**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-Q**

 

| **ý**                         | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                     |
|------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                               |                                                                                                                                                                                                                                                                                                                                  |
| ** **                         | **For the  quarterly period ended June 30, 2004**                                                                                                                                                                                                                                                                                |
|                               |                                                                                                                                                                                                                                                                                                                                  |
| **OR**                             |
|                               |                                                                                                                                                                                                                                                                                                                                  |
| **o**                              | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                    |
|                               |                                                                                                                                                                                                                                                                                                                                  |
| ** **                         | **For the  transition period from                           to                          ** |
|                               |                                                                                                                                                                                                                                                                                                                                  |
| **Commission File Number 0-28312** |

 

**FIRSTFEDERAL BANCSHARES OF ARKANSAS, INC.**

(Exact name of registrant as specified in its charter)

 
| **Texas**                                                       | ** ** | **71-0785261**                           |
|-----------------------------------------------------------------|------------|------------------------------------------|
| (State or other jurisdiction of incorporation  or organization) |       | (I.R.S. Employer  Identification Number) |
|                                                            |       |                                     |
| **1401 Highway 62-65 North  Harrison, Arkansas**                | ** ** | **72601**                                |
| (Address of principal executive office)                         |       | (Zip Code)                               |

 

**(870) 741-7641**

(Registrant’s telephone number, including area code)

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

Yes ý  No o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

Yes ý  No o

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date:  As of July 29,2004, there were issued and outstanding 5,199,482 shares of the Registrant’sCommon Stock, par value $.01 per share.

 

 

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**FIRST FEDERALBANCSHARES OF ARKANSAS, INC.**

 

**TABLE OF CONTENTS**

 
| ** **    | ** **                                                                                                                                                     | **Page**   |
|---------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Part I.**   | **Financial Information**                                                                                                                                      | ** ** |
|          |                                                                                                                                                           |       |
| Item 1.       | Consolidated Financial Statements                                                                                                                              |       |
|          |                                                                                                                                                           |       |
|          | Consolidated Statements of Financial  Condition as of  June 30, 2004 and December 31, 2003 (unaudited)                                               | 1          |
|          |                                                                                                                                                           |       |
|          | Consolidated Statements of Income for the  three and six months ended  June 30, 2004 and 2003 (unaudited)                                                 | 2          |
|          |                                                                                                                                                           |       |
|          | Consolidated Statement of Stockholders’  Equity for the six months ended  June 30, 2004 (unaudited)                                                  | 3          |
|          |                                                                                                                                                           |       |
|          | Consolidated Statements of Cash Flows for  the six months ended  June 30, 2004 and 2003 (unaudited)                                                       | 4          |
|          |                                                                                                                                                           |       |
|          | Notes to Unaudited Consolidated Financial  Statements                                                                                                          | 5          |
|          |                                                                                                                                                           |       |
| Item 2.       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                                                    | 7          |
|          |                                                                                                                                                           |       |
| Item 3.       | Quantitative and Qualitative Disclosures  About Market Risk                                                                                                    | 21         |
|          |                                                                                                                                                           |       |
| Item 4.       | Controls and Procedures                                                                                                                                        | 21         |
|          |                                                                                                                                                           |       |
| **Part  II.** | **Other  Information**                                                                                                                                         |       |
|          |                                                                                                                                                           |       |
| Item 1.       | Legal Proceedings                                                                                                                                              | 22         |
| Item 2.       | Changes in Securities, Use of Proceeds, and  Issuer Purchases of Equity Securities                                                                             | 22         |
| Item 3.       | Defaults Upon Senior Securities                                                                                                                                | 22         |
| Item 4.       | Submission of Matters to a Vote of Security  Holders                                                                                                           | 22         |
| Item 5.       | Other Information                                                                                                                                              | 23         |
| Item 6.       | Exhibits and Reports on Form 8-K                                                                                                                               | 23         |
|          |                                                                                                                                                           |       |
| Signatures    |                                                                                                                                                           |       |
|          |                                                                                                                                                           |       |
| **Exhibits**  | ** **                                                                                                                                                     | ** ** |
| 31.1          | Certification of Chief Executive Officer  pursuant to Rule 13a-14a of Exchange Act, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |       |
| 31.2          | Certification of Chief Financial Officer  pursuant to Rule 13a-14a of Exchange Act, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |       |
| 32.1          | Section 906 Certification of the CEO                                                                                                                      |       |
| 32.2          | Section 906 Certification of the CFO                                                                                                                      |       |

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATED STATEMENTS OF FINANCIALCONDITION**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                                                                                                                                                        | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                                                            |       |                    |       |                        |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                         |       | $                       | 15,509     |                        | $          | 56,201 |   |
| Investment securities held to maturity                                                                                                                                                            |       | 77,378                  |       | 80,379                      |       |
| Federal Home Loan Bank stock                                                                                                                                                                      |       | 3,322                   |       | 3,749                       |       |
| Loans receivable, net                                                                                                                                                                             |       | 578,682                 |       | 512,756                     |       |
| Accrued interest receivable                                                                                                                                                                       |       | 4,269                   |       | 4,089                       |       |
| Real estate acquired in settlement of loans,  net                                                                                                                                                 |       | 523                     |       | 822                         |       |
| Office properties and equipment, net                                                                                                                                                              |       | 14,599                  |       | 14,238                      |       |
| Cash surrender value of life insurance                                                                                                                                                            |       | 17,509                  |       | 17,102                      |       |
| Prepaid expenses and other assets                                                                                                                                                                 |       | 850                     |       | 1,317                       |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| TOTAL ASSETS                                                                                                                                                                                      |       | $                       | 712,641    |                        | $          | 690,653 |   |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                         |       |                    |       |                        |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| LIABILITIES:                                                                                                                                                                                      |       |                    |       |                        |       |
| Deposits                                                                                                                                                                                          |       | $                       | 581,641    |                        | $          | 573,580 |   |
| Federal Home Loan Bank advances                                                                                                                                                                   |       | 53,497                  |       | 39,562                      |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                                            |       | 591                     |       | 725                         |       |
| Other liabilities                                                                                                                                                                                 |       | 2,339                   |       | 1,708                       |       |
| Total liabilities                                                                                                                                                                                 |       | 638,068                 |       | 615,575                     |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                        |       |                    |       |                        |       |
| Preferred stock, no par value, 5,000,000  shares authorized, none issued                                                                                                                          |       |                    |       |                        |       |
| Common stock, $.01 par value, 20,000,000  shares authorized, 10,307,502 shares issued, 5,195,482 and 5,340,086 shares  outstanding at June 30, 2004 and December 31, 2003, respectively |       | 103                     |       | 103                         |       |
| Additional paid-in capital                                                                                                                                                                        |       | 53,690                  |       | 52,950                      |       |
| Employee stock benefit plans                                                                                                                                                                      |       | (804                    | )          | (1,025                      | )          |
| Retained earnings-substantially restricted                                                                                                                                                        |       | 75,273                  |       | 72,634                      |       |
|                                                                                                                                                                                              |       | 128,262                 |       | 124,662                     |       |
| Treasury stock, at cost, 5,112,020 and  4,967,416 shares at June 30, 2004 and December 31, 2003,  respectively                                                                          |       | (53,689                 | )          | (49,584                     | )          |
| Total stockholders’ equity                                                                                                                                                                   |       | 74,573                  |       | 75,078                      |       |
|                                                                                                                                                                                              |       |                    |       |                        |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                   |       | $                       | 712,641    |                        | $          | 690,653 |   |

 

See notes to unauditedconsolidated financial statements.

 

1

----

 

**FIRST FEDERALBANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATED STATEMENTS OF INCOME**

(In thousands, except share data)

(Unaudited)

 
| ** **                                          | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                          | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|                                                |       |                    |       |                    |       |   |   |   |   |
| INTEREST INCOME:                                    |       |                    |       |                    |       |   |   |   |   |
| Loans receivable                                    |       | $                       | 8,745      |                    | $          | 8,584 |   | $ | 17,074 |   | $ | 17,392 |   |
| Investment securities:                              |       |                    |       |                    |       |   |   |   |   |
| Taxable                                             |       | 778                     |       | 826                     |       | 1,572 |   | 1,878 |   |
| Nontaxable                                          |       | 172                     |       | 115                     |       | 338 |   | 219 |   |
| Other                                               |       | 18                      |       | 191                     |       | 110 |   | 318 |   |
| Total interest income                               |       | 9,713                   |       | 9,716                   |       | 19,094 |   | 19,807 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| INTEREST EXPENSE:                                   |       |                    |       |                    |       |   |   |   |   |
| Deposits                                            |       | 3,107                   |       | 3,766                   |       | 6,295 |   | 7,789 |   |
| Other borrowings                                    |       | 326                     |       | 352                     |       | 645 |   | 717 |   |
| Total interest expense                              |       | 3,433                   |       | 4,118                   |       | 6,940 |   | 8,506 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| NET INTEREST INCOME                                 |       | 6,280                   |       | 5,598                   |       | 12,154 |   | 11,301 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| PROVISION FOR LOAN LOSSES                           |       | 202                     |       | 136                     |       | 461 |   | 415 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES |       | 6,078                   |       | 5,462                   |       | 11,693 |   | 10,886 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| NONINTEREST INCOME:                                 |       |                    |       |                    |       |   |   |   |   |
| Deposit fee income                                  |       | 802                     |       | 646                     |       | 1,495 |   | 1,202 |   |
| Earnings on life insurance policies                 |       | 197                     |       | 209                     |       | 407 |   | 426 |   |
| Gain on sale of loans                               |       | 196                     |       | 510                     |       | 322 |   | 913 |   |
| Gain on contributed assets                          |       | —                  |       | 414                     |       | — |   | 414 |   |
| Other                                               |       | 390                     |       | 366                     |       | 792 |   | 733 |   |
| Total noninterest income                            |       | 1,585                   |       | 2,145                   |       | 3,016 |   | 3,688 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| NONINTEREST EXPENSES:                               |       |                    |       |                    |       |   |   |   |   |
| Salaries and employee benefits                      |       | 2,758                   |       | 2,557                   |       | 5,437 |   | 5,011 |   |
| Net occupancy expense                               |       | 510                     |       | 527                     |       | 1,002 |   | 886 |   |
| Data processing                                     |       | 389                     |       | 388                     |       | 797 |   | 754 |   |
| Professional fees                                   |       | 121                     |       | 102                     |       | 229 |   | 194 |   |
| Advertising and public relations                    |       | 304                     |       | 152                     |       | 431 |   | 303 |   |
| Postage and supplies                                |       | 169                     |       | 205                     |       | 348 |   | 382 |   |
| Contributions                                       |       | 5                       |       | 508                     |       | 9 |   | 519 |   |
| Other                                               |       | 568                     |       | 555                     |       | 1,045 |   | 979 |   |
| Total noninterest expenses                          |       | 4,824                   |       | 4,994                   |       | 9,298 |   | 9,028 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| INCOME BEFORE INCOME TAXES                          |       | 2,839                   |       | 2,613                   |       | 5,411 |   | 5,546 |   |
| INCOME TAX PROVISION                                |       | 908                     |       | 726                     |       | 1,720 |   | 1,675 |   |
| NET INCOME                                          |       | $                       | 1,931      |                    | $          | 1,887 |   | $ | 3,691 |   | $ | 3,871 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| EARNINGS PER SHARE:                                 |       |                    |       |                    |       |   |   |   |   |
| Basic                                               |       | $                       | 0.38       |                    | $          | 0.37 |   | $ | 0.72 |   | $ | 0.76 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| Diluted                                             |       | $                       | 0.36       |                    | $          | 0.35 |   | $ | 0.68 |   | $ | 0.73 |   |
|                                                |       |                    |       |                    |       |   |   |   |   |
| Cash Dividends Declared                             |       | $                       | 0.10       |                    | $          | 0.08 |   | $ | 0.20 |   | $ | 0.16 |   |

 

See notes to unaudited consolidated financial statements.

 

2

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’EQUITY**

**FOR THE SIX MONTHS ENDED JUNE 30, 2004**

(In thousands, except share data)

(Unaudited)

 
| ** **                                                 | ** ** | ** ** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Employee  Stock  Benefit  Plans** | ** ** | **Retained  Earnings** | ** ** |
|------------------------------------------------------------|------------|------------|------------|----------------------------------|------------|-------------------------------------|------------|------------------------|------------|
| **Issued  Common Stock**                                   |
| **Shares**                                                 | ** ** | **Amount** |
|                                                       |       |       |       |                             |       |                                |       |                   |       |   |   |
| Balance, January 1, 2004                              |       | 10,307,502 |       | $                                | 103        |                                | $          | 52,950                 |       | $ | (1,025 | ) | $ | 72,634 |   |
| Net income                                                 |       |       |       |                             |       |                                |       |                   |       | 3,691 |   |
| Release of ESOP shares                                     |       |       |       |                             |       | 634                                 |       | 208                    |       |   |   |
| Tax effect of stock compensation plan                      |       |       |       |                             |       | 164                                 |       |                   |       |   |   |
| Treasury shares reissued due to exercise of  stock options |       |       |       |                             |       | (58                                 | )          |                   |       |   |   |
| Purchase of treasury stock, at cost                        |       |       |       |                             |       |                                |       |                   |       |   |   |
| Vesting of MRP shares                                      |       |       |       |                             |       |                                |       | 13                     |       |   |   |
| Dividends paid                                             |       |       |       |                             |       |                                |       |                   |       | (1,052 | ) |
|                                                       |       |       |       |                             |       |                                |       |                   |       |   |   |
| Balance, June 30, 2004                                |       | 10,307,502 |       | $                                | 103        |                                | $          | 53,690                 |       | $ | (804 | ) | $ | 75,273 |   |

 

 
| ** **                                                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|------------------------------------------------------------|------------|------------|------------|------------|------------|---------------------------------------|------------|
| **Treasury Stock**                                         |
| **Shares**                                                 | ** ** | **Amount** |
|                                                       |       |       |       |       |       |                                  |       |
| Balance, January 1, 2004                              |       | 4,967,416  |       | $          | (49,584    | )                                     | $          | 75,078 |   |
| Net income                                                 |       |       |       |       |       | 3,691                                 |       |
| Release of ESOP shares                                     |       |       |       |       |       | 842                                   |       |
| Tax effect of stock compensation plan                      |       |       |       |       |       | 164                                   |       |
| Treasury shares reissued due to exercise of  stock options |       | (112,096   | )          | 1,137      |       | 1,079                                 |       |
| Purchase of treasury stock, at cost                        |       | 256,700    |       | (5,242     | )          | (5,242                                | )          |
| Vesting of MRP shares                                      |       |       |       |       |       | 13                                    |       |
| Dividends paid                                             |       |       |       |       |       | (1,052                                | )          |
|                                                       |       |       |       |       |       |                                  |       |
| Balance, June 30, 2004                                |       | 5,112,020  |       | $          | (53,689    | )                                     | $          | 74,573 |   |

 

See notes to unauditedconsolidated financial statements.

 

3

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(In Thousands)

(Unaudited)

 
| ** **                                                                         | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                           | ** ** | **2003** | ** ** |
|                                                                               |       |                               |       |   |   |
| OPERATING ACTIVITIES:                                                              |       |                               |       |   |   |
| Net income                                                                         |       | $                                  | 3,691      |   | $ | 3,871 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                               |       |   |   |
| Provision for loan losses                                                          |       | 461                                |       | 415 |   |
| Provision for real estate losses                                                   |       | 32                                 |       | 27 |   |
| Deferred tax provision (benefit)                                                   |       | (105                               | )          | (147 | ) |
| Accretion of discounts on investment  securities, net                              |       | (34                                | )          | (36 | ) |
| Federal Home Loan Bank stock dividends                                             |       | (26                                | )          | (63 | ) |
| (Gain) loss on disposition of office  properties and equipment                     |       | (37                                | )          | 93 |   |
| (Gain) loss on sale of repossessed assets,  net                                    |       | 2                                  |       | (2 | ) |
| Originations of loans held for sale                                                |       | (26,196                            | )          | (65,004 | ) |
| Proceeds from sales of loans                                                       |       | 26,876                             |       | 69,145 |   |
| Gain on sale of loans originated to sell                                           |       | (322                               | )          | (913 | ) |
| Depreciation                                                                       |       | 594                                |       | 531 |   |
| Amortization (accretion) of deferred loan  fees, net                               |       | 26                                 |       | (236 | ) |
| Release of ESOP shares                                                             |       | 842                                |       | 568 |   |
| MRP compensation expense                                                           |       | 13                                 |       | 31 |   |
| Earnings on life insurance policies                                                |       | (407                               | )          | (426 | ) |
| Changes in operating assets and  liabilities:                                      |       |                               |       |   |   |
| Accrued interest receivable                                                        |       | (180                               | )          | 496 |   |
| Prepaid expenses and other assets                                                  |       | 455                                |       | (272 | ) |
| Other liabilities                                                                  |       | 125                                |       | 357 |   |
| Net cash provided by operating activities                                          |       | 5,810                              |       | 8,435 |   |
|                                                                               |       |                               |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                               |       |   |   |
| Purchases of investment securities held to  maturity                               |       | (83,019                            | )          | (141,615 | ) |
| Proceeds from maturities/calls of  investment securities held to maturity          |       | 86,479                             |       | 187,412 |   |
| Purchases of FHLB stock                                                            |       | (225                               | )          | — |   |
| Redemptions of FHLB stock                                                          |       | 678                                |       | — |   |
| Loan participations sold                                                           |       | 2,709                              |       | 5,000 |   |
| Loan originations, net of repayments                                               |       | (69,613                            | )          | (13,149 | ) |
| Proceeds from sales of repossessed assets                                          |       | 426                                |       | 536 |   |
| Proceeds from sales of office properties  and equipment                            |       | 576                                |       | 14 |   |
| Purchases of office properties and  equipment                                      |       | (1,160                             | )          | (4,369 | ) |
| Net cash provided by (used in) investing  activities                               |       | (63,149                            | )          | 33,829 |   |
|                                                                               |       |                               |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                               |       |   |   |
| Net increase in deposits                                                           |       | 8,061                              |       | 4,015 |   |
| Advances from FHLB                                                                 |       | 21,233                             |       | 19,000 |   |
| Repayment of advances from FHLB                                                    |       | (7,298                             | )          | (10,151 | ) |
| Net decrease in advance payments by  borrowers for taxes and insurance             |       | (134                               | )          | (357 | ) |
| Purchase of treasury stock                                                         |       | (5,242                             | )          | (1,828 | ) |
| Reissued treasury stock                                                            |       | 1,079                              |       | 831 |   |
| Dividends paid                                                                     |       | (1,052                             | )          | (854 | ) |
| Net cash provided by financing activities                                          |       | 16,647                             |       | 10,656 |   |
|                                                                               |       |                               |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                              |       | (40,692                            | )          | 52,920 |   |
|                                                                               |       |                               |       |   |   |
| CASH AND CASH EQUIVALENTS:                                                         |       |                               |       |   |   |
| Beginning of period                                                                |       | $                                  | 56,201     |   | $ | 44,493 |   |
| End of period                                                                      |       | $                                  | 15,509     |   | $ | 97,413 |   |
|                                                                               |       |                               |       |   |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:                                |       |                               |       |   |   |
| Cash paid for:                                                                     |       |                               |       |   |   |
| Interest                                                                           |       | $                                  | 6,939      |   | $ | 8,569 |   |
| Income taxes                                                                       |       | $                                  | 1,469      |   | $ | 1,952 |   |
|                                                                               |       |                               |       |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH  INVESTING ACTIVITIES:                       |       |                               |       |   |   |
| Real estate and other assets acquired in  settlement of loans                      |       | $                                  | 330        |   | $ | 1,111 |   |
| Loans to facilitate sales of real estate  owned                                    |       | $                                  | 197        |   | $ | 137 |   |
| Investment securities traded, recorded in  investments not yet settled in cash     |       | $                                  | 425        |   | $ | 3,875 |   |

 

See notes to unaudited consolidated financialstatements.

 

4

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**FIRST FEDERALBANCSHARES OF ARKANSAS, INC.**

 

**NOTES TO UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS**

 

# **Note 1 - Basis of Presentation and Principlesof Consolidation**

 

First Federal Bancshares of Arkansas, Inc. (the “Company”) is a unitaryholding company which owns all of the stock of First Federal Bank of Arkansas,FA (the “Bank”).  The Bank provides abroad line of financial products to individuals and small- to medium-sizedbusinesses in Northwest and Northcentral Arkansas.  The consolidated financial statements alsoinclude the accounts of the Bank’s wholly-owned subsidiary, First HarrisonService Corporation (“FHSC”), which is inactive.

 

The accompanying unaudited consolidated financial statements of theCompany have been prepared in accordance with instructions to Form 10-Q.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements. However, such information reflects all adjustments which are, in theopinion of management, necessary for a fair statement of results for theinterim periods.

 

The accompanying unaudited consolidated financial statements includethe accounts of the Company and the Bank. All material intercompany transactions have been eliminated inconsolidation.

 

The results ofoperations for the six months ended June 30, 2004, are not necessarilyindicative of the results to be expected for the year ending December 31,2004.  The unaudited consolidatedfinancial statements and notes thereto should be read in conjunction with theaudited financial statements and notes thereto for the year endedDecember 31, 2003, contained in the Company’s 2003 Annual Report toStockholders.

 

Certain amounts in the June 30, 2003, unaudited consolidatedfinancial statements have been reclassified to conform to the classificationsadopted for reporting in 2004.

 

**Note 2 - Earnings per Share**

 

The weighted average number of common shares used to calculate earningsper share for the periods ended June 30, 2004 and 2003 were as follows:

 
| ** **                        | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                        | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Basic weighted - average shares   |       | 5,113,191                            |       | 5,088,516                          |       | 5,129,969 |   | 5,086,720 |   |
| Effect of dilutive securities     |       | 313,711                              |       | 255,572                            |       | 329,339 |   | 231,513 |   |
| Diluted weighted - average shares |       | 5,426,902                            |       | 5,344,088                          |       | 5,459,308 |   | 5,318,233 |   |

 

5

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# **Note 3 – Stock Option Plan**

 

At June 30, 2004, the Company had one stock option plan in effectcovering key employees and directors. The plan is more fully described in the Notes to Consolidated FinancialStatements included in the Company’s 2003 Annual Report to Stockholders.  The Company accounts for this plan under therecognition and measurement principles of APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and related interpretations.  Nostock-based employee or director compensation cost is recognized in net income,as all options granted under the plan had an exercise price equal to the marketvalue of the underlying stock on the date of grant.  The following table illustrates the effect onnet income and earnings per share if the Company had applied the fair valuerecognition provisions of FASB Statement 123, *Accountingfor Stock-Based Compensation*, to stock-based employee and directorcompensation:

 
| ** **                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                 | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (in thousands): |       |                                 |       |                               |       |   |   |   |   |
| As reported                |       | $                                    | 1,931      |                               | $          | 1,887 |   | $ | 3,691 |   | $ | 3,871 |   |
| Proforma                   |       | 1,928                                |       | 1,885                              |       | 3,682 |   | 3,862 |   |
| Earnings per share:        |       |                                 |       |                               |       |   |   |   |   |
| Basic, as reported         |       | $                                    | 0.38       |                               | $          | 0.37 |   | $ | 0.72 |   | $ | 0.76 |   |
| Basic, proforma            |       | 0.38                                 |       | 0.37                               |       | 0.72 |   | 0.76 |   |
| Diluted, as reported       |       | 0.36                                 |       | 0.35                               |       | 0.68 |   | 0.73 |   |
| Diluted, proforma          |       | 0.36                                 |       | 0.35                               |       | 0.67 |   | 0.73 |   |

 

6

----

 

**MANAGEMENT’SDISCUSSION AND ANALYSIS**

**OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

### **CRITICAL ACCOUNTING POLICIES**

 

Various elements of ouraccounting policies, by their nature, are inherently subject to estimationtechniques, valuation assumptions and other subjective assessments.  In particular, the methodology for thedetermination of our allowance for loan losses, due to the judgments, estimatesand assumptions inherent in that policy, is critical to preparation of ourfinancial statements.  This policy andthe judgments, estimates and assumptions are described in greater detail insubsequent sections of Management’s Discussion and Analysis and in the notes tothe unaudited financial statements included herein.  We believe that the judgments, estimates andassumptions used in the preparation of our financial statements are appropriategiven the factual circumstances at the time. However, given the sensitivity of our financial statements to thiscritical accounting policy, the use of other judgments, estimates andassumptions could result in material differences in our financial condition orresults of operations.

 

In estimating the amount ofcredit losses inherent in our loan portfolio, various judgments and assumptionsare made.  For example, when assessingthe condition of the overall economic environment, assumptions are maderegarding future market conditions and their impact on the loan portfolio.  In the event the national economy were tosustain a prolonged downturn, the loss factors applied to our portfolios mayneed to be revised, which may significantly impact the measurement of theallowance for loan losses.  For impairedloans that are collateral-dependent, the estimated fair value of the collateralmay deviate significantly from the proceeds received when the collateral issold.

 

## **CHANGES IN FINANCIAL CONDITION**

##  

Changes in financialcondition between June 30, 2004 and December 31, 2003 are presentedin the following table (dollars in thousands). Material changes between the periods are discussed in the sections whichfollow the table.

 
| ** **                                    | ** ** | **June 30,****2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage****Change** | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|-----------------------------|------------|--------------------------|------------|--------------------------|------------|
| **ASSETS**                                    |       |                      |       |                        |       |                     |       |                     |       |
|  Cash  and cash equivalents              |       | $                         | 15,509     |                        | $          | 56,201                   |       | $                        | (40,692    | ) | (72.4 | )% |
|  Investment securities held to maturity  |       | 77,378                    |       | 80,379                      |       | (3,001                   | )          | (3.7                     | )%         |
|  Loans receivable, net                   |       | 578,682                   |       | 512,756                     |       | 65,926                   |       | 12.9                     | %          |
|  Prepaid expenses and other assets       |       | 41,072                    |       | 41,317                      |       | (245                     | )          | (0.6                     | )%         |
|                                          |       |                      |       |                        |       |                     |       |                     |       |
| TOTAL                                         |       | $                         | 712,641    |                        | $          | 690,653                  |       | $                        | 21,988     |   | 3.2 | % |
|                                          |       |                      |       |                        |       |                     |       |                     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |                      |       |                        |       |                     |       |                     |       |
| LIABILITIES:                                  |       |                      |       |                        |       |                     |       |                     |       |
|  Deposits                                |       | $                         | 581,641    |                        | $          | 573,580                  |       | $                        | 8,061      |   | 1.4 | % |
|  Federal Home Loan Bank advances         |       | 53,497                    |       | 39,562                      |       | 13,935                   |       | 35.2                     | %          |
|  Other liabilities                       |       | 2,930                     |       | 2,433                       |       | 497                      |       | 20.4                     | %          |
|                                          |       |                      |       |                        |       |                     |       |                     |       |
| Total liabilities                             |       | 638,068                   |       | 615,575                     |       | 22,493                   |       | 3.7                      | %          |
|                                          |       |                      |       |                        |       |                     |       |                     |       |
| STOCKHOLDERS’ EQUITY                     |       | 74,573                    |       | 75,078                      |       | (505                     | )          | (0.7                     | )%         |
|                                          |       |                      |       |                        |       |                     |       |                     |       |
| TOTAL                                         |       | $                         | 712,641    |                        | $          | 690,653                  |       | $                        | 21,988     |   | 3.2 | % |
|                                          |       |                      |       |                        |       |                     |       |                     |       |
| BOOK VALUE PER SHARE                          |       | $                         | 14.35      |                        | $          | 14.06                    |       |                     |       |   |   |
|                                          |       |                      |       |                        |       |                     |       |                     |       |
| EQUITY TO ASSETS                              |       | 10.5                      | %          | 10.9                        | %          |                     |       |                     |       |

 

7

----

 

**LoansReceivable. **Changes in loan composition between June 30,2004 and December 31, 2003 are presented in the following table (dollarsin thousands).

 
| ** **                                     | ** ** | **June 30,****2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage****Change** | ** ** |
|------------------------------------------------|------------|---------------------------|------------|-----------------------------|------------|--------------------------|------------|--------------------------|------------|
|                                           |       |                      |       |                        |       |                     |       |                     |       |
| One- to four- family residential               |       | $                         | 270,904    |                        | $          | 259,121                  |       | $                        | 11,783     |   |   |   |
| Multi-family residential                       |       | 12,049                    |       | 7,673                       |       | 4,376                    |       |                     |       |
| Commercial real estate                         |       | 122,892                   |       | 97,310                      |       | 25,582                   |       |                     |       |
| Construction                                   |       | 125,537                   |       | 89,332                      |       | 36,205                   |       |                     |       |
| Total first mortgage loans                     |       | 531,382                   |       | 453,436                     |       | 77,946                   |       | 17.2                     | %          |
|                                           |       |                      |       |                        |       |                     |       |                     |       |
| Commercial                                     |       | 27,255                    |       | 21,491                      |       | 5,764                    |       | 26.8                     | %          |
|                                           |       |                      |       |                        |       |                     |       |                     |       |
| Home equity and second mortgage                |       | 42,973                    |       | 42,421                      |       | 552                      |       |                     |       |
| Automobile                                     |       | 20,307                    |       | 22,087                      |       | (1,780                   | )          |                     |       |
| Other                                          |       | 11,216                    |       | 10,780                      |       | 436                      |       |                     |       |
| Total consumer                                 |       | 74,496                    |       | 75,288                      |       | (792                     | )          | (1.1                     | )%         |
|                                           |       |                      |       |                        |       |                     |       |                     |       |
| Total loans receivable                         |       | 633,133                   |       | 550,215                     |       | 82,918                   |       | 15.1                     | %          |
| Less:                                          |       |                      |       |                        |       |                     |       |                     |       |
| Undisbursed loan funds                         |       | (52,163                   | )          | (35,181                     | )          | (16,982                  | )          |                     |       |
| Unearned discounts and net deferred loan  fees |       | (598                      | )          | (657                        | )          | 59                       |       |                     |       |
| Allowance for loan losses                      |       | (1,690                    | )          | (1,621                      | )          | (69                      | )          |                     |       |
|                                           |       |                      |       |                        |       |                     |       |                     |       |
| Total loans receivable, net                    |       | $                         | 578,682    |                        | $          | 512,756                  |       | $                        | 65,926     |   | 12.9 | % |

 

Certain 2003 amounts in the table above havebeen reclassified to conform to the 2004 presentation.

 

The interest rate environment and robusteconomies of our market areas have continued to provide increased demand forour loan products.  The Bank hascontinued its emphasis on real estate lending, particularly commercial realestate lending, to increase the average yield on its portfolio, expand itsoperations, and provide greater opportunities to cross-sell its products.  We experienced an increase in one-to four-family residential loans held for investment, primarily due to an increase inadjustable rate mortgages.  Constructionlending has continued to increase, with $23 million of the increase due to one-to four- family residential construction, $1.6 million due to multi-familyconstruction, and $11.6 million due to commercial real estate construction.

 

8

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**Asset Quality. **The following table sets forth the amounts andcategories of the Bank’s nonperforming assets at the dates indicated (dollarsin thousands).

 
| ** **                                                                         | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------|------------|
|                                                                               |       |                   |       |                       |       |
| Nonaccrual loans:                                                                  |       |                   |       |                       |       |
| One- to four-family residential                                                    |       | $                      | 2,108      |                       | $          | 1,537 |   |
| Multi-family residential                                                           |       | —                 |       | —                     |       |
| Construction loans                                                                 |       | —                 |       | —                     |       |
| Commercial real estate                                                             |       | 245                    |       | 99                         |       |
| Commercial loans                                                                   |       | 255                    |       | 131                        |       |
| Consumer loans                                                                     |       | 322                    |       | 564                        |       |
| Total nonaccrual loans                                                             |       | 2,930                  |       | 2,331                      |       |
|                                                                               |       |                   |       |                       |       |
| Nonperforming restructured loans                                                   |       | —                 |       | 1,352                      |       |
| Real estate owned                                                                  |       | 523                    |       | 822                        |       |
|                                                                               |       |                   |       |                       |       |
| Nonperforming assets                                                               |       | $                      | 3,453      |                       | $          | 4,505 |   |
|                                                                               |       |                   |       |                       |       |
| Total nonaccrual and restructured loans as  a percentage of total loans receivable |       | 0.46                   | %          | 0.67                       | %          |
|                                                                               |       |                   |       |                       |       |
| Total nonperforming assets as a percentage  of total assets                        |       | 0.48                   | %          | 0.65                       | %          |

 

The amount of restructured loans reported at December 31, 2003 wascomprised of a group of loans to related borrowers.  At that date the loans were not over 90 dayspast due, but such loans were maintained on nonaccrual status.  At June 30, 2004, there were nononperforming restructured loans.

 

**Allowancefor Loan Losses**.  A summary of theactivity in the allowance for loan losses is as follows (in thousands):

 
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                      | ** ** | **2004**                             | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Balance at beginning of period  |       | $                                    | 1,703      |                               | $          | 1,661 |   | $ | 1,621 |   | $ | 1,529 |   |
| Provisions for estimated losses |       | 202                                  |       | 136                                |       | 461 |   | 415 |   |
| Recoveries                      |       | 25                                   |       | 14                                 |       | 49 |   | 41 |   |
| Losses charged off              |       | (240                                 | )          | (94                                | )          | (441 | ) | (268 | ) |
| Balance at end of period        |       | $                                    | 1,690      |                               | $          | 1,717 |   | $ | 1,690 |   | $ | 1,717 |   |

 

Changes in the composition ofthe allowance for loan losses between June 30, 2004 and December 31,2003 are presented in the following table (in thousands):

 
| ** **  | ** ** | **June 30,****2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** |
|-------------|------------|---------------------------|------------|-----------------------------|------------|--------------------------|------------|
| General     |       | $                         | 1,405      |                        | $          | 1,306                    |       | $ | 99 |   |
| Specific    |       | 235                       |       | 252                         |       | (17                      | )          |
| Unallocated |       | 50                        |       | 63                          |       | (13                      | )          |
|        |       | $                         | 1,690      |                        | $          | 1,621                    |       | $ | 69 |   |

 

The allowance for loan losses isevaluated on a regular basis by management and is based upon management’s periodicreview of the collectibility of the loans in light of historical experience,the nature and volume of the loan portfolio, adverse situations that may affectthe borrower’s ability to repay, the estimated value of any underlyingcollateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates thatare susceptible to significant revision as conditions change and moreinformation becomes available.

 

9

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The allowance consists of specific, general and unallocated components.The specific component relates to loans that are classified as loss, doubtful,substandard or special mention. For such loans that are also classified asimpaired, an allowance is established when the discounted cash flows (or collateralvalue or observable market price) of the impaired loan is lower than thecarrying value of that loan. The general component covers non-classified loansand is based primarily on historical loss experience. An unallocated componentis maintained to cover uncertainties that could affect management’s estimate ofprobable losses. The unallocated component of the allowance reflects the marginof imprecision inherent in the underlying assumptions used in the methodologiesfor estimating specific and general losses in the portfolio.

 

The Bank reviews its non-homogeneousloans for impairment on a quarterly basis. The Bank considers commercial real estate, construction, multi-family,and commercial loans to be non-homogeneous loans.  A loan is considered impaired when, based oncurrent information and events, it is probable that the Bank will be unable tocollect the scheduled payments of principal or interest when due according tothe contractual terms of the loan agreement. Factors considered by management in determining impairment includepayment status, collateral value, and the probability of collecting scheduledprincipal and interest payments when due. Loans that experience insignificant payment delays and paymentshortfalls generally are not classified as impaired.  Management determines the significance ofpayment delays and payment shortfalls on a case-by-case basis, taking intoconsideration all of the circumstances surrounding the loan and the borrower,including the length of the delay, the reasons for the delay, the borrower’sprior payment record, and the amount of the shortfall in relation to theprincipal and interest owed.  Impairmentis measured on a loanby loan basis by either the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, the loan’s obtainable marketprice, or the fair value of the collateral if the loan is collateral dependent.

 

Large groups of smaller balancehomogeneous loans are collectively evaluated for impairment.  Accordingly, the Bank does not separatelyidentify individual consumer and residential loans for impairmentdisclosures.  Homogeneous loans are thosethat are considered to have common characteristics that provide for evaluationon an aggregate or pool basis.  The Bankconsiders the characteristics of (1) one- to- four family residential firstmortgage loans; (2) unsecured consumer loans; and (3) collateralized consumerloans to permit consideration of the appropriateness of the allowance forlosses of each group of loans on a pool basis. Homogeneous loans and non-homogeneous loans which are not judged to beimpaired are aggregated into pools by purpose and type of collateral. Theprimary methodology used to determine the appropriateness of the allowance forlosses includes segregating certainspecific, poorly performing loans based on their performance characteristicsfrom the pools of loans as to type, valuing these loans, and then applying aloss factor to the remaining pool balance based on several factors, includingpast loss experience, inherent risks, and economic conditions in the primarymarket areas.

 

In estimating theamount of credit losses inherent in our loan portfolio, various judgments andassumptions are made.  For example, whenassessing the condition of the overall economic environment, assumptions aremade regarding future market conditions and their impact on the loanportfolio.  In the event the nationaleconomy were to sustain a prolonged downturn, the loss factors applied to ourportfolios may need to be revised, which may significantly impact themeasurement of the allowance for loan losses. For impaired loans that are collateral-dependent, the estimated fairvalue of the collateral may deviate significantly from the proceeds receivedwhen the collateral is sold.

 

Although we considerthe allowance for loan losses of approximately $1.7 million appropriate andadequate to cover losses inherent in our loan portfolio at June 30, 2004,no assurance can be given that we will not sustain loan losses that are significantlydifferent from the amount provided, or that subsequent evaluations of the loanportfolio, in light of factors then prevailing, would not result in asignificant change in the allowance for loan losses.

 

10

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**Investment Securities. **Changes in the composition ofinvestment securities held to maturity between June 30, 2004 andDecember 31, 2003 are presented in the following table (in thousands).

 
| ** **                             | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** |
|----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Certificates of deposit                |       | $                       | 7,000      |                        | $          | 9,000                    |       | $ | (2,000 | ) |
| U.S. Government and agency obligations |       | 54,959                  |       | 57,076                      |       | (2,117                   | )          |
| Municipal securities                   |       | 15,419                  |       | 14,303                      |       | 1,116                    |       |
| Total                                  |       | $                       | 77,378     |                        | $          | 80,379                   |       | $ | (3,001 | ) |

 

During the first six monthsof 2004, investment securities totaling $83.4 million were purchased and $86.5million matured or were called.  Themajority of these purchases and maturities were shorter-term certificates ofdeposit.  The decrease in U.S. Governmentand agency obligations was due to calls and maturities in excess of purchases.

 

At June 30, 2004, estimated fair valuesof investment securities held to maturity were as follows (in thousands):

 
| ** **                              | ** ** | **Amortized Cost** | ** ** | **Fair Value** | ** ** |
|-----------------------------------------|------------|--------------------|------------|----------------|------------|
|                                    |       |               |       |           |       |
| Certificates of deposit                 |       | $                  | 7,000      |           | $          | 6,988 |   |
| U.S. Government and agency  obligations |       | 54,959             |       | 53,826         |       |
| Municipal securities                    |       | 15,419             |       | 15,431         |       |
| Total                                   |       | $                  | 77,378     |           | $          | 76,245 |   |

 

**Deposits. **Changes in the composition of depositsbetween June 30, 2004 and December 31, 2003 are presented in thefollowing table (dollars in thousands).

 
| ** **              | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|-------------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|------------------------|------------|
|                    |       |                    |       |                        |       |                     |       |                   |       |
| DDA and NOW accounts    |       | $                       | 103,301    |                        | $          | 96,090                   |       | $                      | 7,211      |   | 7.5 | % |
| Money Market accounts   |       | 117,330                 |       | 108,400                     |       | 8,930                    |       | 8.2                    | %          |
| Savings accounts        |       | 31,004                  |       | 29,269                      |       | 1,735                    |       | 5.9                    | %          |
| Certificates of deposit |       | 330,006                 |       | 339,821                     |       | (9,815                   | )          | (2.9                   | )%         |
|                    |       |                    |       |                        |       |                     |       |                   |       |
| Total deposits          |       | $                       | 581,641    |                        | $          | 573,580                  |       | $                      | 8,061      |   | 1.4 | % |

 

The Bank continued toexperience a change in the mix of deposits due to the low interest rateenvironment during the six months ended June 30, 2004.  Certificates of deposit decreased while moneymarket, savings, and demand and NOW deposit accounts increased.  During the second quarter of 2004, the Banklaunched a new marketing program aimed at increasing retail checkingaccounts.  As part of this program, theBank changed its checking account offerings to make them more attractive topotential customers as well as offering “thank you” gifts with account openingsand referrals.  Checking accounts are anattractive source of funds for the Bank as they offer low-interest deposits,fee income potential, and the opportunity to cross-sell other financialservices.  The Bank does not advertisefor deposits outside of its primary market area of Northwest and Northcentral Arkansas.

 

**Federal Home Loan Bank Advances.**  FHLB advances increased primarily due to newadvances which were used to help fund loan growth.

 

**Stockholders’Equity. **Stockholders’ equity decreased $505,000from December 31, 2003 to June 30, 2004.  The decrease in stockholders’ equity wasprimarily due to the purchase of treasury stock totaling $5.2 million duringthe first six months of 2004, offset by net income of $3.7 million and theissuance of treasury stock due to exercise of stock options of $1.1 million.  In addition, during the six months endedJune 30, 2004, cash dividends of $1.1 million were paid.  See the Unaudited Consolidated Statement ofStockholders’ Equity for the six months ended June 30, 2004 for moredetail.

 

11

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### **Average Balance Sheets**

###  

The following table sets forth certaininformation relating to the Company’s average balance sheets and reflects theaverage yield on assets and average cost of liabilities for the periodsindicated and the yields earned and rates paid at June 30, 2004.  Such yields and costs are derived by dividingincome or expense by the average balance of assets or liabilities,respectively, for the periods presented. Average balances are based on daily balances during the period.

 
| ** **                                                        | ** ** | ** **              | ** ** | **Quarter Ended  June 30,** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|
| **2004**                                                          | ** ** | **2003**                |
| ** **                                                        | ** ** | **June 30,  2004** | ** ** | **Average  Balance**             | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| **Yield/Cost**                                                    |
| ** **                                                        | ** ** | ** **              | ** ** | **(Dollars in Thousands)**       | ** ** |
| Interest-earning assets:                                          |       |                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | 6.22                    | %          | $                                | 558,359    |   | $ | 8,745 |   | 6.26 | % | $ | 488,102 |   | $ | 8,584 |   | 7.03 | % |
| Investment securities(2)                                          |       | 4.73                    |       | 87,979                           |       | 950 |   | 4.32 |   | 94,526 |   | 941 |   | 3.98 |   |
| Other interest-earning  assets                                    |       | 0.91                    |       | 8,294                            |       | 18 |   | 0.89 |   | 67,306 |   | 191 |   | 1.14 |   |
| Total interest-earning  assets                                    |       | 6.02                    |       | 654,632                          |       | 9,713 |   | 5.94 |   | 649,934 |   | 9,716 |   | 5.98 |   |
| Noninterest-earning assets                                        |       |                    |       | 48,107                           |       |   |   |   |   | 45,039 |   |   |   |   |   |
| Total assets                                                      |       |                    |       | $                                | 702,739    |   |   |   |   |   | $ | 694,973 |   |   |   |   |   |
| Interest-bearing liabilities:                                     |       |                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 2.17                    |       | 580,472                          |       | 3,107 |   | 2.14 |   | 572,925 |   | 3,766 |   | 2.63 |   |
| FHLB advances                                                     |       | 2.71                    |       | 41,727                           |       | 326 |   | 3.13 |   | 46,412 |   | 352 |   | 3.04 |   |
| Total interest-bearing liabilities                                |       | 2.22                    |       | 622,199                          |       | 3,433 |   | 2.21 |   | 619,337 |   | 4,118 |   | 2.66 |   |
| Noninterest-bearing  liabilities                                  |       |                    |       | 4,867                            |       |   |   |   |   | 3,647 |   |   |   |   |   |
| Total liabilities                                                 |       |                    |       | 627,066                          |       |   |   |   |   | 622,984 |   |   |   |   |   |
| Stockholders’ equity                                         |       |                    |       | 75,673                           |       |   |   |   |   | 71,989 |   |   |   |   |   |
| Total liabilities and stockholders’  equity                  |       |                    |       | $                                | 702,739    |   |   |   |   |   | $ | 694,973 |   |   |   |   |   |
|                                                              |       |                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                    |       |                             |       | $ | 6,280 |   |   |   |   |   | $ | 5,598 |   |   |   |
| Net earning assets                                                |       |                    |       | $                                | 32,433     |   |   |   |   |   | $ | 30,597 |   |   |   |   |   |
| Interest rate spread                                              |       | 3.80                    | %          |                             |       |   |   | 3.73 | % |   |   |   |   | 3.32 | % |
| Net interest margin                                               |       |                    |       |                             |       |   |   | 3.84 | % |   |   |   |   | 3.45 | % |
| Ratio of interest-earning  assets to interest-bearing liabilities |       |                    |       |                             |       |   |   | 105.21 | % |   |   |   |   | 104.94 | % |
|                                                                   |            |                         |            |                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                        | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                        | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**          | ** ** |
| Interest-earning assets:                                          |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | $                                   | 539,633    |   | $ | 17,074 |   | 6.33 | % | $ | 487,839 |   | $ | 17,392 |   | 7.13 | % |
| Investment securities(2)                                          |       | 88,015                              |       | 1,910 |   | 4.34 |   | 102,214 |   | 2,097 |   | 4.10 |   |
| Other interest-earning  assets                                    |       | 24,676                              |       | 110 |   | 0.89 |   | 55,935 |   | 318 |   | 1.14 |   |
| Total interest-earning  assets                                    |       | 652,324                             |       | 19,094 |   | 5.85 |   | 645,988 |   | 19,807 |   | 6.13 |   |
| Noninterest-earning assets                                        |       | 47,534                              |       |   |   |   |   | 43,638 |   |   |   |   |   |
| Total assets                                                      |       | $                                   | 699,858    |   |   |   |   |   | $ | 689,626 |   |   |   |   |   |
| Interest-bearing  liabilities:                                    |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 579,150                             |       | 6,295 |   | 2.17 |   | 570,308 |   | 7,789 |   | 2.73 |   |
| FHLB advances                                                     |       | 40,109                              |       | 645 |   | 3.22 |   | 43,978 |   | 717 |   | 3.26 |   |
| Total interest-bearing liabilities                                |       | 619,259                             |       | 6,940 |   | 2.24 |   | 614,286 |   | 8,506 |   | 2.77 |   |
| Noninterest-bearing  liabilities                                  |       | 5,030                               |       |   |   |   |   | 4,064 |   |   |   |   |   |
| Total liabilities                                                 |       | 624,289                             |       |   |   |   |   | 618,350 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 75,569                              |       |   |   |   |   | 71,276 |   |   |   |   |   |
| Total liabilities and stockholders’  equity                  |       | $                                   | 699,858    |   |   |   |   |   | $ | 689,626 |   |   |   |   |   |
|                                                              |       |                                |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                               |       |                                |       | $ | 12,154 |   |   |   |   |   | $ | 11,301 |   |   |   |
| Net earning assets                                                |       | $                                   | 33,065     |   |   |   |   |   | $ | 31,702 |   |   |   |   |   |
| Interest rate spread                                              |       |                                |       |   |   | 3.61 | % |   |   |   |   | 3.36 | % |
| Net interest margin                                               |       |                                |       |   |   | 3.73 | % |   |   |   |   | 3.50 | % |
| Ratio of interest-earning  assets to interest-bearing liabilities |       |                                |       |   |   | 105.34 | % |   |   |   |   | 105.16 | % |

 

----

(1)  Includesnonaccrual loans.

(2)  IncludesFHLB of Dallas stock.

 

12

----

 

## **Rate/Volume Analysis**

##  

The table below sets forth certaininformation regarding changes in interest income and interest expense of the Companyfor the periods indicated.  For eachcategory of interest-earning assets and interest-bearing liabilities,information is provided on changes attributable to (i) changes in volume(changes in average volume multiplied by prior rate); (ii) changes in rate(change in rate multiplied by prior average volume); (iii) changes inrate-volume (changes in rate multiplied by the change in average volume); and(iv) the net change.

 
| ** **                          | ** ** | **Quarter Ended June 30,  2004 vs. 2003** |
|-------------------------------------|------------|------------------------------------------------|
| ** **                          | ** ** | **Increase (Decrease)  Due to**                | ** ** | **Total  Increase  (Decrease)** | ** ** |
| ** **                          | ** ** | **Volume**                                     | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                             | ** ** |
| Interest income:                    |       |                                           |   |   |   |   |   |   |   |
| Loans receivable                    |       | $                                              | 1,235 |   | $ | (939 | ) | $ | (135 | ) | $ | 161 |   |
| Investment securities               |       | (65                                            | ) | 80 |   | (6 | ) | 9 |   |
| Other interest-earning assets       |       | (168                                           | ) | (42 | ) | 37 |   | (173 | ) |
| Total interest-earning  assets      |       | 1,002                                          |   | (901 | ) | (104 | ) | (3 | ) |
|                                |       |                                           |   |   |   |   |   |   |   |
| Interest expense:                   |       |                                           |   |   |   |   |   |   |   |
| Deposits                            |       | 49                                             |   | (699 | ) | (9 | ) | (659 | ) |
| FHLB advances                       |       | (35                                            | ) | 10 |   | (1 | ) | (26 | ) |
| Total interest-bearing  liabilities |       | 14                                             |   | (689 | ) | (10 | ) | (685 | ) |
| Net change in net interest  income  |       | $                                              | 988 |   | $ | (212 | ) | $ | (94 | ) | $ | 682 |   |

 
| ** **                          | ** ** | **Six Months Ended June 30,  2004 vs. 2003** | ** ** |
|-------------------------------------|------------|---------------------------------------------------|------------|
| ** **                          | ** ** | **Increase (Decrease)  Due to**                   | ** ** | **Total** | ** ** |
| ** **                          | ** ** | **Volume**                                        | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | **Increase  (Decrease)** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                                | ** ** |
| Interest income:                    |       |                                              |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                                 | 1,847      |   | $ | (1,957 | ) | $ | (208 | ) | $ | (318 | ) |
| Investment securities               |       | (291                                              | )          | 121 |   | (17 | ) | (187 | ) |
| Other interest-earning  assets      |       | (178                                              | )          | (68 | ) | 38 |   | (208 | ) |
| Total interest-earning  assets      |       | 1,378                                             |       | (1,904 | ) | (187 | ) | (713 | ) |
|                                |       |                                              |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                              |       |   |   |   |   |   |   |
| Deposits                            |       | 121                                               |       | (1,590 | ) | (25 | ) | (1,494 | ) |
| FHLB advances                       |       | (63                                               | )          | (10 | ) | 1 |   | (72 | ) |
| Total interest-bearing  liabilities |       | 58                                                |       | (1,600 | ) | (24 | ) | (1,566 | ) |
| Net change in net interest  income  |       | $                                                 | 1,320      |   | $ | (304 | ) | $ | (163 | ) | $ | 853 |   |

 

13

----

 

**CHANGES IN RESULTS OF OPERATIONS**

 

The table below presents acomparison of results of operations for the three months ended June 30,2004 and 2003 (dollars in thousands). Specific changes in captions are discussed in the sections which followthe table.

 
| ** **                                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                                            | ** ** | **2004**                              | ** ** | **2003**                 | ** ** | **2004 vs 2003**       | ** ** | **2004 vs 2003** | ** ** |
| Interest income:                                      |       |                                  |       |                     |       |                   |       |   |   |
| Loans receivable                                      |       | $                                     | 8,745      |                     | $          | 8,584                  |       | $ | 161 |   |   |   |
| Investment securities                                 |       | 950                                   |       | 941                      |       | 9                      |       |   |   |
| Other                                                 |       | 18                                    |       | 191                      |       | (173                   | )          |   |   |
| Total interest income                                 |       | 9,713                                 |       | 9,716                    |       | (3                     | )          | 0.0 | % |
| Interest expense:                                     |       |                                  |       |                     |       |                   |       |   |   |
| Deposits                                              |       | 3,107                                 |       | 3,766                    |       | (659                   | )          |   |   |
| Other borrowings                                      |       | 326                                   |       | 352                      |       | (26                    | )          |   |   |
| Total interest expense                                |       | 3,433                                 |       | 4,118                    |       | (685                   | )          | (16.6 | )% |
| Net interest income before provision for  loan losses |       | 6,280                                 |       | 5,598                    |       | 682                    |       |   |   |
| Provision for loan losses                             |       | 202                                   |       | 136                      |       | 66                     |       |   |   |
| Net interest income after provision for  loan losses  |       | 6,078                                 |       | 5,462                    |       | 616                    |       | 11.3 | % |
| Noninterest income:                                   |       |                                  |       |                     |       |                   |       |   |   |
| Deposit fee income                                    |       | 802                                   |       | 646                      |       | 156                    |       |   |   |
| Gain on sale of loans                                 |       | 196                                   |       | 510                      |       | (314                   | )          |   |   |
| Gain on contributed assets                            |       | —                                |       | 414                      |       | (414                   | )          |   |   |
| Other                                                 |       | 587                                   |       | 575                      |       | 12                     |       |   |   |
| Total noninterest income                              |       | 1,585                                 |       | 2,145                    |       | (560                   | )          | (26.1 | )% |
| Noninterest expenses:                                 |       |                                  |       |                     |       |                   |       |   |   |
| Salaries and employee benefits                        |       | 2,758                                 |       | 2,557                    |       | 201                    |       |   |   |
| Net occupancy expense                                 |       | 510                                   |       | 527                      |       | (17                    | )          |   |   |
| Advertising and public relations                      |       | 304                                   |       | 152                      |       | 152                    |       |   |   |
| Contributions                                         |       | 5                                     |       | 508                      |       | (503                   | )          |   |   |
| Other                                                 |       | 1,247                                 |       | 1,250                    |       | (3                     | )          |   |   |
| Total noninterest expenses                            |       | 4,824                                 |       | 4,994                    |       | (170                   | )          | (3.4 | )% |
| Income before income taxes                            |       | 2,839                                 |       | 2,613                    |       | 226                    |       |   |   |
| Provision for income taxes                            |       | 908                                   |       | 726                      |       | 182                    |       |   |   |
| Net income                                            |       | 1,931                                 |       | 1,887                    |       | 44                     |       | 2.3 | % |
|                                                  |       |                                  |       |                     |       |                   |       |   |   |
| Basic earnings per share                              |       | $                                     | 0.38       |                     | $          | 0.37                   |       | $ | 0.01 |   | 2.7 | % |
| Diluted earnings per share                            |       | $                                     | 0.36       |                     | $          | 0.35                   |       | $ | 0.01 |   | 2.9 | % |
|                                                  |       |                                  |       |                     |       |                   |       |   |   |
| Interest rate spread                                  |       | 3.73                                  | %          | 3.32                     | %          | 0.41                   | %          | 12.3 | % |
| Net interest margin                                   |       | 3.84                                  | %          | 3.45                     | %          | 0.39                   | %          | 11.3 | % |
|                                                  |       |                                  |       |                     |       |                   |       |   |   |
| Average full-time equivalents                         |       | 246.3                                 |       | 245.5                    |       | .8                     |       | .3 | % |

 

14

----

 

The table below presents acomparison of results of operations for the six months ended June 30,2004 and 2003 (dollars in thousands). Specific changes in captions are discussed in the sections which followthe table.

 
| ** **                                            | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                                            | ** ** | **2004**                            | ** ** | **2003**                 | ** ** | **2004 vs 2003**       | ** ** | **2004 vs 2003** | ** ** |
| Interest income:                                      |       |                                |       |                     |       |                   |       |   |   |
| Loans receivable                                      |       | $                                   | 17,074     |                     | $          | 17,392                 |       | $ | (318 | ) |   |   |
| Investment securities                                 |       | 1,910                               |       | 2,097                    |       | (187                   | )          |   |   |
| Other                                                 |       | 110                                 |       | 318                      |       | (208                   | )          |   |   |
| Total interest income                                 |       | 19,094                              |       | 19,807                   |       | (713                   | )          | (3.6 | )% |
| Interest expense:                                     |       |                                |       |                     |       |                   |       |   |   |
| Deposits                                              |       | 6,295                               |       | 7,789                    |       | (1,494                 | )          |   |   |
| Other borrowings                                      |       | 645                                 |       | 717                      |       | (72                    | )          |   |   |
| Total interest expense                                |       | 6,940                               |       | 8,506                    |       | (1,566                 | )          | (18.4 | )% |
| Net interest income before provision for  loan losses |       | 12,154                              |       | 11,301                   |       | 853                    |       |   |   |
| Provision for loan losses                             |       | 461                                 |       | 415                      |       | 46                     |       |   |   |
| Net interest income after provision for  loan losses  |       | 11,693                              |       | 10,886                   |       | 807                    |       | 7.4 | % |
| Noninterest income:                                   |       |                                |       |                     |       |                   |       |   |   |
| Deposit fee income                                    |       | 1,495                               |       | 1,202                    |       | 293                    |       |   |   |
| Gain on sale of loans                                 |       | 322                                 |       | 913                      |       | (591                   | )          |   |   |
| Gain on contributed assets                            |       | —                              |       | 414                      |       | (414                   | )          |   |   |
| Other                                                 |       | 1,199                               |       | 1,159                    |       | 40                     |       |   |   |
| Total noninterest income                              |       | 3,016                               |       | 3,688                    |       | (672                   | )          | (18.2 | )% |
| Noninterest expenses:                                 |       |                                |       |                     |       |                   |       |   |   |
| Salaries and employee benefits                        |       | 5,437                               |       | 5,011                    |       | 426                    |       |   |   |
| Net occupancy expense                                 |       | 1,002                               |       | 886                      |       | 116                    |       |   |   |
| Advertising and public relations                      |       | 431                                 |       | 303                      |       | 128                    |       |   |   |
| Contributions                                         |       | 9                                   |       | 519                      |       | (510                   | )          |   |   |
| Other                                                 |       | 2,419                               |       | 2,309                    |       | 110                    |       |   |   |
| Total noninterest expenses                            |       | 9,298                               |       | 9,028                    |       | 270                    |       | 3.0 | % |
| Income before income taxes                            |       | 5,411                               |       | 5,546                    |       | (135                   | )          |   |   |
| Provision for income taxes                            |       | 1,720                               |       | 1,675                    |       | 45                     |       |   |   |
| Net income                                            |       | 3,691                               |       | 3,871                    |       | (180                   | )          | (4.6 | )% |
|                                                  |       |                                |       |                     |       |                   |       |   |   |
| Basic earnings per share                              |       | $                                   | 0.72       |                     | $          | 0.76                   |       | $ | (0.04 | ) | (5.3 | )% |
| Diluted earnings per share                            |       | $                                   | 0.68       |                     | $          | 0.73                   |       | $ | (0.05 | ) | (6.8 | )% |
|                                                  |       |                                |       |                     |       |                   |       |   |   |
| Interest rate spread                                  |       | 3.61                                | %          | 3.36                     | %          | 0.25                   | %          | 7.4 | % |
| Net interest margin                                   |       | 3.73                                | %          | 3.50                     | %          | 0.23                   | %          | 6.6 | % |
|                                                  |       |                                |       |                     |       |                   |       |   |   |
| Average full-time equivalents                         |       | 248.9                               |       | 242.1                    |       | 6.8                    |       | 2.8 | % |

 

15

----

 

**Net Interest Income. **Net interest incomeis determined by the Company’s interest rate spread (i.e., the differencebetween the yields earned on its interest-earning assets and the rates paid onits interest-bearing liabilities) and the relative amounts of interest-earningassets and interest-bearing liabilities. The Company’s net interest income increased due to increases in interestrate spread and interest rate margin. There was a general decrease in market interest rates from the quarterended June 30, 2003 to the quarter ended June 30, 2004, as evidencedby the changes in key interest rates presented below:

 
| ** **     | ** ** | **June  2004** | ** ** | **December  2003** | ** ** | **June  2003** | ** ** | **December  2002** | ** ** |
|----------------|------------|----------------|------------|--------------------|------------|----------------|------------|--------------------|------------|
|           |       |           |       |               |       |           |       |               |       |
| Fed funds rate |       | 1.03           | %          | 0.98               | %          | 1.22           | %          | 1.24               | %          |
| Prime rate     |       | 4.00           | %          | 4.00               | %          | 4.22           | %          | 4.25               | %          |

 

Source: www.federalreserve.gov

 

In the 2004 vs. 2003 period, due to theBank’s negative interest rate repricing gap, rates paid on deposits decreasedmore quickly than rates on earning assets. As a result, the Company experienced an increase in the interest ratespread and net interest margin.

 

### **INTEREST INCOME AND INTERESTEXPENSE**

###  

Dollar and percentage changes in interestincome and interest expense for the comparison periods are presented in therate/volume analysis table which appears on page 14.

 

**Interest Income. **The decreases forboth the three and six month comparative periods were primarily due to adecrease in the average yield earned on loans and other interest-earning assetsand a decrease in the average balance of investment securities and otherinterest-earning assets, partially offset by an increase in the average balanceof loans.  The decrease in the averageyield earned on loans and other interest-earning assets was primarily due tothe declining level of interest rates in 2004 compared to the same period in2003.  The decrease in the averagebalance of investment securities held to maturity was primarily the result ofcalled U.S. Government and agency securities and maturing certificates ofdeposit.  The average balance of otherinterest-earning assets decreased as such assets were used to fund loangrowth.  The average balance of loansincreased primarily due to increased construction, commercial real estate, andone- to four- family loan origination activity since 2003.

 

**Interest Expense. **The decreases forboth the three and six month comparative periods were primarily due to adecrease in the average rate paid on deposit accounts, offset slightly by an increasein the average balance of deposits.  Thedecrease in the average interest rate paid on deposits was primarily the resultof maturing certificates and variable interest bearing deposits being repricedto lower interest rates.

 

**Provision for Loan Losses.**  The provision for loan losses includescharges to maintain an allowance for loan losses adequate to cover probablecredit losses related to specifically identified loans as well as probablecredit losses inherent in the remainder of the loan portfolio that have beenincurred as of the balance sheet date. Such provision and the adequacy of the allowance for loan losses isevaluated quarterly by management of the Bank based on the Bank’s past loanloss experience, known and inherent risks in the portfolio, adverse situationsthat may affect the borrower’s ability to repay, the estimated value of anyunderlying collateral and current economic conditions.

 

While the loan portfolio increased by $65.9million since December 31, 2003, the estimated allowance for loan lossesdid not increase significantly since the majority of the growth was in realestate loans, which have lower estimated loss rates than consumer loans.  Further, there was a decrease in the balanceof consumer loans as well as a trend of decreasing charge-offs on allcategories of consumer loans except unsecured loans.  Specifically, there was a decrease of $1.8million in the balance of automobile loans as well as a decrease in automobileloan charge-offs, which accounted for approximately $178,000 of the decrease inthe allowance for loan losses on consumer loans.  Since the balance of unsecured loans is onlyapproximately $2.8 million, the increased loss rate on those loans did notmaterially affect the overall allowance for loan losses.

 

16

----

 

The composition of the allowance for loanlosses at June 30, 2004 and December 31, 2003 is presented below (inthousands):

 
| ** **                      | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|---------------------------------|------------|------------------------|------------|----------------------------|------------|
|                            |       |                   |       |                       |       |
| One- to four-family residential |       | $                      | 259        |                       | $          | 239 |   |
| Multi-family residential        |       | 36                     |       | 31                         |       |
| Commercial real estate          |       | 385                    |       | 256                        |       |
| Commercial loans                |       | 538                    |       | 404                        |       |
| Consumer loans                  |       | 422                    |       | 628                        |       |
| Unallocated                     |       | 50                     |       | 63                         |       |
| Total allowance for loan losses |       | $                      | 1,690      |                       | $          | 1,621 |   |

 

**Noninterest Income. **Deposit fee incomeincreased as a result of the Bank’s continued promotion of Bounce ProtectionTM overdraftservice as well as an increase in the number of checking accounts and achange in the insufficient funds fee structure. The number of checking accounts increased approximately 6% fromJune 30, 2003 to June 30, 2004. The Bank began aggressively promoting checking accounts in the secondquarter of 2004 through direct mail campaigns to expand its checking accountsand increase deposit fee income.

 

Gain on sale of loans decreased due to adecrease in originations of loans for sale. Sales of loans peaked in 2003 due to record low interest rates in 2003and the resulting refinancing activity. We do not expect loan sales to continue at this level in 2004.

 

The gain on contributed assets was recordedin connection with an adjustment of the carrying value of donated real estateto estimated fair value.  A correspondingexpense in the amount of $500,000 was also recorded and is included in thebalance of contributions expense.  Theeffect of this contribution is further described below.

 

**NoninterestExpense**

 

**Salaries and Employee Benefits. **The changes in thecomposition of this line item are presented below (in thousands):

 
| ** **                        | ** ** | **Three Months Ended June 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Six Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|----------------------------|------------|------------------------------------|------------|--------------------------|------------|
| ** **                        | ** ** | **2004**                             | ** ** | **2003**                   | ** ** | **2004 vs 2003**                   | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2004 vs 2003** | ** ** |
| Salaries                          |       | $                                    | 1,894      |                       | $          | 1,859                              |       | $                        | 35         |   | $ | 3,762 |   | $ | 3,656 |   | $ | 106 |   |
| Payroll taxes                     |       | 158                                  |       | 160                        |       | (2                                 | )          | 379                      |       | 345 |   | 34 |   |
| Insurance                         |       | 148                                  |       | 143                        |       | 5                                  |       | 292                      |       | 283 |   | 9 |   |
| ESOP expense (1)                  |       | 394                                  |       | 278                        |       | 116                                |       | 804                      |       | 525 |   | 279 |   |
| MRP expense (2)                   |       | 7                                    |       | 31                         |       | (24                                | )          | 13                       |       | 31 |   | (18 | ) |
| Defined benefit plan contribution |       | 122                                  |       | 54                         |       | 68                                 |       | 113                      |       | 108 |   | 5 |   |
| Other                             |       | 35                                   |       | 32                         |       | 3                                  |       | 74                       |       | 63 |   | 11 |   |
| Total                             |       | $                                    | 2,758      |                       | $          | 2,557                              |       | $                        | 201        |   | $ | 5,437 |   | $ | 5,011 |   | $ | 426 |   |

 

----

(1)          Employee Stock Ownership Plan

(2)          Management Recognition and Retention Plan

 

The increase in salaries and employeebenefits for both the three and six month comparative periods was due primarilyto increases in ESOP expense. The increase in ESOP expense was due to anincrease in the Company’s average stock price in 2004 compared to the sameperiods in 2003.  The increase insalaries was due to an increase in personnel and normal salary and meritincreases.  Payroll taxes for the sixmonths ended June 30, 2004 increased due to the increase in salaries andthe exercise of stock options.

 

17

----

 

**Net occupancy expense. **The changes in thecomposition of this line item are presented below (in thousands):

 
| ** **                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Six Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|----------------------------|------------|------------------------------------|------------|--------------------------|------------|
| ** **                                 | ** ** | **2004**                             | ** ** | **2003**                   | ** ** | **2004 vs 2003**                   | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2004 vs 2003** | ** ** |
| Depreciation                               |       | $                                    | 276        |                       | $          | 253                                |       | $                        | 23         |   | $ | 551 |   | $ | 475 |   | $ | 76 |   |
| Furniture, fixtures, and equipment expense |       | 54                                   |       | 147                        |       | (93                                | )          | 91                       |       | 163 |   | (72 | ) |
| Utilities                                  |       | 51                                   |       | 45                         |       | 6                                  |       | 110                      |       | 83 |   | 27 |   |
| Building repairs and maintenance           |       | 66                                   |       | 37                         |       | 29                                 |       | 128                      |       | 75 |   | 53 |   |
| Taxes and insurance                        |       | 47                                   |       | 28                         |       | 19                                 |       | 89                       |       | 54 |   | 35 |   |
| Rent                                       |       | 16                                   |       | 17                         |       | (1                                 | )          | 33                       |       | 36 |   | (3 | ) |
| Total                                      |       | $                                    | 510        |                       | $          | 527                                |       | $                        | (17        | ) | $ | 1,002 |   | $ | 886 |   | $ | 116 |   |

 

The decrease in net occupancy expense for thethree month comparative period was primarily due to furniture and accessoriesfor the new corporate office that opened June 2, 2003.  Furniture and accessories totaling $120,000were expensed in the three months ended June 30, 2003.  This decrease was offset by increases indepreciation, building repairs and maintenance, and taxes and insurance relatedto three months of expense associated with the new corporate office in 2004compared to one month in the 2003 comparable period.

 

The increase in net occupancy expense for thesix month comparative period was due primarily to increases in depreciation,building repairs and maintenance, and taxes and insurance related to six monthsof expense associated with the new corporate office in 2004 compared to onemonth in the 2003, offset by the decrease in furniture, fixtures and equipmentexpense discussed above.

 

**Advertising and public relations.**  The increase in advertising and publicrelations for the three and six month comparative periods was due to costsincurred in the second quarter associated with the new checking accountmarketing program, including direct mail, “thank you” gifts, marketing brochures,posters, and billboards.  Approximately$117,000 of the increase in both periods was due to this program.

 

**Contributions.** Contributions expense decreased in both thethree and six month periods ended June 30 mainly due to the contributionof real estate discussed above.  The fairvalue of the donated real estate of $500,000 is included in contributionsexpense for both the three and six months ended June 30, 2003.

 

**Other expenses.**  The changes in the composition of this lineitem are presented below (in thousands):

 
| ** **                     | ** ** | **Three Months Ended June 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Six Months Ended June 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|--------------------------------|------------|--------------------------------------|------------|----------------------------|------------|------------------------------------|------------|--------------------------|------------|
| ** **                     | ** ** | **2004**                             | ** ** | **2003**                   | ** ** | **2004 vs 2003**                   | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2004 vs 2003** | ** ** |
| Consultant and management fees |       | $                                    | 111        |                       | $          | 82                                 |       | $                        | 29         |   | $ | 204 |   | $ | 100 |   | $ | 104 |   |
| Other                          |       | 1,136                                |       | 1,168                      |       | (32                                | )          | 2,215                    |       | 2,209 |   | 6 |   |
| Total                          |       | $                                    | 1,247      |                       | $          | 1,250                              |       | $                        | (3         | ) | $ | 2,419 |   | $ | 2,309 |   | $ | 110 |   |

 

Other expenses increased in the six monthcomparative period primarily due to consultant and management fees.  These fees increased primarily due to feespaid to a consulting firm for assistance in promotion of checking accounts.

 

**IncomeTaxes.**

 

The increase in income tax expense for thethree month comparable periods ended June 30 was primarily due to anincrease in taxable income and, to a lesser extent, an increase in theeffective tax rate.  The increase in theeffective

 

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tax rate from 27.8% for the second quarter of2003 to 32.0% for the second quarter of 2004 was attributable to the non-recurringtax benefit in 2003 resulting from the contribution of real estate.

 

The increase in income tax expense for thesix month comparable periods ended June 30 was primarily due to anincrease in the effective tax rate.  Theincrease in the effective tax rate from 30.2% for the six months endedJune 30, 2003 to 31.8% for the six months ended June 30, 2004 wasattributable to the non-recurring tax benefit in 2003 resulting from thecontribution of real estate.

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

The Company, in the normal course ofbusiness, makes commitments to buy or sell assets or to incur or fundliabilities.  Commitments include, butare not limited to:

 

•                  the origination,purchase or sale of loans;

•                  the purchase ofinvestment securities;

•                  the fulfillmentof commitments under letters-of-credit, extensions of credit on home equitylines of credit, construction loans, and predetermined overdraft protectionlimits; and

•                  the commitmentto fund withdrawals of certificates of deposit at maturity.

 

At June 30, 2004, the Bank’s off-balancesheet arrangements principally included lending commitments, which aredescribed below.  At June 30, 2004,the Company had no interests in non-consolidated special purpose entities.

 

At June 30, 2004, commitments included:

 

•                  total approvedcommitments to originate loans amounting to $19.5 million, including $7.7million of loans committed to sell;

•                  total approvedcommitments to purchase loans of $5 million;

•                  rate lockagreements with customers of $7.7 million, all of which have been locked withan investor;

•                  funded mortgageloans committed to sell of $2.6 million;

•                  unadvancedportion of construction loans of $52.2 million;

•                  unused lines ofcredit of $20.0 million;

•                  outstandingstandby letters of credit of $1.8 million;

•                  totalpredetermined overdraft protection limits of $9.9 million; and

•                  certificates ofdeposit scheduled to mature in one year or less totaling $162.4 million.

 

Total unfunded commitments to originate loansfor sale and the related commitments to sell of $7.7 million meet thedefinition of a derivative financial instrument.  The related asset and liability areconsidered immaterial at June 30, 2004.

 

Historically, a very small percentage ofpredetermined overdraft limits have been used. At June 30, 2004, overdrafts of accounts with Bounce ProtectionTMrepresented usage of 2.2% of the limit. We expect utilization of these overdraft limits to remain at comparablelevels in the future.

 

Based on historical experience, managementbelieves that a significant portion of maturing deposits will remain with theBank.  We anticipate that we willcontinue to have sufficient funds, through repayments, deposits and borrowings,to meet our current commitments.

 

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### **LIQUIDITY AND CAPITAL RESOURCES**

###  

The Bank’s liquidity,represented by cash and cash equivalents and eligible investment securities, isa product of its operating, investing and financing activities.  The Bank’s primary sources of funds aredeposits, collections on outstanding loans, maturities and calls of investmentsecurities and other short-term investments and funds provided fromoperations.  While scheduled loanamortization and maturing investment securities and short-term investments arerelatively predictable sources of funds, deposit flows and loan prepayments aregreatly influenced by general interest rates, economic conditions andcompetition.  The Bank manages thepricing of its deposits to maintain a steady deposit balance.  In addition, the Bank invests excess funds inovernight deposits and other short-term interest-earning assets which provideliquidity to meet lending requirements. The Bank has generally been able to generate enough cash through theretail deposit market, its traditional funding source, to offset the cashutilized in investing activities.  As anadditional source of funds, the Bank has borrowed from the FHLB of Dallas.  At June 30, 2004, available borrowingcapacity with the FHLB was approximately $195 million.

 

Liquidity management is botha daily and long-term function of business management.  Excess liquidity is generally invested inshort-term investments such as overnight deposits and certificates of deposit.  On a longer-term basis, the Bank maintains astrategy of investing in various lending products.  The Bank uses its sources of funds primarilyto meet its ongoing commitments, to pay maturing savings certificates andsavings withdrawals, to repay maturing FHLB of Dallas advances, and to fundloan commitments.

 

As of June 30, 2004, theBank’s regulatory capital was in excess of all applicable regulatoryrequirements.  At June 30, 2004, theBank’s tangible, core and risk-based capital ratios amounted to 10.22%, 10.22%and 15.04%, respectively, compared to regulatory requirements of 1.5%, 4.0% and8.0%, respectively.

 

### **IMPACT OF INFLATION AND CHANGING PRICES**

###  

The financial statements and relatedfinancial data presented herein have been prepared in accordance with generallyaccepted accounting principles, which require the measurement of financialposition and operating results in terms of historical dollars, withoutconsidering changes in relative purchasing power over time due to inflation.

 

Unlike most industrial companies,virtually all of the Bank’s assets and liabilities are monetary in nature.  As a result, interest rates generally have amore significant impact on a financial institution’s performance than does theeffect of inflation.

 

### **FORWARD-LOOKINGSTATEMENTS**

###  

The Company’s Quarterly Report on Form 10-Qcontains certain forward-looking statements and information relating to theCompany that are based on the beliefs of management as well as assumptions madeby and information currently available to management.  In addition, in this document, thewords “anticipate”, “believe,” “estimate,”****“expect,”“intend,” “should” and similar expressions, or the negative thereof, as theyrelate to the Company or the Company’s management, are intended to identifyforward-looking statements.  Suchstatements reflect the current views of the Company with respect to futurelooking events and are subject to certain risks, uncertainties andassumptions.  Should one or more of theserisks or uncertainties materialize or should underlying assumptions prove incorrect,actual results may vary materially from those described herein as anticipated,believed, estimated, expected or intended. The Company does not intend to update these forward-looking statements.

 

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**QUANTITATIVE AND QUALITATIVE DISCLOSURES**

**ABOUT MARKET RISK**

 

For a discussion of the Company’s asset andliability management policies as well as the potential impact of interest ratechanges upon the market value of the Bank’s portfolio equity, see “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” inthe Company’s 2003 Annual Report to Stockholders.  There has been no material change in theCompany’s asset and liability position or the market value of the Bank’s portfolioequity since December 31, 2003.

 

**CONTROLSAND PROCEDURES**

 

Our management evaluated, with theparticipation of our Chief Executive Officer and Chief Financial Officer, theeffectiveness of our disclosure controls and procedures (as defined in Rules13a-15e and 15d-15e) under the Securities Exchange Act of 1934) as of the endof the period covered by this report. Based on such evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and procedures aredesigned to ensure that information required to be disclosed by us in thereports that we file or submit under the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and regulations and are operating in an effective manner.

 

No change in our internal control overfinancial reporting (as defined in Rules 13a-15f and 15d-15f under theSecurities Exchange Act of 1934) occurred during the most recent fiscal quarterthat has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

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**FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.**

 

**PartII**

 

Item 1.                                     LegalProceedings

 

Neither theCompany nor the Bank is involved in any pending legal proceedings other thannon-material legal proceedings occurring in the ordinary course of business.

 

Item 2.                                     Changes inSecurities, Use of Proceeds, and Issuer Purchases of Equity Securities

 

ISSUER PURCHASES OF EQUITYSECURITIES

 
| **Period**                   | ** ** | **(a) Total  Number of  Shares  Purchased** | ** ** | **(b) Average  Price Paid  per Share** | ** ** | **(c) Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **(d) Maximum Number  of Shares that May Yet  Be Purchased Under the  Plans or Programs** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
|                         |       |                                        |       |                                   |       |                                                                                         |       |                                                                                      |       |
| May 27 to  June 7, 2004 |       | 157,700                                     |       | $                                      | 20.27      |                                                                                         | 157,700    |                                                                                      | 250,591    |   |
|                              |            |                                             |            |                                        |            |                                                                                              |            |                                                                                           |            |  |

 

During the quarter endedJune 30, 2004, the Company completed its 15th announcedrepurchase program and began its 16th program.  The 16th announced repurchase program wasapproved by the board of directors on May 26, 2004, and publicly announced onJune 8, 2004. Total shares approved to be purchased in this program are260,257, of which 9,666 have been purchased as of June 30, 2004.  All treasury stock purchases are made underpublicly announced repurchase programs.

 

Item 3.                                     DefaultsUpon Senior Securities

 

Not applicable.

 

Item 4.                                     Submissionof Matters to a Vote of Security Holders

 

On April 28, 2004, theCorporation held an annual meeting of stockholders for the following purposes:

 

(1)                          To elect two directors for a term of threeyears; and

 

(2)                          Toratify the appointment by the Board of Directors of Deloitte and Touche LLP asthe Corporation’s independent auditors for the year ending December 31,2004.

 

The results of the voting areset forth below:

 

Proposal One (Election of Directors):

 
| **NAME**        | ** ** | **FOR**   | ** ** | **AGAINST/  WITHHELD** | ** ** | **NOT  VOTED** | ** ** |
|-----------------|------------|-----------|------------|------------------------|------------|----------------|------------|
| Larry J. Brandt |       | 4,646,084 |       | 110,682                |       | 558,490        |       |
| Frank Conner    |       | 4,754,760 |       | 2,006                  |       | 558,490        |       |

 

Proposal Two (Ratification of Auditors):

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **NOT  VOTED** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|----------------|------------|
| 4,733,078 |       | 5,596       |       | 18,092      |       | 558,490        |       |

 

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Item 5.                                     OtherInformation

 

None.

 

Item 6.                                     Exhibitsand Reports on Form 8-K

 

Exhibit 31.1 – Certification ofChief Executive Officer

Pursuant toSection 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

Exhibit 31.2 – Certification ofChief Financial Officer

Pursuant toSection 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

Exhibit 32.1 – Certification ofChief Executive Officer,

Pursuant toSection 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

Exhibit 32.2 – Certification ofChief Financial Officer,

Pursuant toSection 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. 1350)

 

Reports on Form 8-K

On April 28, 2004, a Form8-K was filed for the Company’s April 28, 2004 press release thatannounced results of operations for the quarter ended March 31, 2004.

 

On May 4, 2004, a Form 8-K wasfiled for the Company’s May 3, 2004 press release that announced the reductionin the Board of Directors to five members and the designation of James DavidHeuer as an honorary director.

 

On May 26, 2004, a Form 8-K wasfiled for the Company’s May 26, 2004 press release that announced a quarterlycash dividend of $.10 per share.

 

On June 8, 2004, a Form8-K was filed for the Company’s June 8, 2004 press release that announcedstock repurchase program activity.

 

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**SIGNATURES**

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|                            | **FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.** |
|---------------------------------|------------------------------------------------|
|                            |                                           |   |   |
|                            |                                           |   |   |
| Date:  August 5, 2004 |                                           | By: | /s/Larry J.  Brandt |   |
|                            |                                           |   | Larry J.  Brandt |
|                            |                                           |   | President/CEO |
|                            |                                           |   |   |
|                            |                                           |   |   |
| Date:  August 5, 2004 |                                           | By: | /s/Sherri R.  Billings |   |
|                            |                                           |   | Sherri R.  Billings |
|                            |                                           |   | EVP/CFO |

 

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