**STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES**

 

**Consolidated Statements of Operations**

**Three and Nine-Months Ended September 30,2005 and 2004**

**(Unaudited)**

 
| ** **                                                                     | ** ** | **Three Months**                          | ** ** | **Nine Months**              | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------|------------|
| ** **                                                                     | ** ** | **Ended September 30,**              | ** ** | **Ended September 30,** | ** ** |
| ** **                                                                     | ** ** | **2005**                                  | ** ** | **2004**                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                     | ** ** | **(In thousands, except per share data)** | ** ** |
| Interest income:                                                               |       |                                      |       |                         |       |   |   |   |   |
| Loans, including fees                                                          |       | $                                         | 17,728     |                         | $          | 14,015 |   | $ | 50,519 |   | $ | 37,463 |   |
| Securities                                                                     |       | 1,277                                     |       | 1,737                        |       | 4,100 |   | 5,727 |   |
| Deposits in other banks                                                        |       | 127                                       |       | 116                          |       | 237 |   | 131 |   |
| Federal funds sold                                                             |       | 457                                       |       | 151                          |       | 740 |   | 262 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Total interest income                                                          |       | 19,589                                    |       | 16,019                       |       | 55,596 |   | 43,583 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Interest expense:                                                              |       |                                      |       |                         |       |   |   |   |   |
| Deposits                                                                       |       | 2,862                                     |       | 1,776                        |       | 7,267 |   | 4,841 |   |
| Federal funds purchased and securities sold under agreements  to repurchase    |       | 178                                       |       | 52                           |       | 387 |   | 99 |   |
| Subordinated notes payable                                                     |       | 832                                       |       | 596                          |       | 2,314 |   | 1,587 |   |
| Notes payable                                                                  |       | 10                                        |       | 11                           |       | 30 |   | 37 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Total interest expense                                                         |       | 3,882                                     |       | 2,435                        |       | 9,998 |   | 6,564 |   |
| Net interest income                                                            |       | 15,707                                    |       | 13,584                       |       | 45,598 |   | 37,019 |   |
| Provision for loan losses                                                      |       | 150                                       |       | 300                          |       | 750 |   | 300 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Net interest income after provision for loan losses                            |       | 15,557                                    |       | 13,284                       |       | 44,848 |   | 36,719 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Noninterest income:                                                            |       |                                      |       |                         |       |   |   |   |   |
| Service charges on deposit accounts                                            |       | 2,600                                     |       | 2,490                        |       | 7,416 |   | 6,833 |   |
| Gain on sale of loans                                                          |       | 804                                       |       | 636                          |       | 2,153 |   | 1,723 |   |
| Bank owned life insurance                                                      |       | 316                                       |       | 323                          |       | 948 |   | 951 |   |
| Other income                                                                   |       | 1,211                                     |       | 728                          |       | 3,286 |   | 2,297 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Total noninterest income                                                       |       | 4,931                                     |       | 4,177                        |       | 13,803 |   | 11,804 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Noninterest expenses:                                                          |       |                                      |       |                         |       |   |   |   |   |
| Salaries and employee benefits                                                 |       | 7,297                                     |       | 6,491                        |       | 21,614 |   | 17,587 |   |
| Net occupancy and equipment expense                                            |       | 2,322                                     |       | 1,983                        |       | 6,628 |   | 5,654 |   |
| Amortization of intangible assets                                              |       | 824                                       |       | 778                          |       | 2,471 |   | 2,035 |   |
| Advertising                                                                    |       | 330                                       |       | 204                          |       | 864 |   | 591 |   |
| Professional fees                                                              |       | 326                                       |       | 276                          |       | 1,017 |   | 806 |   |
| Communication expense                                                          |       | 300                                       |       | 267                          |       | 856 |   | 718 |   |
| Data processing expense                                                        |       | 203                                       |       | 202                          |       | 622 |   | 575 |   |
| Supplies                                                                       |       | 166                                       |       | 225                          |       | 587 |   | 589 |   |
| Merger expenses                                                                |       | 19                                        |       | 284                          |       | 59 |   | 285 |   |
| Net (gain) costs applicable to other real estate and  other repossessed assets |       | (6                                        | )          | 8                            |       | 23 |   | 173 |   |
| Other expenses                                                                 |       | 2,244                                     |       | 2,020                        |       | 6,378 |   | 5,372 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Total noninterest expenses                                                     |       | 14,025                                    |       | 12,738                       |       | 41,119 |   | 34,385 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Income before income taxes                                                     |       | 6,463                                     |       | 4,723                        |       | 17,532 |   | 14,138 |   |
| Income tax expense                                                             |       | 2,085                                     |       | 1,387                        |       | 5,857 |   | 4,579 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Net income                                                                     |       | $                                         | 4,378      |                         | $          | 3,336 |   | $ | 11,675 |   | $ | 9,559 |   |
|                                                                           |       |                                      |       |                         |       |   |   |   |   |
| Basic income per share                                                         |       | $                                         | 0.43       |                         | $          | 0.34 |   | $ | 1.16 |   | $ | 1.02 |   |
| Diluted income per share                                                       |       | $                                         | 0.42       |                         | $          | 0.33 |   | $ | 1.14 |   | $ | 1.00 |   |

 

See Accompanying Notes to Consolidated Financial Statements.

 

2

----

 

**STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES**

 

**Consolidated Statements of Change in Shareholders’Equity**

**For the nine months ended September 30, 2005 andthe year ended December 31, 2004**

**(In thousands, except number of shares)**

**(Unaudited)**

 

 

 
| ** **                                                                                | ** ** | ** **        | ** ** | ** **  | ** **   | ** **       | ** ** | ** **     | ** ** | ** **   | ** **    | **Accumulated**   | ** ** | ** **          | ** **   | ** **   | ** ** | ** **  | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------|--------------|------------------|------------|----------------|------------|--------------|---------------|-------------------|------------|---------------------|--------------|--------------|------------|-------------|------------|------------|------------|
| ** **                                                                                | ** ** | ** **        | ** ** | ** **  | ** **   | **Additional**   | ** ** | ** **     | ** ** | ** **   | ** **    | **Retained**      | ** ** | **Other**           | ** **   | ** **   | ** ** | ** **  | ** ** | ** ** | ** ** |
| ** **                                                                                | ** ** | **Common  Stock** | ** ** | **Paid-in** | ** **   | **Subscription** | ** ** | ** **     | ** ** | **Earnings** | ** **    | **Comprehensive** | ** ** | **Treasury  Stock** | ** **   | ** **   | ** ** |
| ** **                                                                                | ** ** | **Shares**        | ** ** | **Amount**  | ** **   | **Capital**      | ** ** | **Receivable** | ** ** | ** **   | ** **    | **(Deficit)**     | ** ** | **Income  (Loss)**  | ** **   | **Shares**   | ** ** | **Amount**  | ** ** | **Total**  | ** ** |
| **Balance January 1, 2004**                                                          |       | 9,517,725         |       | $           |  9,518  |             | $          |  122,400  |       | —       |          |              |       | $                   |  (5,796 | )            | $          |  2,488 |       | (416,841   | )          | $ |  (7,362 | ) | $ |  121,248 |   |
| Comprehensive income:                                                                     |       |              |       |        |         |             |       |           |       |         |          |              |       |                |         |         |       |        |       |       |       |
| Net income                                                                                |       | —            |       | —      |         | —           |       | —         |       |         |          | 13,355            |       | —              |         | —       |       | —      |       | 13,355     |       |
| Change in unrealized gain on available-for-sale  securities, net of deferred income taxes |       | —            |       | —      |         | —           |       | —         |       |         |          | —            |       | (2,184              | )            | —       |       | —      |       | (2,184     | )          |
| Reclassification adjustment for gains included in net  income                             |       | —            |       | —      |         | —           |       | —         |       |         |          | —            |       | —              |         | —       |       | —      |       | —     |       |
| Total comprehensive income                                                                |       |              |       |        |         |             |       |           |       |         |          |              |       |                |         |         |       |        |       | 11,171     |       |
| Sale of treasury stock                                                                    |       | —            |       | —      |         | —           |       | —         |       |         |          | —            |       | —              |         | 378,732      |       | 6,714       |       | 6,714      |       |
| Issuance of new stock                                                                     |       | 521,268           |       | 521         |         | 10,628           |       |           |       |         |          | —            |       | —              |         | —       |       | —      |       | 11,149     |       |
| Warrants exercised                                                                        |       | —            |       | —      |         | —           |       | —         |       |         |          | (77               | )          | —              |         | 38,109       |       | 648         |       | 571        |       |
| Stock option award expense                                                                |       | —            |       | —      |         | 236              |       | —         |       |         |          | —            |       | —              |         | —       |       | —      |       | 236        |       |
| Stock option exercised                                                                    |       | 8,467             |       | 9           |         | 130              |       | —         |       |         |          | —            |       | —              |         | —       |       | —      |       | 139        |       |
| Stock issued for directors’ fees                                                     |       | 7,122             |       | 7           |         | 125              |       | —         |       |         |          | —            |       | —              |         | —       |       | —      |       | 132        |       |
| **Balance December 31, 2004**                                                        |       | 10,054,582        |       | $           |  10,055 |             | $          |  133,519  |       |         |          |              |       | $                   |  7,482  |         | $          |  304   |       | —     |       | $ |  — |   | $ |  151,360 |   |
| Net income                                                                                |       | —            |       | —      |         | —           |       | —         |       |         |          | 11,675            |       | —              |         | —       |       | —      |       | 11,675     |       |
| Change in unrealized gain on available-for-sale  securities, net of deferred income taxes |       | —            |       | —      |         | —           |       | —         |       |         |          | —            |       | (980                | )            | —       |       | —      |       | (980       | )          |
| Reclassification adjustment for gains included in net  income                             |       | —            |       | —      |         | —           |       | —         |       |         |          | —            |       | (1                  | )            | —       |       | —      |       | (1         | )          |
| Total comprehensive income                                                                |       |              |       |        |         |             |       |           |       |         |          |              |       |                |         |         |       |        |       | 10,694     |       |
| Issuance of new stock                                                                     |       | 1,907,692         |       | 1,908       |         | 42,986           |       | —         |       |         |          | —            |       | —              |         | —       |       | —      |       | 44,894     |       |
| Subscriptions receivable                                                                  |       | —            |       | —      |         | —           |       | (46,128        | )          |         |          | —            |       | —              |         | —       |       | —      |       | (46,128    | )          |
| Stock option award expense                                                                |       | —            |       | —      |         | 362              |       | —         |       |         |          | —            |       | —              |         | —       |       | —      |       | 362        |       |
| Stock options exercised                                                                   |       | 8,833             |       | 8           |         | 145              |       | —         |       |         |          | —            |       | —              |         | —       |       | —      |       | 153        |       |
| **Balance, September 30, 2005**                                                      |       | 11,971,107        |       | $           |  11,971 |             | $          |  177,012  |       | $            |  (46,128 | )                 |       |                | $            |  19,157 |       | $           |  (677 | )          | —     |   | $ |  — |   | $ |  161,335 |   |
|                                                                                           |            |                   |            |             |              |                  |            |                |            |              |               |                   |            |                     |              |              |            |             |            |            |            |  |  |  |  |  |  |  |

 

See Accompanying Notes to Consolidated Financial Statements.

 

3

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**STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES**

 

**Consolidated Statements of Cash Flows**

**For the Nine-Months Ended September 30, 2005and 2004**

**(In thousands)**

**(Unaudited)**

 
| ** **                                                                                                                    | ** ** | **Nine Months**              | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                    | ** ** | **Ended September 30,** | ** ** |
| ** **                                                                                                                    | ** ** | **2005**                     | ** ** | **2004** | ** ** |
| **Cash Flows from Operating Activities:**                                                                                     |       |                         |       |   |   |
| Net income                                                                                                                    |       | $                            | 11,675     |   | $ | 9,559 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:                                            |       |                         |       |   |   |
| Provision for loan losses                                                                                                     |       | 750                          |       | 300 |   |
| Depreciation and amortization                                                                                                 |       | 4,744                        |       | 4,140 |   |
| Stock compensation expense                                                                                                    |       | 362                          |       | 115 |   |
| Loans originated for sale                                                                                                     |       | (93,420                      | )          | (74,177 | ) |
| Proceeds from sales of loans held-for-sale                                                                                    |       | 97,194                       |       | 75,708 |   |
| Gain on sale of loans                                                                                                         |       | (2,153                       | )          | (1,723 | ) |
| Gain on sale of premise and equipment                                                                                         |       | —                       |       | (15 | ) |
| Net (gain) loss on sale of other real estate and  repossessed assets                                                          |       | (55                          | )          | 19 |   |
| Deferred income tax benefit                                                                                                   |       | (862                         | )          | (704 | ) |
| Write-down of premises and equipment                                                                                          |       | 80                           |       | 20 |   |
| Net amortization of premium on securities                                                                                     |       | 492                          |       | 852 |   |
| Net gain on sale of securities                                                                                                |       | (1                           | )          | — |   |
| Net change in other assets and liabilities                                                                                    |       | 1,597                        |       | 1,606 |   |
| **Net cash provided by operating activities**                                                                                 |       | 20,403                       |       | 15,700 |   |
| **Investing Activities:**                                                                                                     |       |                         |       |   |   |
| Purchases of securities available-for-sale                                                                                    |       | (7,966                       | )          | (105,817 | ) |
| Purchases of Federal Reserve Bank stock and other  investments                                                                |       | (91                          | )          | (76 | ) |
| Proceeds from maturities and calls of securities  available-for-sale                                                          |       | 40,062                       |       | 162,741 |   |
| Proceeds from maturities and calls of Federal  Reserve Bank stock & other investments                                     |       | 413                          |       | — |   |
| Acquisition, net of cash acquired from Mercantile                                                                             |       | —                       |       | (16,410 | ) |
| Net increase in loans held for investment                                                                                     |       | (30,393                      | )          | (50,435 | ) |
| Proceeds from sale of premises and equipment                                                                                  |       | 312                          |       | 1,478 |   |
| Proceeds from sales of other real estate and other  repossessed assets                                                        |       | 1,259                        |       | 941 |   |
| Purchases of premises and equipment                                                                                           |       | (4,435                       | )          | (4,264 | ) |
| Purchases of bank-owned life insurance                                                                                        |       | —                       |       | (300 | ) |
| **Net cash used in investing activities**                                                                                     |       | (839                         | )          | (12,142 | ) |
| **Financing Activities:**                                                                                                     |       |                         |       |   |   |
| Net increase in deposits                                                                                                      |       | 24,382                       |       | 11,853 |   |
| Proceeds from issuance of common stock                                                                                        |       | —                       |       | 18,435 |   |
| Net proceeds from issuance of guaranteed preferred  beneficial interests in the Company’s junior subordinated debentures |       | —                       |       | 10,000 |   |
| Stock issued through exercise of stock  options & warrants                                                           |       | 153                          |       | 57 |   |
| Net increase in federal funds purchased and  securities sold under agreement to repurchase                                    |       | 8,940                        |       | 1,263 |   |
| Initial public offering issuance costs                                                                                        |       | (334                         | )          | — |   |
| Principal payments on Federal Home Loan Bank notes                                                                            |       | (89                          | )          | (85 | ) |
| **Net Cash provided by financing activities**                                                                                 |       | 33,052                       |       | 41,523 |   |
| Net increase in cash and cash equivalents                                                                                     |       | 52,616                       |       | 45,081 |   |
| Cash and cash equivalents at beginning of period                                                                              |       | 89,467                       |       | 61,559 |   |
| Cash and cash equivalents at end of period                                                                                    |       | $                            | 142,083    |   | $ | 106,640 |   |
|                                                                                                                          |       |                         |       |   |   |
| Supplemental disclosures of cash flow information:                                                                            |       |                         |       |   |   |
| Cash paid during the period for:                                                                                              |       |                         |       |   |   |
| Interest                                                                                                                      |       | $                            | 9,631      |   | $ | 6,532 |   |
| Income taxes paid                                                                                                             |       | 5,248                        |       | 4,871 |   |
| Noncash transactions:                                                                                                         |       |                         |       |   |   |
| Transfer of loans to other real estate owned, net                                                                             |       | 1,120                        |       | 1,481 |   |

 

See Accompanying Notes toConsolidated Financial Statements.

 

4

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**STATE NATIONAL BANCSHARES, INC. AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements**

**(Unaudited)**

 

**1.****            ****Nature of Operations and Basis ofPresentation**

 

State National Bancshares, Inc.(the “Company” or “SNBI”) is a bank holding company headquartered in FortWorth, Texas, offering a broad range of financial products and servicesprimarily through the Company’s main subsidiary, State National Bank (the “Bank”),a national banking association.  At September 30,2005, the Bank operated 38 banking centers located in three distinct geographicmarkets throughout Texas and New Mexico: the greater Tarrant County area (FortWorth, Texas); West Texas (Lubbock, Abilene and Odessa), and Rio Grande (ElPaso, Texas and Southern New Mexico). As a financial holding company, theCompany is subject to the provisions of the Bank Holding Company Act, and tosupervision and regulation by the Board of Governors of the Federal ReserveSystem.

 

The unaudited condensed consolidatedfinancial statements include the accounts of the Company and itssubsidiaries.  Intercompany accounts andtransactions have been eliminated in consolidation.  These statements are, in the opinion ofmanagement, a fair presentation of the financial position and results for theperiods presented. These financial statements are unaudited but, in the opinionof management, reflect all necessary adjustments, including usual recurring adjustments,for a fair presentation of such financial statements.

 

The presentation of theconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amount of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe consolidated financial statements and the reported amount of revenue andexpenses during the reporting periods. These estimates are based on information available as of the date of theconsolidated financial statements. Therefore, actual results could differ from those estimates.

 

Certain information andnote disclosures normally included in the financial statements prepared inaccordance with generally accepted accounting principles in the United Statesof America have been condensed or omitted from these statements pursuant to rules andregulations of the Securities and Exchange Commission (the “SEC”) and,accordingly, these financial statements should be read in conjunction with theaudited consolidated financial statements of the Company for the year ended December 31,2004, which we included in our Registration Statement on Form S-1 filed onJuly 21, 2005, as amended. The results of operations for the nine monthperiod ended September 30, 2005 are not necessarily indicative of theresults to be expected for the full year.

 

**2.****            ****Earnings Per Share**

 

Basic earnings per sharerepresent income available to common stockholders divided by the weightedaverage number of common shares outstanding during the period.  Diluted earnings per share reflect additionalcommon shares that would have been outstanding if dilutive potential common shareshad been issued, as well as any adjustment to income that would result from theassumed issuance.  Potential commonshares that may be issued by the Company relate solely to outstanding stockoptions and are determined using the treasury stock method.

 

The computation of earnings per share is presentedbelow:

 
| ** **                                                                                                             | ** ** | **Three months ended**                    | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                             | ** ** | **September 30,**                    | ** ** | **September 30,** | ** ** |
| ** **                                                                                                             | ** ** | **2005**                                  | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                             | ** ** | **(In thousands, except per share data)** | ** ** |
| Reported net income                                                                                                    |       | $                                         | 4,378      |                   | $          | 3,336 |   | $ | 11,675 |   | $ | 9,559 |   |
| Add: Stock-based employee compensation expense  included in reported net income, net of tax                            |       | 78                                        |       | 56                     |       | 235 |   | 75 |   |
| Deduct: Total stock-based employee compensation  expense determined under fair value method for all awards, net of tax |       | (81                                       | )          | (61                    | )          | (247 | ) | (89 | ) |
| Pro forma net income                                                                                                   |       | 4,375                                     |       | 3,331                  |       | 11,663 |   | 9,545 |   |
| Earning per share:                                                                                                     |       |                                      |       |                   |       |   |   |   |   |
| Basic – as reported                                                                                               |       | $                                         | 0.43       |                   | $          | 0.34 |   | $ | 1.16 |   | $ | 1.02 |   |
| Basic – pro forma                                                                                                 |       | $                                         | 0.43       |                   | $          | 0.34 |   | $ | 1.16 |   | $ | 1.02 |   |
|                                                                                                                   |       |                                      |       |                   |       |   |   |   |   |
| Diluted – as reported                                                                                             |       | $                                         | 0.42       |                   | $          | 0.33 |   | $ | 1.14 |   | $ | 1.00 |   |
| Diluted – pro forma                                                                                               |       | $                                         | 0.42       |                   | $          | 0.33 |   | $ | 1.14 |   | $ | 1.00 |   |

 

5

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**3.****            ****Adoption of Accounting Standards**

 

SFAS No. 123, “Share-BasedPayment (Revised 2004)” (“SFAS 123R”) establishes standards for the accountingfor transactions in which an entity (i) exchanges its equity instrumentsfor goods or services, or (ii) incurs liabilities in exchange for goods orservices that are based on the fair value of the entity’s equity instruments orthat may be settled by the issuance of the equity instruments.  This statement focuses primarily onaccounting for transactions in which an entity obtains employee services inshare-based payment transactions.  Thisstatement requires an entity to measure the cost of employee services receivedin exchange for an award of equity instruments based on the grant-date fairvalue of the award (with limited exceptions). That cost will be recognized overthe period during which an employee is required to provide service in exchangefor the award—the requisite service period (usually the vesting period). Nocompensation cost is recognized for equity instruments for which employees donot render the requisite service. Employee share purchase plans will not resultin recognition of compensation cost if certain conditions are met; thoseconditions are much the same as the related conditions in SFAS No. 123.  An entity will initially measure the cost ofemployee services received in exchange for an award of liability instrumentsbased on its current fair value.  Underthe SEC’s rule, approved on April 2005, SFAS No. 123 (R) will beeffective for public entities that do not file as small business issuers forannual periods that begin after June 15, 2005.  SNBI intends to implement SFAS 123R on January 1,2006 and its adoption is not anticipated to have a material impact on SNBI’sconsolidated financial position, results of operations or cash flows.

 

In July 2003, theBoard of Governors of the Federal Reserve System issued a supervisory letterinstructing bank holding companies to continue to include the trust preferredsecurities in their Tier I capital for regulatory capital purposes. Under thecurrent regulatory criteria, our Tier 1 capital ratio is 11.74%.  However, under the new Federal Reserve’sproposed rules effective March 31, 2009, our Tier 1 capital ratiowould be 10.33%. Under the proposed rules, we would still exceed the regulatoryrequired minimum capital ratios to qualify as “well-capitalized” under thecapital adequacy guidelines for bank holding companies.

 

In June 2005, theEmerging Issues Task Force (EITF) reached a consensus on the application ofIssue 05-06, *Determining the AmortizationPeriod for Leasehold Improvements Purchased after Lease Inception or Acquiredin a Business Combination*. The EITF reached a consensus that theleasehold improvements acquired through a business combination or purchasedsubsequent to the lease inception should be amortized over the lesser of theuseful life of the leasehold improvements or the period of the lease, whichshould include all the renewal periods that are reasonably assured of exerciseat the time of acquisition.  Theamortization period requirements described in this issue were effective forleasehold improvements acquired or purchased in reporting periods beginningafter June 29, 2005.  However, theEITF has addressed the FASB staff to further develop a separate issue forconsideration of whether the amortization period for a leasehold improvementshould be reevaluated after the initial determination of the amortizationperiod.

 

**4.****            ****Initial Public Offering**

 

OnSeptember 30, 2005, SNBI completed an initial public offering of 1,907,692shares of common stock at the initial offering price of $26 per share. Theproceeds received after the underwriters’ discounts and commissions but beforeexpenses related to the offering were $46.1 million. All of the proceeds fromthe offering, net of estimated issuance costs of $1.2 million, were used tofund a portion of the purchase price of Heritage Financial Corporation, whichthe Company acquired on October 6, 2005.

 

Becausethe initial public offering occurred on September 30, 2005 and proceedsfrom the underwriters’ were received on October 5, 2005, SNBI recorded thestock issuance as of September 30, 2005 and recorded a receivable as acontra account in the equity section of its balance sheet in the amount of$46.1 million.

 

6

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**5.****            ****Subsequent Events**

 

OnOctober 6, 2005, SNBI completed the acquisition of Heritage FinancialCorporation and its wholly owned subsidiary bank, Heritage National Bank. Theaggregate purchase price for all of the capital stock of Heritage FinancialCorporation was $53.5 million. The acquisition of Heritage National Bank addedfour banking centers located in Granbury, Benbrook, Crowley and Fort Worth,Texas to State National Bank’s network of banking centers. As of September 30,2005, Heritage National Bank had total assets of $225.7 million, total depositsof $198.6 million, net loans of $105.0 million, and stockholders’ equity of$15.5 million.

 

**6.****            ****Regulatory Matters**

 

The Company (on aconsolidated basis) and the Bank are subject to various regulatory capitalrequirements administered by the federal banking agencies.  The Bank, as a national bank, is subject tothe dividend restrictions set forth in the National Bank Act of 1864 and theregulations and policies of the Office of the Comptroller of the Currency, orthe OCC. Failure to meet minimum capital requirements can initiate certainmandatory - and possibly additional discretionary - actions by regulators that,if undertaken, could have a direct material effect on the Bank’s financialstatements.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, the Companyand the Bank must meet specific capital guidelines that involve quantitativemeasures of their assets, liabilities, and certain off-balance-sheet items ascalculated under regulatory accounting practices.  The capital amounts and classifications are alsosubject to qualitative judgments by the regulators about components, riskweightings, and other factors.

 

Quantitative measuresestablished by regulations to ensure capital adequacy require the Company andthe Bank to maintain minimum amounts and ratios (set forth in the followingtable) of total and Tier 1 Capital (as defined in the regulations) torisk-weighted assets (as defined), and of Tier 1 Capital (as defined) toaverage assets (Leverage) (as defined). Management believes, as of September 30, 2005, that the Company andthe Bank met all capital adequacy requirements to which they are subject.

 

The most recentnotification from the OCC categorized the Bank as “well-capitalized” under theregulatory framework for prompt corrective action.  To be categorized as “well-capitalized,” aninstitution must maintain minimum total risk-based, Tier 1 risk-based, andTier 1 Leverage ratios as set forth in the following tables. There are noconditions or events since the most recent notification that managementbelieves have changed the institution’s capital category. The Company’s and theBank’s actual capital amounts and ratios as of September 30, 2005 are alsopresented in the table.

 

At September 30,2005 and December 31, 2004, required and actual regulatory capital amountsand ratios for SNBI are as follow:

 
| ** **                              | ** ** | ** **                 | ** ** | ** **            | ** ** | **Minimum** | ** ** | **Well-**       | ** ** |
|-----------------------------------------|------------|----------------------------|------------|-----------------------|------------|-------------|------------|-----------------|------------|
| ** **                              | ** ** | **September 30,**     | ** ** | **December 31,** | ** ** | **Capital** | ** ** | **Capitalized** | ** ** |
| ** **                              | ** ** | **2005**                   | ** ** | **2004**              | ** ** | **Ratios**  | ** ** | **Ratios**      | ** ** |
| ** **                              | ** ** | **(Dollars in Thousands)** | ** ** | ** **            | ** ** | ** **  | ** ** |
| Tier 1 capital                          |       | $                          | 125,902    |                  | $          | 113,536     |       |            |       |   |   |
| Total capital                           |       | 137,522                    |       | 124,919               |       |        |       |            |       |
| Total risk-weighted  assets             |       | 1,072,330                  |       | 1,042,935             |       |        |       |            |       |
| Adjusted quarterly  average assets      |       | 1,297,230                  |       | 1,287,094             |       |        |       |            |       |
|                                    |       |                       |       |                  |       |        |       |            |       |
| **Capital ratios:**                     |       |                       |       |                  |       |        |       |            |       |
| Leverage ratio                          |       | 9.71                       | %          | 8.82                  | %          | 4.00        | %          | 5.00            | %          |
| Tier 1 capital to  risk-weighted assets |       | 11.74                      |       | 10.89                 |       | 4.00        |       | 6.00            |       |
| Total capital to  risk-weighted assets  |       | 12.82                      |       | 11.98                 |       | 8.00        |       | 10.00           |       |
|                                         |            |                            |            |                       |            |             |            |                 |            |  |  |

 

7

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The minimum capitalratios as determined by the regulators for well-capitalized banks and StateNational Bank’s actual capital ratios at September 30, 2005 were asfollows:

 
| ** **                              | ** ** | **Minimum Ratios for**     | ** ** | **Actual Ratios at**        | ** ** |
|-----------------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| ** **                              | ** ** | **Well-Capitalized Banks** | ** ** | **September 30, 2005** | ** ** |
|                                    |       |                       |       |                        |       |
| Leverage ratio                          |       | 5.00                       | %          | 8.41                        | %          |
| Tier 1 capital to  risk-weighted assets |       | 6.00                       |       | 10.19                       |       |
| Total capital to  risk-weighted assets  |       | 10.00                      |       | 11.27                       |       |

 

8

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## **ITEM2.  Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

## ** **

**MANAGEMENT’SDISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

The following discussion and analysis presentsmanagement’s analysis of our results of operations for the three months andnine months ended September 30, 2005 and 2004 and our financial conditionas of December 31, 2004 and September 30, 2005.  The discussion should be read in conjunctionwith our financial statements and the notes related thereto which appearelsewhere in this Quarterly Report on Form 10-Q.

 

Statements contained in this report that are notpurely historical are forward-looking statements within the meaning of Section 21Eof the Securities Exchange Act of 1934, as amended, including our expectations,intentions, beliefs, or strategies regarding the future.  Any statements in this document aboutexpectations, beliefs, plans, objectives, assumptions or future events orperformance are not historical facts and are forward-looking statements. Thesestatements are often, but not always, made through the use of words or phrasessuch as “may,” “should,” “could,” “predict,” “potential,” “believe,” “willlikely result,” “expect,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,”“would” and “outlook,” and similar expressions. Accordingly, these statements involve estimates, assumptions anduncertainties, which could cause actual results to differ materially from thoseexpressed in them.  Any forward-lookingstatements are qualified in their entirety by reference to the factors discussedthroughout this document.  All forward-lookingstatements concerning economic conditions, rates of growth, rates of income orvalues as may be included in this document are based on information availableto us on the dates noted, and we assume no obligation to update any suchforward-looking statements.  It isimportant to note that our actual results may differ materially from those insuch forward-looking statements due to fluctuations in interest rates,inflation, government regulations, economic conditions, customerdisintermediation and competitive product and pricing pressures in thegeographic and business areas in which we conduct operations, including ourplans, objectives, expectations and intentions and other factors discussed inour Registration Statement on Form S-1 filed on July 21, 2005, asamended, including the following:

 

•      ifa significant number of our clients fail to perform under their loans, ourbusiness, profitability, and financialcondition would be adversely affected;

 

•      ourcurrent level of interest rate spread may decline in the future, and anymaterial reduction in our interestspreadcould have a material impact on our business and profitability;

 

•      themodification of the Federal Reserve Board’s current position on the capitaltreatment of our juniorsubordinateddebt and trust preferred securities could have a material adverse effect on ourfinancial conditionandresults of operations;

 

•      adversechanges in domestic or global economic conditions could have a material adverseeffect on ourbusiness,growth, and profitability;

 

•      wecould be liable for breaches of security in our online banking services, andfear of security breaches couldlimitthe growth of our online services;

 

•      maintainingor increasing our market share depends on market acceptance and regulatoryapproval of newproductsand services;

 

•      significantreliance on loans secured by real estate may increase our vulnerability todownturns in the realestatemarket and other variables impacting the value of real estate;

 

•      ifwe fail to retain our key employees, growth and profitability could beadversely affected;

 

•      wemay be unable to manage our future growth;

 

•      increasesin our allowance for loan and lease losses could materially adversely affectour earnings;

 

•      ourdirectors and executive officers beneficially own a significant portion of ouroutstanding common stock;

 

9

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•      weface substantial competition in our primary market area;

 

These factors and the risk factors identified in ourRegistration Statement on Form S-1 filed on July 21, 2005, asamended, could cause actual results or outcomes to differ materially from thoseexpressed in any forward-looking statements made by us, and you should notplace undue reliance on any such forward-looking statements.  Any forward-looking statement speaks only asof the date on which it is made and we do not undertake any obligation toupdate any forward-looking statement or statements to reflect events orcircumstances after the date on which such statement is made or to reflect theoccurrence of unanticipated events.  Newfactors emerge from time to time, and it is not possible for us to predictwhich will arise.  In addition, we cannotassess the impact of each factor on our business or the extent to which anyfactor, or combination of factors, may cause actual results to differmaterially from those contained in any forward-looking statements.

 

**Executive Overview**

** **

***Introduction***

*** ***

We are a registered bank holding company headquartered in Fort Worth,Texas, offering a broad array of financial services through our wholly ownedbanking subsidiary, State National Bank. As of September 30, 2005, we had,on a consolidated basis, total assets of $1.4 billion, net loans of $954.9million, total deposits of $1.2 billion, and stockholders’ equity of $161.3million, and operate through a network of 38 banking centers located throughoutTexas and New Mexico. On July 30, 2004, we acquired all of the capitalstock of Mercantile Bank, a commercial bank headquartered in Fort Worth, Texaswith approximately $215.7 million in total assets as of July 30, 2004.

 

As a bank holding company, we generate most of our revenue frominterest on loans and investments, service charges, and gains on the sale ofloans. Our primary source of funding for our loans is deposits we hold in oursubsidiary bank. Our largest expenses are interest on these deposits andsalaries and related employee benefits. We usually measure our performance bycalculating our return on average assets, return on average equity, ourregulatory leverage and risk-based capital ratios. We also measure ourperformance by our efficiency ratio, which is calculated by dividingnoninterest expense less amortization of core deposit intangibles by the sum ofnet interest income on a tax equivalent basis and noninterest income.

 

Our consolidated financial statements for the three and nine monthperiods ended September 30, 2005, and 2004 and the fiscal year ended December 31,2004 include the results of operations for each of our wholly ownedsubsidiaries: State National Bank, TWOENC, Inc., State NationalProperties, LLC and State National Bancshares of Delaware. Our statutory trustsubsidiaries are special purpose vehicles that were used to issue trustpreferred securities. It should be noted, however, that in December 2003,the FASB issued a revision to Financial Accounting Standards BoardInterpretation No. 46, *Consolidation ofVariable Interest Entities,* that required the deconsolidation ofcertain “variable interest entities,” such as our statutory trust subsidiaries.Effective December 31, 2003, we adopted the provisions of FIN No. 46R,requiring the deconsolidation of these trusts. As a result, our statutorytrusts are no longer consolidated with us or State National Bank.

 

Since 2000, wehave raised approximately $48.5 million through the issuance of juniorsubordinated debentures in connection with our trust preferred securitiesissuances, which we have applied to achieve and maintain our status as awell-capitalized institution, to sustain our continued loan growth and tofinance acquisitions. 

 

10

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***Critical AccountingPolicies***

*** ***

We prepare our consolidated financial statements basedon the selection of certain accounting policies, generally accepted accountingprinciples and customary practices in the banking industry. We deem a policycritical if (1) the accounting estimate required us to make assumptionsabout matters that are highly uncertain at the time we make the accounting estimate;and (2) different estimates that reasonably could have been used in thecurrent period, or changes in the accounting estimate that are reasonablylikely to occur from period to period, would have a material impact on ourfinancial statements

 

*Loansand Allowance for Loan Losses*

* *

Loans that management has the intent and ability tohold for the foreseeable future, or until maturity or payoff, are reported attheir outstanding unpaid principal balances adjusted by any charge-offs,unearned finance charges, allowance for loan and lease losses, and net deferrednonrefundable fees or costs on origination. The allowance for loan and lease losses is an estimate to provide forprobable collection losses in our loan portfolio.  Losses are charged and recoveries arecredited to the allowance account at the time a loss is incurred or a recoveryis received.  The allowance for loanlosses amounted to $11.6 million and $11.4 million as of September 30,2005 and December 31, 2004, respectively. Losses charged to the allowance amounted to $1.5 million for the ninemonths ended September 30, 2005 compared to $1.0 million for the sameperiod in 2004.  Recoveries were creditedto the allowance in the amounts of $977,000 and $721,000 for those sameperiods, respectively.

 

We follow a consistent procedural discipline andaccount for loan loss contingencies in accordance with Statement of FinancialAccounting Standards (SFAS) No. 5, Accounting for Contingencies, and SFAS No. 114,Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118,Accounting by Creditors for Impairment of a Loan — Income Recognition andDisclosures.

 

To mitigate any difference between estimates andactual results relative to the calculation of the allowance for loan losses,our loan review department is specifically charged with reviewing monthlydelinquency reports to determine if additional reserves are necessary.  Delinquency reports and analysis of theallowance for loan losses are also provided to senior management and the Board ofDirectors on a monthly basis.

 

The loan review department evaluates significantchanges in delinquency with regard to a particular loan portfolio to determinethe potential for continuing trends, and loss projections are estimated andadjustments are made to the historical loss factor applied to that portfolio inconnection with the calculation of loss reserves.  Portfolio performance is also monitoredthrough the monthly calculation of the percentage of non-performing loans tothe total portfolio outstanding.  Asignificant change in this percentage may trigger a review of the portfolio andeventually lead to additional reserves. We also track the ratio of net charge-offs to total portfoliooutstanding.

 

We classify loans as nonperforming when they become 90days past due.  Nonperforming loansamounted to $5.2 million and $7.0 million as of September 30, 2005 and December 31,2004, respectively.

 

*OtherReal Estate Owned and Repossessed Assets*

* *

Other real estate owned (“OREO”) and repossessedassets, normally obtained through foreclosure or other workout situations, areinitially recorded at the lower of fair value or book value at the date offoreclosure, establishing a new cost basis. Any resulting loss is charged to the allowance for loan losses.  An appraisal of other real estate propertiesand valuations of repossessed assets is made periodically after acquisition,and comparison between the appraised value and the carrying value isperformed.  Additional declines in valueafter acquisition, if any, are charged to current operations.  OREO and repossessed assets amounted to $1.9million and $2.0 million as of September 30, 2005 and December 31,2004, respectively.

 

**Results of Operations for the Three Months and NineMonths Ended September 30, 2005 and 2004**

** **

**Net Interest Income andNet Interest Margin**

** **

Net interest income is the difference between interestincome, principally from loans and investment securities portfolio, andinterest expense, principally on customer deposits and borrowings.  Net interest income is our principal sourceof earnings.  Changes in net interestincome result from changes in volume, spread and margin.  Volume refers to the average dollar level ofinterest-earning assets and interest-bearing liabilities.  Spread refers to the difference between theaverage yield on interest-earning assets and the average cost ofinterest-bearing liabilities.  Marginrefers to net interest income divided by average interest-earning assets, andis influenced by the level and relative mix of interest-earning assets andinterest-bearing liabilities.

 

11

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Net interest income increased 15.6%, or $2.1 million,to $15.7 million and by 23.2%, or $8.6 million, to $45.6 million in the thirdquarter and nine months ended September 30, 2005, respectively, from $13.6million and $37.0 million in the same periods of 2004. These increases resultedprimarily from higher volumes in our loan portfolio due to organic growth andthe increase in interest rates due to the prime rate increasing.

 

Total interest income for the third quarter of 2005was $19.6 million, compared to $16.0 million for the same period in 2004.  Total interest income for the nine monthsended September 30, 2005 was $55.6 million, compared to total interestincome of $43.6 million for the same period in 2004.  These increases were due to the combinedeffect of increases in average interest-earning assets and increased yieldsresulting from higher interest rates during 2005.  Average interest-earning assets for the threemonths and nine months ended September 30, 2005 increased to $1.162billion and $1.141 billion, respectively, compared to $1.135 billion and $1.035billion for the same periods in 2004.

 

Total interest expense was $3.9 million for the thirdquarter ended September 30, 2005, compared to $2.4 million for the samequarter in 2004.  Total interest expensefor the nine months ended September 30, 2005 was $10.0 million, comparedto total interest expense of $6.6 million for the same period in 2004.  These increases resulted primarily from thecombination of increased deposit balances due to our acquisition of Mercantile,higher rates paid on interest-bearing deposits and higher rates on subordinatednotes payable during 2005.  Averageinterest-bearing liabilities for the quarter ended September 30, 2005decreased to $793.2 million compared to $837.3 million for the third quarter of2004. Average interest-bearing liabilities increased to $790.4 million for thenine months ended September 30, 2005, as compared to $762.6 million forthe same period in 2004.

 

Net interest margin on afully taxable equivalent basis increased to 5.41% and 5.33% for the thirdquarter and nine months ended September 30, 2005, as compared to 4.79% and4.78% for the same periods in 2004, respectively.  Net interest spread on a fully taxableequivalent basis increased to 4.79% and 4.81% for the third quarter and ninemonths ended September 30, 2005, as compared to 4.49% and 4.47% for thesame periods in 2004.

 

The following tables, for the periods indicated,present our average balance sheets and indicates the interest earned or paid oneach major category of interest-earning assets and interest-bearing liabilitieson a fully taxable equivalent basis, and the average rates earned or paid oneach major category. This analysis details the contribution of ourinterest-earning assets and the overall impact of the cost of funds on our netinterest income.

 

12

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| ** **                                                             | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | ** **                                | ** ** | **Interest** | ** ** | ** ** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** ** | ** ** |
| ** **                                                             | ** ** | **Average**                               | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                                             | ** ** | **Balance**                               | ** ** | **Expense** | ** ** | **Rate(1)** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate(1)** | ** ** |
| ** **                                                             | ** ** | **(Dollars in thousands)**                | ** ** |
| ASSETS:                                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                               |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Loans, net of unearned income                                          |       | $                                         | 963,379    |   | $ | 17,728 |   | 7.36 | % | $ | 871,952 |   | $ | 14,015 |   | 6.43 | % |
| Securities                                                             |       | 130,028                                   |       | 1,288 |   | 3.96 |   | 179,927 |   | 1,752 |   | 3.89 |   |
| Time deposits in other banks                                           |       | 13,591                                    |       | 127 |   | 3.74 |   | 23,474 |   | 116 |   | 1.98 |   |
| Fed funds sold                                                         |       | 54,786                                    |       | 457 |   | 3.34 |   | 59,594 |   | 151 |   | 1.01 |   |
| Total interest-earning assets                                          |       | 1,161784                                  |       | 19,600 |   | 6.75 | % | 1,134,947 |   | 16,034 |   | 5.65 | % |
|                                                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-earning assets:                                            |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                                |       | 62,622                                    |       |   |   |   |   | 59,560 |   |   |   |   |   |
| Intangible assets                                                      |       | 84,175                                    |       |   |   |   |   | 66,716 |   |   |   |   |   |
| Premises and equipment, net                                            |       | 35,835                                    |       |   |   |   |   | 28,471 |   |   |   |   |   |
| Accrued interest receivable and other assets                           |       | 46,713                                    |       |   |   |   |   | 44,557 |   |   |   |   |   |
| Allowance for loan losses                                              |       | (11,627                                   | )          |   |   |   |   | (11,524 | ) |   |   |   |   |
| Total noninterest-earning assets                                       |       | 217,718                                   |       |   |   |   |   | 187,780 |   |   |   |   |   |
| TOTAL ASSETS                                                           |       | $                                         | 1,379,502  |   |   |   |   |   | $ | 1,322,727 |   |   |   |   |   |
|                                                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY:                             |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                          |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Demand, savings and money market deposits                              |       | $                                         | 443,542    |   | $ | 1,104 |   | 1.00 | % | $ | 470,978 |   | $ | 581 |   | 0.49 | % |
| Time deposits                                                          |       | 277,956                                   |       | 1,758 |   | 2.53 |   | 296,715 |   | 1,195 |   | 1.61 |   |
| Fed funds purchased and securities sold under  agreement to repurchase |       | 23,869                                    |       | 178 |   | 2.98 |   | 23,600 |   | 52 |   | 0.88 |   |
| Junior subordinated debentures                                         |       | 47,000                                    |       | 832 |   | 7.08 |   | 45,023 |   | 596 |   | 5.30 |   |
| Notes payable                                                          |       | 823                                       |       | 10 |   | 4.86 |   | 937 |   | 11 |   | 4.70 |   |
| Total interest-bearing liabilities                                     |       | 793,190                                   |       | 3,882 |   | 1.96 | % | 837,253 |   | 2,435 |   | 1.16 | % |
|                                                                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                        |       | 412,567                                   |       |   |   |   |   | 332,183 |   |   |   |   |   |
| Accrued interest payable and other liabilities                         |       | 12,412                                    |       |   |   |   |   | 12,678 |   |   |   |   |   |
| Total noninterest-bearing liabilities                                  |       | 424,979                                   |       |   |   |   |   | 344,861 |   |   |   |   |   |
| TOTAL LIABILITIES                                                      |       | 1,218,169                                 |       |   |   |   |   | 1,182,114 |   |   |   |   |   |
| STOCKHOLDERS’ EQUITY                                              |       | 161,333                                   |       |   |   |   |   | 140,613 |   |   |   |   |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’S EQUITY                       |       | $                                         | 1,379,502  |   |   |   |   |   | $ | 1,322,727 |   |   |   |   |   |
| Net interest income                                                    |       |                                      |       | $ | 15,718 |   |   |   |   |   | $ | 13,599 |   |   |   |
| Net interest spread(2)                                                 |       |                                      |       |   |   | 4.79 | % |   |   |   |   | 4.49 | % |
| Net interest margin(3)                                                 |       |                                      |       |   |   | 5.41 | % |   |   |   |   | 4.79 | % |

 

----

(1)   Yields on tax-exempt securities are calculatedon a fully taxable equivalent basis assuming a 35% tax rate.

(2)   Represents the average rate earned oninterest-earning assets less the average rate paid on interest-bearingliabilities.

(3)   Representsnet interest income on a fully taxable equivalent basis as a percentage ofaverage interest-earning assets.

 

13

----

 
| ** **                                                             | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                             | ** ** | **2005 **                           | ** ** | **2004 ** | ** ** |
| ** **                                                             | ** ** | ** **                               | ** ** | **Interest** | ** ** | ** ** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** ** | ** ** |
| ** **                                                             | ** ** | **Average**                              | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                                             | ** ** | **Balance**                              | ** ** | **Expense** | ** ** | **Rate(1)** | ** ** | **Balance** | ** ** | **Expense** | ** ** | **Rate(1)** | ** ** |
| ** **                                                             | ** ** | **(Dollars in thousands)**               | ** ** |
| ASSETS:                                                                |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                               |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Loans, net of unearned income                                          |       | $                                        | 958,497    |   | $ | 50,519 |   | 7.03 | % | $ | 787,256 |   | $ | 37,463 |   | 6.34 | % |
| Securities                                                             |       | 139,414                                  |       | 4,140 |   | 3.96 |   | 200,993 |   | 5,766 |   | 3.82 |   |
| Time deposits in other banks                                           |       | 10,807                                   |       | 237 |   | 2.92 |   | 15,020 |   | 131 |   | 1.16 |   |
| Fed funds sold                                                         |       | 32,302                                   |       | 740 |   | 3.05 |   | 31,362 |   | 262 |   | 1.11 |   |
| Total interest-earning assets                                          |       | 1,141,020                                |       | 55,636 |   | 6.50 | % | 1,034,631 |   | 43,622 |   | 5.62 | % |
|                                                                   |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-earning assets:                                            |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                                |       | 61,594                                   |       |   |   |   |   | 50,932 |   |   |   |   |   |
| Intangible assets                                                      |       | 85,007                                   |       |   |   |   |   | 56,150 |   |   |   |   |   |
| Premises and equipment, net                                            |       | 34,921                                   |       |   |   |   |   | 26,199 |   |   |   |   |   |
| Accrued interest receivable and other assets                           |       | 46,233                                   |       |   |   |   |   | 40,355 |   |   |   |   |   |
| Allowance for loan losses                                              |       | (11,511                                  | )          |   |   |   |   | (10,562 | ) |   |   |   |   |
| Total noninterest-earning assets                                       |       | 216,244                                  |       |   |   |   |   | 163,074 |   |   |   |   |   |
| TOTAL ASSETS                                                           |       | $                                        | 1,357,264  |   |   |   |   |   | $ | 1,197,705 |   |   |   |   |   |
|                                                                   |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND STOCKHOLDER”S EQUITY:                             |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                          |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Demand, savings and money market deposits                              |       | $                                        | 444,520    |   | $ | 2,768 |   | 0.83 | % | $ | 402,638 |   | $ | 1,273 |   | 0.42 | % |
| Time deposits                                                          |       | 277,072                                  |       | 4,499 |   | 2.17 |   | 293,459 |   | 3,568 |   | 1.62 |   |
| Fed funds purchased and securities sold under  agreement to repurchase |       | 20,919                                   |       | 387 |   | 2.47 |   | 21,954 |   | 99 |   | 0.60 |   |
| Junior subordinated debentures                                         |       | 47,000                                   |       | 2,314 |   | 6.56 |   | 43,563 |   | 1,587 |   | 5.10 |   |
| Notes payable                                                          |       | 851                                      |       | 30 |   | 4.70 |   | 967 |   | 37 |   | 4.86 |   |
| Total interest-bearing liabilities                                     |       | 790,362                                  |       | 9,998 |   | 1.69 | % | 762,581 |   | 6,564 |   | 1.15 | % |
|                                                                   |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                       |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                        |       | 399,425                                  |       |   |   |   |   | 295,879 |   |   |   |   |   |
| Accrued interest payable and other liabilities                         |       | 9,544                                    |       |   |   |   |   | 8,816 |   |   |   |   |   |
| Total noninterest-bearing liabilities                                  |       | 408,969                                  |       |   |   |   |   | 304,695 |   |   |   |   |   |
| TOTAL LIABILITIES                                                      |       | 1,199,331                                |       |   |   |   |   | 1,067,276 |   |   |   |   |   |
| STOCKHOLDER”S EQUITY                                              |       | 157,933                                  |       |   |   |   |   | 130,429 |   |   |   |   |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’S EQUITY                       |       | $                                        | 1,357,264  |   |   |   |   |   | $ | 1,197,705 |   |   |   |   |   |
| Net interest income                                                    |       |                                     |       | $ | 45,638 |   |   |   |   |   | $ | 37,058 |   |   |   |
| Net interest spread(2)                                                 |       |                                     |       |   |   | 4.81 | % |   |   |   |   | 4.47 | % |
| Net interest margin(3)                                                 |       |                                     |       |   |   | 5.33 | % |   |   |   |   | 4.78 | % |

 

----

(1)   Yields on tax-exempt securities arecalculated on a fully taxable equivalent basis assuming a 35% tax rate.

(2)   Represents the average rate earned oninterest-earning assets less the average rate paid on interest-bearingliabilities.

(3)   Representsnet interest income on a fully taxable equivalent basis as a percentage ofaverage interest-earning assets.

 

14

----

 

Thefollowing table sets forth, for the periods indicated, the dollar amount ofchanges in interest earned and paid for interest-earning assets andinterest-bearing liabilities and the amount of change attributable to changesin average daily balances (volume) or changes in average daily interest rates(rate) on a fully taxable equivalent basis. All changes in interest owed and paid for interest-earning assets andinterest-bearing liabilities are attributable to either volume or rate.  The impact of changes in the mix of interest-earningassets and interest-bearing liabilities is reflected in our net interestincome.

 
| ** **                                                             | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                             | ** ** | **2005 Over 2004**                        | ** ** | **2005 Over 2004**                       | ** ** |
| ** **                                                             | ** ** | **Increases/(Decreases)**                 | ** ** | **Increases/(Decreases)**                | ** ** |
| ** **                                                             | ** ** | **Due to Change in**                      | ** ** | **Due to Change in**                     | ** ** |
| ** **                                                             | ** ** | **Volume**                                | ** ** | **Rate**                                 | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
| ** **                                                             | ** ** | **(Dollars in thousands)**                | ** ** |
| ** **                                                             | ** ** | ** **                                | ** ** |
| INTEREST-EARNING ASSETS:                                               |       |                                      |       |                                     |       |   |   |   |   |   |   |   |   |
| Loans, net of unearned income                                          |       | $                                         | 1,470      |                                     | $          | 2,243 |   | $ | 3,713 |   | $ | 8,149 |   | $ | 4,907 |   | $ | 13,056 |   |
| Securities                                                             |       | (487                                      | )          | 23                                       |       | (464 | ) | (1,766 | ) | 140 |   | (1,626 | ) |
| Time deposits in other banks                                           |       | (49                                       | )          | 60                                       |       | 11 |   | (37 | ) | 143 |   | 106 |   |
| Fed funds sold                                                         |       | (12                                       | )          | 318                                      |       | 306 |   | 8 |   | 470 |   | 478 |   |
| Total interest income                                                  |       | 922                                       |       | 2,644                                    |       | 3,567 |   | 6,354 |   | 5,660 |   | 12,014 |   |
|                                                                   |       |                                      |       |                                     |       |   |   |   |   |   |   |   |   |
| INTEREST-BEARING LIABILITIES:                                          |       |                                      |       |                                     |       |   |   |   |   |   |   |   |   |
| Demand, savings and money market deposits                              |       | (34                                       | )          | 557                                      |       | 523 |   | 132 |   | 1,363 |   | 1,495 |   |
| Time deposits                                                          |       | (76                                       | )          | 639                                      |       | 563 |   | (199 | ) | 1,130 |   | 931 |   |
| Fed funds purchased and securities sold under agreement  to repurchase |       | 1                                         |       | 125                                      |       | 126 |   | (5 | ) | 293 |   | 288 |   |
| Junior subordinated debentures                                         |       | 26                                        |       | 210                                      |       | 236 |   | 125 |   | 602 |   | 727 |   |
| Notes Payable                                                          |       | (1                                        | )          | 0                                        |       | (1 | ) | (4 | ) | (3 | ) | (7 | ) |
| Total interest expense                                                 |       | (84                                       | )          | 1,531                                    |       | 1,447 |   | 49 |   | 3,385 |   | 3,434 |   |
| Increase in net interest income                                        |       | $                                         | 1,006      |                                     | $          | 1,113 |   | $ | 2,119 |   | $ | 6,305 |   | $ | 2,275 |   | $ | 8,580 |   |

 

***Provisionfor Loan Losses***

*** ***

The amount of our provision for loan losses is basedon periodic (not less than quarterly) evaluations of the loan portfolio,especially nonperforming and other potential problem loans. As discussed above,during these evaluations, we consider various factors. For additionalinformation concerning the factors considered in these evaluations, see “*Executive Overview-Critical Accounting Policies- Loans and Allowancesfor Loan Losses.”*

 

Our provision for loan losses for the nine monthsended September 30, 2005 and 2004 were $750,000 and $300,000,respectively. We did not record a provision for the first six months of 2004,due to the improved loan quality and recoveries that were received during theprior year, which exceeded management’s expectation.

 

***NoninterestIncome***

*** ***

***Our noninterest income for the third quarter and nine monthsended September 30, 2005 was $4.9 million and $13.8 million, respectively,representing an 18.1% and 16.9% increase, respectively, from $4.2 million and$11.8 million for the same periods in 2004. Annualized noninterest income forthe nine months ended September 30, 2005 and 2004 representedapproximately 1.4% and 1.3%, respectively, of our average assets for the sameperiods. Additionally, noninterest income represented approximately 19.9% and21.3% of our total revenues for the nine months ended September 30, 2005and 2004, respectively.***

*** ***

As a result of our efforts to diversify our revenue sources, we currentlyearn noninterest income from various sources. Our largest noninterest incomesource is service charges, primarily on deposit accounts, representing 52.7%and 59.6% of our total noninterest income for the third quarter of 2005 and2004, respectively. This income source increased to $4.9 million in the thirdquarter of 2005 from $4.2 million in the third quarter of 2004 and to $13.8million in the nine months ended September 30, 2005 from $11.8 million inthe nine months ended September 30, 2004. These increases were primarilydue to an increase in our number of transactional and savings accountsresulting from our acquisition of Mercantile Bank. We periodically reviewservice charge rates in

 

15

----

 

aneffort to maximize service charge income while maintaining a competitiveposition.

 

Gain on sale of loans was the second largest source ofour noninterest income for the nine months ended September 30, 2005 and2004, respectively. For the third quarter and nine months ended September 30,2005, gain on sale of loans was $804,000 and $2.2 million, respectively, ascompared to $636,000 and $1.7 million for the same periods in 2004. Income fromgain on sale of loans as a percentage of total noninterest income was 16.3% and15.2% for the third quarter of 2005 and 2004, respectively. This source ofnoninterest income is derived primarily from the origination and subsequentsale of mortgage loans. The origination of these loans is primarily from twosources, the purchase of new homes as well as the refinancing of existing homeloans. The increase in our gain on sale of loans from 2004 to 2005 isattributable to the expansion of our mortgage origination activities in theTarrant County market. We hedge our interest rate risk by selling our mortgageloans on a “best efforts” basis to secondary mortgage buyers at the time therate is locked, which in effect eliminates most of the risk at the time of thesale.

 

***Other income forthe third quarter and nine months ended September 30, 2005 was $1.2million and $3.3 million, respectively, as compared with $728,000 and $2.3million for the same periods in 2004. The $988,000 increase in other income forthe nine month period ended September 30, 2005 compared to the same periodin 2004 was due, in part, to a $283,000 gain recorded due to the sale of PulseNetwork to Discover Financial Services on January 31, 2005 in which we hada shared interest based on network usage. The sales proceeds were allocated tothe network members based on network usage. There was not an effect on anysharing arrangements with the ATM network in the form of fees or services.***

*** ***

The following tables set forth the various componentsof our noninterest income for the periods indicated:

 
| ** **                              | ** ** | **Three Months Ended September 30,**      | ** ** |
|-----------------------------------------|------------|------------------------------------------------|------------|
| ** **                              | ** ** | **2005**                                       | ** ** | **2004 ** | ** ** |
| ** **                              | ** ** | **Amount**                                     | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)**                     | ** ** |
| Service charges on deposit accounts     |       | $                                              | 2,600      |   | 52.7 | % | $ | 2,490 |   | 59.6 | % |
| Gain on sale of loans                   |       | 804                                            |       | 16.3 |   | 636 |   | 15.2 |   |
| Bank owned life insurance               |       | 316                                            |       | 6.4 |   | 323 |   | 7.8 |   |
| Other                                   |       | 1,211                                          |       | 24.6 |   | 728 |   | 17.4 |   |
|                                    |       |                                           |       |   |   |   |   |   |   |
| Total noninterest income                |       | $                                              | 4,931      |   | 100 | % | $ | 4,177 |   | 100 | % |
|                                    |       |                                           |       |   |   |   |   |   |   |
|                                    |       |                                           |       |   |   |   |   |   |   |
| ** **                              | ** ** | **Nine Months Ended September 30, ** | ** ** |
| ** **                              | ** ** | **2005**                                       | ** ** | **2004 ** | ** ** |
| ** **                              | ** ** | **Amount**                                     | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)**                     | ** ** |
| Service charges on deposit accounts     |       | $                                              | 7,416      |   | 53.7 | % | $ | 6,833 |   | 57.9 | % |
| Gain on sale of loans                   |       | 2,153                                          |       | 15.6 |   | 1,723 |   | 14.6 |   |
| Bank owned life insurance               |       | 948                                            |       | 6.9 |   | 951 |   | 8.0 |   |
| Net realized gain on sale of securities |       | 1                                              |       | — |   | — |   | — |   |
| Other                                   |       | 3,285                                          |       | 23.8 |   | 2,297 |   | 19.5 |   |
|                                    |       |                                           |       |   |   |   |   |   |   |
| Total noninterest income                |       | $                                              | 13,803     |   | 100.0 | % | $ | 11,804 |   | 100.0 | % |

 

16

----

 

***NoninterestExpense***

*** ***

The following tables set forth a summary ofnoninterest expenses for the periods indicated:

 
| ** **                                                                    | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                                                    | ** ** | **Amount**                                | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                                                                    | ** ** | **(Dollars in thousands)**                | ** ** |
| Salaries and Employee Benefits:                                               |       |                                      |       |   |   |   |   |   |   |
| Salaries                                                                      |       | $                                         | 6,066      |   | 43.3 | % | $ | 5,432 |   | 42.6 | % |
| Medical and other benefits                                                    |       | 577                                       |       | 4.1 |   | 500 |   | 3.9 |   |
| Pension                                                                       |       | 273                                       |       | 1.9 |   | 214 |   | 1.7 |   |
| Payroll taxes                                                                 |       | 381                                       |       | 2.7 |   | 345 |   | 2.7 |   |
| Total salaries and employee benefits                                          |       | 7,297                                     |       | 52.0 |   | 6,491 |   | 50.9 |   |
| Net occupancy and equipment expense                                           |       | 2,322                                     |       | 16.6 |   | 1,983 |   | 15.6 |   |
| Amortization of intangibles                                                   |       | 824                                       |       | 5.9 |   | 778 |   | 6.1 |   |
| Advertising                                                                   |       | 330                                       |       | 2.3 |   | 204 |   | 1.6 |   |
| Professional fees                                                             |       | 326                                       |       | 2.3 |   | 276 |   | 2.2 |   |
| Communication expense                                                         |       | 300                                       |       | 2.1 |   | 267 |   | 2.1 |   |
| Courier                                                                       |       | 221                                       |       | 1.6 |   | 179 |   | 1.4 |   |
| Data processing                                                               |       | 203                                       |       | 1.5 |   | 202 |   | 1.6 |   |
| Postage                                                                       |       | 185                                       |       | 1.3 |   | 176 |   | 1.4 |   |
| Supplies                                                                      |       | 166                                       |       | 1.2 |   | 225 |   | 1.8 |   |
| Merger expenses                                                               |       | 19                                        |       | 0.1 |   | 284 |   | 2.2 |   |
| Net (gain) costs applicable to other real  estate and repossessed assets |       | (6                                        | )          | 0.0 |   | 8 |   | 0.0 |   |
| Other                                                                         |       | 1,838                                     |       | 13.1 |   | 1,665 |   | 13.1 |   |
|                                                                          |       |                                      |       |   |   |   |   |   |   |
| Total noninterest expense                                                     |       | $                                         | 14,025     |   | 100.0 | % | $ | 12,738 |   | 100.0 | % |

 
| ** **                                                             | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **Amount**                               | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                                                             | ** ** | **(Dollars in thousands)**               | ** ** |
| Salaries and Employee Benefits:                                        |       |                                     |       |   |   |   |   |   |   |
| Salaries                                                               |       | 17,834                                   |       | 43.4 | % | $ | 14,534 |   | 42.3 | % |
| Medical and other benefits                                             |       | 1,692                                    |       | 4.1 |   | 1,394 |   | 4.0 |   |
| Pension                                                                |       | 800                                      |       | 2.0 |   | 607 |   | 1.8 |   |
| Payroll taxes                                                          |       | 1,288                                    |       | 3.1 |   | 1,052 |   | 3.1 |   |
| Total salaries and employee benefits                                   |       | 21,614                                   |       | 52.6 |   | 17,587 |   | 51.2 |   |
|                                                                   |       |                                     |       |   |   |   |   |   |   |
| Net occupancy and equipment expense                                    |       | 6,628                                    |       | 16.1 |   | 5,654 |   | 16.4 |   |
| Amortization of intangibles                                            |       | 2,471                                    |       | 6.0 |   | 2,035 |   | 5.9 |   |
| Advertising                                                            |       | 864                                      |       | 2.1 |   | 591 |   | 1.7 |   |
| Professional fees                                                      |       | 1,017                                    |       | 2.5 |   | 806 |   | 2.4 |   |
| Communication expense                                                  |       | 856                                      |       | 2.1 |   | 718 |   | 2.1 |   |
| Courier                                                                |       | 620                                      |       | 1.5 |   | 570 |   | 1.7 |   |
| Data processing                                                        |       | 622                                      |       | 1.5 |   | 575 |   | 1.7 |   |
| Postage                                                                |       | 517                                      |       | 1.3 |   | 489 |   | 1.4 |   |
| Supplies                                                               |       | 587                                      |       | 1.4 |   | 589 |   | 1.7 |   |
| Merger expenses                                                        |       | 59                                       |       | 0.1 |   | 285 |   | 0.8 |   |
| Net costs applicable to other real estate and  repossessed assets |       | 23                                       |       | 0.1 |   | 173 |   | 0.5 |   |
| Other                                                                  |       | 5,241                                    |       | 12.7 |   | 4,313 |   | 12.5 |   |
|                                                                   |       |                                     |       |   |   |   |   |   |   |
| Total noninterest expense                                              |       | $                                        | 41,119     |   | 100.0 | % | $ | 34,385 |   | 100.0 | % |
|                                                                        |            |                                          |            |  |  |  |  |  |  |  |  |

 

17

----

 

Our total noninterest expense increased to $14.0million and $41.1 million in the third quarter and the nine months ended September 30,2005, compared to $12.7 million and $34.4 million for the same periods in 2004,representing an increase of 10.1% and 19.6%, respectively.  These increases can be attributed to expandedpersonnel, professional fees, occupancy costs, and other operating expenseassociated with our business growth, in part due to our acquisition ofMercantile Bank in July 2004.  Theefficiency ratio was 63.93% for the third quarter of 2005, as compared to67.28% for the same quarter in 2004, and 65.02% for the nine months ended September 30,2005, as compared to 66.21% for same period in 2004.  The efficiency ratio is determined bydividing total noninterest expense, less amortization of intangibles, by anamount equal to net interest income (fully taxable equivalent) plus noninterestincome.

 

Salaries and employee benefits totaled $7.3 millionand $21.6 million for the third quarter and nine months ended September 30,2005, compared to $6.5 million and $17.6 million for the same periods in 2004,representing an increase of 12.4% and 22.9%, respectively, for the comparableperiods.  The increase is primarily dueto the addition of Mercantile employees.

 

Occupancy and equipment expenses totaled $2.3 millionand $6.6 million for the third quarter and nine months ended September 30,2005, respectively, compared to $2.0 million and $5.7 million for the sameperiods in 2004.  This represented anincrease of 17.1% and 17.2% for the third quarter and nine months ended September 30,2005, respectively, from the comparable prior year periods.  These cost increases are attributableprimarily to the expansion and construction of new branches, as well as theacquisition of Mercantile in July 2004.

 

Professional fees were $326,000 and $276,000, or 2.3%and 2.2% of total noninterest expenses, for the third quarter of 2005 and 2004,respectively.  For the nine months ended September 30,2005, these expenses increased to $1.0 million from $806,000 for the sameperiod in 2004.  This increase isattributable primarily to the growth of our business and also to legal, audit,consulting and professional fees related to becoming a publicly-traded company.

 

Advertising expenses were $330,000 and $204,000, or2.4% and 1.6% of total noninterest expenses, for the third quarter of 2005 and2004. For the nine months ended September 30, 2005, these expensesincreased to $864,000, or 2.1% of total noninterest expenses, from $591,000, or1.7% of total noninterest expenses, for the comparable period in 2004.

 

Merger expenses were $19,000 and $284,000 for thethird quarter of 2005 and 2004, respectively. The expenses in 2005 wereattributable to the initial cost associated with the Heritage acquisition whichoccurred on October 6, 2005 and the 2004 expenses were due to theMercantile acquisition which occurred July 30, 2004.

 

Net costs applicable to other real estate and otherrepossessed assets consist of expense associated with holding and maintainingrepossessed assets, the net gain or loss on the sales of such assets and thewrite-down of the carrying value of the assets. We recorded net revenues of$6,000 for the third quarter of 2005 and net cost of $8,000 for the same periodin 2004.  These expenses decreased to$23,000 for the nine months ended September 30, 2005 from $173,000 for thecomparable period in 2004.  In 2004, a reservefor loss on sale of OREO in the amount of $142,000 was recorded due to adecrease in fair market value based on periodic evaluations.  Repossessed assets are initially recorded atthe lower of fair value or book value upon repossession and resulting lossesare charged to the allowance for loan losses. These assets are then periodically evaluated and recorded at fair value.Any subsequent decline in the fair value is charged to current operations.

 

Other noninterest expenses also increased for the thirdquarter and nine months ended September 30, 2005 compared to the sameperiods in 2004.  This increase wasprimarily due to our asset growth.  Duein part to management’s commitment to overhead control, these noninterestexpense increases were outpaced by our revenue growth rate.

 

18

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***Provisionfor Income Taxes***

*** ***

***Income tax expense increased $698,000 to $2.1 million forthe quarter ended September 30, 2005 compared with $1.4 million for thesame period in 2004. For the nine months ended September 30, 2005, incometax expense totaled $5.9 million, an increase of $1.3 million, or 27.9%,compared with $4.6 million for the same period in 2004. Both increases wereprimarily attributable to higher pretax earnings for the quarter and ninemonths ended September 30, 2005 when compared to the respective periods in2004. Our effective tax rate for the nine months ended September 30, 2005was 33.41% and 32.39% for the same period in 2004.***

*** ***

**Financial Condition as of September 30, 2005 and December 31,2004**

** **

Our total assets as of September 30, 2005 were$1.4 billion, compared to $1.4 billion as of December 31, 2004.  Total deposits increased to $1.2 billion asof September 30, 2005, compared to $1.1 billion as of December 31,2004.

 

As of September 30, 2005, our stockholders’equity was $161.3 million, compared to $151.4 million as of December 31,2004.  The increase was primarily due toearnings from operations, less the change in other comprehensive income and theissuance cost of 1,907,692 shares of common stock in our initial publicoffering on September 30, 2005.  Theinitial public offering, together with stock options exercised, increased ourshares of common stock from 10,054,582 as of December 31, 2004 to11,971,107 as of September 30, 2005. The issuance of these sharesincreased additional paid-in capital to $177.0 million as of September 30,2005 from $133.5 million as of December 31, 2004. Due to the timing of theinitial public offering, the net proceeds from the offering ($46.1 million)were not received until October 5, 2005. This required us to record asubscription receivable as of September 30, 2005 for $46.1 million whichwas netted against shareholders’ equity.

 

***InvestmentSecurities***

*** ***

Our investment portfolio primarily serves as a sourceof interest income and, secondarily, as a source of liquidity and a managementtool for our interest rate sensitivity. We manage our investment portfolio according to a written investmentpolicy implemented by our Asset/Liability Management Committee.  Our investment policy is reviewed annually byour Board of Directors.  Investmentbalances, including cash equivalents and interest-bearing deposits in otherfinancial institutions, are subject to change over time based on our asset/liabilityfunding needs and our interest rate risk management objectives.  Our liquidity levels take into considerationanticipated future cash flows and all available sources of credits and aremaintained at levels management believes are appropriate to assure futureflexibility in meeting our anticipated funding needs.

 

Our investment portfolio consists of securities thatare classified as “available-for-sale” and securities we intend to hold untilmaturity, or “held-to-maturity securities.” The carrying values of our available-for-sale securities are adjustedfor unrealized gain or loss as a valuation allowance, and any gain or loss isreported on an after-tax basis as a component of other comprehensive income(loss).

 

The following tablepresents the composition, book value and fair value of our investment portfolioby major category as of the dates indicated:

 
| ** **                                       | ** ** | **Available-for-Sale**     | ** ** | **Held-to-Maturity** | ** ** | **Total**     | ** ** |
|--------------------------------------------------|------------|----------------------------|------------|----------------------|------------|---------------|------------|
| ** **                                       | ** ** | **Amortized**              | ** ** | **Estimated**        | ** ** | **Amortized** | ** ** | **Estimated** | ** ** | **Amortized** | ** ** | **Estimated** | ** ** |
| ** **                                       | ** ** | **Cost**                   | ** ** | **Fair Value**       | ** ** | **Cost**      | ** ** | **Fair Value** | ** ** | **Cost** | ** ** | **Fair Value** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** ** |
| **September 30, 2005:**                     |       |                       |       |                 |       |          |       |   |   |   |   |   |   |
| U.S. treasury securities                         |       | $                          | 7,083      |                 | $          | 7,018         |       | $ | — |   | $ | — |   | $ | 7,083 |   | $ | 7,018 |   |
| U.S. government agencies obligations             |       | 61,131                     |       | 60,899               |       | —        |       | — |   | 61,131 |   | 60,899 |   |
| Collateralized mortgage obligations              |       | 185                        |       | 187                  |       | —        |       | — |   | 185 |   | 187 |   |
| Mortgage-backed securities                       |       | 45,985                     |       | 45,218               |       | —        |       | — |   | 45,985 |   | 45,218 |   |
| State and municipal obligations                  |       | 2,219                      |       | 2,246                |       | —        |       | — |   | 2,219 |   | 2,246 |   |
| Federal Reserve Bank stock and other investments |       | 1,390                      |       | 1,390                |       | 7,941         |       | 8,623 |   | 9,331 |   | 10,013 |   |
|                                             |       |                       |       |                 |       |          |       |   |   |   |   |   |   |
| Total                                            |       | $                          | 117,993    |                 | $          | 116,958       |       | $ | 7,941 |   | $ | 8,623 |   | $ | 125,934 |   | $ | 125,581 |   |
|                                             |       |                       |       |                 |       |          |       |   |   |   |   |   |   |
| **December 31, 2004:**                      |       |                       |       |                 |       |          |       |   |   |   |   |   |   |
| U.S. treasury securities                         |       | $                          | 7,270      |                 | $          | 7,228         |       | $ | — |   | $ | — |   | $ | 7,270 |   | $ | 7,228 |   |
| U.S. government agencies obligations             |       | 76,647                     |       | 77,421               |       | —        |       | — |   | 76,647 |   | 77,421 |   |
| Collateralized mortgage obligations              |       | 1,398                      |       | 1,396                |       | —        |       | — |   | 1,398 |   | 1,396 |   |
| Mortgage-backed securities                       |       | 60,837                     |       | 60,501               |       | —        |       | — |   | 60,837 |   | 60,501 |   |
| State and municipal obligations                  |       | 3,034                      |       | 3,101                |       | —        |       | — |   | 3,034 |   | 3,101 |   |
| Federal Reserve Bank stock and other investments |       | 1,361                      |       | 1,361                |       | 8,306         |       | 8,306 |   | 9,667 |   | 9,667 |   |
|                                             |       |                       |       |                 |       |          |       |   |   |   |   |   |   |
| Total                                            |       | $                          | 150,547    |                 | $          | 151,008       |       | $ | 8,306 |   | $ | 8,306 |   | $ | 158,853 |   | $ | 159,314 |   |

 

19

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Our investment portfolio decreased by approximately$34.4 million to $124.9 million as of September 30, 2005 from $159.3million as of December 31, 2004. This decrease was primarily due to the net effect of increasing loandemand and liquidity needs.  Due to ourincreasing loan demand, securities that were paydowns or matured were used toprovide funding for loans. In anticipation of the Heritage acquisition,management decided to build our liquidity position.

 

*Investment Portfolio — Maturity and Yields*

 

The estimated fair value of our securities portfolioat September 30, 2005 is presented below by contractual maturity:

 
| ** **                                                             | ** ** | **As of  September 30, 2005** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                             | ** ** | ** **                         | ** ** | ** ** | ** ** | **After  one but** | ** ** | **After  Five but** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                             | ** ** | **Within**                         | ** ** | **Within** | ** ** | **Within** | ** ** | **After** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                             | ** ** | **One Year**                       | ** ** | **Five  Years** | ** ** | **Ten  Years** | ** ** | **Ten  Years** | ** ** | **Total** | ** ** |
| ** **                                                             | ** ** | **Amount**                         | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** |
| ** **                                                             | ** ** | **(Dollars  in thousands)**        | ** ** |
| Investments Available-for-Sale(1)(2):                                  |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. treasury obligations                                              |       | $3,073                             |       | 2.15 | % | $3,945 |   | 3.53 | % | $— |   | — |   | $— |   | — |   | $7,018 |   | 2.92 | % |
| U.S. government agencies obligations                                   |       | 7,749                              |       | 5.78 |   | 53,150 |   | 3.78 |   | — |   | — |   | — |   | — |   | 60,899 |   | 4.04 |   |
| Mortgage-backed securities and collateralized  mortgage obligations(3) |       | 390                                |       | 5.17 |   | 44,145 |   | 3.91 |   | 867 |   | 4.82 |   | 3 |   | 5.25 |   | 45,405 |   | 3.94 |   |
| State and municipal obligations                                        |       | 1,053                              |       | 3.62 |   | 1,071 |   | 4.25 |   | — |   | — |   | 122 |   | 5.50 |   | 2,246 |   | 4.02 |   |
| Other Securities                                                       |       | —                             |       |   |   | — |   |   |   | — |   |   |   | 1,390 |   | 3.34 |   | 1,390 |   | 3.34 |   |
|                                                                   |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total investments available-for-sale                                   |       | 12,265                             |       | 4.67 | % | 102,311 |   | 3.83 | % | 867 |   | 4.82 | % | 1,515 |   | 3.52 | % | 116,958 |   | 3.92 | % |
|                                                                   |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other Investments:                                                     |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal Reserve Bank stock and other investments                       |       | —                             |       |   |   | — |   |   |   | — |   |   |   | 7,941 |   | 5.14 |   | 7,941 |   | 5.14 |   |
| Total other investments                                                |       | —                             |       |   |   | — |   |   |   | — |   |   |   | 7.941 |   | 5.14 |   | 7.941 |   | 5.14 |   |
| Total investments                                                      |       | $12,265                            |       | 4.67 | % | $102,311 |   | 3.83 | % | $867 |   | 4.82 | % | $9,456 |   | 4.88 | % | $124,899 |   | 4.00 | % |

 

----

(1)     Based onestimated fair value.

 

(2)     The yields shownin the above table are not calculated on a fully taxable equivalent basis.

 

(3)     Maturities ofmortgage-backed securities and collateralized mortgage obligations, or CMOs,are based on anticipated lives of the underlying mortgages, not contractualmaturities. CMO maturities are based on cash flow (or payment) windows derivedfrom broker market consensus.

 

20

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Securities with carrying values of approximately$99,510,000 and $106,356,000 were pledged to secure certain deposits at September 30,2005 and December 31, 2004, respectively.

 

The following table discloses gross unrealized lossesand the related fair value of our investment category and length of time thatindividual available-for-sale securities have been in a continuous unrealizedloss position as of September 30, 2005:

 
| ** **                            | ** ** | **Available-for-Sale Securities** | ** ** |
|---------------------------------------|------------|-----------------------------------|------------|
| ** **                            | ** ** | **Less than 12 months**           | ** ** | **12 months or longer** | ** ** | **Total** | ** ** |
| ** **                            | ** ** | **Fair**                          | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                            | ** ** | **Value**                         | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| ** **                            | ** ** | **(Dollars in thousands)**        | ** ** |
| ** **                            | ** ** | ** **                        | ** ** |
| Treasury/Agency (1)                   |       | $                                 | 36,032     |   | $ | 483 |   | $ | 12,853 |   | $ | 256 |   | $ | 48,886 |   | $ | 739 |   |
| Mortgage Backed (2)                   |       | 11,796                            |       | 162 |   | 29,053 |   | 639 |   | 40,849 |   | 801 |   |
| Other                                 |       | 1,104                             |       | 6 |   | — |   | — |   | 1,104 |   | 6 |   |
| Total temporarily impaired securities |       | $                                 | 48,932     |   | $ | 651 |   | $ | 41,906 |   | $ | 895 |   | $ | 90,838 |   | $ | 1,546 |   |

 

----

(1)           ***U.S. Treasury/Agency DebtSecurities –*** The unrealized losses oninvestments in U.S. treasury and agency debt securities were caused byinterest rate increases.  The contractualterms of these investments do not permit the issuer to settle the securities ata price less than the amortized cost of the investment.  Because we have the ability and intent tohold these investments until a market price recovery or maturity, theseinvestments are not considered other-than-temporarily impaired.

 

(2)           ***Mortgage-Backed Securities*** – The unrealized losses on investmentsin mortgage-backed securities were caused by interest rate increases. Thecontractual cash flows of these securities are guaranteed by Federal NationalMortgage Association (FNMA) and Federal Home Loan Mortgage Corporation(FHLMC).  It is expected that thesecurities would not be settled at a price less than the amortized cost of theinvestment. Because the decline in fair value is attributable to changes ininterest rates and not credit quality, and because we have the ability andintent to hold these investments until a market price recovery or maturity,these investments are not considered other-than-temporarily impaired.

 

**Loans**

 

Our loan portfolio consists of loans made tobusinesses, individuals, and farm and ranch operations located in our primarytrade areas. Real estate loans represent loans primarily for residentialconstruction, commercial non-owner-occupied and owner-occupied real estate.

 

The following table presents our loan balances bycategory as of the dates indicated:

 
| ** **                          | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                          | ** ** | ** **                  | ** ** | **Loan Category**          | ** ** | ** ** | ** ** | **Loan Category** | ** ** |
| ** **                          | ** ** | ** **                  | ** ** | **to Total**               | ** ** | ** ** | ** ** | **to Total** | ** ** |
| ** **                          | ** ** | **Amount**                  | ** ** | **Loans**                  | ** ** | **Amount** | ** ** | **Loans** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)**  | ** ** |
| Real estate – construction     |       | $                           | 140,985    |                       | 14.6       | % | $ | 132,717 |   | 14.1 | % |
| Real estate – 1-4 family       |       | 92,586                      |       | 9.6                        |       | 94,427 |   | 10.1 |   |
| Real estate – other            |       | 347,557                     |       | 35.9                       |       | 332,871 |   | 35.5 |   |
| Commercial loans                    |       | 264,036                     |       | 27.3                       |       | 260,923 |   | 27.8 |   |
| Consumer loans                      |       | 37,945                      |       | 3.9                        |       | 39,134 |   | 4.2 |   |
| Agriculture and other loans         |       | 83,948                      |       | 8.7                        |       | 78,215 |   | 8.3 |   |
|                                |       |                        |       |                       |       |   |   |   |   |
| Total loans                         |       | $                           | 967,057    |                       | 100.0      | % | $ | 938,287 |   | 100.0 | % |
|                                |       |                        |       |                       |       |   |   |   |   |
| Less: Unearned income               |       | (496                        | )          |                       |       | (503 | ) |   |   |
| Total loans, net of unearned income |       | 966,561                     |       |                       |       | 937,784 |   |   |   |
|                                |       |                        |       |                       |       |   |   |   |   |
| Less: Allowance for loan losses     |       | (11,620                     | )          |                       |       | (11,383 | ) |   |   |
|                                |       |                        |       |                       |       |   |   |   |   |
| Loans, net                          |       | $                           | 954,941    |                       |       |   | $ | 926,401 |   |   |   |

 

21

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As of September 30, 2005 our total loans, net ofunearned income, were $966.6 million, an increase of $28.8 million, as comparedto $937.8 million at December 31, 2004. As of September 30, 2005, our real estate loans increased $21.1million, commercial loans increased $3.1 million, consumer loans decreased $1.2million and agriculture and other loans increased $5.7 million. The increase inour loan portfolio is primarily attributable to increased loan demand.  Our total loans, net of unearned income as apercentage of total assets was 69.2% as of September 30, 2005, comparedwith 69.4% at December 31, 2004.

 

Real estate loans, the largest component of our loanportfolio, consist primarily of commercial real estate loans and/or commerciallines of credit that are extended to finance the purchase and/or improvement ofcommercial real estate.  Loans secured byreal estate equaled $581.1 million and $560.0 million as of September 30,2005 and December 31, 2004, respectively. The percentage of our real estate secured loans in relation to our totalloan portfolio, increased to 60.1% as of September 30, 2005, as comparedto 59.7% at December 31, 2004.

 

Our commercial loans, the second largest component ofour loan portfolio, typically have floating rates of interest, are for varyingterms (generally not exceeding five years), are personally guaranteed by theprincipal owners and are collateralized by real estate, accounts receivable,inventory or other business assets. Commercial loans increased to $264.0million as of September 30, 2005 from $260.9 million as of December 31,2004. Commercial loans as a percentage of total loans were 27.3% as of September 30,2005, and 27.8% at the end of 2004.

 

Consumer loans have historically represented a smallpart of our total loan portfolio. Consumer loans decreased to $37.9 million asof September 30, 2005 from $39.1 million as of December 31,2004.  Consumer loans as a percentage oftotal loans were 3.9% and 4.2% at September 30, 2005 and December 31,2004.

 

Agriculture and other loans increased to $83.9 millionas of September 30, 2005 from $78.2 million as of December 31, 2004.The increase in loan balance is primarily due to organic growth andseasonality. Agriculture and other loans as a percentage of total loans were8.7% and 8.3% at September 30, 2005 and December 31, 2004,respectively

 

The following table presents the distribution of thematurity of our loans at September 30, 2005. The table also presents theportion of our loans that have fixed interest rates or interest rates thatfluctuate over the life of the loans in accordance with changes in the interestrate environment as represented by the prime rate.

 
| ** **                      | ** ** | **As of September 30, 2005** | ** ** |
|---------------------------------|------------|-----------------------------------|------------|
| ** **                      | ** ** | **One Year**                      | ** ** | **One to** | ** ** | **Over** | ** ** | **Total Carrying** | ** ** |
| ** **                      | ** ** | **and Less**                      | ** ** | **Five Years** | ** ** | **Five Years** | ** ** | **Value** | ** ** |
| ** **                      | ** ** | **(Dollars in thousands)**        | ** ** |
| Real estate – construction |       | $                                 | 94,962     |   | $ | 33,045 |   | $ | 12,978 |   | $ | 140,985 |   |
| Real estate – 1-4 family   |       | 19,569                            |       | 50,709 |   | 22,308 |   | 92,586 |   |
| Real estate – other        |       | 59,015                            |       | 205,625 |   | 82,917 |   | 347,557 |   |
| Commercial loans                |       | 143,994                           |       | 88,495 |   | 31,547 |   | 264,036 |   |
| Consumer loans                  |       | 18,814                            |       | 17,678 |   | 2,041 |   | 38,533 |   |
| Agriculture and other loans     |       | 75,069                            |       | 5,735 |   | 2,556 |   | 83,360 |   |
|                            |       |                              |       |   |   |   |   |   |   |
| Total loans                     |       | $                                 | 411,423    |   | $ | 401,287 |   | $ | 154,347 |   | $ | 967,057 |   |
|                            |       |                              |       |   |   |   |   |   |   |
| With fixed interest rates       |       | $                                 | 99,202     |   | $ | 213,792 |   | $ | 43,225 |   | $ | 356,219 |   |
| With variable interest rates    |       | 312,221                           |       | 187,495 |   | 111,122 |   | 610,838 |   |
|                            |       |                              |       |   |   |   |   |   |   |
| Total loans                     |       | $                                 | 411,423    |   | $ | 401,287 |   | $ | 154,347 |   | $ | 967,057 |   |

 

***NonperformingAssets***

*** ***

Nonperforming assets consist of loans on nonaccrualstatus, loans 90 days or more past due and still accruing interest, loans thathave been restructured resulting in a reduction or deferral of interest orprincipal, OREO, and other repossessed assets.

 

The following table lists nonaccrual, past due andrestructured loans, and OREO and other repossessed assets as of the datesindicated:

 

22

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| ** **                                                             | ** ** | **September 30,**     | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                                             | ** ** | **2005**                   | ** ** | **2004**              | ** ** |
| ** **                                                             | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                   |       |                       |       |                  |       |
| Nonaccrual loans                                                       |       | $                          | 5,188      |                  | $          | 6,926 |   |
| Accruing loans past due over 90 days                                   |       | —                     |       | 68                    |       |
| Restructured loans                                                     |       | 92                         |       | 226                   |       |
| Other real estate                                                      |       | 1,836                      |       | 1,943                 |       |
| Other repossessed assets                                               |       | 15                         |       | 9                     |       |
|                                                                   |       |                       |       |                  |       |
| Total nonperforming assets                                             |       | $                          | 7,131      |                  | $          | 9,172 |   |
|                                                                   |       |                       |       |                  |       |
| Total nonperforming assets to total loans and other  real estate owned |       | 0.74                       | %          | 0.98                  | %          |

 

The nonperforming assets decreased $2.0 million to$7.1 million as of September 30, 2005 from $9.2 million as of December 31,2004.  The ratio of nonperforming assetsover total loans and OREO decreased to 0.74% as of September 30, 2005,from 0.98% as of December 31, 2004.

 

At September 30, 2005, loans identified as beingimpaired consisted of nonhomogeneous loans placed on nonaccrual status. Wegenerally places a loan on nonaccrual status and ceases accruing interest whenthe payment of principal or interest is delinquent for 90 days, or earlier insome cases, unless the loan is in the process of collection and the underlyingcollateral fully supports the carrying value of the loan.

 

As of September 30, 2005 and December 31,2004, the average investment in loans that are considered to be impaired underSFAS No. 114 was approximately $6.1 million and $6.2 million,respectively. Included in these amounts at September 30, 2005 and December 31,2004 was $5.2 million and $6.9 million, respectively, of impaired loans forwhich our related specific reserve for loan losses was approximately $1.0million and $1.4 million, respectively. We had $2,963 and $38,000 of impairedloans at September 30, 2005 and December 31, 2004, respectively, thatdid not have a specific related reserve for loan losses.

 

***Allowancefor Loan Losses***

*** ***

Management actively monitors the Company’s assetquality and provides specific loss allowances when necessary. Loans arecharged-off against the allowance for loan losses when appropriate. Althoughmanagement believes it uses the best information available to makedeterminations with respect to the allowance for loan loss, future adjustmentsmay be necessary if economic conditions differ from the assumptions used inmaking the initial determinations.  Inaddition, various regulatory agencies, as an integral part of their examinationprocess, periodically review the adequacy of our allowance for loanlosses.  Such agencies may require us tomake additional provisions to the allowance based upon their judgments aboutinformation available to them at the time of their examinations.  As of September 30, 2005, the allowancefor loan losses amounted to $11.6 million, or 1.20% of total loans, comparedwith $11.4 million, or 1.21% of total loans, at December 31, 2004.

 

The following table presents the activity in ourallowance for loan losses for the nine months ended September 30, 2005 andthe year ended December 31, 2004. The table also presents our average loanbalances and certain pertinent ratios for the nine months ended September 30,2005 and the year ended December 31, 2004.

 
| ** **                                                                          | ** ** | **Nine months ended**      | ** ** | **Year Ended**        | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                                                          | ** ** | **September 30,**     | ** ** | **December 31,** | ** ** |
| ** **                                                                          | ** ** | **2005**                   | ** ** | **2004**              | ** ** |
| ** **                                                                          | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                |       |                       |       |                  |       |
| Analysis of allowance for loan losses:                                              |       |                       |       |                  |       |
| Balance, beginning of period                                                        |       | $                          | 11,383     |                  | $          | 10,026 |   |
| Provision for loan losses                                                           |       | 750                        |       | 450                   |       |
| Loan loss reserves of acquired banks                                                |       | —                     |       | 2,410                 |       |
|                                                                                |       |                       |       |                  |       |
| Loans Charged-Off:                                                                  |       |                       |       |                  |       |
| Real estate – construction                                                     |       | 72                         |       | 23                    |       |
| Real estate – 1-4 family                                                       |       | 60                         |       | 69                    |       |
| Real estate – other                                                            |       | —                     |       | 222                   |       |
| Commercial loans                                                                    |       | 795                        |       | 1,410                 |       |
| Loans to individuals                                                                |       | 563                        |       | 639                   |       |
| Agriculture and other loans                                                         |       | —                     |       | 2                     |       |
| Total charge-offs                                                                   |       | $                          | 1,490      |                  | $          | 2,365 |   |
|                                                                                |       |                       |       |                  |       |
| Recoveries of Loans Previously Charge-Off:                                          |       |                       |       |                  |       |
| Real estate – construction                                                     |       | 45                         |       | —                |       |
| Real estate – 1-4 family                                                       |       | 17                         |       | 28                    |       |
| Real estate – other                                                            |       | 9                          |       | 12                    |       |
| Commercial loans                                                                    |       | 559                        |       | 609                   |       |
| Loans to individuals                                                                |       | 340                        |       | 208                   |       |
| Agriculture and other loans                                                         |       | 7                          |       | 5                     |       |
| Total recoveries                                                                    |       | 977                        |       | 862                   |       |
|                                                                                |       |                       |       |                  |       |
| Net loans charged-off                                                               |       | 513                        |       | 1,503                 |       |
|                                                                                |       |                       |       |                  |       |
| Balance, end of period                                                              |       | $                          | 11,620     |                  | $          | 11,383 |   |
|                                                                                |       |                       |       |                  |       |
| Average Loans Outstanding, Net of Unearned Income                                   |       | $                          | 958,497    |                  | $          | 825,981 |   |
|                                                                                |       |                       |       |                  |       |
| Ratio of Net Loan Charge-Offs to Average Loans, Net of  Unearned Income (1)         |       | 0.07                       | %          | 0.18                  | %          |
|                                                                                |       |                       |       |                  |       |
| Ratio of Allowance for Possible Loan Losses to Total  Loans, Net of Unearned Income |       | 1.20                       | %          | 1.21                  | %          |

 

----

(1) Annualized as of September 30, 2005.

 

23

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***NonearningAssets***

*** ***

Premises, leasehold improvements and equipment, net ofaccumulated depreciation and amortization, totaled $35.6 million at September 30,2005 and $33.9 million at December 31, 2004, an increase of $1.7million.  We anticipate that acquisitionsor expansion of our banking network will cause increases in future periods.

 

***Deposits***

*** ***

Deposits are our primary source of funds.  The following table sets forth, for theperiods indicated, the distribution of our average deposit account balances andaverage cost of funds on each category of deposits:

 
| ** **                                                  | ** ** | **Nine Months Ended**       | ** ** | **Year Ended**             | ** ** |
|-------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                                                  | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
| ** **                                                  | ** ** | **Average**                 | ** ** | **Percent of**             | ** ** | **Average** | ** ** | **Average** | ** ** | **Percent of** | ** ** | **Average** | ** ** |
| ** **                                                  | ** ** | **Balance**                 | ** ** | **Deposits**               | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Deposits** | ** ** | **Rate** | ** ** |
| ** **                                                  | ** ** | **(Dollars in thousands)**  | ** ** |
|                                                        |       |                        |       |                       |       |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                         |       | $                           | 399,425    |                       | 35.6       | % | — | % | $ | 316,207 |   | 30.7 | % | — | % |
| Interest-bearing demand, savings and money market  deposits |       | 444,520                     |       | 39.7                       |       | 0.83 |   | 420,091 |   | 40.8 |   | 0.44 |   |
| Time deposits of less than $100,000                         |       | 157,241                     |       | 14.0                       |       | 1.96 |   | 174,920 |   | 17.0 |   | 1.55 |   |
| Time deposits of $100,000 or more                           |       | 119,831                     |       | 10.7                       |       | 2.44 |   | 118,237 |   | 11.5 |   | 1.75 |   |
|                                                        |       |                        |       |                       |       |   |   |   |   |   |   |   |   |
| Total deposits                                              |       | $                           | 1,121,017  |                       | 100.0      | % | 0.86 | % | $ | 1,029,455 |   | 100.0 | % | 0.64 | % |

 

Total deposits at September 30,2005 and December 31, 2004 were $1.2 billion and $1.1 billion,respectively, representing an increase of $24.4 million, or 2.2%, for the ninemonths ended September 30, 2005. Average deposits for the nine months ended September 30, 2005 were$1.1 billion, as compared to $992 million for the same period in 2004.  These increases in average deposits duringthe nine months ended September 30, 2005 were attributable to our organicgrowth and the acquisition of Mercantile.

 

24

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Total deposits as of September 30, 2005 and December 31,2004 consisted of the following:

 
| ** **                          | ** ** | **September 30,**     | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2005**                   | ** ** | **2004**              | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)** | ** ** |
|                                |       |                       |       |                  |       |
| Noninterest-bearing demand deposits |       | $                          | 428,795    |                  | $          | 390,159 |   |
| Interest-bearing deposits:          |       |                       |       |                  |       |
| NOW & Money Market         |       | 378,627                    |       | 381,395               |       |
| Savings                             |       | 62,648                     |       | 68,956                |       |
| Time deposits                       |       | 280,706                    |       | 285,884               |       |
| Total Interest-bearing deposits:    |       | 721,981                    |       | 736,235               |       |
| Total Deposits                      |       | $                          | 1,150,776  |                  | $          | 1,126,394 |   |

 

The followingtable sets forth the amount and maturities of the time deposits of $100,000 ormore as of the dates indicates:

 
| ** **                              | ** ** | **September 30,**     | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **2005**                   | ** ** | **2004**              | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                              | ** ** | ** **                 | ** ** |
| Three months or less                    |       | $                          | 21,756     |                  | $          | 39,482 |   |
| Over three through six months           |       | 26,544                     |       | 21,272                |       |
| Over six through 12 months              |       | 34,039                     |       | 29,917                |       |
| Over 12 months                          |       | 48,114                     |       | 31,331                |       |
| Total time deposits of $100,000 or more |       | $                          | 130,453    |                  | $          | 122,002 |   |

 

***CapitalResources and Capital Adequacy Requirements***

*** ***

Total shareholders’ equity was $161.3 million at September 30,2005 compared with $151.4 million at December 31, 2004, an increase of$9.9 million, or 6.5%. The increase was due primarily to net earnings of $11.7million.

 

Both the Board of Governors of the Federal ReserveSystem, with respect to the Company, and the OCC, with respect to the Bank, hasestablished certain minimum risk-based capital standards that apply to bankholding companies and national banks. As of September 30, 2005, our Tier 1risk based capital, total risk-based capital and leverage capital ratios were11.74%, 12.82% and 9.71%, respectively. As of September 30, 20005, theBank’s risk-based capital ratios were above the levels required for the Bank tobe designated as “well capitalized” by the FDIC, with Tier-1 risk-basedcapital, total risk-based capital and leverage capital ratios of 10.19%, 11.27%and 8.41%, respectively.

 

***LiquidityManagement***

*** ***

***Liquidity involves our ability to raise funds to supportasset growth or reduce assets to meet deposit withdrawals and other paymentobligations, to maintain reserve requirements and otherwise to operate on anongoing basis. Our liquidity needs have primarily been met by growth in coredeposits and the issuance of junior subordinated debentures. Although access topurchased funds from correspondent banks is available, we do not generally relyon these external funding sources. The cash and federal funds sold position,supplemented by amortizing investment and loan portfolios, have generallycreated an adequate liquidity position.***

*** ***

***Asset liquidity is provided by cash and assets which arereadily marketable or which will mature in the near future. As of September 30,2005, we had cash and cash equivalents of $142.1 million compared with $89.5million at December 31, 2004.***

*** ***

***AggregateContractual Obligations***

*** ***

The following table represents our on and off-balancesheet aggregate contractual obligations, other than deposit liabilities, tomake future payments to third parties as of the date specified:

 

25

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| ** **                     | ** ** | **As of September 30, 2005** | ** ** |
|--------------------------------|------------|-----------------------------------|------------|
| ** **                     | ** ** | **Less than  One Year**           | ** ** | **One Year to  Three Years** | ** ** | **Over Three Years  to Five Years** | ** ** | **Over Five Years** | ** ** |
| ** **                     | ** ** | **(Dollars in thousands)**        | ** ** |
| FHLB advances                  |       | $                                 | 122        |   | $ | 227 |   | $ | 155 |   | $ | 306 |   |
| Junior subordinated debentures |       | —                            |       | — |   | — |   | 48,461 |   |
| Operating leases               |       | 1,279                             |       | 2,178 |   | 1,560 |   | 924 |   |
| Total                          |       | $                                 | 1,401      |   | $ | 2,405 |   | $ | 1,715 |   | $ | 49,691 |   |

 

Aggregate contractual obligations above exclude theinterest on our guaranteed preferred beneficial interests in our juniorsubordinated debentures.

 

***Off-BalanceSheet Arrangements***

*** ***

We are a party to financial instruments withoff-balance sheet risk in the normal course of business to meet the financingneeds of our customers.  These financialinstruments include commitments to extend credit and standby letters-of-credit,which involve varying degrees of credit risk in excess of the amount recognizedin the consolidated statement of financial position.  Our exposure to credit loss in the event ofnonperformance by the other party to the financial instrument for commitmentsto extend credit and standby letters of credit is represented by thecontractual amount of these instruments. We use the same credit policies in making commitments and conditionalobligations as we do for on-balance sheet instruments.

 

As of September 30, 2005 and December 31,2004, we had commitments to extend credit of $247.6 million and $217.6 million,respectively.  We also had standbyletters of credit of $16.3 million and $12.2 million at September 30, 2005and December 31, 2004, respectively.

 

The effect on our revenues, expenses, cash flows andliquidity of the unused portions of these commitments cannot reasonably bepredicted because there is no guarantee that the lines of credit will be used.

 

## **ITEM3.  Quantitative and QualitativeDisclosures about Market Risk**

## ** **

***The Company manages market risk, which is primarily interestrate risk, through its Asset Liability Committee which is composed of seniorofficers of the Company and members from our Board of Directors, in accordancewith policies approved by the Company’s Board of Directors.***

*** ***

***The Company uses shock and simulation analysis to examinethe potential effects of market changes on net interest income and marketvalue. We consider macroeconomic variables, Company strategy, liquidity andother factors as it quantifies market risk. For additional information, refer to our Registration Statement on Form S-1filed on July 21, 2005, as amended. There has been no significant change in the types of market risks facedby the Company since June 30, 2005.***

*** ***

## **ITEM4.  Controls and Procedures**

## ** **

As of the end of the period covered by this QuarterlyReport on Form 10-Q for the quarter ended September 30, 2005, wecarried out an evaluation, under the supervision and with the participation ofour management, including our chief executive officer and chief financialofficer, of the effectiveness of the design and operation of our “disclosurecontrols and procedures,” as such term is defined under Exchange Act Rule 13a-15(e).

 

Based on this evaluation, our chief executive officerand chief financial officer concluded that, as of the end of the fiscal quartercovered by this report, such disclosure controls and procedures were reasonablydesigned to ensure that information required to be disclosed by us in thereports we file or submit under the Exchange Act is: (a) recorded, processed,summarized and reported within the time periods specified in the rules andforms of the Securities and Exchange Commission, and (b) accumulated andcommunicated to our management, including our chief executive officer and chieffinancial officer, as appropriate to allow timely decisions regarding requireddisclosure.

 

In designing and evaluating the disclosure controlsand procedures, our management recognized that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives and in reaching a reasonable level ofassurance our management necessarily was required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

 

26

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There were no changes in our internal controls overfinancial reporting during the quarter ended September 30, 2005 thatmaterially affected, or were reasonably likely to materially affect, ourinternal controls over financial reporting.

 

# **PART II- OTHER INFORMATION**

# ** **

## **ITEM 1.  Legal Proceedings**

## ** **

The Company isinvolved as plaintiff or defendant in a variety of routine litigationincidental to the normal course of business. Management believes, based on the opinion of legal counsel, that it hasadequate defense or insurance protection with respect to such litigations andthat any losses there from, whether or not insured, would not have a materialadverse effect on the results of operations, financial position, or cash flowsof the Company.

 

## **ITEM2.  Unregistered Sales of EquitySecurities and Use of Proceeds**

## ** **

The Securities andExchange Commission declared our registration statement, filed on Form S-1(File No. 333-126793) under the Securities Act of 1933 in connection withthe initial public offering of our common stock, $1.00 par value, effective on September 30,2005. Keefe, Bruyette & Woods, Inc. acted as Lead Manager andSole Bookrunner for the transaction and Sandler O’Neill & Partners,L.P. acted as co-manager.

 

Our initial publicoffering commenced on September 30, 2005. All 1,907,692 shares of commonstock registered under the Registration Statement were sold by us and therewere no selling shareholders in the offering. The offering did not terminateuntil after the sale of all of the securities registered by the RegistrationStatement.

 

The aggregategross proceeds from the shares of common stock sold were $49.6 million. Theaggregate net proceeds to us were $46.1 million after deducting $3.5 million in underwriters’ discounts and commissionsbut before expenses related to the offering were $46.1 million.  Net proceeds from the offering, net ofestimated issuance costs of $1.2 million, were $44.9 million.  None of the expenses of the offeringconstituted direct or indirect payments to directors, officers, ten percentshareholders or affiliates of the Company.

 

All of the netproceeds from the offering were used to fund a portion of the purchase price ofour acquisition of Heritage Financial Corporation on October 6, 2005.

 

## **ITEM3.  Defaults Upon SeniorSecurities**

## ** **

Not applicable.

 

## **ITEM4.  Submission of Matters to avote of Security Holders**

## ** **

Not applicable.

 

## **ITEM 5.  Other Information**

## ** **

Not applicable.

 

## **ITEM 6.  Exhibits**

 
| **Exhibit Number** | ** ** | **Description of Exhibit**                                                                                                                                     |
|-------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                    |       | Rule 13a-14(a) Certification  of Chief Executive Officer.                                                                                            |
|                    |       |                                                                                                                                                           |
| 31.2                    |       | Rule 13a-14(a) Certification  of Chief Financial Officer.                                                                                            |
|                    |       |                                                                                                                                                           |
| 32.1                    |       | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|                    |       |                                                                                                                                                           |
| 32.2                    |       | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

27

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SIGNATURES

 

Pursuant to the requirements of the Securities Act of1934, the registrant has duly caused this Report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|   | STATE NATIONAL BANCSHARES, INC. |
|--------|---------------------------------|
|   |                            |
|   |                            |
| Date:  | November 14, 2005          | By: | /s/ Tom C. Nichols |   |   |
|   |                            |   | Tom C. Nichols |   |
|   |                            |   | Chairman of the Board, President and Chief |   |
|   |                            |   | Executive Officer (Principal Executive Officer) |   |
|   |                            |   |   |   |
| Date:  | November 14, 2005          | By: | /s/ Don E. Cosby |   |   |
|   |                            |   | Don E. Cosby |   |
|   |                            |   | Executive Vice President, Chief Financial |   |
|   |                            |   | Officer, Secretary and Treasurer (Principal |   |
|   |                            |   | Financial and Accounting Officer) |   |
|        |                                 |  |  |  |  |  |

 

28

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