**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

 

**Washington,D.C.  20549**

 

**FORM 10-QSB**

 

**(Mark One)**

 
| **ý**                                              | **QUARTERLY REPORT UNDER SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**        |
|---------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                    |                                                                                                    |
| **For the Quarterly Period  Ended: June 30, 2005** |
|                                                    |                                                                                                    |
| **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 BusinessIssuer as Specified 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 andFiscal Year, if Changed Since Last Report)

 

Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days

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

 

State the outstanding numberof shares of the issuer’s common stock as of July 31, 2005:  1,077,111

 

Transitional Small Business Disclosure Format (check one):

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

 

 

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

 

**FORM 10-QSB**

**Quarterended June 30, 2005**

 
| ***PART I.***  | ***FINANCIAL  INFORMATION*** |
|---------------------|------------------------------|
|                |                         |
|                | ***Item  1.***               | Financial Statements |
|                |                         |   |
|                |                         | Consolidated Balance Sheets – June 30, 2005 (Unaudited) and  December 31, 2004 |
|                |                         |   |
|                |                         | Consolidated Statements of Operations – Three and six months ended  June 30, 2005 and 2004 (Unaudited) |
|                |                         |   |
|                |                         | Consolidated Statements of  Cash Flows - Six months ended June 30, 2005 and 2004 (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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**SOUTHERNHERITAGE BANCSHARES, INC.**

**Consolidated Balance Sheets**

**June 30,2005**

 

*($ amounts in thousands except share and per share data)*

 
| ** **                                                                        | ** ** | **(Unaudited)** | ** **  | ** **       | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------|-------------|------------------|------------|
| ** **                                                                        | ** ** | **June 30,**    | ** **  | **December 31,** | ** ** |
| ** **                                                                        | ** ** | **2005**        | ** **  | **2004**         | ** ** |
| ***Assets***                                                                      |       |            | ** **  |             |       |
| Cash and due from banks                                                           | ** ** | **$**           | **3,849**   | ** **       | 4,653      |   |
| Federal funds sold                                                                | ** ** | **12,083**      | ** **  | 440              |       |
| ***Cash and cash equivalents***                                                   | ** ** | **15,932**      | ** **  | 5,093            |       |
| Securities available-for-sale, at fair  value                                     | ** ** | **20,686**      | ** **  | 19,667           |       |
| Mortgage loans held for sale                                                      | ** ** | **108**         | ** **  | 683              |       |
| Loans                                                                             | ** ** | **135,082**     | ** **  | 125,925          |       |
| Allowance for loan losses                                                         | ** ** | **(1,886**      | **)**       | (1,723           | )          |
| ***Loans, net***                                                                  | ** ** | **133,196**     | ** **  | 124,202          |       |
| Premises and equipment                                                            | ** ** | **5,497**       | ** **  | 5,580            |       |
| Restricted stock                                                                  | ** ** | **509**         | ** **  | 455              |       |
| Accrued interest receivable                                                       | ** ** | **649**         | ** **  | 529              |       |
| Other assets                                                                      | ** ** | **770**         | ** **  | 652              |       |
| ** **                                                                        |       | **$**           | **177,347** | ** **       | 156,861    |   |
|                                                                              |       |            | ** **  |             |       |
| ***Liabilities and Shareholders’ Equity***                                   |       |            | ** **  |             |       |
| **Liabilities:**                                                                  |       |            | ** **  |             |       |
| **Deposits:**                                                                     |       |            | ** **  |             |       |
| Noninterest-bearing                                                               | ** ** | **$**           | **24,380**  | ** **       | 22,724     |   |
| Interest-bearing                                                                  | ** ** | **133,147**     | ** **  | 114,635          |       |
| ***Total deposits***                                                              | ** ** | **157,527**     | ** **  | 137,359          |       |
| Repurchase agreements                                                             | ** ** | **285**         | ** **  | 1,052            |       |
| Accrued interest payable                                                          | ** ** | **609**         | ** **  | 429              |       |
| Subordinated debentures                                                           | ** ** | **5,155**       | ** **  | 5,155            |       |
| Other liabilities                                                                 | ** ** | **426**         | ** **  | 339              |       |
| ***Total liabilities***                                                           | ** ** | **164,002**     | ** **  | 144,334          |       |
| **Shareholders’ equity:**                                                    |       |            | ** **  |             |       |
| Preferred stock, no par value. Authorized  1,000,000 shares; none issued          | ** ** | **—**      | ** **  | —           |       |
| Common stock, $1 par value. Authorized  2,000,000 shares; issued 1,077,111 shares | ** ** | **1,077**       | ** **  | 1,025            |       |
| Additional paid-in-capital                                                        | ** ** | **10,719**      | ** **  | 9,222            |       |
| Retained earnings                                                                 | ** ** | **1,629**       | ** **  | 2,277            |       |
| Accumulated other comprehensive income  (loss)                                    | ** ** | **(80**         | **)**       | 3                |       |
| ***Total shareholders’ equity***                                             | ** ** | **13,345**      | ** **  | 12,527           |       |
| ** **                                                                        |       | **$**           | **177,347** | ** **       | 156,861    |   |

 

See accompanying notes to consolidatedfinancial statements.

 

3

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**SOUTHERN HERITAGE BANCSHARES, INC.**

**Consolidated Statements of Operations**

**Three and Six Months Ended June 30**

**(Unaudited)**

 

*($ amounts in thousands except share and per share data)*

 
| ** **                                                 | ** ** | **Three Months Ended   June 30** |       | **Six Months Ended   June 30** | ** ** |
|------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                 | ** ** | **2005**                         | ** ** | **2004**                       |       | **2005** | ** ** | **2004** | ** ** |
| **Interest income:**                                       |       |                             | ** ** |                           |       |   | ** ** |   |   |
| Loans, including fees                                      | ** ** | **$**                            | **2,135**  | ** **                     | 1,672      |   | **$** | **4,170** | ** ** | 3,282 |   |
| Securities                                                 | ** ** | **192**                          | ** ** | 141                            |       | **368** | ** ** | 274 |   |
| Federal funds sold                                         | ** ** | **84**                           | ** ** | 15                             |       | **105** | ** ** | 20 |   |
| ***Total interest income***                                | ** ** | **2,411**                        | ** ** | 1,828                          |       | **4,643** | ** ** | 3,576 |   |
| **Interest expense:**                                      |       |                             | ** ** |                           |       |   | ** ** |   |   |
| Deposits                                                   | ** ** | **784**                          | ** ** | 566                            |       | **1,466** | ** ** | 1,100 |   |
| Other borrowed funds                                       | ** ** | **69**                           | ** ** | —                         |       | **127** | ** ** | — |   |
| ***Total interest expense***                               | ** ** | **853**                          | ** ** | **566**                        |       | **1,593** | ** ** | **1,100** | ** ** |
| ***Net interest income***                                  | ** ** | **1,558**                        | ** ** | 1,262                          |       | **3,050** | ** ** | 2,476 |   |
| **Provision for loan losses**                              | ** ** | **58**                           | ** ** | 67                             |       | **187** | ** ** | 180 |   |
| ***Net interest income after provision for  loan losses*** | ** ** | **1,500**                        | ** ** | 1,195                          |       | **2,863** | ** ** | 2,296 |   |
| **Noninterest income:**                                    |       |                             | ** ** |                           |       |   | ** ** |   |   |
| Service charges on deposit accounts                        | ** ** | **339**                          | ** ** | 297                            |       | **658** | ** ** | 498 |   |
| Mortgage banking activities                                | ** ** | **116**                          | ** ** | 107                            |       | **203** | ** ** | 205 |   |
| Gain (loss) on sale of securities                          | ** ** | **(1**                           | **)**      | (5                             | )          | **(4** | **)** | 20 |   |
| Other service charges, commissions and fees                | ** ** | **63**                           | ** ** | 58                             |       | **143** | ** ** | 112 |   |
| ***Total noninterest income***                             | ** ** | **517**                          | ** ** | 457                            |       | **1,000** | ** ** | 835 |   |
| **Noninterest  expenses:**                                 |       |                             | ** ** |                           |       |   | ** ** |   |   |
| Salaries and employee benefits                             | ** ** | **688**                          | ** ** | 538                            |       | **1,255** | ** ** | 1,045 |   |
| Occupancy expense                                          | ** ** | **87**                           | ** ** | 84                             |       | **175** | ** ** | 168 |   |
| Other operating expenses                                   | ** ** | **527**                          | ** ** | 430                            |       | **1,069** | ** ** | 817 |   |
| ***Total noninterest expenses***                           | ** ** | **1,302**                        | ** ** | 1,052                          |       | **2,499** | ** ** | 2,030 |   |
| ***Income before income taxes***                           | ** ** | **715**                          | ** ** | 600                            |       | **1,364** | ** ** | 1,101 |   |
| **Income taxes**                                           | ** ** | **238**                          | ** ** | 221                            |       | **472** | ** ** | 403 |   |
| ***Net income***                                           | ** ** | **477**                          | ** ** | 379                            |       | **892** | ** ** | 698 |   |
|                                                       |       |                             | ** ** |                           |       |   | ** ** |   |   |
| **Other comprehensive income (loss):**                     |       |                             | ** ** |                           |       |   | ** ** |   |   |
| Unrealized gains/losses on securities net  of tax          | ** ** | **144**                          | ** ** | (530                           | )          | **(83** | **)** | (342 | ) |
|                                                       |       |                             | ** ** |                           |       |   | ** ** |   |   |
| **Comprehensive income (loss)**                            | ** ** | **621**                          | ** ** | (151                           | )          | **809** | ** ** | 356 |   |
|                                                       |       |                             | ** ** |                           |       |   | ** ** |   |   |
| Basic earnings per share                                   | ** ** | **$**                            | **0.44**   | ** **                     | $          | 0.35 |   | **$** | **0.83** | ** ** | $ | 0.65 |   |
| Diluted earnings per share                                 | ** ** | **$**                            | **0.41**   | ** **                     | $          | 0.33 |   | **$** | **0.76** | ** ** | $ | 0.61 |   |
|                                                       |       |                             | ** ** |                           |       |   | ** ** |   |   |
| Shares used in computation of earnings per  share          |       |                             | ** ** |                           |       |   | ** ** |   |   |
| Basic                                                      | ** ** | **1,077,111**                    | ** ** | 1,075,956                      |       | **1,077,111** | ** ** | 1,075,956 |   |
| Diluted                                                    | ** ** | **1,166,790**                    | ** ** | 1,141,481                      |       | **1,166,790** | ** ** | 1,141,481 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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**SOUTHERN HERITAGE BANCSHARES, INC.**

**ConsolidatedStatements of Cash flows**

**Six Months Ended June 30**

**(Unaudited)**

** **

*($ amounts in thousands except share and per sharedata)*

 
| ** **                                                                                | ** ** | **2005**    | ** ** | **2004**   | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|
| **Cash  flows from operating activities:**                                                |       |        | ** ** |       |       |
| **Net  income**                                                                           | ** ** | **$**       | **892**    | ** ** | 698        |   |
| Adjustments to reconcile net income to net  cash provided (used) by operating activities: |       |        | ** ** |       |       |
| Depreciation and amortization                                                             | ** ** | **199**     | ** ** | 214        |       |
| Provision for loan losses                                                                 | ** ** | **187**     | ** ** | 180        |       |
| (Gain) loss on sale of securities available  for sale                                     | ** ** | **4**       | ** ** | (20        | )          |
| FHLB stock dividends                                                                      | ** ** | **5**       | ** ** | (2         | )          |
| Mortgage loans originated for sale                                                        | ** ** | **(11,113** | **)**      | (10,064    | )          |
| Proceeds from sale of mortgage loans                                                      | ** ** | **11,688**  | ** ** | 10,023     |       |
| Decrease (increase) in accrued interest  receivable                                       | ** ** | **(120**    | **)**      | 33         |       |
| Increase (decrease) in accrued interest  payable                                          | ** ** | **180**     | ** ** | 47         |       |
| Other, net                                                                                | ** ** | **(18**     | **)**      | (23        | )          |
| ***Net cash provided by  operating activities***                                          | ** ** | **1,904**   | ** ** | 1,086      |       |
| **Cash  flows from investing activities:**                                                |       |        | ** ** |       |       |
| Proceeds from maturities and redemptions of  securities available for sale                | ** ** | **636**     | ** ** | 1,649      |       |
| Proceeds from sales of securities available  for sale                                     | ** ** | **4,408**   | ** ** | 3,151      |       |
| Purchases of securities available for sale                                                | ** ** | **(6,207**  | **)**      | (4,867     | )          |
| Purchases of restricted stock                                                             | ** ** | **(54**     | **)**      | (29        | )          |
| Net increase in loans                                                                     | ** ** | **(9,157**  | **)**      | (11,638    | )          |
| Purchases of premises and equipment                                                       | ** ** | **(92**     | **)**      | (163       | )          |
| ***Net cash used by investing  activities***                                              | ** ** | **(10,466** | **)**      | (11,897    | )          |
| **Cash  flows from financing activities:**                                                |       |        | ** ** |       |       |
| Decrease in repurchase agreements                                                         | ** ** | **(767**    | **)**      | (1,669     | )          |
| Increase in deposits                                                                      | ** ** | **20,168**  | ** ** | 15,682     |       |
| ***Net cash provided by  financing activities***                                          | ** ** | **19,401**  | ** ** | 14,013     |       |
|                                                                                      |       |        | ** ** |       |       |
| ***Net increase (decrease) in  cash***                                                    | ** ** | **10,839**  | ** ** | 3,202      |       |
| **Cash and  cash equivalents, beginning of period**                                       | ** ** | **5,093**   | ** ** | 4,545      |       |
|                                                                                      |       |        | ** ** |       |       |
| **Cash and  cash equivalents, end of period**                                             | ** ** | **$**       | **15,932** | ** ** | 7,747      |   |
|                                                                                      |       |        | ** ** |       |       |
| **Cash  payments for interest**                                                           | ** ** | **$**       | **1,413**  | ** ** | 1,053      |   |
| **Cash  payments for income taxes**                                                       | ** ** | **638**     | ** ** | 438        |       |

 

See accompanying notes to consolidatedfinancial statements.

 

5

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**SOUTHERNHERITAGE BANCSHARES, INC.**

**Notes to Consolidated Financial Statements**

**June 30,2005**

**(Unaudited)**

 

*Basis ofPresentation*

 

The accompanying financialstatements have been prepared in accordance with generally accepted accountingprincipals for interim financial information and with the instructions to Form 10-QSB.  Accordingly they do not include allinformation and footnotes required by generally accepted accounting principalsfor complete financial statements.

 

The consolidated financialstatements include Southern Heritage Bancshares, Inc. and its wholly ownedsubsidiary, Southern Heritage Bank, together referred to as “the Company”.  Intercompany transactions and balances areeliminated in consolidation.

 

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

 

In the opinion ofmanagement, the financial statements contain all adjustments necessary tosummarize fairly the financial position of the Bank as of June 30, 2005,the results of operations for the six months ended June 30, 2005, and cashflows for the six months ended June 30, 2005.  The interim financial statements should beread in conjunction with the notes to the financial statements presented in theBank’s December 31, 2004, financial statements.  The results for the interim periods are notnecessary indicative of the results to be expected for the complete year.

 

*Allowance for Loan Losses*

 

Transactions in the allowance for loan losseswere as follows:

 
| ** **                       | ** ** | **Six Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2004** | ** ** |
|----------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                       | ** ** | **(In Thousands)**                        | ** ** | **(In Thousands****)**                    | ** ** |
|                             |       |                                      |       |                                      |       |
| Balance January 1           |       | $                                         | 1,723      |                                      | $          | 1,372 |   |
| Add (deduct):                    |       |                                      |       |                                      |       |
| Losses charged to allowance      |       | (37                                       | )          | (15                                       | )          |
| Recoveries credited to allowance |       | 13                                        |       | 4                                         |       |
| Provision for loan losses        |       | 187                                       |       | 180                                       |       |
|                             |       |                                      |       |                                      |       |
| Balance June 30             |       | $                                         | 1,886      |                                      | $          | 1,541 |   |

 

6

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Management’s determinationof the appropriate level of the provision for loan losses and the adequacy ofthe allowance for loan losses is based, in part on an evaluation of specificloans, as well as other factors considered by management, including thecomposition of the loan portfolio, current economic conditions, and thecreditworthiness of the Bank’s borrowers and other related factors.

 

At June 30, 2005, theBank had two loans totaling $226,000 in nonaccrual status.  This compares with December 31, 2004,where there were five loans for a total of $85,000 in nonaccrual.  The Bank had no loans that were more than 90days delinquent on June 30, 2005, compared to two loans totaling$1,518,000 as of December 31, 2004. In the first six months of 2005, loans totaling $37,000 were charged offand $13,000 was recovered on loans previously charged off.  Management believes the allowance for loanlosses at June 30, 2005, is adequate to absorb probable incurred losses inthe loan portfolio.

 

Stock Dividend:  The Company declared a stock dividend of oneshare for each 20 shares owned for shareholders of record as of May 19,2005.  The effects of this stock dividendhave been reflected in earnings per share and shares used in the computation ofearnings per share for all periods presented.

 

Stock Compensation:  Employee compensation expense under stockoptions is reported using the intrinsic value method.  No stock-based compensation cost is reflectedin net income; as all options granted had an exercise price equal to or greaterthan the market price of 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 forStock-Based Compensation.

 
| ** **                                                                         | ** ** | **Six Months  Ended  June 30, 2005** | ** ** | **Six Months  Ended  June 30, 2004** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
|                                                                               |       |                                      |       |                                      |       |
| Net income as reported                                                             |       | $                                         | 892        |                                      | $          | 698 |   |
| Deduct: Stock-based compensation expense determined  under fair value based method |       | 24                                        |       | 24                                        |       |
|                                                                               |       |                                      |       |                                      |       |
| Pro Forma net income                                                               |       | $                                         | 868        |                                      | $          | 674 |   |
|                                                                               |       |                                      |       |                                      |       |
| Basic earnings per share as reported                                               |       | $                                         | 0.83       |                                      | $          | 0.65 |   |
| Pro Forma basic earnings per share                                                 |       | 0.81                                      |       | 0.63                                      |       |
|                                                                               |       |                                      |       |                                      |       |
| Diluted earnings per share as reported                                             |       | 0.76                                      |       | 0.61                                      |       |
| Pro Forma diluted earnings per share                                               |       | 0.74                                      |       | 0.59                                      |       |

 

Earnings Per ShareAmount:  Basic earnings per share iscomputed using the weighted average number of common shares outstanding duringthe period and excludes any dilutive effects of options.  Diluted earnings per share is computed usingthe weighted average number of common and common stock equivalent sharesoutstanding during the period; common stock equivalent shares are excluded fromthe computation if their effect is antidilutive.  The effect of these options on earnings percommon share was to increase average shares outstanding by 89,679 and 65,525 in2005 and 2004 and decrease earnings per share by $.07 and $.04.  No shares were antidilutive at June 30,2005 and 2004.

 

7

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# ***ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS***

 

# **OVERVIEW**

 

The following discussioncompares the financial condition of Southern Heritage Bancshares, Inc.(the “Company”) at June 30, 2005, to December 31, 2004, and theresults of operations for the three and six months ended June 30, 2005 and2004.  Reasons for changes in thequarterly results are the same as those for the year to date results.  The Company is a one bank holding companythat owns 100% of Southern Heritage Bank (the “Bank”).  Substantially all of the consolidatedoperations are that of the Bank.  Thisdiscussion should be read in conjunction with the interim financial statementsand footnotes included herein.

 

Certain statements containedin this report that are not historical facts are forward looking statementsthat are subject to certain risks and uncertainties.  When used herein, the terms “anticipates,” “plans,”“expects,” “believes,” and similar expressions as they relate to the Company orits management are intended to identify such forward looking statements.  The Company’s actual results, performance orachievements may materially differ from those expressed or implied in theforward-looking statements.  Risks anduncertainties that could cause or contribute to such material differencesinclude, but are not limited to, general economic conditions, the interest rateenvironment, competitive conditions in the financial services industry, changesin law, governmental policies and regulations, and rapidly changing technologyaffecting financial services.

 

# **FINANCIALCONDITION**

 

Total assets as of June 30,2005 increased 13.1%, or $20,486,000, to $177,347,000, compared with$156,861,000 at December 31, 2004. The increase in total assets was funded by a comparable increase intotal deposits of $20,168,000.  Cash andcash equivalents increased $10,839,000 to $15,932,000 at June 30, 2005from $5,093,000 at December 31, 2004. Securities increased $1,019,000 to $20,686,000 at June 30, 2005compared to $19,667,000 at December 31, 2004.

 

Loans are the principalcomponent of the Bank’s assets and the primary source of income.  Total loans at June 30, 2005, were$135,082,000 compared to $125,925,000 at December 31, 2004, an increase of$9,157,000.  Most of the net loan growthin the first six months of 2005 was in construction loans secured by realestate which increased $2,656,000; commercial loans increased $2,068,000, andother loans increased $2,395,000. As of June 30, 2005, $41,359,000 or 31%of total loans were commercial loans secured by real estate.  Commercial loans were $35,571,000 or 27% oftotal loans.  Loans secured by 1-4 familyresidential real estate were $24,661,000 or 18% of total loans.  Construction loans secured by real estatewere $24,669,000 or 18% of total loans. Consumer loans were $4,237,000 or 3% of total loans.  Other loans were $4,149,000 or 3% of totalloans.  Of the total loans, $90,173,000or 66.8% mature or reprice within 12 months. Only $2,014,000 or 1.5% mature or reprice over five years.

 

There was $108,000 inmortgage loans held for sale at June 30, 2005, compared with $683,000 at December 31,2004.  The decrease in mortgage loansheld for sale was primarily due to timing issues related to secondary marketinvestor funding.

 

8

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**FINANCIALCONDITION (continued)**

 

Management anticipates thatloan demand will continue to be strong. The loan-to-deposit ratio as of June 30, 2005, was 85.8%, comparedto 91.7% at December 31, 2004, and the loan-to-assets ratio was 76.2% at June 30,2005, compared to 80.3% at December 31, 2004.  Management expects that the loan-to-depositratio for the remainder of 2005 will remain in the range of approximately 85% -90% and the loans-to-assets ratio will be between 75% - 80%.

 

The securities portfolioprovides a balance to interest rate and credit risk while providing a vehiclefor investing available funds, furnishing liquidity, and supplying securitiesto pledge as required for certain deposits and borrowed funds.  All securities are classified as “availablefor sale”.  We have no plans to liquidatea significant amount of the securities portfolio.

 

As of June 30, 2005,the company owned $20,686,000 of securities available-for-sale, an increase of$1,019,000 or 5.2% over the $19,667,000 at December 31, 2004.

 

Deposits which are the Bank’sprimary source of funds, totaled $157,527,000 at June 30, 2005, for anincrease of $20,168,000, or 14.7%, compared to $137,359,000 at December 31,2004.  Deposits at June 30, 2005consisted of $24,380,000 or 15.4% in non-interest bearing demand deposits,$43,767,000 or 27.8% in interest-bearing demand deposits, $82,897,000 or 52.6%in time certificates of deposit and $6,483,000 or 4.2% in savings accounts.  There was $16,371,000 in brokered CDs at June 30,2005 compared to $11,470,000 at December 31, 2004.  The Bank has targeted local consumers,professionals, and small businesses as its central clientele.  These customers are being offered variousdeposit instruments such as demand deposits, savings accounts, money marketaccounts, certificates of deposit and IRAs. Rates paid on such instruments are set based on various factors such asliquidity needs and market conditions. The Bank believes it has a competitive advantage by being a locallyowned financial institution which will contribute to increased marketshare.  However, no assurance of marketgrowth can be given.

 

The majority of the depositscontinue to be CDs, which increased $12,954,000 in the first six months of2005.  At June 30, 2005, theweighted average rate on CDs was 3.12% compared to 2.68% for the six monthsended June 30, 2004. The Bank has time deposits maturing within one yearof $46,022,000 or 55.5% of total time deposits. Time deposits maturing greater than one year is $36,875,000 or 44.5% oftotal time deposits.  Interest-bearingaccounts, other than CDs, increased $5,558,000 in the first six months of2005.  Noninterest bearing depositsincreased $1,656,000 for the six months ended June 30, 2005.  The weighted average cost of all depositaccounts during the first six months of 2005 was 1.98% compared to 1.74% forthe same period in 2004.

 

Total shareholders’ equityincreased $818,000, to $13,345,000 at June 30, 2005, from $12,527,000 at December 31,2004.  This increase was due to theCompany’s net income of $892,000 for the first six months of 2005 along with anet increase in unrealized losses on securities available for sale of $83,000net of tax.

 

The Company declared a stockdividend of one share for each 20 shares owned for shareholders of record as ofMay 19, 2005.  The effects of thestock dividend have been reflected in earnings per share and shares used in thecomputation of earnings per share for all periods presented.

 

As of June 30, 2005 theBank is categorized as well capitalized under the regulatory framework forprompt corrective action.  The totalcapital to risk-weighted assets ratio was 13.68%.  Tier-1 to risk-weighted assets ratio was12.43% and Tier-1 to average asset ratio was 10.55%.

 

9

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# **RESULTSOF OPERATIONS**

 

For the first six months of2005, net income after tax was $892,000, compared to $698,000 for the sameperiod in 2004, an increase of 27.8%. The increase in earnings over the previous year was primarily a resultof the increase in net interest income as a result of the overall growth of thebank.  Net interest income before theprovision for loan losses for the first six months of 2005 was $3,050,000, anincrease of $574,000 or 23.2% from $2,476,000 for the first six months of2004.  The net interest margin increased13 basis points to 4.32% at June 30, 2005 compared to 4.19% for the sameperiod in 2004.

 

Interest and fee income onloans for the first six months of 2005 was $4,170,000, an increase of $888,000or 27.1% from $3,282,000 for the six months ended June 30, 2004.  The increase in interest and fee income onloans is primarily due to increased volume in construction real estate andcommercial loans and an increase in rates following the Federal Reserve’sefforts to increase short term rates.

 

Interest income fromsecurities and short-term funds totaled $473,000 for the first six months of2005, an increase of $179,000 over the same period of 2004.  The increase in 2005 was due to an increasein the average dollar amount of securities and short-term funds outstanding;$26,328,000 at June 30, 2005 compared to $18,521,000 at June 30, 2004and the increase in short term rates.

 

Interest expense totaled$1,593,000 in the first six months of 2005, compared to $1,100,000 for the sameperiod of 2004.  The increase in interestexpense in 2005 was due to the significant growth of deposits. The Bank’s costof funds increased to 1.98% at June 30, 2005 compared to 1.74% at June 30,2004 as a result of the increase in short term rates. Total depositsoutstanding at June 30, 2005 were $157,527,000 compared to $137,359,000 atDecember 31, 2004.

 

The Bank’s net interestmargin for the first six months of 2005 was 4.32% compared to 4.19% for the sixmonths ended June 30, 2004.

 

The Bank’s yield on earningassets has increased to 6.20%, for the first six months of 2005 compared to5.91% for the same period of 2004.  Thecost of interest-bearing funds has followed the same trend, increasing to 2.39%for the first six months of 2005, up from 2.10% for the six months ended June 30,2004.

 

In the first six months of2005, the Bank provided $187,000 for probable incurred loan losses, compared to$180,000 for the same period of 2004. Management’s determination of the appropriate level of the provision forloan losses and the adequacy of the allowance for loan losses is based, inpart, on an evaluation of specific loans, as well as a conservative posture dueto the bank’s short history.  Otherfactors considered by management include the composition of the loan portfolio,current economic conditions, and the creditworthiness of the Bank’s borrowersand other related factors.  The netcharge-offs for the first six months of 2005 were $24,000 compared to $11,000for the same period in 2004.

 

At June 30, 2005, theBank had two loans totaling $226,000 in nonaccrual status.  This compares with December 31, 2004,where there were five loans totaling $85,000 in nonaccrual.  At June 30, 2005 there were no loans thatwere more than 90 days delinquent compared to two loans totaling $1,518,000 asof December 31, 2004.  In the firstsix months of 2005, loans totaling $37,000 were charged off and $13,000 wasrecovered on loans previously charged off. Management believes the allowance for loan losses at June 30, 2005,is adequate to absorb probable incurred losses in the loan portfolio.

 

Total noninterest income forthe first six months of 2005 was $1,000,000 compared to $835,000 for the sameperiod in 2004.  The Bank originates andsells long-term fixed rate mortgages and the related servicing.  Mortgage loans originated and sold generated$203,000 of fees; 89 loans closed, as of June 30, 2005 compared to$205,000; 78 loans closed, for the six months ended June 30, 2004.  The average loan closed declined $1,000 to$131,000 from $132,000 in the previous year. The other large component of non-interest income is service charges ondeposit accounts which totaled $658,000 as of June 30, 2005 compared to$498,000 for the same period in 2004. The increase here is primarily due to the new “bounce protection”overdraft product introduced in May 2004 and overall deposit growth of theBank.

 

10

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# **RESULTSOF OPERATIONS (continued)**

 

Noninterest expenses were$2,499,000 for the first six months of 2005 compared with $2,030,000 for thesame period of 2004; an increase of $469,000 or 23.1%.  The growth in noninterest expenses in thefirst six months of 2005 is attributable primarily to the increase in salariesand benefits expense ($210,000 or 20.1%) and other operating expense ($252,000or 30.8%).

 

As of June 30, 2005,the Bank had 45 full-time equivalent employees compared to 48 for the sameperiod of 2004.  Salaries and wagesrepresent $112,000 of the increase.  Theemployee bonus program was revised in 2005 resulting in an additional $45,000charge over the previous year amount. The employer match of $31,000 on the 401K plan was not in existence at June 30,2004 (implemented September 2004). During 2005, $8,000 was paid for recruiting and hiring key staff.

 

The increase in otheroperating expense was primarily in outside fees $147,000.  This area includes FDIC and State Assessmentfees, $8,000, director fees $29,000, accounting, audit, and consulting$100,000. The increase in directors’ fees is due to an increase in the annualretainer for non management directors from $3,000 to $6,000 per year and anincrease in the number of meetings called. The increase in accounting, audit and consulting is due to outsourcingparts of internal audit, compliance and information technology testing, as wellas the cost for external audit and tax services. Management expects that thecost of compliance with the internal control requirements of Section 404of the Sarbanes-Oxley Act of 2002 will have an adverse effect on noninterestexpense in future years.

 

The remaining increase inother operating expense includes increases in postage and supplies $20,000,human resources training and seminars $25,000, direct fees for the new “bounceprotection” program $26,000, data processing software $10,000, loan processingexpense $14,000 and loss on the sale of foreclosed property $5,000.

 

The Bank booked income taxexpense of $472,000 for the period ended June 30, 2005 compared to $403,000for the same period in 2004.  Theeffective tax rate is 34.6% for 2005 compared to 36.6% for 2004.  The decrease is due to the Company’s emphasison a larger percentage of the security portfolio being in tax freesecurities.  Total outstanding at June 30,2005 was $14,472,000 or 70% of the portfolio compared to $7,325,000 or 47% inthe prior year.  Income for the periodwas $216,000 compared to $100,000 in the prior year.

 

# **LIQUIDITYAND CAPITAL RESOURCES**

 

Liquidity refers to the Company’sability to fund loan demand, meet deposit customers’ withdrawal needs andprovide for operating expenses.  Assummarized in the Statement of Cash Flows, the Company’s main source of cashflow is from receiving deposits from its customers, and to a lesser extent,repayment of loan principal and interest income on loans and investments.  The primary uses of cash are lending to theCompany’s borrowers, and investing in securities and short-terminterest-earning assets.

 

In the first six months of2005, deposit growth has exceeded loan growth; however, this is more of atiming issue and is not expected to continue. Other potential sources ofliquidity include the sale of available-for-sale securities from the Bank’sportfolio, the sale of loans, the purchase of federal funds, or repurchaseagreements. The Company currently has $16,371,000 in brokered certificates ofdeposit.

 

11

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# **LIQUIDITYAND CAPITAL RESOURCES (continued)**

 

At June 30, 2005 and December 31,2004, the Bank’s risk-based capital ratios and the minimums to be consideredwell-capitalized under the Federal Reserve Board’s prompt corrective actionguidelines were as follows:

 
| ** **                             | ** ** | **June 30, 2005** | ** ** | **Dec. 31, 2004** | ** ** | **Well-capitalized** | ** ** |
|----------------------------------------|------------|------------------------|------------|------------------------|------------|----------------------|------------|
|                                   |       |                   |       |                   |       |                 |       |
| Tier 1 capital to risk-weighted assets |       | 12.43                  | %          | 11.96                  | %          | 6.0                  | %          |
| Total capital to risk-weighted assets  |       | 13.68                  | %          | 13.79                  | %          | 10.0                 | %          |
| Tier 1 leverage ratio                  |       | 10.55                  | %          | 10.73                  | %          | 5.0                  | %          |

 

As discussed above, totalshareholders’ equity increased $818,000, to $13,345,000 at June 30, 2005from $12,527,000 at December 31, 2004. This increase was due to the Company’s net income of $892,000 for thefirst six months of 2005 along with a net increase in unrealized losses onsecurities available for sale of $83,000, net of tax.

 

# **INTERESTRATE SENSITIVITY**

 

Financial institutions aresubject to interest rate risk to the degree that their interest-bearingliabilities (consisting principally of customer deposits) mature or repricemore or less frequently than their interest-earning assets (generallyconsisting of loans and investment securities). The match between the scheduled repricing and maturities of earningassets and liabilities within defined time periods is referred to as “gap”analysis.  At June 30, 2005 thecumulative one-year gap was a positive (or asset sensitive) $6,418,000 or 3.8%of earning assets compared to a positive gap of $7,679,000 or 5.2% of earningassets at December 31, 2004.

 

One of management’sobjectives in managing the Bank’s balance sheet for interest rate sensitivityis to reduce volatility in the net interest margin by matching, as closely aspossible, the timing of the repricing of its interest rate sensitive assetswith interest rate sensitive liabilities. During the first six months of 2005 the Bank experienced four rateincreases after only one increase during the same period in 2004.  As a result of the positive gap position, theBank’s net interest margin improved to 4.32% at June 30, 2005 compared tothe 3.85% margin at December 31, 2004. Management believes that interest rates will continue to increase during2005.  The Bank’s strategy of being in apositive one year gap position should result in stable to increasing netinterest margin as rates begin to rise. Many of the Bank’s loans arecommercial real estate loans with rates that are tied to New York Prime or thatare fixed for up to three years, and this strategy allows the Bank to matchlonger-term funding with these loans, thus minimizing volatility in the netinterest margin.

 

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# ***ITEM 3.  CONTROLS ANDPROCEDURES***

# ** **

As of June 30, 2005, anevaluation was carried out under the supervision and with the participation ofthe registrant’s management, including our President and Chief FinancialOfficer, of the effectiveness of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934 (the “Exchange Act”)). Based on their evaluation, our President and Chief Financial Officerhave concluded that the registrant’s disclosure controls and procedures areeffective to ensure that information required to be disclosed by the registrantin reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms.

 

There have been no changesin the Company’s internal controls over financial reporting or in other factorsthat has materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

13

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**PART II - OTHER INFORMATION**

 

**Item 1.  LegalProceedings**

 

None

 

**Item 2.  UnregisteredSales of Equity Securities and Use of Proceeds**

 

(a)                                  Sharesof the Company’s common stock were issued to non-employee director pursuant toa stock option plan of the Company as follows:

 
| ** **         | ** ** | **Number of Shares of** | ** ** | ** **          | ** ** |
|--------------------|------------|-------------------------|------------|---------------------|------------|
| **Date  of Sale**  | ** ** | **Common Stock Sold**   | ** ** | **Price Per Share** | ** ** |
| ** **         | ** ** | ** **              | ** ** | ** **          | ** ** |
| April 1, 2005 |       | 1,100                   |       | $                   | 10         |   |
|                    |            |                         |            |                     |            |  |

 

The aggregate proceedsof the shares sold were $11,000.

 

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

 

The Companybelieves that an exemption from registration of these shares was available tothe Company in that the issuance thereof did not constitute a public offeringof securities within the meaning of the Securities Act of 1933, asamended.  The Company relied on theexemption provided by Section 4(2) of the Securities Act of 1933.

 

The commonstock is not convertible or exchangeable into other equity securities.

 

The proceedsof the sales are being used by the Company for general corporate purposes.

 

(b)                                 Not applicable.

 

(c)                                  No repurchasesfor our securities were made during the quarter ended June 30, 2005.

 

The payment of dividends bythe Company depends to a great extent on the ability of the Bank to paydividends to the Company.  The Company issubject to the Tennessee Banking Act, which provides that the Bank may not declaredividends in any calendar year that exceeds the total of its net income of thatyear combined with its retained net income of the preceding two years withoutthe approval of the TDFI.  Thereafter,10% of net profits must be transferred to capital surplus prior to payment ofdividends until capital surplus equals capital stock.  The Bank is also subject to the minimumcapital requirements of the FDIC which impact the Bank’s ability to paydividends.  If the Bank fails to meetthese standards, it may not be able to pay dividends or to accept additionaldeposits 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 agencies have indicatedthat paying dividends that deplete a depository institution’s capital base toan inadequate level would be such an unsafe and unsound banking practice.  Moreover, the Federal Reserve Board, theComptroller of the Currency and the FDIC have issued policy statements whichprovide that bank holding companies and insured depository institutionsgenerally should only pay dividends out of current earnings.

 

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**Item 3.  Default UponSenior Securities**

 

None

 

**Item 4.  Submission ofMatters to a Vote of Security Holders**

 

(a)                                  The annualmeeting of the Bank’s stockholders was held May 19, 2005.

 

(b)                                 The followingmembers of the board of directors were each re-elected as Class IIIdirectors to serve for additional three year terms or until their respectivesuccessors are duly elected and qualified.

 

Len D. Graham

Clyde A. Kyle, Jr., M.D.

Lester T. Simerville, Sr.

James F.Williams, Jr.

 

The term of office for thefollowing members of the board of directors continued after the meeting:  R. Danny Hays, M.D., Steven W. Ledbetter,Henry F. Smith and Jim A. Workman (Class I) and Eddie N. Duncan, M.D.,Roger E. Jenne, Esq., Larry S. McDaniel and J. Lee Stewart (Class II).

 

(c)           (1)           Thefollowing directors were elected by the following tabulation:

 
| ** **                     | ** ** | **Number  of  Shares  Voting** | ** ** | **For** | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker  Non-  Votes** | ** ** |
|--------------------------------|------------|--------------------------------|------------|---------|------------|-------------|------------|-------------|------------|-------------------------|------------|
|                           |       |                           |       |    |       |        |       |        |       |                    |       |
| Len D. Graham                  |       | 601,954                        |       | 595,854 |       | 0           |       | 6,100       |       | 0                       |       |
| Clyde A. Kyle, Jr., M.D.  |       | 601,954                        |       | 595,854 |       | 0           |       | 2,500       |       | 0                       |       |
| Lester T. Simerville, Sr. |       | 601,954                        |       | 595,854 |       | 0           |       | 6,100       |       | 0                       |       |
| James F. Williams, Jr.    |       | 601,954                        |       | 600,954 |       | 0           |       | 1,000       |       | 0                       |       |

 

(2)                                  Theratification of the appointment of Crowe, Chizek and Company, LLP asindependent auditors for the Company for the fiscal year 2005 was as follows:

 
| **Number  of  Shares  Voting** | ** ** | **For** | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker  Non-  Votes** | ** ** |
|--------------------------------|------------|---------|------------|-------------|------------|-------------|------------|-------------------------|------------|
|                           |       |    |       |        |       |        |       |                    |       |
| 601,954                        |       | 595,054 |       | 1,500       |       | 5,400       |       | 0                       |       |

 

**Item 5.  OtherInformation**

 

None

 

15

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**Item6.  Exhibits**

 

Rule 13a-14(a) Certifications

Section 1350 Certifications

 

16

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# **SIGNATURES**

# ** **

 

Pursuant to the requirementsof the Securities and Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|   | Southern Heritage Bancshares, Inc. |                    |
|--------|-----------------------------------------|-------------------------|
|   | (Registrant)                            |
|   |                                    |
|   |                                    |
| 8/8/05 |                                    | /s/ J. Lee Stewart      |   |
| (Date) | J. Lee Stewart                          |
|   | President                               |
|   |                                    |
|   |                                    |
| 8/8/05 |                                    | /s/ Steven W. Ledbetter |   |
| (Date) | Steven W. Ledbetter,                    |
|   | Chief Financial Officer                 |

 

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