**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: March 31, 2005** |
|                                                     |       |                                                                                                    |
| **o**                                                    | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                     |       |                                                                                                    |
| **Commission  File No. 00050921**                   |

 

**SOUTHERN HERITAGE 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 AreaCode)

 

**None**

(Former Name, Address and Fiscal Year, ifChanged 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 April 30, 2005:    **1,025,820**

 

Transitional Small Business Disclosure Format(check one):

 

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

 

 

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

 

**FORM 10-QSB**

**Quarter ended March 31, 2005**

 
| ***PART I.***  | *** *** | ***FINANCIAL INFORMATION***                                                                           |   |
|---------------------|--------------|-------------------------------------------------------------------------------------------------------|--------|
|                |         |                                                                                                  |   |
| ***Item 1.***       |         | Financial Statements                                                                                  |   |
|                |         |                                                                                                  |   |
|                |         | Consolidated Balance Sheets – March 31, 2005 (Unaudited) and  December 31, 2004        |   |
|                |         |                                                                                                  |   |
|                |         | Consolidated Statements of Operations -  Three months ended March 31, 2005 and 2004 (Unaudited)  |   |
|                |         |                                                                                                  |   |
|                |         | Consolidated  Statements of Cash Flows - Three months ended March 31, 2005 and 2004  (Unaudited) |   |
|                |         |                                                                                                  |   |
|                |         | Notes to Consolidated Financial Statements                                                            |   |
|                |         |                                                                                                  |   |
| ***Item 2.***       |         | Management’s  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

----

 

**SOUTHERN HERITAGEBANCSHARES, INC.**

**Consolidated Balance Sheets**

**March 31, 2005**

 

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

 
| *** ***                                                                      | ** ** | **(Unaudited)  March 31,  2005** | ** **  | **December 31,  2004** | ** ** | **Amount  Change** | ** ** | **%****Change** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------|-------------|-----------------------------|------------|--------------------|------------|-----------------|------------|
| ***Assets***                                                                      | ** ** | ** **                            | ** **  |                        |       |               |       |            |       |   |
| Cash and due from banks                                                           | ** ** | **$**                                 | **4,472**   |                        | 4,653      |               | (181       | )               | -3.9       | % |
| Federal funds sold                                                                | ** ** | **4,747**                             |        | 440                         |       | 4,307              |       | 978.9           | %          |
| ***Cash and cash equivalents***                                                   | ** ** | **9,219**                             |        | 5,093                       |       |               |       |            |       |
| Securities available-for-sale, at fair  value                                     | ** ** | **17,778**                            |        | 19,667                      |       | (1,889             | )          | -9.6            | %          |
| Mortgage loans held for sale                                                      | ** ** | **721**                               |        | 683                         |       | 38                 |       | 5.6             | %          |
| Loans                                                                             | ** ** | **132,046**                           |        | 125,925                     |       | 6,121              |       | 4.9             | %          |
| Allowance for loan losses                                                         | ** ** | **(1,839**                            | )           | (1,723                      | )          | (116               | )          | 6.7             | %          |
| ***Loans, net***                                                                  | ** ** | **130,207**                           |        | 124,202                     |       | 6,005              |       | 4.8             | %          |
| Premises and equipment                                                            | ** ** | **5,544**                             |        | 5,580                       |       | (36                | )          | -0.6            | %          |
| Restricted stock                                                                  | ** ** | **473**                               |        | 455                         |       | 18                 |       | 4.0             | %          |
| Accrued income receivable                                                         | ** ** | **620**                               |        | 529                         |       | 91                 |       | 17.2            | %          |
| Other assets                                                                      | ** ** | **789**                               |        | 652                         |       | 137                |       | 21.0            | %          |
| ** **                                                                        |       | **$**                                 | **165,351** |                        | 156,861    |               | 8,490      |            | 5.4        | % |
|                                                                              |       |                                  |        |                        |       |               |       |            |       |
| ***Liabilities and Shareholders’ Equity***                                   |       |                                  |        |                        |       |               |       |            |       |
| **Liabilities:**                                                                  |       |                                  |        |                        |       |               |       |            |       |
| **Deposits:**                                                                     |       |                                  |        |                        |       |               |       |            |       |
| Noninterest-bearing                                                               | ** ** | **$**                                 | **24,576**  |                        | 22,724     |               | 1,852      |            | 8.1        | % |
| Interest-bearing                                                                  | ** ** | **121,856**                           |        | 114,635                     |       | 7,221              |       | 6.3             | %          |
| ***Total deposits***                                                              | ** ** | **146,432**                           |        | 137,359                     |       | 9,073              |       | 6.6             | %          |
| Repurchase agreements                                                             | ** ** | **183**                               |        | 1,052                       |       | (869               | )          | -82.6           | %          |
| Accrued interest payable                                                          | ** ** | **463**                               |        | 429                         |       | 34                 |       | 7.9             | %          |
| Subordinated debentures                                                           | ** ** | **5,155**                             |        | 5,155                       |       | 0                  |       | 0.0             | %          |
| Other liabilities                                                                 | ** ** | **403**                               |        | 339                         |       | 64                 |       | 18.9            | %          |
| ***Total liabilities***                                                           | ** ** | **152,636**                           |        | 144,334                     |       | 8,302              |       | 5.8             | %          |
| **Shareholders’ equity:**                                                    |       |                                  |        |                        |       |               |       |            |       |
| Preferred stock, no par value. Authorized  1,000,000 shares; none issued          | ** ** | **—**                            |        | —                      |       | —             |       | 0.0             | %          |
| Common stock, $1 par value. Authorized  2,000,000 shares; issued 1,024,720 shares | ** ** | **1,025**                             |        | 1,025                       |       | 0                  |       | 0.0             | %          |
| Additional paid-in-capital                                                        | ** ** | **9,222**                             |        | 9,222                       |       | 0                  |       | 0.0             | %          |
| Retained Earnings                                                                 | ** ** | **2,692**                             |        | 2,277                       |       | 415                |       | 18.2            | %          |
| Accumulated other comprehensive income  (loss)                                    | ** ** | **(224**                              | )           | 3                           |       | (227               | )          | -7566.7         | %          |
| ***Total shareholders’ equity***                                             | ** ** | **12,715**                            |        | 12,527                      |       | 188                |       | 1.5             | %          |
| ** **                                                                        |       | **$**                                 | **165,351** |                        | 156,861    |               | 8,490      |            | 5.4        | % |

 

See accompanying notes to consolidatedfinancial statements.

 

3

----

 

**SOUTHERNHERITAGE BANCHARES, INC.**

**Consolidated Statements of Operations**

**Three Months Ended March 31**

**(Unaudited)**

 

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

 
| ** **                                                 | ** ** | **2005**      | ** ** | **2004**   | ** ** | **Amount  Change** | ** ** | **%  Change** | ** ** |
|------------------------------------------------------------|------------|---------------|------------|------------|------------|--------------------|------------|---------------|------------|
| **Interest income:**                                       |       |          |       |       |       |               |       |          |       |
| Loans, including fees                                      | ** ** | **$**         | **2,035**  |       | 1,610      |               | 425        |          | 26.4       | % |
| Securities                                                 | ** ** | **176**       |       | 133        |       | 43                 |       | 32.3          | %          |
| Federal funds sold                                         | ** ** | **21**        |       | 5          |       | 16                 |       | 320.0         | %          |
| ***Total interest income***                                | ** ** | **2,232**     |       | 1,748      |       | 484                |       | 27.7          | %          |
| **Interest expense:**                                      |       |          |       |       |       |               |       |          |       |
| Deposits                                                   | ** ** | **682**       |       | 534        |       | 148                |       | 27.7          | %          |
| Other borrowed funds                                       | ** ** | **58**        |       | —     |       | 58                 |       |          |       |
| ***Total interest expense***                               | ** ** | **740**       |       | 534        |       | 206                |       | 38.6          | %          |
| ***Net interest income***                                  | ** ** | **1,492**     |       | 1,214      |       | 278                |       | 22.9          | %          |
| **Provision for loan losses**                              | ** ** | **129**       |       | 113        |       | 16                 |       | 14.2          | %          |
| ***Net interest income after provision for  loan losses*** | ** ** | **1,363**     |       | 1,101      |       | 262                |       | 23.8          | %          |
| **Noninterest income:**                                    |       |          |       |       |       |               |       |          |       |
| Service charges on deposit accounts                        | ** ** | **319**       |       | 201        |       | 118                |       | 58.7          | %          |
| Mortgage banking activities                                | ** ** | **87**        |       | 98         |       | (11                | )          | -11.2         | %          |
| Gain (loss) on sale of securities                          | ** ** | **(3**        | )          | 25         |       | (28                | )          | -112.0        | %          |
| Other service charges, commissions and fees                | ** ** | **80**        |       | 54         |       | 26                 |       | 48.1          | %          |
| ***Total noninterest income***                             | ** ** | **483**       |       | 378        |       | 105                |       | 27.8          | %          |
| **Noninterest expenses:**                                  |       |          |       |       |       |               |       |          |       |
| Salaries and employee benefits                             | ** ** | **567**       |       | 507        |       | 60                 |       | 11.8          | %          |
| Occupancy expense                                          | ** ** | **88**        |       | 84         |       | 4                  |       | 4.8           | %          |
| Other operating expenses                                   | ** ** | **542**       |       | 387        |       | 155                |       | 40.1          | %          |
| ***Total noninterest expenses***                           | ** ** | **1,197**     |       | 978        |       | 219                |       | 22.4          | %          |
| ***Income before income taxes***                           | ** ** | **649**       |       | 501        |       | 148                |       | 29.5          | %          |
| **Income taxes**                                           | ** ** | **234**       |       | 182        |       | 52                 |       | 0.0           | %          |
| ***Net income***                                           | ** ** | **415**       |       | 319        |       | 96                 |       | 30.1          | %          |
|                                                       |       |          |       |       |       |               |       |          |       |
| **Other comprehensive income:**                            |       |          |       |       |       |               |       |          |       |
| Unrealized gains/losses on securities                      | ** ** | **(227**      | )          | 188        |       |               |       |          |       |
|                                                       |       |          |       |       |       |               |       |          |       |
| **Comprehensive income**                                   | ** ** | **188**       |       | 507        |       |               |       |          |       |
|                                                       |       |          |       |       |       |               |       |          |       |
|                                                       |       |          |       |       |       |               |       |          |       |
| Basic earnings per share                                   | ** ** | **$**         | **0.39**   | ** ** | **$**      | **0.30**           |       | 0.09          |       | 30.1 | % |
| Diluted earnings per share                                 | ** ** | **$**         | **0.36**   | ** ** | **$**      | **0.28**           |       |          |       |   |   |
|                                                       |       |          |       |       |       |               |       |          |       |
| Shares used in computation of earnings per  share          |       |          |       |       |       | 0                  |       | 0.0           | %          |
| Basic                                                      | ** ** | **1,075,956** |       | 1,075,956  |       | 0                  |       | 0.0           | %          |
| Diluted                                                    | ** ** | **1,161,288** |       | 1,132,196  |       |               |       |          |       |

 

See accompanying notes to consolidatedfinancial statements.

 

4

----

 

**SOUTHERN HERITAGEBANCSHARES, INC.**

**Consolidated Statements of Cash Flows**

**Three Months Ended March 31**

**(Unaudited)**

* *

*($ amounts in thousands )*

 
| ** **                                                                 | ** ** | **2005**   | ** ** | **2004**  | ** ** | **Amount  Change** | ** ** | **%  Change** | ** ** |
|----------------------------------------------------------------------------|------------|------------|------------|-----------|------------|--------------------|------------|---------------|------------|
| **Cash flows from operating activities:**                                  |       |       |       |      |       |               |       |          |       |
| **Net income**                                                             | ** ** | **$**      | **415**    |      | 319        |               | 96         |          | 30         | % |
| Adjustments to reconcile net income to net  cash                           |       |       |       |      |       |               |       |          |       |
| provided (used) by operating activities:                                   |       |       |       |      |       |               |       |          |       |
| Depreciation and amortization                                              | ** ** | **104**    |       | 112       |       | (8                 | )          | -7            | %          |
| Provision for loan losses                                                  | ** ** | **129**    |       | 113       |       | 16                 |       | 14            | %          |
| Gain (loss) on sale of securities available  for sale                      | ** ** | **(3**     | )          | 25        |       |               |       |          |       |
| FHLB stock dividends                                                       | ** ** | **2**      |       | 1         |       |               |       |          |       |
| Mortgage loans originated for sale                                         | ** ** | **(4,725** | )          | (4,675    | )          |               |       |          |       |
| Proceeds from sale of mortgage loans                                       | ** ** | **4,687**  |       | 4,572     |       |               |       |          |       |
| Decrease (increase) in accrued income  receivable                          | ** ** | **(91**    | )          | (6        | )          | (85                | )          | 1417          | %          |
| Increase in accrued income payable                                         | ** ** | **34**     |       | 44        |       |               |       |          |       |
| Other, net                                                                 | ** ** | **32**     |       | (7        | )          | 39                 |       | -557          | %          |
| ***Net cash provided by operating activities***                            | ** ** | **584**    |       | 498       |       | 86                 |       | 17            | %          |
| **Cash flows from investing activities:**                                  |       |       |       |      |       |               |       |          |       |
| Proceeds from maturities and redemptions of  securities available for sale | ** ** | **321**    |       | 542       |       |               |       |          |       |
| Proceeds from sales of securities available  for sale                      | ** ** | **4,408**  |       | 3,151     |       | 1,257              |       | 100           | %          |
| Purchases of securities available for sale                                 | ** ** | **(3,196** | )          | 0         |       | (3,196             | )          | 100           | %          |
| Purchases of restricted stock                                              | ** ** | **(18**    | )          | (3        | )          |               |       |          |       |
| Net increase in loans                                                      | ** ** | **(6,121** | )          | (5,097    | )          | (1,024             | )          | 20            | %          |
| Purchases of premises and equipment                                        | ** ** | **(56**    | )          | (22       | )          | (34                | )          | 155           | %          |
| ***Net cash used by investing activities***                                | ** ** | **(4,662** | )          | (1,429    | )          | (3,233             | )          | 226           | %          |
| **Cash flows from financing activities:**                                  |       |       |       |      |       |               |       |          |       |
| Decrease in repurchase agreements                                          | ** ** | **(869**   | )          | (1,467    | )          | 598                |       |          |       |
| Increase in deposits                                                       | ** ** | **9,073**  |       | 12,199    |       | (3,126             | )          | -26           | %          |
| ***Net cash provided by financing activities***                            | ** ** | **8,204**  |       | 10,732    |       | (2,528             | )          | -24           | %          |
|                                                                       |       |       |       |      |       |               |       |          |       |
| ***Net increase in cash***                                                 | ** ** | **4,126**  | ** ** | **9,801** |       | (5,675             | )          | -58           | %          |
| **Cash and cash equivalents, beginning of  period**                        | ** ** | **5,093**  |       | 4,545     |       | 548                |       | 12            | %          |
|                                                                       |       |       |       |      |       |               |       |          |       |
| **Cash and cash equivalents, end of period**                               | ** ** | **$**      | **9,219**  |      | 14,346     |               | (5,127     | )             | -36        | % |
|                                                                       |       |       |       |      |       |               |       |          |       |
| **Cash payments for interest**                                             | ** ** | **$**      | **706**    |      | 489        |               | 4,747      |          |       |   |
| **Cash payments for income taxes**                                         | ** ** | **329**    |       | 163       |       |               |       |          |       |

 

See accompanying notes to consolidated financial statements.

 

5

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**Notes to Consolidated Financial Statements**

**March 31,2005**

**(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 companythat owns 100% of Southern Heritage Bank (the Bank).   Substantially all of the consolidatedoperations 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, 2005, the results of operations for the three months ended March 31,2005, and cash flows for the three months ended March 31, 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.

 

6

----

 

*Allowance for Loan Losses*

 

Transactions in the allowance for loan losseswere as follows:

 
| ** **                       | ** **   | **Three Months  Ended  March 31,  2005** | ** ** | **Three Months  Ended  March 31,  2004** | ** **   |
|----------------------------------|--------------|-----------------------------------------------|------------|-----------------------------------------------|--------------|
| *** ***                     | *** *** | **(In Thousands)**                            | ** ** | **(In Thousands)**                            | *** *** |
| * *                         | * *     | * *                                      | * *   | * *                                      | * *     |
| Balance January 1           |         | $                                             | 1,723      |                                          | $            | 1,372 |   |
|                             |         |                                          |       |                                          |         |
| Add (deduct):                    |         |                                          |       |                                          |         |
| Losses charged to allowance      |         | (22                                           | )          | (4                                            | )            |
| Recoveries credited to allowance |         | 9                                             |       | 2                                             |         |
| Provision for loan losses        |         | 129                                           |       | 113                                           |         |
|                             |         |                                          |       |                                          |         |
| Balance March 31            |         | $                                             | 1,839      |                                          | $            | 1,483 |   |

 

7

----

 

**SOUTHERN HERITAGEBANCSHARES, INC.**

**Notes to Consolidated Financial Statements**

**March 31, 2005**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Three Months**         | ** ** | **Three Months**         | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                                                                         | ** ** | **Ended**                | ** ** | **Ended**                | ** ** |
| ** **                                                                         | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
|                                                                               |       |                     |       |                     |       |
| Net income as reported                                                             |       | $                        | 415        |                     | $          | 319 |   |
| Deduct: Stock-based compensation expense determined  under fair value based method |       | 12                       |       | 12                       |       |
|                                                                               |       |                     |       |                     |       |
| Pro Forma net income                                                               |       | $                        | 403        |                     | $          | 307 |   |
|                                                                               |       |                     |       |                     |       |
| Basic earnings per share as reported                                               |       | $                        | 0.39       |                     | $          | 0.30 |   |
| Pro Forma basic earnings per share                                                 |       | 0.37                     |       | 0.29                     |       |
|                                                                               |       |                     |       |                     |       |
| Diluted earnings per share as reported                                             |       | 0.36                     |       | 0.28                     |       |
| Pro Forma diluted earnings per share                                               |       | 0.35                     |       | 0.27                     |       |

 

Earnings Per ShareAmounts:  Basicearnings per share is computed using the weighted average number of commonshares outstanding during the period and excludes any dilutive effects ofoptions.  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 effect of these options on earnings percommon share was to increase average shares outstanding by 85,332 and 56,240 in2005 and 2004 and decrease earnings per share by $.03 and $.02.  No shares were antidilutive at March 31,2005 and 2004.

 

8

----

 

**SOUTHERN HERITAGE BANK**

**Statements of Income**

**(Unaudited)**

 

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

 
| ** **                                  | ** ** | **2002**  | ** ** | **2001** | ** ** | **Amount  Change** | ** ** | **%  Change** | ** ** |
|---------------------------------------------|------------|-----------|------------|----------|------------|--------------------|------------|---------------|------------|
| **Interest income:**                        |       |      |       |     |       |               |       |          |       |
| Loans, including fees                       | ** ** | **$**     | **1,024**  |     | 759        |               | 265        |          | 34.9       | % |
| Securities-taxable                          | ** ** | **165**   |       | 164      |       | 1                  |       | 0.6           | %          |
| Federal funds sold                          | ** ** | **17**    |       | 59       |       | (42                | )          | -71.2         | %          |
| ***Total interest income***                 | ** ** | **1,206** |       | 982      |       | 224                |       | 22.8          | %          |
| **Interest expense:**                       |       |      |       |     |       |               |       |          |       |
| Deposits                                    | ** ** | **406**   |       | 541      |       | (135               | )          | -25.0         | %          |
|                                        |       |      |       |     |       |               |       |          |       |
| ***Total interest expense***                | ** ** | **406**   |       | 541      |       | (135               | )          | -25.0         | %          |
| ***Net interest income***                   | ** ** | **800**   |       | 441      |       | 359                |       | 81.4          | %          |
| **Provision for loan losses**               | ** ** | **132**   |       | 53       |       | 79                 |       | 149.1         | %          |
| ***Net interest income after provision***   | ** ** | **668**   |       | 388      |       | 280                |       | 72.2          | %          |
| **Noninterest income:**                     |       |      |       |     |       |               |       |          |       |
| Service charges on deposit accounts         | ** ** | **98**    |       | 50       |       | 48                 |       | 96.0          | %          |
| Mortgage banking activities                 | ** ** | **102**   |       | 48       |       | 54                 |       | 112.5         | %          |
| ** **                                  |       | **19**    |       | 22       |       |               |       |          |       |
| Other service charges, commissions and fees | ** ** | **41**    |       | 17       |       | 24                 |       | 141.2         | %          |
| ***Total noninterest income***              | ** ** | **260**   |       | 137      |       | 123                |       | 89.8          | %          |
| **Noninterest expenses:**                   |       |      |       |     |       |               |       |          |       |
| Salaries and employee benefits              | ** ** | **390**   |       | 291      |       | 99                 |       | 34.0          | %          |
| Occupancy expense                           | ** ** | **57**    |       | 43       |       | 14                 |       | 24.6          | %          |
| Other operating expenses                    | ** ** | **284**   |       | 239      |       | 45                 |       | 18.8          | %          |
| ***Total noninterest expenses***            | ** ** | **731**   |       | 574      |       | 157                |       | 27.4          | %          |
| ***Loss before income taxes***              | ** ** | **197**   |       | (49      | )          | 246                |       | -502.0        | %          |
| **Income taxes**                            | ** ** | **0**     |       | 0        |       | 0                  |       | 0.0           | %          |
| ***Net loss***                              | ** ** | **$**     | **197**    |     | (49        | )                  | 246        |          | -502.0     | % |
|                                        |       |      |       |     |       |               |       |          |       |
| Earnings (loss) per share                   |       |      |       |     |       |               |       |          |       |
| Basic                                       | ** ** | **$**     | **0.19**   |     | (0.09      | )                  | 0.28       |          | -324.9     | % |
|                                        |       |      |       |     |       |               |       |          |       |
| Weighted average shares outstanding         |       |      |       |     |       |               |       |          |       |
| Basic                                       |       |      |       | 572,753  |       | (572,753           | )          | -100.0        | %          |
| Diluted                                     |       |      |       | 608,353  |       | (608,353           | )          | -100.0        | %          |

 

9

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**Item 2.****  Management’sDiscussion and Analysis**

 

# **OVERVIEW**

# ** **

The following discussion compares the financialcondition of Southern Heritage Bancshares, Inc. (the “Company”) at March 31,2005, to December 31, 2004, and the results of operations for the threemonths ended March 31, 2005 and 2004. The Company is a one bank holding company that owns 100% of SouthernHeritage Bank (the “Bank”). Substantially all of the consolidated operations are that of theBank.  This discussion should be read inconjunction with the interim financial statements and footnotes includedherein.

 

Certain statements contained in this report that arenot historical facts are forward looking statements that are subject to certainrisks and uncertainties.  When usedherein, the terms “anticipates,” “plans,” “expects,” “believes,” and similarexpressions as they relate to the Company or its management are intended toidentify such forward looking statements. The Company’s actual results, performance or achievements may materiallydiffer from those expressed or implied in the forward-looking statements.  Risks and uncertainties that could cause orcontribute to such material differences include, but are not limited to,general economic conditions, the interest rate environment, competitiveconditions in the financial services industry, changes in law, governmentalpolicies and regulations, and rapidly changing technology affecting financialservices.

 

# **FINANCIAL CONDITION**

# ** **

Total assets as of March 31, 2005 increased5.4%, or $8,490,000, to $165,351,000, compared with $156,861,000 at December 31,2004.  The increase in total assets wasfunded by a comparable increase in total deposits of $9,073,000.  Cash and cash equivalents increased$4,126,000 to $9,219,000 at March 31, 2005 from $5,093,000 at December 31,2004.  Securities decreased $1,889,000 to$17,778,000 at March 31, 2005 compared to $19,667,000 at December 31,2004.

 

Loans are the principal component of the Bank’sassets and the primary source of income. Total loans at March 31, 2005, were $132,046,000 compared to$125,925,000 at December 31, 2004, an increase of $6,121,000.  Most of the net loan growth in the firstthree months of 2005 was in construction loans secured by real estate whichincreased $2,666,000; commercial loans secured by real estate increased$1,119,000, and other loans increased $1,805,000. As of March 31, 2005,$41,751,000 or 32% of total loans were commercial loans secured by realestate.  Commercial loans were$33,921,000 or 26% of total loans.  Loanssecured by 1-4 family residential real estate were $24,152,000 or 18% of totalloans.  Construction loans secured byreal estate were $24,680,000 or 19% of total loans.  Consumer loans were $4,431,000 or 3% of totalloans.  Other loans were $3,559,000 or 2%of total loans.  Of the total loans,$87,393,000 or 66.2% mature or reprice within 12 months.  Only $2,371,000 or 1.8% mature or repriceover five years.

 

There was $721,000 in mortgage loans held for saleat March 31, 2005, compared with $683,000 at December 31, 2004.  The increase in mortgage loans held for salewas primarily due to timing issues related to secondary market investorfunding.

 

Management anticipates that loan demand willcontinue to be strong.  Theloan-to-deposit ratio as of March 31, 2005, was 90.2%, compared to 91.7%at December 31, 2004, and the loan-to-assets ratio was 79.9% at March 31,2005, 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%.

 

10

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The securities portfolio provides a balance tointerest rate and credit risk while providing a vehicle for investing availablefunds, furnishing liquidity, and supplying securities to pledge as required forcertain deposits and borrowed funds.  Allsecurities are classified as “available for sale”.  We have no plans to liquidate a significantamount of the securities portfolio.

 

As of March 31, 2005, the Bank owned$17,778,000 of securities available-for-sale, a decrease of $1,889,000 or9.6%.  The decrease in securitiesavailable-for-sale is primarily due to the principal payments ofmortgage-backed securities and the funding of loan growth.

 

Deposits which are the Bank’s primary source offunds, totaled $146,432,000 at March 31, 2005, for an increase of$9,073,000, or 6.6%, compared to $137,359,000 at December 31, 2004.  Deposits at March 31, 2005 consisted of$24,576,000 or 16.8% in non-interest bearing demand deposits, $38,566,000 or26.3% in interest-bearing demand deposits, $76,823,000 or 52.5% in timecertificates of deposit and $6,467,000 or 4.4% in savings accounts.  There was $13,644,000 in brokered CDs at March 31,2005 compared to $11,470,000 at December 31, 2004.  The Bank has targeted local consumers,professionals, and small businesses as its central clientele. These customersare being offered various deposit instruments such as demand deposits, savingsaccounts, 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 Bank believes it has a competitiveadvantage by being a locally owned financial institution which will contributeto increased market share.  However, noassurance of market growth can be given.

 

The majority of the deposits continue to be CDs,which increased $6,880,000 in the first three months of 2005.  At March 31, 2005, the weighted averagerate on CDs was 3.04% compared to 2.69% for the three months ended March 31,2004. The Bank has time deposits maturing within one year of $39,447,000 or51.3% of total time deposits.  Timedeposits maturing greater than one year is $37,375,000 or 48.7% of total timedeposits.  Interest-bearing accounts,other than CDs, increased $340,000 in the first three months of 2005.  Noninterest bearing deposits increased$1,852,000 for the three months ended March 31, 2005.  The weighted average cost of all depositaccounts during the first three months of 2005 was 1.96% compared to 1.77% forthe same period in 2004.

 

Total shareholders’ equity increased $188,000, to$12,715,000 at March 31, 2005, from $12,527,000 at December 31,2004.  This increase was due to theCompany’s net income of $415,000 for the first three months of 2005 along witha net increase in unrealized losses on securities available for sale of $227,000net of tax.

 

As of March 31, 2005 the Bank is categorized aswell capitalized under the regulatory framework for prompt correctiveaction.  The total capital torisk-weighted assets ratio was 13.68%. Tier-1 to risk-weighted assets ratio was 11.85% and Tier-1 to averageasset ratio was 10.66%.

 

# **RESULTS OF OPERATIONS**

# ** **

For the first three months of 2005, net income aftertax was $415,000, compared to $319,000 for the same period in 2004, an increaseof 30.1%.  The increase in earnings overthe previous year was primarily a result of the increase in net interest incomeas a result of the overall growth of the bank. Net interest income before the provision for loan losses for the firstthree months of 2005 was $1,492,000, an increase of $278,000 or 22.9% from$1,214,000 for the first three months of 2004. The net interest margin increased 20 basis points to 4.17% at March 31,2005 compared to 3.97% for the same period in 2004.

 

11

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Interest and fee income on loans for the first threemonths of 2005 was $2,035,000, an increase of $425,000 or 26.4% from $1,610,000for the three months ended March 31, 2004. The increase in interest and fee income on loans is primarily due toincreased volume in construction and commercial real estate loans and anincrease in rates following the Federal Reserve’s efforts to increase shortterm rates.

 

Interest income from securities and short-term fundstotaled $197,000 for the first three months of 2005, an increase of $59,000over the same period of 2004.  Theincrease in 2005 was due to an increase in the average dollar amount ofsecurities and short-term funds outstanding; $21,817,000 at March 31, 2005compared to $16,023,000 at March 31, 2004 and the increase in short term rates.

 

Interest expense totaled $740,000 in the first threemonths of 2005, compared to $534,000 for the same period of 2004.  The increase in interest expense in 2005 wasdue to the significant growth of deposits. The Bank’s cost of funds increasedto 2.35% at March 31, 2005 compared to 2.12% at March 31, 2004 as aresult of the increase in short term rates. Total deposits outstanding at March 31,2005 were $146,432,000 compared to $137,359,000 at March 31, 2004.

 

The Bank’s net interest margin for the first threemonths of 2005 was 4.17% compared to 3.97% for the three months ended March 31,2004.

 

The Bank’s yield on earning assets has increased to6.01%, for the first three months of 2005 compared to 5.71% for the same periodof 2004.  The cost of interest-bearingfunds has followed the same trend, increasing to 2.35% for the first threemonths of 2005, up from 2.12% for the three month ended March 31, 2004.

 

In the first three months of 2005, the Bank provided$129,000 for probable incurred loan losses, compared to $113,000 for the sameperiod of 2004.  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 an evaluationof specific loans, as well as a conservative posture due to the bank’s shorthistory.  Other factors considered bymanagement include the composition of the loan portfolio, current economicconditions, and the creditworthiness of the Bank’s borrowers and other relatedfactors.  The net charge-offs for thefirst three months of 2005 were $13,000 compared to $2,000 for the same periodin 2004.

 

At March 31, 2005, the Bank had three loanstotaling $233,000 in nonaccrual status. This compares with December 31, 2004, where there were five loanstotaling $85,000 in nonaccrual.  At March 31,2005 there were no loans that were more than 90 days delinquent compared to twoloans totaling $1,518,000 as of December 31, 2004.  In the first three months of 2005, loanstotaling $22,000 were charged off and $9,000 was recovered on loans previouslycharged off.  Management believes theallowance for loan losses at March 31, 2005, is adequate to absorbprobable incurred losses in the loan portfolio.

 

Total noninterest income for the first three monthsof 2005 was $483,000 compared to $378,000 for the same period in 2004.  The Bank originates and sells long-term fixedrate mortgages and the related servicing. Mortgage loans originated and sold generated $87,000 of fees as of March 31,2005 compared to $98,000 for the three months ended March 31, 2004.  The average loan closed declined $7,000 to$126,000 from $133,000 in the previous year. The other large component of non-interest income is service charges ondeposit accounts which totaled $319,000 as of March 31, 2005 compared to$201,000 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.

 

12

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# **Noninterest expenses were $1,197,000 for the first three months of 2005compared with $978,000 for the same period of 2004; an increase of $219,000 or22.4%.  The growth in noninterestexpenses in the first three months of 2005 is attributable primarily to theincrease in salaries and benefits expense ($60,000 or 11.8%) and otheroperating expense ($155,000 or 40.1%).**

# ** **

# **As of March 31, 2005, the Bank had 44 full-time equivalent employeescompared to 39 for the same period of 2004. Salaries and wages represent $40,000 of the increase plus the employermatch of $15,000 on the 401K plan that was not in existence at March 31,2004 (implemented September 2004).**

# ** **

# **The increase in other operating expense was primarily in outside fees($106,000).  This area includes FDIC andState Assessment fees, $4,000, director fees ($23,000), accounting, audit, andconsulting ($79,000). The increase in directors’ fees is due to an increase inthe annual retainer for non management directors from $3,000 to $6,000 per yearand an increase in the number of meetings called in the first quarter.  The increase in accounting, audit andconsulting is due to outsourcing parts of internal audit, compliance andinformation technology testing, as well as the cost for external audit and taxservices. Management expects that the cost of compliance with the internalcontrol requirements of Section 404 of the Sarbanes-Oxley Act of 2002 willhave an adverse effect on noninterest expense in future years.**

# ** **

# **The remaining increase in other operating expense includes increases inpostage and supplies ($11,000), human resources training and seminars($11,000), direct fees for the new “bounce protection” program ($13,000), andloss on the sale of foreclosed property ($5,000 increase).**

# ** **

The Bank booked income tax expense of $234,000 forthe period ended March 31, 2005 compared to $182,000 for the same periodin 20004.  The effective tax rate forboth years is 36%.

 

# **LIQUIDITY AND CAPITAL RESOURCES**

# ** **

Liquidity refers to the Company’s ability to fundloan demand, meet deposit customers’ withdrawal needs and provide for operatingexpenses.  As summarized in the Statementof Cash Flows, the Company’s main source of cash flow is from receivingdeposits from its customers, and to a lesser extent, repayment of loanprincipal 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 three months of 2005, deposit growthhas exceeded loan growth; however, this is more of a timing issue and is notexpected to continue. Other potential sources of liquidity include the sale ofavailable-for-sale securities from the Bank’s portfolio, the sale of loans, thepurchase of federal funds, or repurchase agreements. The Company currently has$13,644,000 in brokered certificates of deposit.

 

At March 31, 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:

 
| *** ***                           | ** ** | **March 31, 2005** | ** ** | **Dec. 31, 2004** | ** ** | **Well-capitalized** | ** ** |
|----------------------------------------|------------|-------------------------|------------|------------------------|------------|----------------------|------------|
|                                   |       |                    |       |                   |       |                 |       |
| Tier 1 capital to risk-weighted assets |       | 11.85%                  |       | 11.96%                 |       | 6.0%                 |       |
| Total capital to risk-weighted assets  |       | 13.68%                  |       | 13.79%                 |       | 10.0%                |       |
| Tier 1 leverage ratio                  |       | 10.66%                  |       | 10.73%                 |       | 5.0%                 |       |

 

13

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As discussed above, total shareholders’ equityincreased $188,000, to $12,715,000 at March 31, 2005 from $12,527,000 at December 31,2004.  This increase was due to theCompany’s net income of $415,000 for the first three months of 2005 along witha net increase in unrealized losses on securities available for sale of$227,000, net of tax.

 

# **INTEREST RATE SENSITIVITY**

# ** **

Financial institutions are subject to interest rate riskto the degree that their interest-bearing liabilities (consisting principallyof customer deposits) mature or reprice more or less frequently than theirinterest-earning assets (generally consisting of loans and investmentsecurities).  The match between thescheduled repricing and maturities of earning assets and liabilities withindefined time periods is referred to as “gap” analysis.  At March 31, 2005 the cumulativeone-year gap was a positive (or asset sensitive) $8,806,000 or 5.7% of earningassets compared to a positive gap of $7,679,000 or 5.2% of earning assets at December 31,2004.

 

One of management’s objectives in managing the Bank’sbalance sheet for interest rate sensitivity is to reduce volatility in the netinterest margin by matching, as closely as possible, the timing of therepricing of its interest rate sensitive assets with interest rate sensitiveliabilities.  During the first quarter of2005 the Bank experienced two rate increases after five such increases during2004.  As a result of the positive gapposition, the Bank’s net interest margin improved to 4.17% at March 31,2005 compared to the 3.85% margin at December 31, 2004.  Management believes that interest rates willcontinue to increase during 2005.  TheBank’s strategy of being in a positive one year gap position should result instable to increasing net interest margin as rates begin to rise.  Manyof the Bank’s loans are commercial real estate loans with rates that are tiedto New York Prime or that are fixed for up to three years, and this strategyallows the Bank to match longer-term funding with these loans, thus minimizingvolatility in the net interest margin.

 

**Item 3.****  Controls and Procedures**

 

As of March 31, 2005, an evaluation was carriedout under the supervision and with the participation of the registrant’smanagement, including our President and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based on their evaluation, our President andChief Financial Officer have concluded that the registrant’s disclosurecontrols and procedures are effective to ensure that information required to bedisclosed by the registrant in reports that it files or submits under theExchange Act is recorded, processed, summarized and reported within the timeperiods specified in Securities and Exchange Commission rules and forms.

 

There have been no changes in the registrant’sinternal controls over financial reporting or in other factorsthat has materially affected, or is reasonably likely to materiallyaffect, the registrant’s internal control over financial reporting.

 

14

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**SOUTHERN HERITAGE BANCSHARES,INC.**

**FORM 10-QSB**

**Quarter ended March 31, 2005**

**PART II - OTHER INFORMATION**

 

**Item 1.****  Legal Proceedings**

 

None.

 

**Item 2.****  Unregistered Sales of EquitySecurities and Use of Proceeds**

 

(a)           None.

 

(b)           Not applicable.

 

(c)           No repurchases for our securities were made during thequarter ended March 31, 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 notdeclare dividends in any calendar year that exceeds the total of its net incomeof that year combined with its retained net income of the preceding two yearswithout the 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 Legends 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.

 

**Item 3.****  Default Upon Senior Securities**

 

None.

 

**Item 4.****  Submission of Matters to a Voteof Security Holders**

 

None.

 

**Item 5.****  Other Information**

 

None.

 

**Item 6.****  Exhibits**

 

Rule 13a-14(a) Certifications.

Section 1350Certifications.

 

15

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# **SOUTHERN HERITAGE BANCSHARES,INC.**

# ** **

# **FORM 10-QSB**

# ** **

#### Quarter ended March 31,2005

####  

# **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)                            |   |
|   |                                    |
|   | 5/17/05                                 |   | /s/ J. Lee Stewart |   |
| (Date) | J. Lee Stewart                          |
|   | President                               |
|   |                                    |
|   |                                    |
|   | 5/17/05                                 |   | /s/ Steven W. Ledbetter |   |
| (Date) | Steven W. Ledbetter,                    |
|   | Chief Financial Officer                 |
|        |                                         |        |  |  |  |  |

 

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