**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-QSB**

 
| **(Mark One)**                                      |
|-----------------------------------------------------|
| **ý**                                          | ** ** | **QUARTERLY REPORT UNDER SECTION  13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |
| ** **                                          |
| **For the  Quarterly Period Ended: March 31, 2006** |
| ** **                                          |
| **o**                                               | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |

 

**Commission File No. 00050921**

 

**SOUTHERNHERITAGE BANCSHARES, INC.**

(Exact Name of Small Business Issuer asSpecified in its Charter)

 

| **Tennessee**                                     | ** ** | **42-1627829**                       |
|---------------------------------------------------|------------|--------------------------------------|
| (State of Incorporation)                          |       | (I.R.S. Employer Identification No.) |
|                                              |       |                                 |
| **3020 Keith Street, N.W.  Cleveland, Tennessee** | ** ** | **37312**                            |
| (Address of Principal Executive Offices)          |       | (Zip Code)                           |

 

**(423) 473-7980**(Issuer’s Telephone Number, Including Area Code)

 

**None**(Former Name, Address and Fiscal Year, if ChangedSince Last Report)

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days

 
| Yes  ý |   | No  o |
|-----------------------|--------|-----------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Exchange Act Rule12b-2).  Yes  o   No  ý

 

State the outstanding numberof shares of the issuer’s common stock as of April 30, 2006:  1,084,475

 

Transitional Small Business Disclosure Format(check one):

 
| Yes  o |   | No  ý |
|------------------|--------|----------------------|

 

 

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

** **

**FORM 10-QSB****Quarter ended March 31, 2006**

 
| ***PART I.***    | ***FINANCIAL INFORMATION*** |                                                                                             |
|------------------|-----------------------------|--------------------------------------------------------------------------------------------------|
|             |                        |                                                                                             |   |
|             | ***Item 1.***               | Financial Statements                                                                             |   |
|             |                        |                                                                                             |   |
|             |                        | Consolidated Balance Sheets – March 31, 2006 (Unaudited) and December  31, 2005             |   |
|             |                        |                                                                                             |   |
|             |                        | Consolidated Statements of Operations - Three months ended March 31,  2006 and 2005 (Unaudited)  |   |
|             |                        |                                                                                             |   |
|             |                        | Consolidated  Statements of Cash Flows - Three months ended March 31, 2006 and 2005  (Unaudited) |   |
|             |                        |                                                                                             |   |
|             |                        | Notes to Consolidated Financial Statements                                                       |   |
|             |                        |                                                                                             |   |
|             | ***Item  2.***              | Managements Discussion And  Analysis                                                             |   |
|             |                        |                                                                                             |   |
|             | ***Item 3.***               | Controls And Procedures                                                                          |   |
|             |                        |                                                                                             |   |
| ***PART II.***   | ***OTHER  INFORMATION***    |                                                                                             |
|             |                        |                                                                                             |   |
|             | ***Item 1.***               | Legal  Proceedings                                                                               |   |
|             |                        |                                                                                             |   |
|             | ***Item 2.***               | Unregistered Sales of Equity Securities and Use of Proceeds                                      |   |
|             |                        |                                                                                             |   |
|             | ***Item 3.***               | Defaults Upon Senior Securities                                                                  |   |
|             |                        |                                                                                             |   |
|             | ***Item 4.***               | Submission of Matters to a Vote of Security Holders                                              |   |
|             |                        |                                                                                             |   |
|             | ***Item 5.***               | Other  Information                                                                               |   |
|             |                        |                                                                                             |   |
|             | ***Item 6.***               | Exhibits                                                                                         |   |
|             |                        |                                                                                             |   |
| ***Signatures*** |                        |                                                                                             |

 

2

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**Item 1.****  Financial Statements**

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**ConsolidatedBalance Sheets**

**March 31, 2006**

 

($ amounts in thousands exceptshare and earnings per share)

 
| ** **                                                                                                                       | ** ** | **(Unaudited)**          | ** **  | ** **                      | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|-------------|---------------------------------|------------|
| ** **                                                                                                                       | ** ** | **March 31,  2006** | ** **  | **December 31, 2005** | ** ** |
| ***Assets***                                                                                                                     | ** ** | ** **               | ** **  |                            |       |
| Cash and due from banks                                                                                                          | ** ** | **$**                    | **4,928**   | ** **                      | 5,250      |   |
| Federal funds sold                                                                                                               | ** ** | **11,265**               | ** **  | 1,828                           |       |
| ***Cash and cash equivalents***                                                                                                  | ** ** | **16,193**               | ** **  | 7,078                           |       |
| Securities available-for-sale, at fair  value                                                                                    | ** ** | **24,051**               | ** **  | 24,736                          |       |
| Mortgage loans held for sale                                                                                                     | ** ** | **1,049**                | ** **  | 245                             |       |
| Loans                                                                                                                            | ** ** | **146,281**              | ** **  | 151,131                         |       |
| Allowance for loan losses                                                                                                        | ** ** | **(1,880**               | **)**       | (2,036                          | )          |
| ***Loans, net***                                                                                                                 | ** ** | **144,401**              | ** **  | 149,095                         |       |
| Premises and equipment                                                                                                           | ** ** | **5,349**                | ** **  | 5,366                           |       |
| Restricted stock                                                                                                                 | ** ** | **519**                  | ** **  | 515                             |       |
| Accrued income receivable                                                                                                        | ** ** | **737**                  | ** **  | 819                             |       |
| Other assets                                                                                                                     | ** ** | **1,164**                | ** **  | 1,292                           |       |
| ** **                                                                                                                       |       | **$**                    | **193,463** | ** **                      | 189,146    |   |
|                                                                                                                             |       |                     | ** **  |                            |       |
| ***Liabilities and Shareholders’ Equity***                                                                                  |       |                     | ** **  |                            |       |
| **Liabilities:**                                                                                                                 |       |                     | ** **  |                            |       |
| **Deposits:**                                                                                                                    |       |                     | ** **  |                            |       |
| Noninterest-bearing                                                                                                              | ** ** | **$**                    | **26,978**  | ** **                      | 26,788     |   |
| Interest-bearing                                                                                                                 | ** ** | **144,751**              | ** **  | 141,327                         |       |
| ***Total deposits***                                                                                                             | ** ** | **171,729**              | ** **  | 168,115                         |       |
| Repurchase agreements                                                                                                            | ** ** | **333**                  | ** **  | 300                             |       |
| Accrued interest payable                                                                                                         | ** ** | **876**                  | ** **  | 904                             |       |
| Subordinated debentures                                                                                                          | ** ** | **5,155**                | ** **  | 5,155                           |       |
| Other liabilities                                                                                                                | ** ** | **578**                  | ** **  | 501                             |       |
| ***Total liabilities***                                                                                                          | ** ** | **178,671**              | ** **  | 174,975                         |       |
| **Shareholders’ equity:**                                                                                                   |       |                     | ** **  |                            |       |
| Preferred stock, no par value. Authorized  1,000,000 shares; none issued                                                         | ** ** | **—**               | ** **  | —                          |       |
| Common stock, $1 par value. Authorized  2,000,000 shares; issued 1,084,475 shares at Mar 31, 2006 and 1,082,675 at  Dec 31, 2005 | ** ** | **1,084**                | ** **  | 1,082                           |       |
| Additional paid-in-capital                                                                                                       | ** ** | **10,799**               | ** **  | 10,766                          |       |
| Retained Earnings                                                                                                                | ** ** | **3,270**                | ** **  | 2,696                           |       |
| Accumulated other comprehensive income  (loss)                                                                                   | ** ** | **(361**                 | **)**       | (373                            | )          |
| ***Total shareholders’ equity***                                                                                            | ** ** | **14,792**               | ** **  | 14,171                          |       |
| ** **                                                                                                                       |       | **$**                    | **193,463** | ** **                      | 189,146    |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**SOUTHERN HERITAGE BANCHARES, INC.**

**ConsolidatedStatements of Operations**

**Three Months Ended March 31**

**(Unaudited)**

 

($ amounts in thousands except share and earnings per share)

 
| ** **                                                 | ** ** | **2006**      | ** ** | **2005**   | ** ** |
|------------------------------------------------------------|------------|---------------|------------|------------|------------|
| **Interest income:**                                       |       |          | ** ** |       |       |
| Loans, including fees                                      | ** ** | **$**         | **2,646**  | ** ** | 2,035      |   |
| Securities                                                 | ** ** | **242**       | ** ** | 176        |       |
| Federal funds sold                                         | ** ** | **80**        | ** ** | 21         |       |
| ***Total interest income***                                | ** ** | **2,968**     | ** ** | 2,232      |       |
| **Interest expense:**                                      |       |          | ** ** |       |       |
| Deposits                                                   | ** ** | **1,116**     | ** ** | 682        |       |
| Other borrowed funds                                       | ** ** | **87**        | ** ** | 58         |       |
| ***Total interest expense***                               | ** ** | **1,203**     | ** ** | **740**    | ** ** |
| ***Net interest income***                                  | ** ** | **1,765**     | ** ** | 1,492      |       |
| **Provision for loan losses**                              | ** ** | **51**        | ** ** | 129        |       |
| ***Net interest income after provision for  loan losses*** | ** ** | **1,714**     | ** ** | 1,363      |       |
| **Noninterest income:**                                    |       |          | ** ** |       |       |
| Service charges on deposit accounts                        | ** ** | **279**       | ** ** | 319        |       |
| Mortgage banking activities                                | ** ** | **143**       | ** ** | 87         |       |
| Gain (loss) on sale of securities                          | ** ** | **10**        | ** ** | (3         | )          |
| Other service charges, commissions and fees                | ** ** | **80**        | ** ** | 80         |       |
| ***Total noninterest income***                             | ** ** | **512**       | ** ** | 483        |       |
| **Noninterest expenses:**                                  |       |          | ** ** |       |       |
| Salaries and employee benefits                             | ** ** | **716**       | ** ** | 567        |       |
| Occupancy expense                                          | ** ** | **94**        | ** ** | 88         |       |
| Other operating expenses                                   | ** ** | **542**       | ** ** | 542        |       |
| ***Total noninterest expenses***                           | ** ** | **1,352**     | ** ** | 1,197      |       |
| ***Income before income taxes***                           | ** ** | **874**       | ** ** | 649        |       |
| **Income taxes**                                           | ** ** | **298**       | ** ** | 234        |       |
| ***Net income***                                           | ** ** | **576**       | ** ** | 415        |       |
|                                                       |       |          | ** ** |       |       |
| **Other comprehensive income:**                            |       |          | ** ** |       |       |
| Unrealized gains/losses on securities                      | ** ** | **(361**      | **)**      | (227       | )          |
|                                                       |       |          | ** ** |       |       |
| **Comprehensive income**                                   | ** ** | **215**       | ** ** | 188        |       |
|                                                       |       |          | ** ** |       |       |
| Basic earnings per share                                   | ** ** | **$**         | **0.53**   | ** ** | **$**      | **0.39** | ** ** |
| Diluted earnings per share                                 | ** ** | **$**         | **0.49**   | ** ** | **$**      | **0.36** | ** ** |
|                                                       |       |          | ** ** |       |       |
| Shares used in computation of earnings per  share          |       |          | ** ** |       |       |
| Basic                                                      | ** ** | **1,083,875** | ** ** | 1,075,956  |       |
| Diluted                                                    | ** ** | **1,179,933** | ** ** | 1,161,288  |       |

 

See accompanying notes to consolidated financial statements.

 

4

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**ConsolidatedStatements of Cash Flows**

**Three Months Ended March 31**

**(Unaudited)**

*($ amounts in thousands)*

 
| ** **                                                                                | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Cash flows from operating activities:**                                                 |       |       | ** ** |       |       |
| **Net income**                                                                            | ** ** | **$**      | **576**    | ** ** | 415        |   |
| Adjustments to reconcile net income to net  cash provided (used) by operating activities: |       |       | ** ** |       |       |
| Depreciation and amortization                                                             | ** ** | **99**     | ** ** | 104        |       |
| Provision for loan losses                                                                 | ** ** | **51**     | ** ** | 129        |       |
| Gain (loss) on sale of securities available  for sale                                     | ** ** | **10**     | ** ** | (3         | )          |
| FHLB stock dividends                                                                      | ** ** | **(3**     | **)**      | (2         | )          |
| Mortgage loans originated for sale                                                        | ** ** | **(8,150** | **)**      | (4,725     | )          |
| Proceeds from sale of mortgage loans                                                      | ** ** | **7,346**  | ** ** | 4,687      |       |
| Decrease (increase) in accrued interest  receivable                                       | ** ** | **82**     | ** ** | (91        | )          |
| Increase (decrease) in accrued interest  payable                                          | ** ** | **(28**    | **)**      | 34         |       |
| Other, net                                                                                | ** ** | **(16**    | **)**      | 36         |       |
| ***Net cash provided by operating activities***                                           | ** ** | **(33**    | **)**      | 584        |       |
| **Cash flows from investing activities:**                                                 |       |       | ** ** |       |       |
| Proceeds from maturities and redemptions of  securities available for sale                | ** ** | **205**    | ** ** | 321        |       |
| Proceeds from sales of securities available  for sale                                     | ** ** | **3,171**  | ** ** | 4,408      |       |
| Purchases of securities available for sale                                                | ** ** | **(2,670** | **)**      | (3,196     | )          |
| Purchases of restricted stock                                                             | ** ** | **(4**     | **)**      | (18        | )          |
| Net decrease (increase) in loans                                                          | ** ** | **4,850**  | ** ** | (6,121     | )          |
| Purchases of premises and equipment                                                       | ** ** | **(73**    | **)**      | (56        | )          |
| ***Net cash used by investing activities***                                               | ** ** | **5,479**  | ** ** | (4,662     | )          |
| **Cash flows from financing activities:**                                                 |       |       | ** ** |       |       |
| Increase (decrease) in repurchase  agreements                                             | ** ** | **33**     | ** ** | (869       | )          |
| Increase in deposits                                                                      | ** ** | **3,614**  | ** ** | 9,073      |       |
| Proceeds from exercise of stock options                                                   | ** ** | **22**     | ** ** | —     |       |
| ***Net cash provided by financing activities***                                           | ** ** | **3,669**  | ** ** | 8,204      |       |
|                                                                                      |       |       | ** ** |       |       |
| ***Net increase in cash***                                                                | ** ** | **9,115**  | ** ** | **4,126**  | ** ** |
| **Cash and cash equivalents, beginning of  period**                                       | ** ** | **7,078**  | ** ** | 5,093      |       |
|                                                                                      |       |       | ** ** |       |       |
| **Cash and cash equivalents, end of period**                                              | ** ** | **$**      | **16,193** | ** ** | 9,219      |   |
|                                                                                      |       |       | ** ** |       |       |
| **Cash payments for interest**                                                            | ** ** | **$**      | **1,231**  | ** ** | 706        |   |
| **Cash payments for income taxes**                                                        | ** ** | **381**    | ** ** | 329        |       |

 

See accompanying notes to consolidated financial statements.

 

5

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**SOUTHERN HERITAGE BANCSHARES, INC.**

**Notesto Consolidated Financial Statements**

**March 31, 2006**

**(Unaudited)**

 

*Basis of Presentation*

 

The accompanying financial statements have been prepared in accordancewith generally accepted accounting principals for interim financial informationand with the instructions to Form 10-QSB. Accordingly they do not include all information and footnotes requiredby generally accepted accounting principals for complete financial statements.

 

The consolidated financial statements include Southern HeritageBancshares, Inc. and its wholly owned subsidiary, Southern Heritage Bank,together referred to as “the Company”. Intercompany transactions and balances are eliminated in consolidation.

 

Southern Heritage Bancshares, Inc. is a one bank holding company thatowns 100% of Southern Heritage Bank (the Bank). Substantially all of the consolidated operations are that of the Bank.

 

In the opinion of management, the financial statements contain alladjustments necessary to summarize fairly the financial position of the Bank asof March 31, 2006, the results of operations for the three months ended March31, 2006, and cash flows for the three months ended March 31, 2006.  The interim financial statements should beread in conjunction with the notes to the financial statements presented in theBank’s December 31, 2005, financial statements. The results for the interim periods are not necessary indicative of theresults to be expected for the complete year.

 

*Allowance for Loan Losses*

 

Transactions in the allowance for loan losseswere as follows:

 
| ** **                       | ** ** | **Three Months  Ended  March 31, 2006** | ** ** | **Three Months  Ended  March 31, 2005** | ** ** |
|----------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                       | ** ** | **(In Thousands)**                                | ** ** | **(In Thousands)**                                | ** ** |
|                             | * *   | * *                                               | * *   | * *                                               | * *   |
| Balance January 1                |       | $                                                      | 2,036      |                                                   | $          | 1,723 |   |
|                             |       |                                                   |       |                                                   |       |
| Add (deduct):                    |       |                                                   |       |                                                   |       |
| Losses charged to allowance      |       | (218                                                   | )          | (22                                                    | )          |
| Recoveries credited to allowance |       | 11                                                     |       | 9                                                      |       |
| Provision for loan losses        |       | 51                                                     |       | 129                                                    |       |
|                             |       |                                                   |       |                                                   |       |
| Balance March 31                 |       | $                                                      | 1,880      |                                                   | $          | 1,839 |   |

 

6

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**SOUTHERN HERITAGE BANCSHARES, INC.**

**Notes to Consolidated Financial Statements**

**March 31, 2005**

**(Unaudited)**

 

Management’s determination of the appropriate level of the provisionfor loan losses and the adequacy of the allowance for loan losses is based, inpart on an evaluation of specific loans, as well as other factors considered bymanagement, including the composition of the loan portfolio, current economicconditions, and the creditworthiness of the Bank’s borrowers and other relatedfactors.

 

At March 31, 2006, the Bank had three loans totaling $33,000 innonaccrual status.  This compares withDecember 31, 2005, where there was one loan for $27,000 in nonaccrual.  The Bank had no loans that were more than 90days delinquent on March 31, 2006 or December 31, 2005.  In the first three months of 2006, loanstotaling $218,000 were charged off and $11,000 was recovered on loanspreviously charged off, with one loan comprising $192,000 of the chargeoffs.This compares to net chargeoffs of $61,000 and $101,000 for the years endedDecember 31, 2005 and 2004. Management believes that the level of netchargeoffs for the three months ended March 31, 2006 will not be sustained forthe entire year. Accordingly, management believes the allowance for loan lossesat March 31, 2006, is adequate to absorb probable incurred losses in the loanportfolio.

 

*Stock Compensation*

 

The Company established an Incentive Stock Option Plan (ISO) forofficers and employees and a Non-Employee Directors’ Non-Qualified Stock OptionPlan (NQO), which was shareholder approved, effective August 8, 2000, allowingfor the granting of share options and shares to its employees and directors upto 153,543 shares of common stock.  TheCompany believes that such awards better align the interests of its employeesand directors with those of its shareholders. Option awards are generally granted with an exercise price equal to themarket price of the Company’s stock at the date of grant; those option awardsgenerally vest 20% every two years based on 10 years of continuousservice.  Certain option and share awardsprovide for accelerated vesting if there is a change in control (as defined in thePlan).

 

The fair value of each option award is estimated on the date of thegrant using a lattice-based option valuation model that uses the assumptionsnoted in the following table.  Becauselattice-based option valuation models incorporate ranges of assumptions forinputs, those ranges are disclosed. Expected volatilities are based on implied volatilities from tradedoptions on the Company’s stock, historical volatility of the Company’s stock,and other factors.  The Company useshistorical data to estimate option exercise and employee termination within thevaluation model; separate groups of employees that have similar historicalexercise behavior are considered separately for valuation purposes.  The expected term of options granted isderived from the output of the option valuation model and represents the periodof time that options granted are expected to be outstanding; the range givenbelow results from certain groups of employees exhibiting differentbehavior.  The risk-free rate for periodswithin the contractual life of the option is based on the U.S. Treasury yieldcurve in effect at the time of the grant. There were no options granted in2006.

 

7

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A summary of option activity under the Plan as of March 31, 2006, andchanges during the year then ended is presented below:

 
| **Options **              | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Weighted  Average  Intrinsic  Value** | ** ** |
|--------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                     | ** ** | ** ** | ** ** | ** **                             | ** ** | ** **                                          | ** ** | **(In  thousands)**                     | ** ** |
| Outstanding at January 1, 2006 |       | 150,046    |       | $                                      | 12.14      |                                                |       |                                    |       |   |
|                           |       |       |       |                                   |       |                                                |       |                                    |       |
| Granted                        |       | —     |       | —                                 |       |                                                |       |                                    |       |
|                           |       |       |       |                                   |       |                                                |       |                                    |       |
| Exercised                      |       | (1,800     | )          | 12.06                                  |       |                                                |       |                                    |       |
|                           |       |       |       |                                   |       |                                                |       |                                    |       |
| Forfieted or expired           |       | —     |       | —                                 |       |                                                |       |                                    |       |
|                           |       |       |       |                                   |       |                                                |       |                                    |       |
| Outstanding at March 31, 2006  |       | 148,246    |       | $                                      | 12.14      |                                                | 5.90       |                                    | $          | 4,314 |   |
|                           |       |       |       |                                   |       |                                                |       |                                    |       |
| Exercisable at March 31, 2006  |       | 50,846     |       | $                                      | 10.90      |                                                | 5.00       |                                    | $          | 1,525 |   |

 

The total intrinsic value of options exercised during the three monthsended March 31, 2006 was $41,292.

 

8

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As of March 31, 2006, there was $277,000 of total unrecognizedcompensation cost related to nonvested share-based compensation arrangementsgranted under the Plan.  That cost isexpected to be recognized over a weighted-average period of approximately 5years.  The options under the Plan vestevery other year and none have vested in 2006. However, the compensation cost is recorded on a prorata basis over theentire vesting period resulting total compensation cost of $12,000 for thethree months ended March 31, 2006, based on the fair value of the options.  

 

Cash received from options exercised for the three months ended March31, 2006 was $21,708.  All of theseoptions were ISO’s, resulting in no tax benefit for the Company.  The Company’s policy is to issue new sharesto satisfy option exercises.

 

In 2005 and prior, employee compensation expense under stock optionswas reported using the intrinsic value method. No stock-based compensation cost was reflected in net income; as alloptions granted had an exercise price equal to or greater than the market priceof the underlying common stock at date of grant.  The following table illustrates the effect onnet income and earnings per share if expense was measured using the fair valuerecognition provisions of FASB Satement No. 123, Accounting for Stock-BasedCompensation.

 
| ** **                                                                         | ** ** | **Three Months  Ended  March 31, 2005** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
|                                                                               |       |                                                   |       |
| Net income as reported                                                             |       | $                                                      | 415        |   |
| Deduct: Stock-based compensation expense determined  under fair value based method |       | 12                                                     |       |
|                                                                               |       |                                                   |       |
| Pro Forma net income                                                               |       | $                                                      | 403        |   |
|                                                                               |       |                                                   |       |
| Basic earnings per share as reported                                               |       | $                                                      | 0.39       |   |
| Pro Forma basic earnings per share                                                 |       | 0.37                                                   |       |
|                                                                               |       |                                                   |       |
| Diluted earnings per share as reported                                             |       | 0.36                                                   |       |
| Pro Forma diluted earnings per share                                               |       | 0.35                                                   |       |

 

9

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Earnings Per Share Amounts:  Basic earnings per share is computed usingthe weighted average number of common shares outstanding during the period andexcludes any dilutive effects of options. Diluted earnings per share iscomputed using the weighted average number of common and common stockequivalent shares outstanding during the period; common stock equivalent sharesare excluded from the computation if their effect is antidilutive. The effectof these options on earnings per common share was to increase average sharesoutstanding by 96,058 and 85,332 in 2006 and 2005 and decrease earnings pershare by $.04 and $.03. No shares were antidilutive at March 31, 2006 and 2005.

 

10

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**Item 2. Management’s Discussion and Analysis**

 

# **OVERVIEW**

 

The followingdiscussion compares the financial condition of Southern Heritage Bancshares,Inc. (the “Company”) at March 31, 2006, to December 31, 2005, and the resultsof operations for the three months ended March 31, 2006 and 2005. The Companyis a one bank holding company that owns 100% of Southern Heritage Bank (the “Bank”).Substantially all of the consolidated operations are that of the Bank. Thisdiscussion should be read in conjunction with the interim financial statementsand footnotes included herein.

 

Certainstatements contained in this report that are not historical facts are forwardlooking statements that are subject to certain risks and uncertainties. Whenused herein, the terms “anticipates,” “plans,” “expects,” “believes,” andsimilar expressions as they relate to the Company or its management areintended to identify such forward looking statements. The Company’s actualresults, performance or achievements may materially differ from those expressedor implied in the forward-looking statements. Risks and uncertainties thatcould cause or contribute to such material differences include, but are notlimited to, general economic conditions, the interest rate environment,competitive conditions in the financial services industry, changes in law,governmental policies and regulations, and rapidly changing technologyaffecting financial services.

 

# **FINANCIALCONDITION**

 

Total assetsas of March 31, 2006 increased 2.3%, or $4,317,000, to $193,463,000, comparedwith $189,146,000 at December 31, 2005. The increase in total assets was fundedby a comparable increase in total deposits of $3,614,000. Cash and cashequivalents increased $9,115,000 to $16,193,000 at March 31, 2006 from$7,078,000 at December 31, 2005. Securities decreased $685,000 to $24,051,000at March 31, 2006 compared to $24,736,000 at December 31, 2005.

 

Loans are theprincipal component of the Company’s assets and the primary source of income. Totalloans at March 31, 2006, were $146,281,000 compared to $151,131,000 at December31, 2005, a decrease of $4,850,000. The decrease in loans in the first threemonths of 2006 was primarily in commercial loans which decreased $2,349,000;commercial loans secured by real estate which decreased $1,121,000; and loanssecured by 1-4 family residential real estate a decrease of $824,000. As ofMarch 31, 2006, $45,493,000 or 31% of total loans were commercial loans securedby real estate. Commercial loans were $40,699,000 or 28% of total loans. Loanssecured by 1-4 family residential real estate were $24,335,000 or 17% of totalloans. Construction loans secured by real estate were $27,031,000 or 18% oftotal loans. Consumer loans were $4,008,000 or 3% of total loans. Other loanswere $4,715,000 or 3% of total loans. Of the total loans, $100,232,000 or 69.4%mature or reprice within 12 months. Only $2,090,000 or 1.4% mature or repriceover five years.

 

There was$1,049,000 in mortgage loans held for sale at March 31, 2006, compared with$245,000 at December 31, 2005. The increase in mortgage loans held for sale wasprimarily due to timing issues related to secondary market investor funding.

 

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Managementanticipates that loan demand will be moderate in the near future. Theloan-to-deposit ratio as of March 31, 2006, was 85.2%, compared to 89.9% atDecember 31, 2005, and the loan-to-assets ratio was 75.6% at March 31, 2006,compared to 79.9% at December 31, 2005. Management expects that theloan-to-deposit ratio for the remainder of 2006 will remain in the range ofapproximately 85% - 90% and the loans-to-assets ratio will be between 75% -80%.

 

The securitiesportfolio provides a balance to interest rate and credit risk while providing avehicle for investing available funds, furnishing liquidity, and supplyingsecurities to pledge as required for certain deposits and borrowed funds. Allsecurities are classified as “available for sale”. We have no plans toliquidate a significant amount of the securities portfolio.

 

As of March31, 2006, the Company owned $24,051,000 of securities available-for-sale, adecrease of $685,000 or 2.8%. The decrease in securities available-for-sale isprimarily due to the principal payments of mortgage-backed securities.

 

Deposits whichare the Company’s primary source of funds, totaled $171,729,000 at March 31,2006, for an increase of $3,614,000, or 2.2%, compared to $168,115,000 atDecember 31, 2005. Deposits at March 31, 2006 consisted of $26,978,000 or 15.7%in non-interest bearing demand deposits, $37,242,000 or 21.7% ininterest-bearing demand deposits, $100,204,000 or 58.4% in time certificates ofdeposit and $7,305,000 or 4.2% in savings accounts. There was $19,618,000 inbrokered CDs at March 31, 2006 compared to $19,263,000 at December 31, 2005. TheCompany has targeted local consumers, professionals, and small businesses asits central clientele. These customers are being offered various depositinstruments such as demand deposits, savings accounts, money market accounts,certificates of deposit and IRAs. Rates paid on such instruments are set basedon various factors such as liquidity needs and market conditions. The Companybelieves it has a competitive advantage by being a locally owned financialinstitution which will contribute to increased market share. However, noassurance of market growth can be given.

 

The majorityof the deposits continue to be CDs, which increased $4,514,000 in the firstthree months of 2006. At March 31, 2006, the weighted average rate on CDs was3.87% compared to 3.04% for the three months ended March 31, 2005. The Companyhas time deposits maturing within one year of $73,107,000 or 73.0% of totaltime deposits. Time deposits maturing greater than one year is $27,094,000 or27.0% of total time deposits. Interest-bearing accounts, other than CDs,decreased $820,000 in the first three months of 2006. Noninterest bearingdeposits increased $190,000 for the three months ended March 31, 2006. Theweighted average cost of all deposit accounts during the first three months of2006 was 2.67% compared to 1.96% for the same period in 2005.

 

Totalshareholders’ equity increased $621,000, to $14,792,000 at March 31, 2006, from$14,171,000 at December 31, 2005. This increase was due to the Company’s netincome of $576,000 for the first three months of 2006 along with a net decreasein unrealized losses on securities available for sale of $12,000 net of tax. Stockoptions totaling $21,000 were exercised during the year. There was a $12,000increase in additional paid in capital related to stock option compensationaccording to FASB 123R.

 

As of March31, 2006 the Bank is categorized as well capitalized under the regulatoryframework for prompt corrective action. The total capital to risk-weightedassets ratio was 13.50%. Tier-1 to risk-weighted assets ratio was 12.34% andTier-1 to average asset ratio was 10.41%.

 

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# **RESULTSOF OPERATIONS**

 

For the firstthree months of 2006, net income after tax was $576,000, compared to $415,000for the same period in 2005, an increase of 38.8%. The increase in earningsover the previous year was primarily a result of the increase in net interestincome as a result of the overall growth of the Company. Net interest incomebefore the provision for loan losses for the first three months of 2006 was$1,765,000, an increase of $273,000 or 18.3% from $1,492,000 for the firstthree months of 2005. The net interest margin of 4.17% was the same for bothMarch 31, 2006 and 2005.

 

Interest andfee income on loans for the first three months of 2006 was $2,646,000, anincrease of $611,000 or 30.0% from $2,035,000 for the three months ended March31, 2005. The increase in interest and fee income on loans is primarily due toincreased volume in commercial loans as well as construction and commercialreal estate loans along with the increase in rates following the FederalReserve’s efforts to increase short term rates. The yield on all loansincreased 79 basis points to 7.19% at March 31, 2006 compared to 6.40% at March31, 2005. Total loans outstanding at March 31, 2006 were $146,281,000 comparedto $132,046,000 at March 31, 2005.

 

Interestincome from securities and short-term funds totaled $322,000 for the firstthree months of 2006, an increase of $125,000 over the same period of 2005. Theincrease in 2006 was due to an increase in the average dollar amount ofsecurities and short-term funds outstanding; $30,350,000 at March 31, 2005compared to $21,817,000 at March 31, 2005 and the increase in short term rates.The yield on securities and short-term funds increased to 4.26% at March 31,2006 compared to 3.66% at March 31, 2005.

 

Interestexpense totaled $1,203,000 in the first three months of 2006, compared to$740,000 for the same period of 2005. The increase in interest expense in 2006was due to the significant growth of deposits. The Company’s cost of fundsincreased to 3.17% at March 31, 2006 compared to 2.35% at March 31, 2005 as aresult of the increase in short term rates. Total deposits outstanding at March31, 2006 were $171,729,000 compared to $146,432,000 at March 31, 2005.

 

The Company’snet interest margin for the first three months of 2006 and 2005 was unchangedat 4.17%.

 

The Company’syield on earning assets has increased to 6.69%, for the first three months of2006 compared to 6.01% for the same period of 2005. The cost ofinterest-bearing funds has followed the same trend, increasing to 3.17% for thefirst three months of 2006, up from 2.35% for the three month ended March 31,2005.

 

The allowancefor loan losses is maintained by management at a level considered adequate tocover probable future losses in the Company’s loan portfolio. Management’sdetermination of the appropriate level of the provision for loan losses and theadequacy of the allowance for loan losses is based, in part, on theconsideration of loss histories of other similar community financialinstitutions which management believes are representative of the probableexpected loss experience of the Company. Other factors considered by managementinclude the composition of the loan portfolio, current economic conditions, thecreditworthiness of the Company’s borrowers and other related factors. TheCompany’s net charge-off experience has historically been low. For the firstthree months of 2006, the Company provided $51,000 for loan losses compared to$129,000 for the same period of 2005. The net charge-offs for the first threemonths of 2006 were $207,000 compared to $13,000 for the same period in 2005,with one loan comprising $192,000 of the chargeoffs. This compares to netchargeoffs of $61,000 and $101,000 for the years ended December 31, 2005 and2004. Management believes that the level of net chargeoffs for the three monthsended March 31, 2006 will not be sustained for the entire year. At March 31,2006, the Company had three loans totaling $33,000 in nonaccrual status. Thiscompares with December 31, 2005, where there was one loan totaling $27,000 innonaccrual. At March 31, 2006 there were no loans that were more than 90 daysdelinquent. At March 31, 2006, the allowance for loan losses was 1.29% comparedto 1.35% at December 31, 2005. Management believes the allowance for loanlosses at March 31, 2006, is adequate to absorb probable incurred losses in theloan portfolio.

 

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Totalnoninterest income for the first three months of 2006 was $512,000 compared to$483,000 for the same period in 2005. The largest single source of noninterestincome is service charges on deposit accounts. Service charges on depositstotaled $279,000 in 2006 compared to $319,000 in 2005. The decrease is dueprimarily to lower NSF and overdraft protection fee income realized during theperiod ($40,000). Mortgage banking income was $143,000 for the three monthsended March 31, 2006 compared to $87,000 for the same period in 2005. For thefirst quarter of 2006, the Company originated for subsequent sale, 46 loans for$7,346,000 compared to 37 loans for $4,687,000 for the same period in 2005. Theaverage loan closed increased $33,000 to $160,000 from $127,000 in the previousyear. Net securities gains or losses reflected a gain of $10,000 in 2006compared to a loss of $3,000 in 2005. Other service charges, commissions andfees remained the same level as the previous year totaling $80,000. Thisincludes safe deposit box rent, ATM interchange and surcharges, credit cardinterchange income, and the sale of checks to depositors.

 

Noninterestexpenses were $1,352,000 for the first three months of 2006 compared with$1,197,000 for the same period of 2005; an increase of $155,000 or 13.0%. Theincrease in noninterest expenses in the first three months of 2006 isattributable primarily to the increase in salaries and benefits expense; anincrease of $149,000 or 26.3% compared to 2005, and occupancy expense whichincreased $6,000 or 6.8%.

 

# **As of March 31, 2006, the Company had 51 full-time equivalent employeescompared to 44 for the same period of 2004. The additional employees include asenior commercial lender and a human resource director that was not on staffthe first quarter of 2005 which together represents $65,000 of the increase. Mortgagecommissions were $14,000 higher due to increased volume. The Company’s salaryincentive plan was revised in 2005 resulting in estimated compensation awardsbeing $34,000 higher than that for the same period in 2005. There was anadditional $12,000 charge for stock option compensation as required by FASB123R.**

# ** **

The increase in occupancyexpense was due to higher utilities; an increase of $2,000, and property taxes;an increase of $4,000.

 

Other operating expenseremained level between years at $542,000 for the three months ended March 31,2006 and 2005. With the growth of the Company there were increases in someareas such as data processing, $6,000; marketing, $13,000; human resources,$7,000; dues and subscriptions, $6,000; telephone, $6,000; and ATM, $10,000that were offset with decreases in other areas such as consulting fees, $16,000and accounting and audit fess, $42,000.

 

The Companybooked income tax expense of $298,000 for the period ended March 31, 2006compared to $234,000 for the same period in 2005. The effective tax rate forthe three months ended March 31, 2006 is 34% compared to 36% for the sameperiod ended 2005.

 

# **LIQUIDITYAND CAPITAL RESOURCES**

 

Liquidityrefers to the Company’s ability to fund loan demand, meet deposit customers’withdrawal needs and provide for operating expenses. As summarized in theStatement of Cash Flows, the Company’s main source of cash flow is fromreceiving deposits from its customers, and to a lesser extent, repayment ofloan principal and interest income on loans and investments. The primary usesof cash are lending to the Company’s borrowers, and investing in securities andshort-term interest-earning assets.

 

In the firstthree months of 2006, deposit growth has exceeded loan growth; however, this ismore of a timing issue and is not expected to continue. Other potential sourcesof liquidity include the sale of available-for-sale securities from the Company’sportfolio, the sale of loans, the purchase of federal funds, or repurchaseagreements. The Company currently has $19,618,000 in brokered certificates ofdeposit.

 

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At March 31,2006 and December 31, 2005, the Bank’s risk-based capital ratios and theminimums to be considered well-capitalized under the Federal Reserve Board’sprompt corrective action guidelines were as follows:

 
| ** **                             | ** ** | **March. 31, 2006** | ** ** | **Dec. 31, 2005** | ** ** | **Well-capitalized** | ** ** |
|----------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|----------------------|------------|
|                                   |       |                          |       |                        |       |                 |       |
| Tier 1 capital to risk-weighted assets |       | 12.34                         | %          | 11.80                       | %          | 6.0                  | %          |
| Total capital to risk-weighted assets  |       | 13.50                         | %          | 13.04                       | %          | 10.0                 | %          |
| Tier 1 leverage ratio                  |       | 10.41                         | %          | 10.38                       | %          | 5.0                  | %          |

 

As discussedabove, total shareholders’ equity increased $621,000, to $14,792,000 at March31, 2006 from $14,171,000 at December 31, 2005. This increase was due to theCompany’s net income of $576,000 for the first three months of 2006 along witha net decrease in unrealized losses on securities available for sale of$12,000, net of tax. Stock options totaling $21,000 were exercised during theyear. There was a $12,000 increase in additional paid in capital related tostock option compensation according to FASB 123R.

 

# **INTERESTRATE SENSITIVITY**

 

Financialinstitutions are subject to interest rate risk to the degree that theirinterest-bearing liabilities (consisting principally of customer deposits)mature or reprice more or less frequently than their interest-earning assets(generally consisting of loans and investment securities). The match between thescheduled repricing and maturities of earning assets and liabilities withindefined time periods is referred to as “gap” analysis. At March 31, 2006 thecumulative one-year gap was a negative (or liability sensitive) $4,600,000 or2.5% of earning assets compared to an evenly matched or slightly negative gapof $71,000 or .1% of earning assets at December 31, 2005.

 

One ofmanagement’s objectives in managing the Company’s balance sheet for interestrate sensitivity is to reduce volatility in the net interest margin bymatching, as closely as possible, the timing of the repricing of its interestrate sensitive assets with interest rate sensitive liabilities. During thefirst quarter of 2006 the Company experienced two rate increases after eightsuch increases during 2005. Management believes that interest rates willcontinue to increase during the first half of 2006 and then level off over thenext two years. The Company’s strategy of being in a slight negative one yeargap position should result in stable net interest margin as rates level off ordecline. The Company had maintained a positive gap for most of 2005 and movedto a balanced or slightly negative position during the fourth quarter of 2005. Thisposition into the first quarter of 2006 was significant in improving the netinterest margin to 4.17% compared to 4.06% at December 31, 2005. Many of the Company’s loans are commercialreal estate loans with rates that are tied to New York Prime or that are fixedfor up to three years, and this strategy allows the Company to matchlonger-term funding with these loans, thus minimizing volatility in the netinterest margin.

 

Off-balance Sheet Arrangements

 

We are a party to financial instruments withoff-balance sheet risk in the normal course of business to meet the financingneeds of its consumers.  At March 31,2006, we had unfunded loan commitments outstanding of $38.8 million and standbyletters of credit of $2.4 million.  Thesefinancial instruments include commitments to extend credit and standby lettersof credit.  Those instruments involve, tovarying degrees, elements of credit risk in excess of the amount recognized inthe balance sheet.  The contract ornotional amounts of those instruments reflect the extent of our involvement inthose particular financial instruments. We use the same credit policies in making commitments and conditionalobligations as it does for on-balance sheet instruments.

 

Because these commitments generally havefixed expiration dates and many will expire without being drawn upon, the totalcommitment level does not necessarily represent future cash requirements.  If needed, we can liquidate Federal fundssold or securities available for sale or borrow and purchase Federal funds fromother financial institutions where we have available federal funds linestotaling $13.1 million.

 

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**Item3. Controls and Procedures**

 

As of March31, 2005, an evaluation was carried out under the supervision and with theparticipation of the registrant’s management, including our President and ChiefFinancial Officer, of the effectiveness of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934 (the “Exchange Act”)). Based on their evaluation, ourPresident and Chief Financial Officer have concluded that the registrant’sdisclosure controls and procedures are effective to ensure that informationrequired to be disclosed by the registrant in reports that it files or submitsunder the Exchange Act is recorded, processed, summarized and reported withinthe time periods specified in Securities and Exchange Commission rules andforms.

 

There havebeen no changes in the registrant’s internal controls over financial reportingor in other factors that has materially affected, or is reasonably likely tomaterially affect, the registrant’s internal control over financial reporting.

 

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**PARTII - OTHER INFORMATION**

 

**Item1. Legal Proceedings**

 

None

 

**Item2. Unregistered Sales of Equity Securities and Use of Proceeds**

 

(a)          Sharesof the Company’s common stock were issued to Employees pursuant to the Company’sStock Option Plan as follows:

 
| **Date of Sale** | ** ** | **Number of Shares of  Common Stock Sold** | ** ** | **Price Per Share** | ** ** |
|----------------------------|------------|---------------------------------------------------------------------|------------|-------------------------------|------------|
| February 16, 2006          |       | 1,200                                                               |       | $                             | 9.52       |   |
| February16, 2006           |       | 600                                                                 |       | $                             | 17.14      |   |

 

The aggregate proceeds of the shares soldwere $21,708.

 

There were no underwriters and no underwriting discounts or commissions.All sales were for cash.

 

The Company believes that an exemption fromregistration of these shares was available to the Company in that the issuancethereof did not constitute a public offering of securities within the meaningof the Securities Act of 1933, as amended. The Company relied on the exemptionprovided by Section 4(2) of the Securities Act of 1933.

 

The common stock is not convertible or exchangeable into other equitysecurities.

 

The proceeds of the sales are being used by the Company for generalcorporate purposes.

 

(b)         Notapplicable.

 

(c)          Norepurchases for our securities were made during the quarter ended March 31,2006.

 

Thepayment of dividends by the Company depends to a great extent on the ability ofthe Bank to pay dividends to the Company. The Company is subject to theTennessee Banking Act, which provides that the Bank may not declare dividendsin any calendar year that exceeds the total of its net income of that yearcombined with its retained net income of the preceding two years without theapproval of the TDFI. Thereafter, 10% of net profits must be transferred tocapital surplus prior to payment of dividends until capital surplus equalscapital stock. The Bank is also subject to the minimum capital requirements ofthe FDIC which impact the Bank’s ability to pay dividends. If the Bank fails tomeet these standards, it may not be able to pay dividends or to acceptadditional deposits because of regulatory requirements.

 

If, in the opinion of theapplicable federal bank regulatory authority, a depository institution isengaged in or is about to engage in an unsafe or unsound practice (which,depending on the financial condition of the depository institution, couldinclude the payment of dividends), such authority may require that suchinstitution cease and desist from such practice. The federal banking agencieshave indicated that paying dividends that deplete a depository institution’scapital base to an inadequate level would be such an unsafe and unsound bankingpractice. Moreover, the Federal Reserve Board, the Comptroller of the Currencyand the FDIC have issued policy statements which provide that bank holdingcompanies and insured depository institutions generally should only paydividends out of current earnings.

 

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**Item3. Default Upon Senior Securities**

 

None

 

**Item4. Submission of Matters to a Vote of Security Holders**

 

None

 

**Item5. Other Information**

 

None

 

**Item6. Exhibits**

 

31.1         Rule13a-14(a)/15d-15(e) Certification of the President.

31.2         Rule13a-14(a)/15d-15(e) Certification of the Chief Financial Officer.

 

32.1         Section 1350Certification of the President.

32.2         Section 1350Certification of the Chief Financial Officer

 

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**SOUTHERN HERITAGE BANCSHARES, INC.**

 

**FORM 10-QSB**

 

Quarter ended March 31, 2006

 

# **SIGNATURES**

# ** **

Pursuant tothe requirements of the Securities and Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|         |   | Southern Heritage Bancshares, Inc. |   |
|--------------|--------|------------------------------------|--------|
|         |   | (Registrant)                       |   |
|         |   |                               |   |
| May 16, 2006 |   | /s/ J. Lee Stewart                 |   |
| (Date)       |   | J. Lee Stewart                     |   |
|         |   | President                          |   |
|         |   |                               |   |
| May 16, 2006 |   | /s/ Steven W. Ledbetter            |   |
| (Date)       |   | Steven W. Ledbetter,               |   |
|         |   | Chief Financial Officer            |   |

 

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