**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                      |
|------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                              |
|       |       | **For the  quarterly period ended September 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**                                                                                                                                                                                |

 

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

(Exact name of registrant as specified in itscharter)

 

| **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, includingarea code)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.
| Yes   ý | No   o |
|-----------------------------|-----------------------|

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange 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 October 25,2004, there were issued and outstanding 5,135,804 shares of the Registrant’sCommon Stock, par value $.01 per share.

 

 

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

 

**TABLE OF CONTENTS**

 
| **Part I.**    | **Financial Information**                                                                                                                                 | **Page**   |
|----------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|           |                                                                                                                                                      |       |
| Item 1.        | Consolidated  Financial Statements                                                                                                                        |       |
|           |                                                                                                                                                      |       |
|           | Consolidated Statements of Financial  Condition as of September 30, 2004 and December 31, 2003 (unaudited)                                                | 1          |
|           |                                                                                                                                                      |       |
|           | Consolidated Statements of Income for the  three and nine months ended September 30, 2004 and 2003 (unaudited)                                            | 2          |
|           |                                                                                                                                                      |       |
|           | Consolidated Statement of Stockholders’  Equity for the nine months ended September 30, 2004 (unaudited)                                             | 3          |
|           |                                                                                                                                                      |       |
|           | Consolidated Statements of Cash Flows for  the nine months ended September 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.        | Unregistered Sales of Equity Securities and  Use of Proceeds                                                                                              | 22         |
| Item 3.        | Defaults Upon Senior Securities                                                                                                                           | 22         |
| Item 4.        | Submission of Matters to a Vote of Security  Holders                                                                                                      | 22         |
| Item 5.        | Other Information                                                                                                                                         | 22         |
| Item  6.       | Exhibits                                                                                                                                                  | 22         |
|           |                                                                                                                                                      |       |
| **Signatures** | ** **                                                                                                                                                | 23         |
|           |                                                                                                                                                      |       |
| **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)

 
| ** **                                                                                                                                                                                   | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ASSETS                                                                                                                                                                                       |       |                    |       |                   |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                                                                                                    |       | $                       | 13,015     |                   | $          | 56,201 |   |
| Investment securities held to maturity                                                                                                                                                       |       | 68,347                  |       | 80,379                 |       |
| Federal Home Loan Bank stock                                                                                                                                                                 |       | 3,825                   |       | 3,749                  |       |
| Loans receivable, net                                                                                                                                                                        |       | 603,613                 |       | 512,756                |       |
| Accrued interest receivable                                                                                                                                                                  |       | 4,376                   |       | 4,089                  |       |
| Real estate acquired in settlement of  loans, net                                                                                                                                            |       | 340                     |       | 822                    |       |
| Office properties and equipment, net                                                                                                                                                         |       | 14,511                  |       | 14,238                 |       |
| Cash surrender value of life insurance                                                                                                                                                       |       | 17,699                  |       | 17,102                 |       |
| Prepaid expenses and other assets                                                                                                                                                            |       | 612                     |       | 1,317                  |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| TOTAL ASSETS                                                                                                                                                                                 |       | $                       | 726,338    |                   | $          | 690,653 |   |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                    |       |                    |       |                   |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| LIABILITIES:                                                                                                                                                                                 |       |                    |       |                   |       |
| Deposits                                                                                                                                                                                     |       | $                       | 582,394    |                   | $          | 573,580 |   |
| Federal Home Loan Bank advances                                                                                                                                                              |       | 65,219                  |       | 39,562                 |       |
| Advance payments by borrowers for taxes and  insurance                                                                                                                                       |       | 634                     |       | 725                    |       |
| Other liabilities                                                                                                                                                                            |       | 3,248                   |       | 1,708                  |       |
| Total liabilities                                                                                                                                                                            |       | 651,495                 |       | 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, 5,133,804 and 5,340,086 shares  outstanding at September 30, 2004 and December 31, 2003, respectively |       | 103                     |       | 103                    |       |
| Additional paid-in capital                                                                                                                                                                   |       | 54,011                  |       | 52,950                 |       |
| Employee stock benefit plans                                                                                                                                                                 |       | (693                    | )          | (1,025                 | )          |
| Retained earnings-substantially restricted                                                                                                                                                   |       | 76,804                  |       | 72,634                 |       |
|                                                                                                                                                                                         |       | 130,225                 |       | 124,662                |       |
| Treasury stock, at cost, 5,173,698 and  4,967,416 shares at September 30, 2004 and December 31, 2003, respectively                                                                           |       | (55,382                 | )          | (49,584                | )          |
| Total stockholders’ equity                                                                                                                                                              |       | 74,843                  |       | 75,078                 |       |
|                                                                                                                                                                                         |       |                    |       |                   |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                              |       | $                       | 726,338    |                   | $          | 690,653 |   |

 

See notes to unauditedconsolidated financial statements.

 

1

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

**CONSOLIDATEDSTATEMENTS OF INCOME**

(In thousands, except share data)

(Unaudited)

 
| ** **                                           | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| INTEREST INCOME:                                     |       |                    |       |                    |       |   |   |   |   |
| Loans receivable                                     |       | $                       | 9,160      |                    | $          | 8,450 |   | $ | 26,234 |   | $ | 25,842 |   |
| Investment securities:                               |       |                    |       |                    |       |   |   |   |   |
| Taxable                                              |       | 727                     |       | 702                     |       | 2,299 |   | 2,579 |   |
| Nontaxable                                           |       | 178                     |       | 143                     |       | 515 |   | 362 |   |
| Other                                                |       | 18                      |       | 180                     |       | 128 |   | 498 |   |
| Total interest income                                |       | 10,083                  |       | 9,475                   |       | 29,176 |   | 29,281 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| INTEREST EXPENSE:                                    |       |                    |       |                    |       |   |   |   |   |
| Deposits                                             |       | 3,178                   |       | 3,459                   |       | 9,472 |   | 11,247 |   |
| FHLB advances                                        |       | 442                     |       | 340                     |       | 1,087 |   | 1,058 |   |
| Total interest expense                               |       | 3,620                   |       | 3,799                   |       | 10,559 |   | 12,305 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| NET INTEREST INCOME                                  |       | 6,463                   |       | 5,676                   |       | 18,617 |   | 16,976 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| PROVISION FOR LOAN LOSSES                            |       | 202                     |       | 204                     |       | 663 |   | 619 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| NET INTEREST INCOME AFTER PROVISION FOR  LOAN LOSSES |       | 6,261                   |       | 5,472                   |       | 17,954 |   | 16,357 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| NONINTEREST INCOME:                                  |       |                    |       |                    |       |   |   |   |   |
| Deposit fee income                                   |       | 883                     |       | 667                     |       | 2,378 |   | 1,869 |   |
| Earnings on life insurance policies                  |       | 190                     |       | 211                     |       | 597 |   | 637 |   |
| Gain on sale of loans                                |       | 141                     |       | 600                     |       | 463 |   | 1,512 |   |
| Gain on contributed assets                           |       | —                  |       | —                  |       | — |   | 414 |   |
| Other                                                |       | 359                     |       | 383                     |       | 1,150 |   | 1,117 |   |
| Total noninterest income                             |       | 1,573                   |       | 1,861                   |       | 4,588 |   | 5,549 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| NONINTEREST EXPENSES:                                |       |                    |       |                    |       |   |   |   |   |
| Salaries and employee benefits                       |       | 2,830                   |       | 2,644                   |       | 8,266 |   | 7,654 |   |
| Net occupancy expense                                |       | 493                     |       | 484                     |       | 1,494 |   | 1,371 |   |
| Data processing                                      |       | 394                     |       | 409                     |       | 1,191 |   | 1,163 |   |
| Professional fees                                    |       | 117                     |       | 67                      |       | 346 |   | 261 |   |
| Advertising and public relations                     |       | 294                     |       | 165                     |       | 726 |   | 468 |   |
| Postage and supplies                                 |       | 149                     |       | 193                     |       | 497 |   | 576 |   |
| Contributions                                        |       | 15                      |       | 4                       |       | 24 |   | 523 |   |
| Other                                                |       | 442                     |       | 581                     |       | 1,487 |   | 1,558 |   |
| Total noninterest expenses                           |       | 4,734                   |       | 4,547                   |       | 14,031 |   | 13,574 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| INCOME BEFORE INCOME TAXES                           |       | 3,100                   |       | 2,786                   |       | 8,511 |   | 8,332 |   |
| INCOME TAX PROVISION                                 |       | 1,002                   |       | 914                     |       | 2,723 |   | 2,589 |   |
| NET INCOME                                           |       | $                       | 2,098      |                    | $          | 1,872 |   | $ | 5,788 |   | $ | 5,743 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| EARNINGS PER SHARE:                                  |       |                    |       |                    |       |   |   |   |   |
| Basic                                                |       | $                       | 0.42       |                    | $          | 0.37 |   | $ | 1.14 |   | $ | 1.13 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| Diluted                                              |       | $                       | 0.39       |                    | $          | 0.35 |   | $ | 1.07 |   | $ | 1.07 |   |
|                                                 |       |                    |       |                    |       |   |   |   |   |
| Cash Dividends Declared                              |       | $                       | 0.11       |                    | $          | 0.09 |   | $ | 0.31 |   | $ | 0.25 |   |

 

See notes to unaudited consolidated financialstatements.

 

2

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

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’EQUITY**

**FOR THE NINE MONTHS ENDED SEPTEMBER 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                                                 |   |       |   |   |   |                             |   |                                |   | 5,788                  |   |
| Release of ESOP shares                                     |   |       |   |   |   | 949                              |   | 312                                 |   |                   |   |
| Tax effect of stock compensation plan                      |   |       |   |   |   | 211                              |   |                                |   |                   |   |
| Treasury shares reissued due to exercise of  stock options |   |       |   |   |   | (99                              | )      |                                |   |                   |   |
| Purchase of treasury stock, at cost                        |   |       |   |   |   |                             |   |                                |   |                   |   |
| Vesting of MRP shares                                      |   |       |   |   |   |                             |   | 20                                  |   |                   |   |
| Dividends paid                                             |   |       |   |   |   |                             |   |                                |   | (1,618                 | )      |
|                                                       |   |       |   |   |   |                             |   |                                |   |                   |   |
| Balance, September 30, 2004                                |   | 10,307,502 |   | $      | 103    |                             | $      | 54,011                              |   | $                      | (693   | ) | $ | 76,804 |   |

 
|                                                       |   |       |   |   |    | **Total  Stockholders’  Equity** |   | ** ** |   | ** ** |   |
|------------------------------------------------------------|--------|------------|--------|--------|---------|---------------------------------------|--------|------------|--------|------------|--------|
| **Treasury Stock**                                         |
| **Shares**                                                 |   | **Amount** |
|                                                       |   |       |   |   |    |                                  |   |       |   |       |   |
| Balance, January 1, 2004                                   |   | 4,967,416  |   | $      | (49,584 | )                                     | $      | 75,078     |   |       |   |   |   |   |   |
| Net income                                                 |   |       |   |   |    |                                  |   | 5,788      |   |       |   |   |   |   |   |
| Release of ESOP shares                                     |   |       |   |   |    |                                  |   | 1,261      |   |       |   |   |   |   |   |
| Tax effect of stock compensation plan                      |   |       |   |   |    |                                  |   | 211        |   |       |   |   |   |   |   |
| Treasury shares reissued due to exercise of  stock options |   | (153,418   | )      |   | 1,575   |                                  |   | 1,476      |   |       |   |   |   |   |   |
| Purchase of treasury stock, at cost                        |   | 359,700    |   |   | (7,373  | )                                     |   | (7,373     | )      |       |   |   |   |   |   |
| Vesting of MRP shares                                      |   |       |   |   |    |                                  |   | 20         |   |       |   |   |   |   |   |
| Dividends paid                                             |   |       |   |   |    |                                  |   | (1,618     | )      |       |   |   |   |   |   |
|                                                       |   |       |   |   |    |                                  |   |       |   |       |   |   |   |   |   |
| Balance, September 30, 2004                                |   | 5,173,698  |   | $      | (55,382 | )                                     | $      | 74,843     |   |       |   |   |   |   |   |

 

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)

 
| ** **                                                                         | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                                                                               |       |                                |       |   |   |
| OPERATING ACTIVITIES:                                                              |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 5,788      |   | $ | 5,743 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                |       |   |   |
| Provision for loan losses                                                          |       | 663                                 |       | 619 |   |
| Provision for real estate losses                                                   |       | 32                                  |       | 34 |   |
| Deferred tax provision (benefit)                                                   |       | (140                                | )          | (29 | ) |
| Accretion of discounts on investment  securities, net                              |       | (34                                 | )          | (66 | ) |
| Federal Home Loan Bank stock dividends                                             |       | (44                                 | )          | (89 | ) |
| (Gain) loss on disposition of office  properties and equipment                     |       | (38                                 | )          | 90 |   |
| (Gain) loss on sale of repossessed assets,  net                                    |       | (1                                  | )          | 5 |   |
| Originations of loans held for sale                                                |       | (35,354                             | )          | (107,100 | ) |
| Proceeds from sales of loans                                                       |       | 36,213                              |       | 113,441 |   |
| Gain on sale of loans originated to sell                                           |       | (463                                | )          | (1,512 | ) |
| Depreciation                                                                       |       | 887                                 |       | 842 |   |
| Amortization (accretion) of deferred loan  fees, net                               |       | 49                                  |       | (350 | ) |
| Release of ESOP shares                                                             |       | 1,261                               |       | 921 |   |
| MRP compensation expense                                                           |       | 20                                  |       | 38 |   |
| Earnings on life insurance policies                                                |       | (597                                | )          | (637 | ) |
| Changes in operating assets and  liabilities:                                      |       |                                |       |   |   |
| Accrued interest receivable                                                        |       | (287                                | )          | 462 |   |
| Prepaid expenses and other assets                                                  |       | 700                                 |       | 79 |   |
| Other liabilities                                                                  |       | 541                                 |       | 77 |   |
| Net cash provided by operating activities                                          |       | 9,196                               |       | 12,568 |   |
|                                                                               |       |                                |       |   |   |
| INVESTING ACTIVITIES:                                                              |       |                                |       |   |   |
| Purchases of investment securities held to  maturity                               |       | (84,744                             | )          | (245,963 | ) |
| Proceeds from maturities/calls of  investment securities held to maturity          |       | 97,810                              |       | 274,027 |   |
| Purchases of FHLB stock                                                            |       | (711                                | )          | — |   |
| Redemptions of FHLB stock                                                          |       | 679                                 |       | — |   |
| Loan participations sold                                                           |       | 3,970                               |       | — |   |
| Loan originations, net of repayments                                               |       | (96,045                             | )          | (13,705 | ) |
| Proceeds from sales of repossessed assets                                          |       | 582                                 |       | 599 |   |
| Proceeds from sales of office properties  and equipment                            |       | 581                                 |       | 38 |   |
| Purchases of office properties and  equipment                                      |       | (1,369                              | )          | (4,772 | ) |
| Net cash provided by (used in) investing  activities                               |       | (79,247                             | )          | 10,224 |   |
|                                                                               |       |                                |       |   |   |
| FINANCING ACTIVITIES:                                                              |       |                                |       |   |   |
| Net increase in deposits                                                           |       | 8,814                               |       | 4,135 |   |
| Advances from FHLB                                                                 |       | 41,733                              |       | 20,000 |   |
| Repayment of advances from FHLB                                                    |       | (16,076                             | )          | (15,088 | ) |
| Net decrease in advance payments by  borrowers for taxes and insurance             |       | (91                                 | )          | (247 | ) |
| Purchase of treasury stock                                                         |       | (7,373                              | )          | (2,367 | ) |
| Reissued treasury stock                                                            |       | 1,476                               |       | 1,065 |   |
| Dividends paid                                                                     |       | (1,618                              | )          | (1,334 | ) |
| Net cash provided by financing activities                                          |       | 26,865                              |       | 6,164 |   |
|                                                                               |       |                                |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                              |       | (43,186                             | )          | 28,956 |   |
|                                                                               |       |                                |       |   |   |
| CASH AND CASH EQUIVALENTS:                                                         |       |                                |       |   |   |
| Beginning of period                                                                |       | $                                   | 56,201     |   | $ | 44,493 |   |
| End of period                                                                      |       | $                                   | 13,015     |   | $ | 73,449 |   |
|                                                                               |       |                                |       |   |   |
| SUPPLEMENTAL DISCLOSURES OF CASH FLOW  INFORMATION:                                |       |                                |       |   |   |
| Cash paid for:                                                                     |       |                                |       |   |   |
| Interest                                                                           |       | $                                   | 10,517     |   | $ | 12,379 |   |
| Income taxes                                                                       |       | $                                   | 2,294      |   | $ | 2,489 |   |
|                                                                               |       |                                |       |   |   |
| SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING  ACTIVITIES:                            |       |                                |       |   |   |
| Real estate and other assets acquired in  settlement of loans                      |       | $                                   | 307        |   | $ | 1,714 |   |
| Loans to facilitate sales of real estate  owned                                    |       | $                                   | 197        |   | $ | 456 |   |
| Investment securities traded, recorded in  investments not yet settled in cash     |       | $                                   | 1,000      |   | $ | 3,000 |   |

 

See notes to unauditedconsolidated financial statements.

 

4

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

 

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1 -Basis of Presentation and Principles of Consolidation**

 

First Federal Bancshares of Arkansas, Inc.(the “Company”) is a unitary holding company which owns all of the stock ofFirst Federal Bank of Arkansas, FA (the “Bank”).  The Bank provides a broad line of financialproducts to individuals and small- to medium-sized businesses in Northwest andNorthcentral Arkansas.  The consolidatedfinancial statements also include the accounts of the Bank’s wholly-ownedsubsidiary, First Harrison Service Corporation (“FHSC”), which is inactive.

 

The accompanying unaudited consolidatedfinancial statements of the Company have been prepared in accordance withinstructions to Form 10-Q.  Accordingly,they do not include all of the information and footnotes required by generallyaccepted accounting principles for complete financial statements.  However, such information reflects alladjustments which are, in the opinion of management, necessary for a fairstatement of results for the interim periods.

 

The accompanying unaudited consolidatedfinancial statements include the accounts of the Company and the Bank.  All material intercompany transactions havebeen eliminated in consolidation.

 

The results of operations for the nine months ended September 30, 2004,are not necessarily indicative of the results to be expected for the yearending December 31, 2004.  The unauditedconsolidated financial statements and notes thereto should be read inconjunction with the audited financial statements and notes thereto for the yearended December 31, 2003, contained in the Company’s 2003 Annual Report toStockholders.

 

Certain amounts in the September 30, 2003,unaudited consolidated financial statements have been reclassified to conformto the classifications adopted 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 September 30, 2004 and 2003 were as follows:

 
| ** **                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Basic weighted - average shares   |       | 5,022,009                            |       | 5,105,834                           |       | 5,093,719 |   | 5,093,162 |   |
| Effect of dilutive securities     |       | 299,808                              |       | 306,972                             |       | 319,389 |   | 256,038 |   |
| Diluted weighted - average shares |       | 5,321,817                            |       | 5,412,806                           |       | 5,413,108 |   | 5,349,200 |   |

 

5

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**Note 3 –Stock Option Plan**

 

At September 30, 2004, theCompany had one stock option plan in effect covering key employees anddirectors.  The plan is more fullydescribed in the Notes to Consolidated Financial Statements included in theCompany’s 2003 Annual Report to Stockholders. The Company accounts for this plan under the recognition and measurementprinciples of APB Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related interpretations.  No stock-based employee or directorcompensation cost is recognized in net income, as all options granted under theplan had an exercise price equal to the market value of the underlying stock onthe date of grant.  The following tableillustrates the effect on net income and earnings per share if the Company hadapplied the fair value recognition provisions of FASB Statement 123, *Accounting for Stock-Based Compensation*,to stock-based employee and director compensation:

 
| ** **                 | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                 | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income (in thousands): |       |                                 |       |                                |       |   |   |   |   |
| As reported                |       | $                                    | 2,098      |                                | $          | 1,872 |   | $ | 5,788 |   | $ | 5,743 |   |
| Proforma                   |       | 2,092                                |       | 1,865                               |       | 5,774 |   | 5,727 |   |
| Earnings per share:        |       |                                 |       |                                |       |   |   |   |   |
| Basic, as reported         |       | $                                    | 0.42       |                                | $          | 0.37 |   | $ | 1.14 |   | $ | 1.13 |   |
| Basic, proforma            |       | 0.42                                 |       | 0.37                                |       | 1.13 |   | 1.12 |   |
| Diluted, as reported       |       | 0.39                                 |       | 0.35                                |       | 1.07 |   | 1.07 |   |
| Diluted, proforma          |       | 0.39                                 |       | 0.34                                |       | 1.07 |   | 1.07 |   |

 

6

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**MANAGEMENT’S DISCUSSION AND ANALYSIS**

**OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**CRITICALACCOUNTING 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 and thejudgments, 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 or local economywere 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.

 

**CHANGES INFINANCIAL CONDITION**

 

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

 
| ** **                                    | ** ** | **September  30,****2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage****Change** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|------------------------|------------|--------------------------|------------|--------------------------|------------|
| **ASSETS**                                    |       |                       |       |                   |       |                     |       |                     |       |
| Cash and cash equivalents                     |       | $                          | 13,015     |                   | $          | 56,201                   |       | $                        | (43,186    | ) | (76.8 | )% |
| Investment securities held to maturity        |       | 68,347                     |       | 80,379                 |       | (12,032                  | )          | (15.0                    | )%         |
| Loans receivable, net                         |       | 603,613                    |       | 512,756                |       | 90,857                   |       | 17.7                     | %          |
| Prepaid expenses and other assets             |       | 41,363                     |       | 41,317                 |       | 46                       |       | 0.1                      | %          |
|                                          |       |                       |       |                   |       |                     |       |                     |       |
| TOTAL                                         |       | $                          | 726,338    |                   | $          | 690,653                  |       | $                        | 35,685     |   | 5.2 | % |
|                                          |       |                       |       |                   |       |                     |       |                     |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |                       |       |                   |       |                     |       |                     |       |
| LIABILITIES:                                  |       |                       |       |                   |       |                     |       |                     |       |
| Deposits                                      |       | $                          | 582,394    |                   | $          | 573,580                  |       | $                        | 8,814      |   | 1.5 | % |
| Federal Home Loan Bank advances               |       | 65,219                     |       | 39,562                 |       | 25,657                   |       | 64.9                     | %          |
| Other liabilities                             |       | 3,882                      |       | 2,433                  |       | 1,449                    |       | 59.6                     | %          |
|                                          |       |                       |       |                   |       |                     |       |                     |       |
| Total liabilities                             |       | 651,495                    |       | 615,575                |       | 35,920                   |       | 5.8                      | %          |
|                                          |       |                       |       |                   |       |                     |       |                     |       |
| STOCKHOLDERS’ EQUITY                     |       | 74,843                     |       | 75,078                 |       | (235                     | )          | (0.3                     | )%         |
|                                          |       |                       |       |                   |       |                     |       |                     |       |
| TOTAL                                         |       | $                          | 726,338    |                   | $          | 690,653                  |       | $                        | 35,685     |   | 5.2 | % |
|                                          |       |                       |       |                   |       |                     |       |                     |       |
| BOOK VALUE PER SHARE                          |       | $                          | 14.58      |                   | $          | 14.06                    |       |                     |       |   |   |
|                                          |       |                       |       |                   |       |                     |       |                     |       |
| EQUITY TO ASSETS                              |       | 10.3                       | %          | 10.9                   | %          |                     |       |                     |       |

 

7

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**LoansReceivable. **Changes in loan composition between September 30,2004 and December 31, 2003 are presented in the following table (dollars inthousands).

 
| ** **                                     | ** ** | **September  30,****2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage****Change** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|------------------------|------------|--------------------------|------------|--------------------------|------------|
|                                           |       |                       |       |                   |       |                     |       |                     |       |
| One- to four- family residential               |       | $                          | 276,535    |                   | $          | 259,121                  |       | $                        | 17,414     |   |   |   |
| Multi-family residential                       |       | 9,683                      |       | 7,673                  |       | 2,010                    |       |                     |       |
| Commercial real estate                         |       | 136,581                    |       | 97,310                 |       | 39,271                   |       |                     |       |
| Construction                                   |       | 143,327                    |       | 89,332                 |       | 53,995                   |       |                     |       |
| Total first mortgage loans                     |       | 566,126                    |       | 453,436                |       | 112,690                  |       | 24.9                     | %          |
|                                           |       |                       |       |                   |       |                     |       |                     |       |
| Commercial                                     |       | 26,150                     |       | 21,491                 |       | 4,659                    |       | 21.7                     | %          |
|                                           |       |                       |       |                   |       |                     |       |                     |       |
| Home equity and second mortgage                |       | 44,822                     |       | 42,421                 |       | 2,401                    |       |                     |       |
| Automobile                                     |       | 20,126                     |       | 22,087                 |       | (1,961                   | )          |                     |       |
| Other                                          |       | 10,781                     |       | 10,780                 |       | 1                        |       |                     |       |
| Total consumer                                 |       | 75,729                     |       | 75,288                 |       | 441                      |       | 0.6                      | %          |
|                                           |       |                       |       |                   |       |                     |       |                     |       |
| Total loans receivable                         |       | 668,005                    |       | 550,215                |       | 117,790                  |       | 21.4                     | %          |
| Less:                                          |       |                       |       |                   |       |                     |       |                     |       |
| Undisbursed construction loan funds            |       | (62,155                    | )          | (35,181                | )          | (26,974                  | )          |                     |       |
| Unearned discounts and net deferred loan  fees |       | (501                       | )          | (657                   | )          | 156                      |       |                     |       |
| Allowance for loan losses                      |       | (1,736                     | )          | (1,621                 | )          | (115                     | )          |                     |       |
|                                           |       |                       |       |                   |       |                     |       |                     |       |
| Total loans receivable, net                    |       | $                          | 603,613    |                   | $          | 512,756                  |       | $                        | 90,857     |   | 17.7 | % |

 

Certain 2003 amounts in the table above have been reclassified toconform to the 2004 presentation.

 

The interest rate environment and robust economies of our market areashave continued to provide increased demand for our loan products.  The Bank has continued its emphasis on realestate lending, particularly commercial real estate lending, to increase theaverage yield on its portfolio, expand its operations, and provide greateropportunities to cross-sell its products. We experienced an increase in one-to four- family residential loans heldfor investment, primarily due to an increase in adjustable rate mortgages.   The $39.2 million increase in commercialreal estate lending resulted primarily from an increase of approximately $13.0 millionin land and land development loans and an increase of $8.9 million in loans onmotel properties.  The increase in landand land development loans was primarily due to loans for the purchase ordevelopment of land for residential building lots. Construction lending hascontinued to increase, with $39.9 million of the increase due to one- to four-family residential construction, $6.8 million due to multi-family construction,and $7.3 million due to commercial real estate construction.

 

8

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**AssetQuality.** Thefollowing table sets forth the amounts and categories of the Bank’snonperforming assets at the dates indicated (dollars in thousands).

 
| ** **                                                                         | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
|                                                                               |       |                    |       |                   |       |
| Nonaccrual loans:                                                                  |       |                    |       |                   |       |
| One- to four-family residential                                                    |       | $                       | 2,235      |                   | $          | 1,537 |   |
| Multi-family residential                                                           |       | —                  |       | —-                |       |
| Construction loans                                                                 |       | —                  |       | —                 |       |
| Commercial real estate                                                             |       | 246                     |       | 99                     |       |
| Commercial loans                                                                   |       | 201                     |       | 131                    |       |
| Consumer loans                                                                     |       | 526                     |       | 564                    |       |
| Total nonaccrual loans                                                             |       | 3,208                   |       | 2,331                  |       |
|                                                                               |       |                    |       |                   |       |
| Nonperforming restructured loans                                                   |       | —                  |       | 1,352                  |       |
| Real estate owned                                                                  |       | 340                     |       | 822                    |       |
|                                                                               |       |                    |       |                   |       |
| Nonperforming assets                                                               |       | $                       | 3,548      |                   | $          | 4,505 |   |
|                                                                               |       |                    |       |                   |       |
| Total nonaccrual and restructured loans as  a percentage of total loans receivable |       | 0.48                    | %          | 0.67                   | %          |
|                                                                               |       |                    |       |                   |       |
| Total nonperforming assets as a percentage  of total assets                        |       | 0.49                    | %          | 0.65                   | %          |

 

The amount of restructured loans reported atDecember 31, 2003 was comprised 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 September 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 September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                      | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Balance at beginning of period  |       | $                                    | 1,690      |                                | $          | 1,717 |   | $ | 1,621 |   | $ | 1,529 |   |
| Provisions for estimated losses |       | 202                                  |       | 204                                 |       | 663 |   | 619 |   |
| Recoveries                      |       | 30                                   |       | 13                                  |       | 79 |   | 54 |   |
| Losses charged off              |       | (186                                 | )          | (193                                | )          | (627 | ) | (461 | ) |
| Balance at end of period        |       | $                                    | 1,736      |                                | $          | 1,741 |   | $ | 1,736 |   | $ | 1,741 |   |

 

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

 
| ** **  | ** ** | **September 30,****2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** |
|-------------|------------|---------------------------|------------|------------------------|------------|--------------------------|------------|
| General     |       | $                         | 1,429      |                   | $          | 1,306                    |       | $ | 123 |   |
| Specific    |       | 257                       |       | 252                    |       | 5                        |       |
| Unallocated |       | 50                        |       | 63                     |       | (13                      | )          |
|        |       | $                         | 1,736      |                   | $          | 1,621                    |       | $ | 115 |   |

 

The allowance for loan losses is evaluated ona 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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Theallowance consists of specific, general and unallocated components. Thespecific 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 (orcollateral value or observable market price) of the impaired loan is lower thanthe carrying value of that loan. The general component covers non-classifiedloans and is based primarily on historical loss experience. An unallocatedcomponent is maintained to cover uncertainties that could affect management’sestimate of probable losses. The unallocated component of the allowancereflects the margin of imprecision inherent in the underlying assumptions usedin the methodologies for estimating specific and general losses in theportfolio.

 

The Bank reviews its non-homogeneous loansfor impairment on a quarterly basis.  TheBank considers commercial real estate, construction, multi-family, and commercialloans to be non-homogeneous loans.  Aloan is considered impaired when, based on current information and events, itis probable that the Bank will be unable to collect the scheduled payments ofprincipal or interest when due according to the contractual terms of the loanagreement.  Factors considered bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest payments whendue.  Loans that experience insignificantpayment delays and payment shortfalls generally are not classified asimpaired.  Management determines thesignificance of payment delays and payment shortfalls on a case-by-case basis,taking into consideration all of the circumstances surrounding the loan and theborrower, including the length of the delay, the reasons for the delay, theborrower’s prior payment record, and the amount of the shortfall in relation tothe principal and interest owed. Impairment is 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 balance homogeneousloans 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 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 or local economywere 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 adequate to coverlosses inherent in our loan portfolio at September 30, 2004, no assurance canbe given that we will not sustain loan losses that are significantly differentfrom the amount provided, or that subsequent evaluations of the loan portfolio,in light of factors then prevailing, would not result in a significant changein the allowance for loan losses.

 

10

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

 
| ** **                             | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** | **Increase  (Decrease)** | ** ** |
|----------------------------------------|------------|-------------------------|------------|------------------------|------------|--------------------------|------------|
| Certificates of deposit                |       | $                       | 3,000      |                   | $          | 9,000                    |       | $ | (6,000 | ) |
| U.S. Government and agency obligations |       | 49,628                  |       | 57,076                 |       | (7,448                   | )          |
| Municipal securities                   |       | 15,719                  |       | 14,303                 |       | 1,416                    |       |
| Total                                  |       | $                       | 68,347     |                   | $          | 80,379                   |       | $ | (12,032 | ) |
|                                        |            |                         |            |                        |            |                          |            |  |  |  |  |

 

During the first nine monthsof 2004, investment securities totaling $85.7 million were purchased and $97.8million 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 September 30, 2004, estimated fair values of investment securitiesheld to maturity were as follows (in thousands):

 
|                                    |   | **Amortized Cost** |   | **Fair Value** |   |
|-----------------------------------------|--------|--------------------|--------|----------------|--------|
|                                    |   | ** **         |   | ** **     |   |
| Certificates of deposit                 |   | $                  | 3,000  |           | $      | 3,000 |   |
| U.S. Government and agency  obligations |   |               | 49,628 |           |   | 49,388 |   |
| Municipal securities                    |   |               | 15,719 |           |   | 16,057 |   |
| Total                                   |   | $                  | 68,347 |           | $      | 68,445 |   |

 

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

 
| ** **              | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** | **Increase (Decrease)** | ** ** | **Percentage Change** | ** ** |
|-------------------------|------------|-------------------------|------------|------------------------|------------|-------------------------|------------|-----------------------|------------|
|                    |       |                    |       |                   |       |                    |       |                  |       |
| DDA and NOW accounts    |       | $                       | 108,160    |                   | $          | 96,090                  |       | $                     | 12,070     |   | 12.6 | % |
| Money Market accounts   |       | 111,195                 |       | 108,400                |       | 2,795                   |       | 2.6                   | %          |
| Savings accounts        |       | 31,770                  |       | 29,269                 |       | 2,501                   |       | 8.5                   | %          |
| Certificates of deposit |       | 331,269                 |       | 339,821                |       | (8,552                  | )          | (2.5                  | )%         |
|                    |       |                    |       |                   |       |                    |       |                  |       |
| Total deposits          |       | $                       | 582,394    |                   | $          | 573,580                 |       | $                     | 8,814      |   | 1.5 | % |

 

The Bank continued toexperience a change in the mix of deposits due to the low interest rateenvironment during the nine months ended September 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 checking accounts.  As part of this program, the Bank changed itschecking account offerings to make them more attractive to potential customersas well as offering “thank you” gifts with account openings and referrals.  Checking accounts are an attractive source offunds for the Bank as they offer low-interest deposits, fee income potential,and the opportunity to cross-sell other financial services.  The Bank does not advertise for depositsoutside 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 $­­­235,000from December 31, 2003 to September 30, 2004.  The decrease in stockholders’ equity wasprimarily due to the purchase of treasury stock totaling $7.4 million duringthe first nine months of 2004, offset by net income of $5.8 million and theissuance of treasury stock due to exercise of stock options of $1.5 million.  In addition, during the nine months endedSeptember 30, 2004, cash dividends of $1.6 million were paid.  See the Unaudited Consolidated Statement ofStockholders’ Equity for the nine months ended September 30, 2004 for moredetail.

 

11

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**AverageBalance Sheets**

 

The following table sets forth certain information relating to the Company’saverage balance sheets and reflects the average yield on assets and averagecost of liabilities for the periods indicated and the yields earned and ratespaid at September 30, 2004.  Such yieldsand costs are derived by dividing income or expense by the average balance ofassets or liabilities, respectively, for the periods presented.  Average balances are based on daily balancesduring the period.

 
| ** **                                                        | ** ** | **September 30,  2004** | ** ** | **Quarter Ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **                                                        | ** ** | ** **              | **2004**   | ** **                       | **2003**   | ** ** |
| ** **                                                        | ** ** | **Yield/Cost**          | ** ** | **Average  Balance**             | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | ** **              | ** ** | **(Dollars in Thousands)**       | ** ** |
| Interest-earning assets:                                          |       |                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | 6.19                    | %          | $                                | 594,460    |   | $ | 9,160 |   | 6.16 | % | $ | 492,229 |   | $ | 8,450 |   | 6.87 | % |
| Investment securities(2)                                          |       | 4.79                    |       | 75,072                           |       | 905 |   | 4.82 |   | 77,684 |   | 845 |   | 4.35 |   |
| Other interest-earning  assets                                    |       | 1.81                    |       | 5,483                            |       | 18 |   | 1.31 |   | 78,404 |   | 180 |   | .92 |   |
| Total interest-earning  assets                                    |       | 6.03                    |       | 675,015                          |       | 10,083 |   | 5.98 |   | 648,317 |   | 9,475 |   | 5.85 |   |
| Noninterest-earning assets                                        |       |                    |       | 48,247                           |       |   |   |   |   | 47,225 |   |   |   |   |   |
| Total assets                                                      |       |                    |       | $                                | 723,262    |   |   |   |   |   | $ | 695,542 |   |   |   |   |   |
| Interest-bearing  liabilities:                                    |       |                    |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 2.18                    |       | 582,552                          |       | 3,178 |   | 2.18 |   | 573,593 |   | 3,459 |   | 2.41 |   |
| FHLB advances                                                     |       | 3.07                    |       | 61,195                           |       | 442 |   | 2.89 |   | 44,886 |   | 340 |   | 3.04 |   |
| Total interest-bearing liabilities                                |       | 2.27                    |       | 643,747                          |       | 3,620 |   | 2.25 |   | 618,479 |   | 3,799 |   | 2.46 |   |
| Noninterest-bearing  liabilities                                  |       |                    |       | 4,617                            |       |   |   |   |   | 3,560 |   |   |   |   |   |
| Total liabilities                                                 |       |                    |       | 648,364                          |       |   |   |   |   | 622,039 |   |   |   |   |   |
| Stockholders’ equity                                         |       |                    |       | 74,898                           |       |   |   |   |   | 73,503 |   |   |   |   |   |
| Total liabilities and stockholders’  equity                  |       |                    |       | $                                | 723,262    |   |   |   |   |   | $ | 695,542 |   |   |   |   |   |
| Net interest income                                               |       |                    |       |                             |       | $ | 6,463 |   |   |   |   |   | $ | 5,676 |   |   |   |
| Net earning assets                                                |       |                    |       | $                                | 31,268     |   |   |   |   |   | $ | 29,838 |   |   |   |   |   |
| Interest rate spread                                              |       | 3.76                    | %          |                             |       |   |   | 3.73 | % |   |   |   |   | 3.39 | % |
| Net interest margin                                               |       |                    |       |                             |       |   |   | 3.83 | % |   |   |   |   | 3.50 | % |
| Ratio of interest-earning  assets to interest-bearing liabilities |       |                    |       |                             |       |   |   | 104.86 | % |   |   |   |   | 104.82 | % |

 
| ** **                                                        | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                        | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| ** **                                                        | ** ** | **Average  Balance**                 | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/  Cost** | ** ** |
| ** **                                                        | ** ** | **(Dollars in Thousands)**           | ** ** |
| Interest-earning assets:                                          |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Loans receivable(1)                                               |       | $                                    | 557,909    |   | $ | 26,234 |   | 6.27 | % | $ | 489,302 |   | $ | 25,842 |   | 7.04 | % |
| Investment securities(2)                                          |       | 83,700                               |       | 2,814 |   | 4.48 |   | 94,037 |   | 2,941 |   | 4.17 |   |
| Other interest-earning  assets                                    |       | 18,278                               |       | 128 |   | 0.93 |   | 63,425 |   | 498 |   | 1.05 |   |
| Total interest-earning  assets                                    |       | 659,887                              |       | 29,176 |   | 5.89 |   | 646,764 |   | 29,281 |   | 6.04 |   |
| Noninterest-earning assets                                        |       | 47,772                               |       |   |   |   |   | 44,834 |   |   |   |   |   |
| Total assets                                                      |       | 707,659                              |       |   |   |   |   | $ | 691,598 |   |   |   |   |   |
| Interest-bearing  liabilities:                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits                                                          |       | 580,284                              |       | 9,472 |   | 2.18 |   | 571,403 |   | 11,247 |   | 2.62 |   |
| FHLB advances                                                     |       | 47,138                               |       | 1,087 |   | 3.07 |   | 44,280 |   | 1,058 |   | 3.19 |   |
| Total interest-bearing liabilities                                |       | 627,422                              |       | 10,559 |   | 2.24 |   | 615,683 |   | 12,305 |   | 2.66 |   |
| Noninterest-bearing  liabilities                                  |       | 4,892                                |       |   |   |   |   | 3,896 |   |   |   |   |   |
| Total liabilities                                                 |       | 632,314                              |       |   |   |   |   | 619,579 |   |   |   |   |   |
| Stockholders’ equity                                         |       | 75,345                               |       |   |   |   |   | 72,019 |   |   |   |   |   |
| Total liabilities and stockholders’  equity                  |       | $                                    | 707,659    |   |   |   |   |   | $ | 691,598 |   |   |   |   |   |
| Net interest income                                               |       |                                 |       | $ | 18,617 |   |   |   |   |   | $ | 16,976 |   |   |   |
| Net earning assets                                                |       | $                                    | 32,465     |   |   |   |   |   | $ | 31,081 |   |   |   |   |   |
| Interest rate spread                                              |       |                                 |       |   |   | 3.65 | % |   |   |   |   | 3.38 | % |
| Net interest margin                                               |       |                                 |       |   |   | 3.76 | % |   |   |   |   | 3.50 | % |
| Ratio of interest-earning  assets to interest-bearing liabilities |       |                                 |       |   |   | 105.17 | % |   |   |   |   | 105.05 | % |

 

----

(1)   Includes nonaccrual loans.

(2)   Includes FHLB of Dallas stock.

 

12

----

 

**Rate/VolumeAnalysis**

 

The table below sets forth certain information regarding changes ininterest income and interest expense of the Company for the periodsindicated.  For each category ofinterest-earning assets and interest-bearing liabilities, information isprovided on changes attributable to (i) changes in volume (changes in averagevolume multiplied by prior rate); (ii) changes in rate (change in ratemultiplied by prior average volume); (iii) changes in rate-volume (changes inrate multiplied by the change in average volume); and (iv) the net change.

 
| ** **                          | ** ** | **Quarter Ended September  30,  2004 vs. 2003** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|
| ** **                          | ** ** | **Increase (Decrease)  Due to**                 | ** ** | **Total  Increase  (Decrease)** | ** ** |
| ** **                          | ** ** | **Volume**                                      | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                              | ** ** |
| Interest income:                    |       |                                            |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                               | 1,755      |   | $ | (865 | ) | $ | (180 | ) | $ | 710 |   |
| Investment securities               |       | (28                                             | )          | 91 |   | (3 | ) | 60 |   |
| Other interest-earning  assets      |       | (168                                            | )          | 77 |   | (71 | ) | (162 | ) |
| Total interest-earning  assets      |       | 1,559                                           |       | (697 | ) | (254 | ) | 608 |   |
|                                |       |                                            |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                            |       |   |   |   |   |   |   |
| Deposits                            |       | 54                                              |       | (330 | ) | (5 | ) | (281 | ) |
| FHLB advances                       |       | 124                                             |       | (17 | ) | (5 | ) | 102 |   |
| Total interest-bearing  liabilities |       | 178                                             |       | (347 | ) | (10 | ) | (179 | ) |
| Net change in net interest  income  |       | $                                               | 1,381      |   | $ | (350 | ) | $ | (244 | ) | $ | 787 |   |

 
| ** **                          | ** ** | **Nine Months Ended September  30,  2004 vs. 2003** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                          | ** ** | **Increase (Decrease)  Due to**                     | ** ** | **Total  Increase  (Decrease)** | ** ** |
| ** **                          | ** ** | **Volume**                                          | ** ** | **Rate** | ** ** | **Rate/  Volume** | ** ** | ** ** |
| ** **                          | ** ** | **(In Thousands)**                                  | ** ** |
| Interest income:                    |       |                                                |       |   |   |   |   |   |   |
| Loans receivable                    |       | $                                                   | 3,623      |   | $ | (2,834 | ) | $ | (397 | ) | $ | 392 |   |
| Investment securities               |       | (323                                                | )          | 220 |   | (24 | ) | (127 | ) |
| Other interest-earning  assets      |       | (355                                                | )          | (54 | ) | 39 |   | (370 | ) |
| Total interest-earning  assets      |       | 2,945                                               |       | (2,668 | ) | (382 | ) | (105 | ) |
|                                |       |                                                |       |   |   |   |   |   |   |
| Interest expense:                   |       |                                                |       |   |   |   |   |   |   |
| Deposits                            |       | 175                                                 |       | (1,920 | ) | (30 | ) | (1,775 | ) |
| FHLB advances                       |       | 68                                                  |       | (37 | ) | (2 | ) | 29 |   |
| Total interest-bearing  liabilities |       | 243                                                 |       | (1,957 | ) | (32 | ) | (1,746 | ) |
| Net change in net interest  income  |       | $                                                   | 2,702      |   | $ | (711 | ) | $ | (350 | ) | $ | 1,641 |   |

 

13

----

 

**CHANGES IN RESULTS OFOPERATIONS**

 

Thetable below presents a comparison of results of operations for the three monthsended September 30, 2004 and 2003 (dollars in thousands).  Specific changes in captions are discussed inthe sections which follow the table.

 
| ** **                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                                            | ** ** | **2004**                              | ** ** | **2003**                 | ** ** | **2004 vs 2003**       | ** ** | **2004 vs 2003** | ** ** |
| Interest income:                                      |       |                                  |       |                     |       |                   |       |   |   |
| Loans receivable                                      |       | $                                     | 9,160      |                     | $          | 8,450                  |       | $ | 710 |   |   |   |
| Investment securities                                 |       | 905                                   |       | 845                      |       | 60                     |       |   |   |
| Other                                                 |       | 18                                    |       | 180                      |       | (162                   | )          |   |   |
| Total interest income                                 |       | 10,083                                |       | 9,475                    |       | 608                    |       | 6.4 | % |
| Interest expense:                                     |       |                                  |       |                     |       |                   |       |   |   |
| Deposits                                              |       | 3,178                                 |       | 3,459                    |       | (281                   | )          |   |   |
| Other borrowings                                      |       | 442                                   |       | 340                      |       | 102                    |       |   |   |
| Total interest expense                                |       | 3,620                                 |       | 3,799                    |       | (179                   | )          | (4.7 | )% |
| Net interest income before provision for  loan losses |       | 6,463                                 |       | 5,676                    |       | 787                    |       |   |   |
| Provision for loan losses                             |       | 202                                   |       | 204                      |       | (2                     | )          |   |   |
| Net interest income after provision for  loan losses  |       | 6,261                                 |       | 5,472                    |       | 789                    |       | 14.4 | % |
| Noninterest income:                                   |       |                                  |       |                     |       |                   |       |   |   |
| Deposit fee income                                    |       | 883                                   |       | 667                      |       | 216                    |       |   |   |
| Gain on sale of loans                                 |       | 141                                   |       | 600                      |       | (459                   | )          |   |   |
| Other                                                 |       | 549                                   |       | 594                      |       | (45                    | )          |   |   |
| Total noninterest income                              |       | 1,573                                 |       | 1,861                    |       | (288                   | )          | (15.5 | )% |
| Noninterest expenses:                                 |       |                                  |       |                     |       |                   |       |   |   |
| Salaries and employee benefits                        |       | 2,830                                 |       | 2,644                    |       | 186                    |       |   |   |
| Net occupancy expense                                 |       | 493                                   |       | 484                      |       | 9                      |       |   |   |
| Advertising and public relations                      |       | 294                                   |       | 165                      |       | 129                    |       |   |   |
| Contributions                                         |       | 15                                    |       | 4                        |       | 11                     |       |   |   |
| Other                                                 |       | 1,102                                 |       | 1,250                    |       | (148                   | )          |   |   |
| Total noninterest expenses                            |       | 4,734                                 |       | 4,547                    |       | 187                    |       | 4.1 | % |
| Income before income taxes                            |       | 3,100                                 |       | 2,786                    |       | 314                    |       |   |   |
| Provision for income taxes                            |       | 1,002                                 |       | 914                      |       | 88                     |       |   |   |
| Net income                                            |       | 2,098                                 |       | 1,872                    |       | 226                    |       | 12.1 | % |
|                                                  |       |                                  |       |                     |       |                   |       |   |   |
| Basic earnings per share                              |       | $                                     | 0.42       |                     | $          | 0.37                   |       | $ | 0.05 |   | 13.5 | % |
| Diluted earnings per share                            |       | $                                     | 0.39       |                     | $          | 0.35                   |       | $ | 0.04 |   | 11.4 | % |
|                                                  |       |                                  |       |                     |       |                   |       |   |   |
| Interest rate spread                                  |       | 3.73                                  | %          | 3.39                     | %          | 0.34                   | %          | 10.0 | % |
| Net interest margin                                   |       | 3.83                                  | %          | 3.50                     | %          | 0.33                   | %          | 9.4 | % |
|                                                  |       |                                  |       |                     |       |                   |       |   |   |
| Average full-time equivalents                         |       | 244                                   |       | 254                      |       | (10                    | )          | (3.9 | )% |

 

14

----

 

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

 
| ** **                                            | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** | **Percentage  Change** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|--------------------------|------------|------------------------|------------|
| ** **                                            | ** ** | **2004**                             | ** ** | **2003**                 | ** ** | **2004 vs 2003**       | ** ** | **2004 vs 2003** | ** ** |
| Interest income:                                      |       |                                 |       |                     |       |                   |       |   |   |
| Loans receivable                                      |       | $                                    | 26,234     |                     | $          | 25,842                 |       | $ | 392 |   |   |   |
| Investment securities                                 |       | 2,814                                |       | 2,941                    |       | (127                   | )          |   |   |
| Other                                                 |       | 128                                  |       | 498                      |       | (370                   | )          |   |   |
| Total interest income                                 |       | 29,176                               |       | 29,281                   |       | (105                   | )          | (0.4 | )% |
| Interest expense:                                     |       |                                 |       |                     |       |                   |       |   |   |
| Deposits                                              |       | 9,472                                |       | 11,247                   |       | (1,775                 | )          |   |   |
| Other borrowings                                      |       | 1,087                                |       | 1,058                    |       | 29                     |       |   |   |
| Total interest expense                                |       | 10,559                               |       | 12,305                   |       | (1,746                 | )          | (14.2 | )% |
| Net interest income before provision for  loan losses |       | 18,617                               |       | 16,976                   |       | 1,641                  |       |   |   |
| Provision for loan losses                             |       | 663                                  |       | 619                      |       | 44                     |       |   |   |
| Net interest income after provision for  loan losses  |       | 17,954                               |       | 16,357                   |       | 1,597                  |       | 9.8 | % |
| Noninterest income:                                   |       |                                 |       |                     |       |                   |       |   |   |
| Deposit fee income                                    |       | 2,378                                |       | 1,869                    |       | 509                    |       |   |   |
| Gain on sale of loans                                 |       | 463                                  |       | 1,512                    |       | (1,049                 | )          |   |   |
| Gain on contributed assets                            |       | —                               |       | 414                      |       | (414                   | )          |   |   |
| Other                                                 |       | 1,747                                |       | 1,754                    |       | (7                     | )          |   |   |
| Total noninterest income                              |       | 4,588                                |       | 5,549                    |       | (961                   | )          | (17.3 | )% |
| Noninterest expenses:                                 |       |                                 |       |                     |       |                   |       |   |   |
| Salaries and employee benefits                        |       | 8,266                                |       | 7,654                    |       | 612                    |       |   |   |
| Net occupancy expense                                 |       | 1,494                                |       | 1,371                    |       | 123                    |       |   |   |
| Advertising and public relations                      |       | 726                                  |       | 468                      |       | 258                    |       |   |   |
| Contributions                                         |       | 24                                   |       | 523                      |       | (499                   | )          |   |   |
| Other                                                 |       | 3,521                                |       | 3,558                    |       | (37                    | )          |   |   |
| Total noninterest expenses                            |       | 14,031                               |       | 13,574                   |       | 457                    |       | 3.4 | % |
| Income before income taxes                            |       | 8,511                                |       | 8,332                    |       | 179                    |       |   |   |
| Provision for income taxes                            |       | 2,723                                |       | 2,589                    |       | 134                    |       |   |   |
| Net income                                            |       | 5,788                                |       | 5,743                    |       | 45                     |       | 0.8 | % |
|                                                  |       |                                 |       |                     |       |                   |       |   |   |
| Basic earnings per share                              |       | $                                    | 1.14       |                     | $          | 1.13                   |       | $ | 0.01 |   | 0.9 | % |
| Diluted earnings per share                            |       | $                                    | 1.07       |                     | $          | 1.07                   |       | $ | 0.00 |   | — |   |
|                                                  |       |                                 |       |                     |       |                   |       |   |   |
| Interest rate spread                                  |       | 3.65                                 | %          | 3.38                     | %          | 0.27                   | %          | 8.0 | % |
| Net interest margin                                   |       | 3.76                                 | %          | 3.50                     | %          | 0.26                   | %          | 7.4 | % |
|                                                  |       |                                 |       |                     |       |                   |       |   |   |
| Average full-time equivalents                         |       | 248                                  |       | 247                      |       | 1                      |       | 0.4 | % |

 

15

----

 

**NetInterest Income. **Netinterest income is determined by the Company’s interest rate spread (i.e., thedifference between the yields earned on its interest-earning assets and therates paid on its interest-bearing liabilities) and the relative amounts ofinterest-earning assets and interest-bearing liabilities.  The Company’s net interest income increaseddue to increases in interest rate spread and interest rate margin.  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.

 

**INTERESTINCOME AND INTEREST EXPENSE**

 

Dollar and percentage changesin interest income and interest expense for the comparison periods arepresented in the rate/volume analysis table which appears on page 13.

 

**InterestIncome. **Theincrease for the three month comparative period was primarily due to anincrease in the average balance of loans and an increase in the average yieldearned on investment securities, partially offset by a decrease in the averagebalance of investment securities and other interest-earning assets and adecrease in the average yield earned on loans.  The decrease for the nine month comparative period was due primarily toa decrease in the average yield earned on loans and a decrease in the averagebalance of investment securities and other interest-earning assets, offset byan increase in the average balance of loans and an increase in the averageyield earned on investment securities. The average balance of loans increased primarily due to increasedconstruction, commercial real estate, and one- to four- family loan originationactivity during 2004.  The average yieldearned on investment securities increased due to a change in the mix of theportfolio with less funds being invested in lower-yielding FHLB CDs.  The decrease in the average yield earned onloans was primarily due to an overall decline in rates during the periods andcustomers’ refinancing to lower rates. The decrease in the average balance of investment securities held to maturitywas primarily the result of called U.S. Government and agency securities andmaturing certificates of deposit.  Theaverage balance of other interest-earning assets decreased as such assets wereused to fund loan growth.

 

**InterestExpense.  **Thedecreases for both the three and nine month comparative periods were primarilydue to a decrease in the average rate paid on deposit accounts, offset slightlyby an increase in the average balance of deposits and FHLB advances.  The decrease in the average interest ratepaid on deposits was primarily the result of maturing certificates and variableinterest bearing deposits being repriced to lower interest rates.

 

**Provisionfor Loan Losses.** The provision for loan losses includes charges to maintain an allowancefor loan losses adequate to cover probable credit losses related tospecifically identified loans as well as probable credit losses inherent in theremainder of the loan portfolio that have been incurred as of the balance sheetdate.  Such provision and the adequacy ofthe allowance for loan losses is evaluated quarterly by management of the Bankbased on the Bank’s past loan loss experience, known and inherent risks in theportfolio, adverse situations that may affect the borrower’s ability to repay,the estimated value of any underlying collateral and current economicconditions.

 

While total loans receivableincreased by $117.8 million since December 31, 2003, the estimated allowancefor loan losses did not increase significantly since the majority of the growthwas in real estate loans, which have lower estimated loss rates than consumerloans.   Further, there was a decrease inthe balance of automobile loans as well as a trend of decreasing charge-offs onall categories of consumer loans except unsecured loans.   Specifically, there was a decrease of $2.0million in the balance of automobile loans as well as a decrease in automobileloan charge-offs, which accounted for approximately $161,000 of the decrease inthe allowance for loan losses on consumer loans.  Since the balance of unsecured loans is onlyapproximately $2.9 million, the increased loss rate on those loans did notmaterially affect the overall allowance for loan losses.

 

16

----

 

The composition of theallowance for loan losses at September 30, 2004 and December 31, 2003 ispresented below (in thousands):

 
| ** **                      | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|---------------------------------|------------|------------------------|------------|-----------------------|------------|
|                            |       |                   |       |                  |       |
| One- to four-family residential |       | $                      | 313        |                  | $          | 239 |   |
| Multi-family residential        |       | 39                     |       | 31                    |       |
| Commercial real estate          |       | 431                    |       | 256                   |       |
| Commercial loans                |       | 484                    |       | 404                   |       |
| Consumer loans                  |       | 419                    |       | 628                   |       |
| Unallocated                     |       | 50                     |       | 63                    |       |
| Total allowance for loan losses |       | $                      | 1,736      |                  | $          | 1,621 |   |

 

**NoninterestIncome. **Depositfee income increased 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 7.7% from September30, 2003 to September 30, 2004.  The Bankbegan aggressively promoting checking accounts in the second quarter of 2004through direct mail campaigns to expand its checking accounts and increasedeposit fee income.

 

Gain on sale of loans decreaseddue to a decrease in originations of loans for sale.  Sales of loans peaked in 2003 due to recordlow interest rates in 2003 and the resulting refinancing activity.

 

The gain on contributed assetswas recorded in connection with an adjustment of the carrying value of donatedreal estate to estimated fair value in the second quarter of 2003.  A corresponding expense in the amount of$500,000 was also recorded and is included in the balance of contributionsexpense.  The effect of this contributionis further described below.

 

**Noninterest Expense**

 

**Salariesand Employee Benefits. **Thechanges in the composition of this line item are presented below (inthousands):

 
| ** **                        | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|----------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** **                        | ** ** | **2004**                              | ** ** | **2003**                   | ** ** | **2004 vs 2003**                     | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2004 vs 2003** | ** ** |
| Salaries                          |       | $                                     | 1,947      |                       | $          | 1,821                                |       | $                        | 126        |   | $ | 5,710 |   | $ | 5,478 |   | $ | 232 |   |
| ESOP expense (1)                  |       | 426                                   |       | 329                        |       | 97                                   |       | 1,230                    |       | 853 |   | 377 |   |
| Defined benefit plan contribution |       | 121                                   |       | 165                        |       | (44                                  | )          | 234                      |       | 273 |   | (39 | ) |
| Other                             |       | 336                                   |       | 329                        |       | 7                                    |       | 1,092                    |       | 1,050 |   | 42 |   |
| Total                             |       | $                                     | 2,830      |                       | $          | 2,644                                |       | $                        | 186        |   | $ | 8,266 |   | $ | 7,654 |   | $ | 612 |   |

 

----

(1)Employee Stock Ownership Plan

 

The increase in salaries andemployee benefits for both the three and nine month comparative periods was dueprimarily to increases in salaries and ESOP expense. The increase in ESOPexpense was due to an increase in the Company’s average stock price in 2004compared to the same periods in 2003. The increase in salaries for the three and nine month comparativeperiods was primarily due to normal salary and merit increases.

 

17

----

 

**Netoccupancy expense. **Thechanges in the composition of this line item are presented below (inthousands):

 
| ** **                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|--------------------------------------------|------------|---------------------------------------|------------|----------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** **                                 | ** ** | **2004**                              | ** ** | **2003**                   | ** ** | **2004 vs 2003**                     | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2004 vs 2003** | ** ** |
| Depreciation                               |       | $                                     | 274        |                       | $          | 283                                  |       | $                        | (9         | ) | $ | 824 |   | $ | 758 |   | $ | 66 |   |
| Furniture, fixtures, and equipment expense |       | 39                                    |       | 39                         |       | —                               |       | 129                      |       | 202 |   | (73 | ) |
| Utilities                                  |       | 55                                    |       | 54                         |       | 1                                    |       | 166                      |       | 137 |   | 29 |   |
| Building repairs and maintenance           |       | 63                                    |       | 58                         |       | 5                                    |       | 191                      |       | 134 |   | 57 |   |
| Taxes and insurance                        |       | 45                                    |       | 36                         |       | 9                                    |       | 134                      |       | 90 |   | 44 |   |
| Rent                                       |       | 17                                    |       | 14                         |       | 3                                    |       | 50                       |       | 50 |   | — |   |
| Total                                      |       | $                                     | 493        |                       | $          | 484                                  |       | $                        | 9          |   | $ | 1,494 |   | $ | 1,371 |   | $ | 123 |   |

 

The increase in net occupancyexpense for the nine month comparative period was due primarily to increases indepreciation, building repairs and maintenance, and taxes and insurance relatedto nine months of expense associated with the new corporate office in 2004compared to four months in 2003, offset by a decrease in furniture, fixturesand equipment expense.  Such decrease wasprimarily due to furniture and accessories for the new corporate office thatopened June 2, 2003.  Furniture andaccessories totaling $120,000 were expensed in the nine months ended September30, 2003.

 

**Advertising and public relations.**  The increase in advertising and publicrelations for the three and nine month comparative periods was due to costsincurred in the second and third quarters associated with the new checkingaccount marketing program, including direct mail, “thank you” gifts, marketingbrochures, posters, and billboards.  Forthe three month and nine month comparative periods, approximately $106,000 and$223,000, respectively, was due to this program.

 

**Contributions. ** Contributions expense decreased in the ninemonth period ended September 30 mainly due to the contribution of real estatediscussed above.  The fair value of thedonated real estate of $500,000 is included in contributions expense for thenine months ended September 30, 2003.

 

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

 
| ** **                     | ** ** | **Three Months Ended  September 30,** | ** ** | **Increase****(Decrease)** | ** ** | **Nine Months Ended  September 30,** | ** ** | **Increase  (Decrease)** | ** ** |
|--------------------------------|------------|---------------------------------------|------------|----------------------------|------------|--------------------------------------|------------|--------------------------|------------|
| ** **                     | ** ** | **2004**                              | ** ** | **2003**                   | ** ** | **2004 vs 2003**                     | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2004 vs 2003** | ** ** |
| Consultant and management fees |       | $                                     | 22         |                       | $          | 132                                  |       | $                        | (110       | ) | $ | 226 |   | $ | 232 |   | $ | (6 | ) |
| Other                          |       | 1,080                                 |       | 1,118                      |       | (38                                  | )          | 3,295                    |       | 3,326 |   | (31 | ) |
| Total                          |       | $                                     | 1,102      |                       | $          | 1,250                                |       | $                        | (148       | ) | $ | 3,521 |   | $ | 3,558 |   | $ | (37 | ) |

 

Other expenses decreased in thethree month comparative periods primarily due to consultant and managementfees.  These fees decreased primarily dueto fees paid in 2003 to a consulting firm related to preparation for internalcontrol assertion and attestation under the new requirements of theSarbanes-Oxley Act of 2002.  Fees paid toa third party vendor related to the Bounce ProtectionTM programalso decreased for the three month comparative periods.

 

**Income Taxes.**

 

The increase in income taxexpense for the three month and nine month periods ended September 30, 2004compared to the same periods in 2003 was primarily due to an increase intaxable income.

 

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**OFF-BALANCESHEET ARRANGEMENTS**

 

The Company, in the normalcourse of business, makes commitments to buy or sell assets or to incur or fundliabilities.  Commitments include, butare not limited to:

 

•      theorigination, purchase or sale of loans;

•      thefulfillment of commitments under letters-of-credit, extensions of credit onhome equity lines of credit, construction loans, and predetermined overdraftprotection limits; and

•      thecommitment to fund withdrawals of certificates of deposit at maturity.

 

At September 30, 2004, theBank’s off-balance sheet arrangements principally included lending commitments,which are described below.  At September30, 2004, the Company had no interests in non-consolidated special purposeentities.

 

At September 30, 2004,commitments included:

 

•      totalapproved commitments to originate loans amounting to $28.6 million, including $18.4million of loans committed to sell;

•      ratelock agreements with customers of $5.5 million, all of which have been lockedwith an investor;

•      fundedmortgage loans committed to sell of $1.3 million;

•      undisbursedportion of construction loans of $62.2 million;

•      unusedlines of credit of $20.8 million;

•      outstanding standby letters of creditof $1.8 million;

•      total predetermined overdraft protectionlimits of $10.2 million; and

•      certificates of deposit scheduled tomature in one year or less totaling $140.1 million.

 

Total unfunded commitments tooriginate loans for sale and the related commitments to sell of $5.5 millionmeet the definition of a derivative financial instrument.  The related asset and liability areconsidered immaterial at September 30, 2004.

 

Historically, a very smallpercentage of predetermined overdraft limits have been used.  At September 30, 2004, overdrafts of accountswith Bounce ProtectionTM represented usage of2.4% of the limit.  We expect utilizationof these overdraft limits to remain at comparable levels in the future.

 

Based on historical experience,management believes that a significant portion of maturing deposits will remainwith the Bank.  We anticipate that wewill continue to have sufficient funds, through repayments, deposits andborrowings, to meet our current commitments.

 

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**LIQUIDITYAND CAPITAL RESOURCES**

 

TheBank’s liquidity, represented by cash and cash equivalents and eligibleinvestment securities, is a product of its operating, investing and financingactivities.  The Bank’s primary sourcesof funds are deposits, collections on outstanding loans, maturities and callsof investment securities and other short-term investments and funds providedfrom operations.  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 September 30, 2004, available borrowingcapacity with the FHLB was approximately $196 million.

 

Liquiditymanagement is both a 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.

 

Asof September 30, 2004, the Bank’s regulatory capital was in excess of allapplicable regulatory requirements.  At September 30,2004, the Bank’s tangible, core and risk-based capital ratios amounted to 10.05%,10.05% and 14.46%, respectively, compared to regulatory requirements of 1.5%, 4.0%and 8.0%, respectively.

 

**IMPACT OFINFLATION AND CHANGING PRICES**

 

The financial statements andrelated financial data presented herein have been prepared in accordance withaccounting principles generally accepted in the United States of America, whichrequire the measurement of financial position and operating results in terms ofhistorical dollars, without considering changes in relative purchasing powerover time due to inflation.

 

Unlikemost industrial companies, virtually all of the Bank’s assets and liabilitiesare monetary in nature.  As a result,interest rates generally have a more significant impact on a financialinstitution’s performance than does the effect of inflation.

 

**FORWARD-LOOKINGSTATEMENTS**

 

The Company’s Quarterly Reporton Form 10-Q contains certain forward-looking statements and informationrelating to the Company that are based on the beliefs of management as well asassumptions made by and information currently available to management.  In addition, in this document, the words“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 proveincorrect, actual results may vary materially from those described herein asanticipated, believed, estimated, expected or intended.  The Company does not intend to update theseforward-looking statements.

 

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**QUANTITATIVE AND QUALITATIVE DISCLOSURES**

**ABOUT MARKET RISK**

 

For a discussion of theCompany’s asset and liability management policies as well as the potentialimpact of interest rate changes upon the market value of the Bank’s portfolioequity, see “Management’s Discussion and Analysis of Financial Condition andResults of Operations” in the Company’s 2003 Annual Report toStockholders.  There has been no materialchange in the Company’s asset and liability position or the market value of theBank’s portfolio equity since December 31, 2003.

 

**CONTROLSAND PROCEDURES**

 

Our management evaluated, withthe participation of our Chief Executive Officer and Chief Financial Officer,the effectiveness of our disclosure controls and procedures (as defined inRules 13a-15e and 15d-15e) under the Securities Exchange Act of 1934) as of theend of the period covered by this report. Based on such evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and proceduresare designed 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 internalcontrol over financial reporting (as defined in Rules 13a-15f and 15d-15f underthe Securities Exchange Act of 1934) occurred during the most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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

 

**Part II**

 

Item 1.            LegalProceedings

 

Neither the Company nor the Bank is involvedin any pending legal proceedings other than non-material legal proceedingsoccurring in the ordinary course of business.

 

Item 2.            UnregisteredSales of Equity Securities and Use of Proceeds

 

ISSUER PURCHASES OF EQUITY SECURITIES

 
| ** **                        | ** ** | **(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** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------|------------|
| ** **                        | ** ** | ** **                                  | ** ** | ** **                             | ** ** | ** **                                                                                   | ** ** | ** **                                                                                | ** ** |
| August 1 to August 31, 2004       |       | 76,000                                      |       | $                                      | 20.57      |                                                                                         | 76,000     |                                                                                      | 174,591    |   |
| September 1 to September 30, 2004 |       | 27,000                                      |       | $                                      | 21.00      |                                                                                         | 27,000     |                                                                                      | 147,591    |   |

 

The Company isin its 16th announced repurchase program, which was approved by theboard of directors on May 26, 2004, and publicly announced on June 8, 2004.Total shares approved to be purchased in this program are 260,257, of which112,666 have been purchased as of September 30, 2004.  All treasury stock purchases are made underpublicly announced repurchase programs.

 

Item 3.            DefaultsUpon Senior Securities

 

Notapplicable.

 

Item 4.            Submissionof Matters to a Vote of Security Holders

 

Not Applicable

 

Item 5.            OtherInformation

 

None.

 

Item 6.            Exhibits

 

Exhibit 31.1 –Certification of Chief Executive Officer

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

 

Exhibit 31.2 –Certification of Chief Financial Officer

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

 

Exhibit 32.1 –Certification of Chief Executive Officer,

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

 

Exhibit 32.2 –Certification of Chief Financial Officer,

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

 

22

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**SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 
|                    | **FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.** |
|-------------------------|------------------------------------------------|
|                    |                                           |
|                    |                                           |
| Date:  October 27, 2004 | By:                                            | /s/Larry J.  Brandt |   |
|                    |  Larry  J. Brandt                         |
|                    |  President/CEO                            |
|                    |                                           |
|                    |                                           |
| Date:  October 27, 2004 | By:                                            | /s/Sherri R.  Billings |   |
|                    |  Sherri  R. Billings                      |
|                    |  EVP/CFO                                  |
|                         |                                                |  |  |  |

 

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