**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: September 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)

 

Checkwhether the issuer (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days

 

Yesý           Noo

 

Statethe outstanding number of shares of the issuer’s common stock as of October 31,2005:  **1,082,675**

 

Transitional Small BusinessDisclosure Format (check one):

 

Yeso           Noý

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).o Yes  No o

 

 

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

 

**FORM 10-QSB**

**Quarterended September 30, 2005**

 
| ***PART I.***  | ***FINANCIAL  INFORMATION***                                                                                           |
|---------------------|------------------------------------------------------------------------------------------------------------------------|
|                |                                                                                                                   |
| ***Item 1.***       | Financial Statements                                                                                                   |
| *** ***        |                                                                                                                   |
| *** ***        | Consolidated Balance Sheets – September 30, 2005 (Unaudited) and  December 31, 2004                     |
| *** ***        |                                                                                                                   |
| *** ***        | Consolidated Statements of Operations – Three and nine months ended September 30,  2005 and 2004 (Unaudited) |
| *** ***        |                                                                                                                   |
| *** ***        | Consolidated Statements of  Cash Flows - Nine months ended September 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

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**Consolidated Balance Sheets**

**September 30, 2005**

 
| ** **                                                                                                                       | ** ** | **(Unaudited)**              | ** **  | ** **                  | ** ** | ** **         | ** ** | ** **   | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|-------------|-----------------------------|------------|--------------------|------------|--------------|------------|
| **($ amounts in thousands except  share and per share data)**                                                               | ** ** | **September 30,  2005** | ** **  | **December 31,  2004** | ** ** | **Amount  Change** | ** ** | **% Change** | ** ** |
| ***Assets***                                                                                                                     |       |                         | ** **  |                        |       |               |       |         |       |
| Cash and due  from banks                                                                                                         | ** ** | **$**                        | **5,218**   | ** **                  | 4,653      |               | 565        |         | 12.1       | % |
| Federal  funds sold                                                                                                              | ** ** | **7,868**                    | ** **  | 440                         |       | 7,428              |       | 1688.2       | %          |
| ***Cash and cash equivalents***                                                                                                  | ** ** | **13,086**                   | ** **  | 5,093                       |       |               |       |         |       |
| Securities  available-for-sale, at fair value                                                                                    | ** ** | **21,886**                   | ** **  | 19,667                      |       | 2,219              |       | 11.3         | %          |
| Mortgage  loans held for sale                                                                                                    | ** ** | **1,152**                    | ** **  | 683                         |       | 469                |       | 68.7         | %          |
| Loans                                                                                                                            | ** ** | **144,176**                  | ** **  | 125,925                     |       | 18,251             |       | 14.5         | %          |
| Allowance  for loan losses                                                                                                       | ** ** | **(1,969**                   | **)**       | (1,723                      | )          | (246               | )          | 14.3         | %          |
| ***Loans, net***                                                                                                                 | ** ** | **142,207**                  | ** **  | 124,202                     |       | 18,005             |       | 14.5         | %          |
| Premises and  equipment                                                                                                          | ** ** | **5,452**                    | ** **  | 5,580                       |       | (128               | )          | -2.3         | %          |
| Restricted  stock                                                                                                                | ** ** | **512**                      | ** **  | 455                         |       | 57                 |       | 12.5         | %          |
| Accrued  interest receivable                                                                                                     | ** ** | **706**                      | ** **  | 529                         |       | 177                |       | 33.5         | %          |
| Other assets                                                                                                                     | ** ** | **997**                      | ** **  | 652                         |       | 345                |       | 52.9         | %          |
| ** **                                                                                                                       |       | **$**                        | **185,998** |                        | 156,861    | ** **         | 29,137     |         | 18.6       | % |
|                                                                                                                             |       |                         | ** **  |                        |       |               |       |         |       |
| ***Liabilities and Shareholders’ Equity***                                                                                  |       |                         | ** **  |                        |       |               |       |         |       |
| **Liabilities:**                                                                                                                 |       |                         | ** **  |                        |       |               |       |         |       |
| **Deposits:**                                                                                                                    |       |                         | ** **  |                        |       |               |       |         |       |
| Noninterest-bearing                                                                                                              | ** ** | **$**                        | **28,801**  | ** **                  | 22,724     |               | 6,077      |         | 26.7       | % |
| Interest-bearing                                                                                                                 | ** ** | **136,647**                  | ** **  | 114,635                     |       | 22,012             |       | 19.2         | %          |
| ***Total deposits***                                                                                                             | ** ** | **165,448**                  | ** **  | 137,359                     |       | 28,089             |       | 20.4         | %          |
| Repurchase agreements                                                                                                            | ** ** | **263**                      | ** **  | 1,052                       |       | (789               | )          | -75.0        | %          |
| Accrued interest payable                                                                                                         | ** ** | **687**                      | ** **  | 429                         |       | 258                |       | 60.1         | %          |
| Subordinated debentures                                                                                                          | ** ** | **5,155**                    | ** **  | 5,155                       |       |               |       |         |       |
| Other liabilities                                                                                                                | ** ** | **570**                      | ** **  | 339                         |       | 231                |       | 68.1         | %          |
| ***Total liabilities***                                                                                                          | ** ** | **172,123**                  | ** **  | 144,334                     |       | 27,789             |       | 19.3         | %          |
| **Shareholders’  equity:**                                                                                                  |       |                         | ** **  |                        |       |               |       |         |       |
| Preferred stock, no par value. Authorized  1,000,000 shares; none issued                                                         | ** ** | **—**                   | ** **  | —                      |       | —             |       | 0.0          | %          |
| Common stock, $1 par value. Authorized  2,000,000 shares; issued 1,079,175 shares at Sept.30,2005 and 1,024,720 at  Dec.31, 2004 | ** ** | **1,079**                    | ** **  | 1,025                       |       | 54                 |       | 5.3          | %          |
| Additional paid-in-capital                                                                                                       | ** ** | **10,736**                   | ** **  | 9,222                       |       | 1,514              |       | 16.4         | %          |
| Retained earnings                                                                                                                | ** ** | **2,140**                    | ** **  | 2,277                       |       | (137               | )          | -6.0         | %          |
| Accumulated other comprehensive income  (loss)                                                                                   | ** ** | **(80**                      | **)**       | 3                           |       | (83                | )          | -2766.7      | %          |
| ***Total shareholders’ equity***                                                                                            | ** ** | **13,875**                   | ** **  | 12,527                      |       | 1,348              |       | 10.8         | %          |
| ** **                                                                                                                       |       | **$**                        | **185,998** |                        | 156,861    | ** **         | 29,137     |         | 18.6       | % |

 

See accompanying notes to consolidatedfinancial statements.

 

3

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**Consolidated Statements of Operations**

**Three and Nine Months Ended September 30**

**(Unaudited)**

 
| **($ amounts in thousands except  share and per share data)** | ** ** | **Three Months Ended Sept. 30** |       | **Nine Months Ended Sept. 30** | ** ** | **Amount  Change** | ** ** | **%  Change** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------|------------|--------------------------------|------------|--------------------|------------|---------------|------------|
| ** **                                                         | **2005**   | ** **                      | **2004**   |                           | **2005**   | ** **         | **2004**   |          | ** ** | ** ** |
| **Interest  income:**                                              |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| Loans, including fees                                              | ** ** | **$**                           | **2,332**  | ** **                     | 1,775      |               | **$**      | **6,502**     | ** ** | 5,057 |   | 1,445 |   | 28.6 | % |
| Securities                                                         | ** ** | **221**                         | ** ** | 156                            |       | **589**            | ** ** | 430           |       | 159 |   | 37.0 | % |
| Federal funds sold                                                 | ** ** | **63**                          | ** ** | 12                             |       | **168**            | ** ** | 32            |       | 136 |   | 425.0 | % |
| ***Total interest income***                                        | ** ** | **2,616**                       | ** ** | 1,943                          |       | **7,259**          | ** ** | 5,519         |       | 1,740 |   | 31.5 | % |
| **Interest  expense:**                                             |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| Deposits                                                           | ** ** | **902**                         | ** ** | 605                            |       | **2,368**          | ** ** | 1,705         |       | 663 |   | 38.9 | % |
| Other borrowed funds                                               | ** ** | **72**                          | ** ** | —                         |       | **199**            | ** ** | —        |       | 199 |   | #DIV/0! |   |
| ***Total interest expense***                                       | ** ** | **974**                         | ** ** | 605                            |       | **2,567**          | ** ** | 1,705         |       | **862** |   | 50.6 | % |
| ***Net interest income***                                          | ** ** | **1,642**                       | ** ** | 1,338                          |       | **4,692**          | ** ** | 3,814         |       | 878 |   | 23.0 | % |
| **Provision  for loan losses**                                     | ** ** | **111**                         | ** ** | 182                            |       | **298**            | ** ** | 362           |       | (64 | ) | -17.7 | % |
| ***Net interest income after provision for  loan losses***         | ** ** | **1,531**                       | ** ** | 1,156                          |       | **4,394**          | ** ** | 3,452         |       | 942 |   | 27.3 | % |
| **Noninterest  income:**                                           |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| Service charges on deposit accounts                                | ** ** | **329**                         | ** ** | 340                            |       | **987**            | ** ** | 838           |       | 149 |   | 17.8 | % |
| Mortgage banking activities                                        | ** ** | **110**                         | ** ** | 90                             |       | **313**            | ** ** | 295           |       | 18 |   | 6.1 | % |
| Gain (loss) on sale of securities                                  | ** ** | **(2**                          | **)**      | (2                             | )          | **(6**             | **)**      | 18            |       | (24 | ) | -133.3 | % |
| Other service charges, commissions and fees                        | ** ** | **59**                          | ** ** | 53                             |       | **202**            | ** ** | 165           |       | 37 |   | 22.4 | % |
| ***Total noninterest income***                                     | ** ** | **496**                         | ** ** | 481                            |       | **1,496**          | ** ** | 1,316         |       | 180 |   | 13.7 | % |
| **Noninterest  expenses:**                                         |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| Salaries and employee benefits                                     | ** ** | **661**                         | ** ** | 538                            |       | **1,916**          | ** ** | 1,583         |       | 333 |   | 21.0 | % |
| Occupancy expense                                                  | ** ** | **88**                          | ** ** | 86                             |       | **263**            | ** ** | 254           |       | 9 |   | 3.5 | % |
| Other operating expenses                                           | ** ** | **531**                         | ** ** | 502                            |       | **1,600**          | ** ** | 1,319         |       | 281 |   | 21.3 | % |
| ***Total noninterest expenses***                                   | ** ** | **1,280**                       | ** ** | 1,126                          |       | **3,779**          | ** ** | 3,156         |       | 623 |   | 19.7 | % |
| ***Income before income taxes***                                   | ** ** | **747**                         | ** ** | 511                            |       | **2,111**          | ** ** | 1,612         |       | 499 |   | 31.0 | % |
| **Income  taxes**                                                  | ** ** | **238**                         | ** ** | 178                            |       | **710**            | ** ** | 581           |       | 129 |   | 0.0 | % |
| ***Net income***                                                   | ** ** | **509**                         | ** ** | 333                            |       | **1,401**          | ** ** | 1,031         |       | 370 |   | 35.9 | % |
|                                                               |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| **Other comprehensive income (loss):**                             |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| Unrealized gains/losses on securities net  of tax                  | ** ** | **3**                           | ** ** | 353                            |       | **(80**            | **)**      | 11            |       |   |   |   |   |
|                                                               |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| **Comprehensive  income (loss)**                                   | ** ** | **512**                         | ** ** | 686                            |       | **1,321**          | ** ** | 1,042         |       |   |   |   |   |
|                                                               |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| Basic  earnings per share                                          | ** ** | **$**                           | **0.47**   | ** **                     | $          | 0.31               |       | **$**         | **1.30**   | ** ** | $ | 0.96 |   | 0.34 |   | 35.5 | % |
| Diluted  earnings per share                                        | ** ** | **$**                           | **0.43**   | ** **                     | $          | 0.29               |       | **$**         | **1.20**   | ** ** | $ | 0.90 |   | 0.30 |   | 33.4 | % |
|                                                               |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| Shares used in computation of earnings per  share                  |       |                            | ** ** |                           |       |               | ** ** |          |       |   |   |   |   |
| Basic                                                              | ** ** | **1,079,175**                   | ** ** | 1,075,956                      |       | **1,079,175**      | ** ** | 1,075,956     |       | 3,219 |   | 0.3 | % |
| Diluted                                                            | ** ** | **1,170,519**                   | ** ** | 1,149,192                      |       | **1,170,519**      | ** ** | 1,149,192     |       | 21,327 |   | 1.9 | % |

 

See accompanying notes to consolidatedfinancial statements.

 

4

----

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**Consolidated Statements of Cash Flows**

**Nine Months Ended September 30**

**(Unaudited)**

 
| **($ amounts in thousands except share and per share data)**                         | ** ** | **2005**    | ** ** | **2004**   | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|------------|------------|------------|------------|
| **Cash  flows from operating activities:**                                                |       |        | ** ** |       |       |       |       |       |       |
| **Net income**                                                                            | ** ** | **$**       | **1,401**  | ** ** | 1,031      |       | 370        |       | 36         | % |
| Adjustments to reconcile net income to net  cash provided (used) by operating activities: |       |        | ** ** |       |       |       |       |       |       |
| Depreciation and amortization                                                             | ** ** | **269**     | ** ** | 317        |       | (48        | )          | -15        | %          |
| Provision for loan losses                                                                 | ** ** | **298**     | ** ** | 362        |       | (64        | )          | -18        | %          |
| (Gain) loss on sale of securities available  for sale                                     | ** ** | **6**       | ** ** | (18        | )          |       |       |       |       |
| FHLB stock dividends                                                                      | ** ** | **(8**      | **)**      | (5         | )          |       |       |       |       |
| Mortgage loans originated for sale                                                        | ** ** | **(19,875** | **)**      | (15,578    | )          |       |       |       |       |
| Proceeds from sale of mortgage loans                                                      | ** ** | **19,406**  | ** ** | 15,618     |       |       |       |       |       |
| Decrease (increase) in accrued interest  receivable                                       | ** ** | **(177**    | **)**      | (136       | )          | (41        | )          | 30         | %          |
| Increase (decrease) in accrued interest  payable                                          | ** ** | **258**     | ** ** | 75         |       |       |       |       |       |
| Other, net                                                                                | ** ** | **(52**     | **)**      | (5         | )          | (47        | )          | 940        | %          |
| ***Net cash provided by operating activities***                                           | ** ** | **1,526**   | ** ** | 1,661      |       | (135       | )          | -8         | %          |
| **Cash flows from investing activities:**                                                 |       |        | ** ** |       |       |       |       |       |       |
| Proceeds from maturities and redemptions of  securities available for sale                | ** ** | **1,044**   | ** ** | 2,283      |       | (1,239     | )          |       |       |
| Proceeds from sales of securities available  for sale                                     | ** ** | **5,294**   | ** ** | 4,729      |       | 565        |       | 100        | %          |
| Purchases of securities available for sale                                                | ** ** | **(8,716**  | **)**      | (7,112     | )          | (1,604     | )          | 18         | %          |
| Purchases of restricted stock                                                             | ** ** | **(57**     | **)**      | (29        | )          |       |       |       |       |
| Net increase in loans                                                                     | ** ** | **(18,251** | **)**      | (20,837    | )          | 2,586      |       | -12        | %          |
| Purchases of premises and equipment                                                       | ** ** | **(147**    | **)**      | (113       | )          | (34        | )          | 30         | %          |
| ***Net cash used by investing activities***                                               | ** ** | **(20,833** | **)**      | (21,079    | )          | 246        |       | -1         | %          |
| **Cash flows from financing activities:**                                                 |       |        | ** ** |       |       |       |       |       |       |
| Decrease in repurchase agreements                                                         | ** ** | **(789**    | **)**      | (1,696     | )          | 907        |       |       |       |
| Increase in deposits                                                                      | ** ** | **28,089**  | ** ** | 22,904     |       | 5,185      |       | 23         | %          |
| ***Net cash provided by financing activities***                                           | ** ** | **27,300**  | ** ** | 21,208     |       | 6,092      |       | 29         | %          |
|                                                                                      |       |        | ** ** |       |       |       |       |       |       |
| ***Net increase (decrease) in cash***                                                     | ** ** | **7,993**   | ** ** | 1,790      |       | 6,203      |       | 347        | %          |
| **Cash and cash equivalents, beginning of  period**                                       | ** ** | **5,093**   | ** ** | 4,545      |       | 548        |       | 12         | %          |
|                                                                                      |       |        | ** ** |       |       |       |       |       |       |
| **Cash and cash equivalents, end of period**                                              | ** ** | **$**       | **13,086** | ** ** | 6,335      |       | 6,751      |       | 107        | % |
|                                                                                      |       |        | ** ** |       |       |       |       |       |       |
| **Cash payments for interest**                                                            | ** ** | **$**       | **2,309**  | ** ** | 1,630      |       | 7,868      |       |       |   |
| **Cash payments for income taxes**                                                        | ** ** | **852**     | ** ** | 613        |       |       |       |       |       |

 

See accompanying notes to consolidated financial statements.

 

5

----

 

**SOUTHERNHERITAGE BANCSHARES, INC.**

**Notes to Consolidated Financial Statements**

**September 30,2005**

**(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 September 30, 2005, the results of operations for the nine months endedSeptember 30, 2005, and cash flows for the nine months ended September 30,2005.  The interim financial statementsshould be read in conjunction with the notes to the financial statementspresented in the Bank’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 LoanLosses*

 

Transactions in the allowance for loan losseswere as follows:

 
| ** **                       | ** ** | **Nine Months**    | ** ** | **Nine Months**    | ** ** |
|----------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                       | ** ** | **Ended**          | ** ** | **Ended**          | ** ** |
| ** **                       | ** ** | **Sept. 30, 2005** | ** ** | **Sept. 30, 2004** | ** ** |
| ** **                       | ** ** | **(In Thousands)** | ** ** | **(In Thousands)** | ** ** |
|                             |       |               |       |               |       |
| Balance  January 1          |       | $                  | 1,723      |               | $          | 1,372 |   |
| Add  (deduct):                   |       |               |       |               |       |
| Losses charged to allowance      |       | (70                | )          | (96                | )          |
| Recoveries credited to allowance |       | 18                 |       | 5                  |       |
| Provision for loan losses        |       | 298                |       | 362                |       |
|                             |       |               |       |               |       |
| Balance September 30        |       | $                  | 1,969      |               | $          | 1,643 |   |

 

6

----

 

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

 

At September 30, 2005, the Bank had one loan totaling $13,000 innonaccrual 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 September 30, 2005, compared to two loans totaling$1,518,000 as of December 31, 2004. In the first nine months of 2005, loans totaling $70,000 were chargedoff and $18,000 was recovered on loans previously charged off.  Management believes the allowance for loanlosses at September 30, 2005, is adequate to absorb probable incurredlosses in the loan portfolio.

 

Stock Dividend:  The Companydeclared a stock dividend of one share for each 20 shares owned forshareholders of record as of May 19, 2005. The effects of this stock dividend have been reflected in earnings pershare and shares used in the computation of earnings per share for all periodspresented.

 

Stock Compensation:  Employee compensationexpense under stock options 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, *Accountingfor Stock-Based Compensation.*

 
| ** **                                                                              | ** ** | **Nine Months**    | ** ** | **Nine Months**    | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                              | ** ** | **Ended**          | ** ** | **Ended**          | ** ** |
| ** **                                                                              | ** ** | **Sept. 30, 2005** | ** ** | **Sept. 30, 2004** | ** ** |
|                                                                                    |       |               |       |               |       |
| Net income  as reported                                                                 |       | $                  | 1,401      |               | $          | 1,031 |   |
| Deduct:  Stock-based compensation expense determined under fair value based method |       | 36                 |       | 36                 |       |
|                                                                                    |       |               |       |               |       |
| Pro Forma  net income                                                                   |       | $                  | 1,365      |               | $          | 995 |   |
|                                                                                    |       |               |       |               |       |
| Basic  earnings per share as reported                                                   |       | $                  | 1.30       |               | $          | 0.96 |   |
| Pro Forma  basic earnings per share                                                     |       | 1.26               |       | 0.92               |       |
|                                                                                    |       |               |       |               |       |
| Diluted  earnings per share as reported                                                 |       | 1.20               |       | 0.90               |       |
| Pro Forma  diluted earnings per share                                                   |       | 1.17               |       | 0.87               |       |

 

 

Earnings Per Share Amount:  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 91,344 and 73,236 in2005 and 2004 and defease earnings per share by $.09 and $.05.  No shares were antidilutive at September 30,2005 and 2004.

 

7

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# ***Item 2.**** Management’s Discussion And Analysis*

# ** **

# **OVERVIEW**

# ** **

Thefollowing discussion compares the financial condition of Southern HeritageBancshares, Inc. (the “Company”) at September 30, 2005, to December 31,2004, and the results of operations for the three and nine months ended September 30,2005 and 2004.  Reasons for changes inthe quarterly 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 consolidated operationsare that of the Bank.  This discussionshould be read in conjunction with the interim financial statements andfootnotes included herein.

 

Certainstatements contained in this report that are not historical facts are forwardlooking statements that 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.

 

# **FINANCIAL CONDITION**

# ** **

Totalassets as of September 30, 2005 increased 18.6%, or $29,137,000, to$185,998,000, compared with $156,861,000 at December 31, 2004.  The increase in total assets was funded by acomparable increase in total deposits of $28,089,000.  Cash and cash equivalents increased$7,993,000 to $13,086,000 at September 30, 2005 from $5,093,000 at December 31,2004.  Securities increased $2,219,000 to$21,886,000 at September 30, 2005 compared to $19,667,000 at December 31,2004.

 

Loansare the principal component of the Bank’s assets and the primary source ofincome.  Total loans at September 30,2005, were $144,176,000 compared to $125,925,000 at December 31, 2004, anincrease of $18,251,000.  Most of the netloan growth in the first nine months of 2005 was in commercial which increased$5,665,000; commercial loans secured by real estate increased $4,300,000; otherloans increased $3,552,000; 1-4 family residential loans increased $2,599,000;and construction loans secured by real estate increased $2,534,000. As of September 30, 2005, $44,932,000 or 31% of total loans were commercial loans secured byreal estate.  Commercial loans were$39,168,000 or 27% of total loans.  Loanssecured by 1-4 family residential real estate were $25,743,000 or 18% of totalloans.  Construction loans secured byreal estate were $24,548,000 or 17% of total loans.  Consumer loans were $4,023,000 or 3% of totalloans.  Other loans were $5,306,000 or 4%of total loans.  Of the total loans,$96,550,000 or 67% mature or reprice within 12 months.  Only $1,858,000 or 1.3% mature or repriceover five years.

 

Therewas $1,152,000 in mortgage loans held for sale at September 30, 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.

 

Managementanticipates that loan demand will continue to be strong.  The loan-to-deposit ratio as of September 30,2005, was 87.1%, compared to 91.7% at December 31, 2004, and the loan-to-assetsratio was 77.5% at September 30, 2005, compared to 80.3% at December 31,2004.  Management expects that

 

8

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theloan-to-deposit ratio for the remainder of 2005 will remain in the range ofapproximately 85% - 90% and the loans-to-assets ratio will be between 75% -80%.

 

Thesecurities portfolio provides a balance to interest rate and credit risk whileproviding a vehicle for investing available funds, furnishing liquidity, andsupplying securities to pledge as required for certain deposits and borrowedfunds.  All securities are classified as “availablefor sale”.  We have no plans to liquidatea significant amount of the securities portfolio.

 

Asof September 30, 2005, the company owned $21,886,000 of securitiesavailable-for-sale, an increase of $2,219,000 or 11.3% over the $19,667,000 at December 31,2004.

 

Depositswhich are the Bank’s primary source of funds, totaled $165,448,000 at September 30,2005, for an increase of $28,089,000, or 20.4%, compared to $137,359,000 at December 31,2004.  Deposits at September 30,2005 consisted of $28,801,000 or 17.4% in non-interest bearing demand deposits,$40,197,000 or 24.3% in interest-bearing demand deposits, $89,589,000 or 54.2%in time certificates of deposit and $6,861,000 or 4.1% in savingsaccounts.  There was $16,383,000 inbrokered CDs at September 30, 2005 compared to $11,470,000 at December 31,2004.  The Bank has targeted localconsumers, 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.

 

Themajority of the deposits continue to be CDs, which increased $19,647,000 in thefirst nine months of 2005.  At September 30,2005, the weighted average rate on CDs was 3.23% compared to 2.72% for the ninemonths ended September 30, 2004. The Bank has time deposits maturingwithin one year of $50,313,000 or 56.2% of total time deposits.  Time deposits maturing greater than one yearis $39,276,000 or 43.8% of total time deposits. Interest-bearing accounts, other than CDs, increased $2,366,000 in thefirst nine months of 2005.  Noninterestbearing deposits increased $6,077,000 for the nine months ended September 30,2005.  The weighted average cost of alldeposit accounts during the first nine months of 2005 was 2.08% compared to1.77% for the same period in 2004.

 

Totalshareholders’ equity increased $1,348,000, to $13,875,000 at September 30,2005, from $12,527,000 at December 31, 2004.  This increase was due to the Company’s netincome of $1,401,000 for the first nine months of 2005 along with a netincrease in unrealized losses on securities available for sale of $83,000 netof tax.  There was $20,000 in stockoptions exercised during the period.

 

TheCompany declared a stock dividend of one share for each 20 shares owned forshareholders of record as of May 19, 2005. The effects of the stock dividend have been reflected in earnings pershare and shares used in the computation of earnings per share for all periodspresented.

 

Asof September 30, 2005 the Bank is categorized as well capitalized underthe regulatory framework for prompt corrective action.  The total capital to risk-weighted assetsratio was 13.21%.  Tier-1 torisk-weighted assets ratio was 11.75% and Tier-1 to average asset ratio was10.40%.

 

9

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# **RESULTS OF OPERATIONS**

# ** **

Forthe first nine months of 2005, net income after tax was $1,401,000, compared to$1,031,000 for the same period in 2004, an increase of 35.9%.  The increase in earnings over the previousyear was primarily a result of the increase in net interest income as a resultof the overall growth of the Bank.  Netinterest income before the provision for loan losses for the first nine monthsof 2005 was $4,692,000, an increase of $878,000 or 23% from $3,814,000 for thefirst nine months of 2004.  The netinterest margin increased 21 basis points to 4.05% at September 30, 2005compared to 3.84% for the same period in 2004.

 

Interestand fee income on loans for the first nine months of 2005 was $6,502,000, anincrease of $1,445,000 or 28.6% from $5,057,000 for the nine months ended September 30,2004.  The increase in interest and feeincome on loans is primarily due to increased volume in commercial andcommercial real estate loans and an increase in rates following the FederalReserve’s efforts to increase short term rates. The yield on all loans increased 54 basis points to 6.48% at September 30,2005 compared to 5.94% at September 30, 2004.

 

Interestincome from securities and short-term funds totaled $757,000 for the first ninemonths of 2005, an increase of $295,000 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;$27,047,000 at September 30, 2005 compared to $18,793,000 at September 30,2004 and the increase in short term rates. The yield on securities and short-term funds was 3.67% at September 30,2005 compared to 3.24% for the period ended September 30, 2004.

 

Interestexpense totaled $2,567,000 in the first nine months of 2005, compared to$1,705,000 for the same period of 2004. The increase in interest expense in 2005 was due to the significantgrowth of deposits. The Bank’s cost of funds increased to 2.08% at September 30,2005 compared to 1.77% at September 30, 2004 as a result of the increasein short term rates. Total deposits outstanding at September 30, 2005 were$165,448,000 compared to $137,359,000 at December 31, 2004.

 

TheBank’s net interest margin for the first nine months of 2005 was 4.05% comparedto 3.84% for the nine months ended September 30, 2004.

 

TheBank’s yield on earning assets has increased to 6.00%, for the first ninemonths of 2005 compared to 5.55% for the same period of 2004.  The cost of interest-bearing funds hasfollowed the same trend, increasing to 2.50% for the first nine months of 2005,up from 2.10% for the nine months ended June 30, 2004.

 

Inthe first nine months of 2005, the Bank provided $298,000 for probable incurredloan losses, compared to $362,000 for the same period of 2004.  Management’s determination of the appropriatelevel of the provision for loan losses and the adequacy of the allowance forloan losses is based, in part, on an evaluation of specific loans, as well as aconservative posture due to the Bank’s short history.  Other factors considered by managementinclude the composition of the loan portfolio, current economic conditions, andthe creditworthiness of the Bank’s borrowers and other related factors.  The net charge-offs for the first nine monthsof 2005 were $52,000 compared to $91,000 for the same period in 2004.

 

AtSeptember 30, 2005, the Bank had one loan totaling $13,000 in nonaccrualstatus.  This compares with December 31,2004, where there were five loans totaling $85,000 in nonaccrual.  At September 30, 2005 there were noloans that were more than 90 days delinquent compared to two loans totaling$1,518,000 as of December 31, 2004. In the first nine months of 2005, loans totaling $70,000 were chargedoff and $18,000 was recovered on loans previously charged off.  Management believes the allowance for loanlosses at September 30, 2005, is adequate to absorb probable incurredlosses in the loan portfolio.

 

10

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Totalnoninterest income for the first nine months of 2005 was $1,496,000 compared to$1,316,000 for the same period in 2004. The Bank originates and sells long-term fixed rate mortgages and therelated servicing.  Mortgage loansoriginated and sold generated $313,000 of fees; 138 loans closed, as of September 30,2005 compared to $295,000; 113 loans closed, for the nine months ended September 30,2004.  The average loan closed increased$3,000 to $141,000 from $138,000 in the previous year.  The other large component of non-interestincome is service charges on deposit accounts which totaled $987,000 as of September 30,2005 compared to $838,000 for the same period in 2004.  The increase here is primarily due to the new“bounce protection” overdraft product introduced in May 2004 and overalldeposit growth of the Bank.

 

Noninterestexpenses were $3,779,000 for the first nine months of 2005 compared with$3,156,000 for the same period of 2004; an increase of $623,000 or 19.7%.  The growth in noninterest expenses in thefirst nine months of 2005 is attributable primarily to the increase in salariesand benefits expense ($333,000 or 21%) and other operating expense ($281,000 or21.3%).

 

Asof September 30, 2005, the Bank had 43 full-time equivalent employeescompared to 48 for the same period of 2004. Salaries and wages represent $194,000 of the increase.  The employee bonus program was revised in2005 resulting in an additional $67,000 charge over the previous yearamount.  The employer match for the 401Kplan was $42,000 more than the previous year (implemented September 2004).  During 2005, $8,000 was paid for recruitingand hiring key staff.   Workman’s compinsurance increased $6,000 over the previous year.

 

Theincrease in other operating expense was primarily in outside fees of$153,000.  This area includes accounting,audit, and consulting fees of $110,000, FDIC and State Assessment fees of$11,000, and director fees of $24,000. 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 increase indirectors’ fees is due to an increase in the annual retainer for non managementdirectors from $6,000 to $7,500 per year and an increase in the number ofmeetings called.

 

Theremaining increase in other operating expense includes increases in postage andsupplies costs of $14,000, human resources training and seminar costs of$23,000, direct fees for the new “bounce protection” program costs of $29,000,data processing software expenses of $11,000, loan processing expense of$32,000 and marketing and public relations expense of $10,000.

 

TheBank recorded income tax expense of $710,000 for the period ended September 30,2005 compared to $581,000 for the same period in 20004.  The effective tax rate is 33.6% for 2005compared to 36.0% for 2004.  The decreasein the effective tax rate is due to the Company’s emphasis on a largerpercentage of the security portfolio being in tax free securities.  Total outstanding at September 30, 2005was $15,645,000 or 71.5% of the portfolio compared to $8,279,000 or 52.5% inthe prior year.  Tax free income for theperiod was $359,000 compared to $174,000 in the prior year.

 

# **LIQUIDITY AND CAPITAL RESOURCES**

# ** **

Liquidityrefers to the Company’s ability to fund loan demand, meet deposit customers’withdrawal needs and provide for operating expenses.  As summarized in the Statement of Cash Flows,the Company’s main source of cash flow is from receiving deposits from the Bank’scustomers, and to a lesser extent, repayment

 

11

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ofloan 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.

 

Inthe first nine months of 2005, deposit growth has exceeded loan growth; however,this is more of a timing issue and is not expected to continue. Other potentialsources of liquidity include the sale of available-for-sale securities from theBank’s portfolio, the sale of loans, the purchase of federal funds, orrepurchase agreements. The Company currently has $16,383,000 in brokeredcertificates of deposit.

 

Thepayment of dividends by the Company depends to a great extent on the ability ofthe Bank to pay dividends to the Company. The Company is subject to the Tennessee Banking Act, which provides thatthe Bank may not declare dividends in any calendar year that exceeds the totalof its net income of that year combined with its retained net income of thepreceding two years without the approval of the TDFI.  Thereafter, 10% of net profits must betransferred to capital surplus prior to payment of dividends until capitalsurplus equals capital stock.  The Bankis also subject to the minimum capital requirements of the FDIC which impactthe Bank’s ability to pay dividends.  Ifthe Bank fails to meet these standards, it may not be able to pay dividends orto accept additional deposits because of regulatory requirements.

 

If,in the opinion of the applicable federal bank regulatory authority, adepository institution is engaged in or is about to engage in an unsafe orunsound practice (which, depending on the financial condition of the depositoryinstitution, could include the payment of dividends), such authority mayrequire that such institution 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.

 

AtSeptember 30, 2005 and December 31, 2004, the Bank’s risk-based capitalratios and the minimums to be considered well-capitalized under the FederalReserve Board’s prompt corrective action guidelines were as follows:

 
| ** **                             | ** ** | **Sept. 30, 2005** | ** ** | **Dec. 31, 2004** | ** ** | **Well-capitalized** | ** ** |
|----------------------------------------|------------|--------------------|------------|------------------------|------------|----------------------|------------|
|                                   |       |               |       |                   |       |                 |       |
| Tier 1 capital to risk-weighted assets |       | 11.75              | %          | 11.96                  | %          | 6.0                  | %          |
| Total capital to risk-weighted assets  |       | 13.21              | %          | 13.79                  | %          | 10.0                 | %          |
| Tier 1 leverage ratio                  |       | 10.40              | %          | 10.73                  | %          | 5.0                  | %          |

 

Asdiscussed above, total shareholders’ equity increased $1,348,000, to$13,875,000 at September 30, 2005 from $12,527,000 at December 31,2004.  This increase was due to theCompany’s net income of $1,401,000 for the first nine months of 2005 along witha net increase in unrealized losses on securities available for sale of$83,000, net of tax.  There was $20,000in stock options exercised during the period ended September 30, 2005.

 

# **INTEREST RATE SENSITIVITY**

# ** **

Financialinstitutions are subject to interest rate risk to the degree that theirinterest-bearing liabilities (consisting principally of customer deposits)mature or reprice more or less frequently than their interest-

 

12

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earningassets (generally consisting of loans and investment securities).  The match between the scheduled repricing andmaturities of earning assets and liabilities within defined time periods isreferred to as “gap” analysis.  At September 30,2005 the cumulative one-year gap was a positive (or asset sensitive) $8,434,000or 4.8% of earning assets compared to a positive gap of $7,679,000 or 5.2% ofearning assets at December 31, 2004.

 

Oneof management’s objectives in managing the Bank’s balance sheet for interestrate sensitivity is to reduce volatility in the net interest margin bymatching, as closely as possible, the timing of the repricing of its interestrate sensitive assets with interest rate sensitive liabilities.  During the first nine months of 2005 the Bankexperienced six rate increases after only three increases during the sameperiod in 2004. As a result of the positive gap position, the Bank’s netinterest margin improved to 4.05% at September 30, 2005 compared to the3.85% margin at December 31, 2004. Management believes that interest rates will continue to increase during2005 and the first quarter of 2006.  TheBank’s strategy of being in a positive one year gap position should result instable to increasing net interest margin as rates 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*

# ** **

Asof September 30, 2005, an evaluation was carried out under the supervisionand with the participation of the registrant’s management, including ourPresident and Chief Financial Officer, of the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe 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.

 

Therehave been no changes in the Company’s internal controls over financialreporting or in other factors that have materially affected, or is reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

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**PART II - OTHER INFORMATION**

 

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

 

None

 

**Item 2.****  Unregistered Sales of Equity Securities andUse of Proceeds**

 

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

 
| ** **           | ** ** | **Number of Shares of** | ** ** | ** **          | ** ** |
|----------------------|------------|-------------------------|------------|---------------------|------------|
| **Date of Sale**     | ** ** | **Common Stock Sold**   | ** ** | **Price Per Share** | ** ** |
| ** **           | ** ** | ** **              | ** ** | ** **          | ** ** |
| August 23, 2005 |       | 2,100                   |       | $                   | 9.52       |   |
|                      |            |                         |            |                     |            |  |

 

The aggregate proceeds of the shares soldwere $19,992.

 

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

 

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

 

The common stock is not convertible orexchangeable into other equity securities.

 

The proceeds of the sales are being used bythe Company for general corporate purposes.

 

(b)                                 Not applicable.

 

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

 

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

 

None

 

**Item 4.****  Submission of Matters to a Vote of SecurityHolders**

 

None

 

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

 

None

 

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

 

Rule 13a-14(a) Certifications

 

Section 1350 Certifications

 

14

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# **SIGNATURES**

# ** **

Pursuantto the requirements of the Securities and Exchange Act of 1934, the Registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 

 
|                   | Southern Heritage Bancshares, Inc. |                    |
|------------------------|-----------------------------------------|-------------------------|
|                   | (Registrant)                            |
|                   |                                    |
|                   |                                    |
| November 14, 2005 |                                    | /s/ J. Lee Stewart      |   |
| (Date)                 | J. Lee Stewart                          |
|                   | President                               |
|                   |                                    |
|                   |                                    |
| November 14, 2005 |                                    | /s/ Steven W. Ledbetter |   |
| (Date)                 | Steven W. Ledbetter,                    |
|                   | Chief Financial Officer                 |
|                        |                                         |                         |  |  |

 

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