***UNITED STATESSECURITIES AND EXCHANGE COMMISSION***

**Washington,D.C.  20549**

**FORM10-QSB**

(Mark One)

[X]                      QUARTERLYREPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

For theQuarterly Period Ended: September 30, 2004

[  ]                         TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIESEXCHANGE ACT OF 1934

CommissionFile No. 00050921

**SOUTHERN HERITAGE BANCSHARES, INC.**

(Exact Name ofSmall Business Issuer 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 and Fiscal Year, if  Changed Since Last Report) |

 

Check whetherthe issuer (1) filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days

Yes [  ]             No[ X ]

State theoutstanding number of shares of the issuer’s common stock as of October 31,2004:  1,024,720

 

 

Transitional Small Business Disclosure Format(check one):

 

Yes [  ]             No[ X ]

**SOUTHERN HERITAGEBANCSHARES, INC.**

**FORM 10-QSB**

**Quarter ended September 30, 2004**

##### ***PART I.           FINANCIALINFORMATION***

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

ConsolidatedBalance Sheets - September 30, 2004 (Unaudited) and December 31, 2003

ConsolidatedStatements of Income and Comprehensive Income (Loss) - Nine monthsended September 30, 2004 and 2003 (Unaudited)

###### Consolidated Statements of Cash Flows - Nine monthsended September 30, 2004 and2003 (Unaudited)

Notes to ConsolidatedFinancial Statements

***Item 2.****** ***Managements Discussion AndAnalysis Of Financial Condition And Results OfOperations

***Item 3.****** ***Disclosure Controls AndProcedures

##### ***PART II.******          OTHER INFORMATION***

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

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

***Item 3.***  Defaults Upon SeniorSecurities

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

***Item 5.***  Other Information

***Item 6.***  Exhibits

***Signatures***

 

**PART I - FINANCIAL INFORMATION**

** **

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

** **

**SOUTHERNHERITAGE BANCSHARES, INC.**

**Consolidated Balance Sheets**

 

 
| * ($ amounts in thousands except share and per  share data )* | **(Unaudited)**          | ** **  |               |    |
|-------------------------------------------------------------------------|--------------------------|-------------|--------------------|---------|
| ***Assets***                                                            | **September  30,  2004** | ** **  | December 31,  2003 |    |
| Cash and due from banks                                                 | **$**                    | **4,222**   | ** **         | 4,455   |   |
| Federal funds sold                                                      | **2,113**                | ** **  | 90                 |    |
| ***     Cash and cash equivalents***                | **6,335**                | ** **  | 4,545              |    |
| Securities available-for-sale, at fair value                            | **15,783**               | ** **  | 15,654             |    |
| Mortgage loans held for sale                                            | **238**                  | ** **  | 278                |    |
| Loans                                                                   | **123,668**              | ** **  | 102,831            |    |
| Allowance for loan losses                                               | **(1,643**               | **)**       | (1,372             | )       |
| ***     Loans, net***                               | **122,025**              | ** **  | 101,459            |    |
| Premises and equipment                                                  | **5,656**                | ** **  | 5,824              |    |
| Restricted stock                                                        | **295**                  | ** **  | 266                |    |
| Accrued interest receivable                                             | **509**                  | ** **  | 373                |    |
| Other assets                                                            | **541**                  | ** **  | 517                |    |
|                                                                    | **$**                    | **151,382** | ** **         | 128,916 |   |
|                                                                    | ** **               | ** **  |               |    |
| ***Liabilities and  Shareholders' Equity***                             | ** **               | ** **  |               |    |
| **Liabilities:**                                                        | ** **               | ** **  |               |    |
| **    Deposits:**                                             | ** **               | ** **  |               |    |
|        Noninterest-bearing                     | **$**                    | **24,796**  | ** **         | 15,341  |   |
|       Interest-bearing                         | **113,808**              | ** **  | 100,359            |    |
| ***     Total deposits***                           | **138,604**              | ** **  | 115,700            |    |
|   Repurchase  agreements                                           | **87**                   | ** **  | 1,783              |    |
|   Accrued  interest payable                                        | **386**                  | ** **  | 311                |    |
|   Other  liabilities                                               | **190**                  | ** **  | 49                 |    |
| ***     Total liabilities***                        | **139,267**              | ** **  | 117,843            |    |
| **Shareholders' equity:**                                               | ** **               | ** **  |               |    |
| Preferred stock,  no par value. Authorized 1,000,000 shares;            | ** **               | ** **  |               |    |
| none issued                                                             | **-**                    | ** **  | -                  |    |
| Common stock, $1  par value. Authorized 2,000,000 shares;               | ** **               | ** **  |               |    |
| issued 1,024,720  shares                                                | **1,025**                | ** **  | 1,025              |    |
| Additional  paid-in-capital                                             | **9,222**                | ** **  | 9,222              |    |
| Retained  earnings (accumulated deficit)                                | **1,932**                | ** **  | 901                |    |
| Accumulated  other comprehensive income                                 | **(64**                  | **)**       | (75                | )       |
| ***     Total shareholders' equity***               | **12,115**               | ** **  | 11,073             |    |
|                                                                    | **$**                    | **151,382** | ** **         | 128,916 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**Consolidated Statements of Income andComprehensive Income**

**Three and Six Months Ended September 30, 2004and 2003**

**(Unaudited)**

 
| * ($ amounts in thousands except share and per  share data)*              | ** **                       | ** **   |                            |         | ** **    | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------------|----------------------------------|--------------|---------------------------------|--------------|---------------|------------|------------|------------|
| * *                                                                            | **Three  Months Ended Sept. 30** |         | **Nine  Months Ended Sept. 30** | ** **   |
| * *                                                                            | ** **                       |         | ** **                      | ** **   |
|                                                                                | **2004**                         | ** **   | 2003                            |         | **2004**      | ** ** | 2003       |       |
| **Interest income:**                                                                | ** **                       | ** **   |                            |         | ** **    | ** ** |       |       |
|    Loans,  including fees                                                 | **$**                            | **1,775**    | ** **                      | 1,460        |          | **$**      | **5,057**  | ** ** | 4,275 |   |
|    Securities                                                             | **156**                          | ** **   | 120                             |         | **430**       | ** ** | 300        |       |
|    Federal  funds sold                                                    | **12**                           | ** **   | 10                              |         | **32**        | ** ** | 46         |       |
| ***     Total interest income***                                | **1,943**                        | ** **   | 1,590                           |         | **5,519**     | ** ** | 4,621      |       |
| **Interest expense:**                                                               | ** **                       | ** **   |                            |         | ** **    | ** ** |       |       |
| Deposits                                                                            | **605**                          | ** **   | 488                             |         | **1,705**     | ** ** | 1,492      |       |
| ***     Total interest expense***                               | **605**                          | ** **   | 488                             |         | **1,705**     | ** ** | 1,492      |       |
| ***     Net interest income***                                  | **1,338**                        | ** **   | 1,102                           |         | **3,814**     | ** ** | 3,129      |       |
| **Provision for loan losses**                                                       | **182**                          | ** **   | 70                              |         | **362**       | ** ** | 219        |       |
| ***     Net interest income after provision for loan  losses*** | **1,156**                        | ** **   | 1,032                           |         | **3,452**     | ** ** | 2,910      |       |
| **Noninterest income:**                                                             | ** **                       | ** **   |                            |         | ** **    | ** ** |       |       |
| Service charges  on deposit accounts                                                | **340**                          | ** **   | 175                             |         | **838**       | ** ** | 476        |       |
| Mortgage banking  activities                                                        | **90**                           | ** **   | 177                             |         | **295**       | ** ** | 556        |       |
| Gain (loss) on  sale of securities                                                  | **(2**                           | **)**        | (15                             | )            | **18**        | ** ** | (33        | )          |
| Other service  charges, commissions and fees                                        | **53**                           | ** **   | 47                              |         | **165**       | ** ** | 139        |       |
| ***     Total noninterest income***                             | **481**                          | ** **   | 384                             |         | **1,316**     | ** ** | 1,138      |       |
| **Noninterest expenses:**                                                           | ** **                       | ** **   |                            |         | ** **    | ** ** |       |       |
| Salaries and  employee benefits                                                     | **538**                          | ** **   | 500                             |         | **1,583**     | ** ** | 1,472      |       |
| Occupancy expense                                                                   | **86**                           | ** **   | 87                              |         | **254**       | ** ** | 244        |       |
| Other operating  expenses                                                           | **502**                          | ** **   | 417                             |         | **1,319**     | ** ** | 1,187      |       |
| ***     Total noninterest expenses***                           | **1,126**                        | ** **   | 1,004                           |         | **3,156**     | ** ** | 2,903      |       |
| ***     Income before income taxes***                           | **511**                          | ** **   | 412                             |         | **1,612**     | ** ** | 1,145      |       |
| **Income taxes**                                                                    | **178**                          | ** **   | 143                             |         | **581**       | ** ** | 363        |       |
| ***     Net income***                                           | **333**                          | ** **   | 269                             |         | **1,031**     | ** ** | 782        |       |
| *** ***                                                                        | *** ***                     | *** *** | *** ***                    | *** *** | ** **    | ** ** |       |       |
| **Other comprehensive income (loss):**                                              | ** **                       | ** **   | ** **                      | ** **   | ** **    | ** ** |       |       |
| Unrealized  gains/losses on securities net of tax                                   | **353**                          | ** **   | (259                            | )            | **11**        | ** ** | (167       | )          |
|                                                                                |                             |         |                            |         | ** **    | ** ** |       |       |
| **Comprehensive income (loss)**                                                     | **686**                          | ** **   | 10                              |         | **1,042**     | ** ** | 615        |       |
|                                                                                |                             |         |                            |         | ** **    | ** ** |       |       |
| Basic earnings per share                                                            | **$**                            | **0.32**     | ** **                      | $            | 0.26          |       | **$**      | **1.01**   | ** ** | $ | 0.76 |   |
| Diluted earnings per share                                                          | **$**                            | **0.30**     | ** **                      | $            | 0.25          |       | **$**      | **0.94**   | ** ** | $ | 0.74 |   |
|                                                                                |                             |         |                            |         | ** **    | ** ** |       |       |
| Shares used in computation of earnings per share                                    |                             |         |                            |         | ** **    | ** ** |       |       |
|     Basic                                                            | **1,024,720**                    | ** **   | 1,024,720                       |         | **1,024,720** | ** ** | 1,024,720  |       |
|     Diluted                                                          | **1,094,469**                    | ** **   | 1,058,565                       |         | **1,094,469** | ** ** | 1,058,565  |       |

 

See accompanying notes to consolidatedfinancial statements.

 

**SOUTHERNHERITAGE BANCSHARES, INC.**

**Consolidated Statements  of Cash Flows**

**Nine Months Ended September 30**

**(Unaudited)**

 
| *($ amounts in thousands except share and per share data)* | ** **  | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------|-------------|------------|------------|------------|
|                                                            | ** **  | ** ** | ** ** | ** ** |
|                                                            | **2004**    | ** ** | 2003       |       |
| **Cash  flows from operating activities:**                      | ** **  | ** ** |       |       |
| **Net income**                                                  | **$**       | **1,031**  | ** ** | 782        |   |
| Adjustments to reconcile net income   to net cash          | ** **  | ** ** |       |       |
| provided (used) by operating activities:                        | ** **  | ** ** |       |       |
| Depreciation and amortization                                   | **317**     | ** ** | 314        |       |
| Provision for loan losses                                       | **362**     | ** ** | 219        |       |
|  (Gain) loss on sale of  securities available for sale     | **(18**     | **)**      | 33         |       |
| FHLB stock dividends                                            | **(5**      | **)**      | (3         | )          |
| Mortgage loans originated for sale                              | **(15,578** | **)**      | (26,765    | )          |
| Proceeds from sale of mortgage loans                            | **15,618**  | ** ** | 27,570     |       |
| Decrease (increase) in accrued interest receivable              | **(136**    | **)**      | (17        | )          |
| Increase (decrease) in accrued interest payable                 | **75**      | ** ** | 39         |       |
| Other, net                                                      | **(5**      | **)**      | (169       | )          |
| ***Net cash provided by operating activities***                 | **1,661**   | ** ** | 2,003      |       |
| **Cash  flows from investing activities:**                      | ** **  | ** ** |       |       |
| Proceeds from maturities and redemptions of securities          | ** **  | ** ** |       |       |
| available for sale                                              | **2,283**   | ** ** | 7,561      |       |
| Proceeds from sales of securities available for sale            | **4,729**   | ** ** | 500        |       |
| Purchases of securities available for sale                      | **(7,112**  | **)**      | (14,365    | )          |
| Purchases of restricted stock                                   | **(29**     | **)**      | (13        | )          |
| Net increase in  loans                                     | **(20,837** | **)**      | (10,479    | )          |
| Purchases of premises and equipment                             | **(113**    | **)**      | (265       | )          |
| ***Net cash used by investing activities***                     | **(21,079** | **)**      | (17,061    | )          |
| **Cash  flows from financing activities:**                      | ** **  | ** ** |       |       |
| Decrease in repurchase agreements                               | **(1,696**  | **)**      | (26        | )          |
| Increase in deposits                                            | **22,904**  | ** ** | 18,856     |       |
| ***Net cash provided by financing activities***                 | **21,208**  | ** ** | 18,830     |       |
| * *                                                        | ** **  | ** ** |       |       |
| ***Net increase (decrease) in cash***                           | **1,790**   | ** ** | 3,772      |       |
| **Cash and  cash equivalents, beginning of period**             | **4,545**   | ** ** | 8,890      |       |
| ** **                                                      | ** **  | ** ** |       |       |
| **Cash and  cash equivalents, end of period**                   | **$**       | **6,335**  | ** ** | 12,662     |   |
| ** **                                                      | ** **  | ** ** |       |       |
| **Cash  payments for interest**                                 | **$**       | **1,630**  | ** ** | 1,453      |   |
| **Cash  payments for income taxes**                             | **613**     | ** ** | 364        |       |

 

See accompanying notes to consolidated financial statements.

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**Notes to Consolidated Financial Statements**

**September 30, 2004**

**(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.

 

Southern Heritage Bancshares, Inc. (Company) was formed in 2004 as aone bank holding company that owns 100% of Southern Heritage Bank.  Shareholders of the Bank received one shareof the Company for every share of the Bank they owned.  Since the transaction involved entities undercommon control, financial information for prior periods of the Bank is shown asif the transaction occurred as of the beginning of the earliest periodpresented.  Substantially all of theconsolidated operations are that of the Bank.

 

In the opinion of management, the financial statements contain alladjustments necessary to summarize fairly the financial position of the Bank asof September 30, 2004, the results of operations for the nine months endedSeptember 30, 2004, and cash flows for the nine months ended September 30,2004.  The interim financial statementsshould be read in conjunction with the notes to the financial statementspresented in the Bank's December 31, 2003, financial statements.  The results for interim periods are notnecessarily indicative of the results to be expected for the complete fiscalyear.

 

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 a conservative posture dueto the bank’s short history.   Otherfactors considered by management include the composition of the loan portfolio,current  economicconditions, and the creditworthiness of the Bank’s borrowers and other relatedfactors.   

 

At September 30, 2004, the Bank had three loans totaling $53,000 innonaccrual status.  This compares withDecember 31, 2003, where there was one loan for $5,000 in nonaccrual.  The bank had no loans that were  more than 90 days delinquent onSeptember 30, 2004 compared to two loans totaling $80,000 as of December 31,2003.  In the first nine months of 2004,loans totaling $96,000 were charged off and $5,000 was recovered on loanspreviously charged off.  Managementbelieves the allowance for loan losses at September 30, 2004, is adequate toabsorb probable incurred losses in the loan portfolio.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*Allowance for Loan Losses*

 

Transactions in the allowance for loan losseswere as follows:

 
|                                    | Nine  Months                         |     | Nine  Months                         |     |
|-----------------------------------------|--------------------------------------|----------|--------------------------------------|----------|
|                                    | Ended                                |     | Ended                                |     |
|                                    | Sept.30,  2004                       |     | Sept.30,  2003                       |     |
|                                    | *(In Thousands)*                     | * * | *(In Thousands)*                     | * * |
|                                    |                                 |     |                                 |     |
| Balance January 1                       | $     1,372 |     | $     1,195 |     |
| Add (deduct):                           |                                 |     |                                 |     |
|   Losses charged to allowance      | (96)                                 |     | (114)                                |     |
|   Recoveries credited to allowance | 5                                    |     | 8                                    |     |
|   Provision for loan losses        | 362                                  |     | 219                                  |     |
| Balance September 30                    | $     1,643 |     | $     1,308 |     |

 

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**September 30, 2004**

**Item 2.****Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

# **OVERVIEW**

The following discussioncompares the financial condition of Southern Heritage Bancshares, Inc. (theCompany) at September 30, 2004, to December 31, 2003, and the results ofoperations for the nine months ended September 30, 2004 and 2003.  Southern Heritage Bancshares, Inc. was formedin 2004 as a one bank holding company that owns 100% of Southern HeritageBank.  Shareholders of the Bank receivedone share of the Company for every share in the Bank they owned.  Since the transaction involved entities undercommon control, financial information for prior periods of the Bank is shown asif the transaction occurred as of the beginning of the earliest periodpresented.  Substantially all of theconsolidated operations are that of the Bank. This discussion should be read in conjunction with the interim financialstatements and footnotes 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 theCompany or its management are intended to identify such forward lookingstatements.  The Company’s actualresults, performance or achievements may materially differ from those expressedor implied in the forward-looking statements. Risks and uncertainties that could cause or contribute to such materialdifferences include, but are not limited to, general economic conditions, theinterest rate environment, competitive conditions in the financial servicesindustry, changes in law, governmental policies and regulations, and rapidlychanging technology affecting financial services.

# **FINANCIAL CONDITION**

Total assets as of September30, 2004 increased 17.4%, or $22,466,000, to $151,382,000, compared with$128,916,000 at December 31, 2003.  Theincrease in total assets was funded by a comparable increase in total depositsof $22,904,000 offset somewhat by a decrease in federal funds purchased and repurchaseagreements of $1,696,000.  Cash and cashequivalents increased $1,790,000 to $6,335,000 at September 30, 2004 from$4,545,000 at December 31, 2003.

Loans are the principalcomponent of the Bank’s assets and the primary source of income.  Total loans at September 30, 2004, were$123,668,000 compared to $102,831,000 at December 31, 2003, an increase of$20,837,000.  Most of the net loan growthin the first nine months of 2004 was in commercial loans secured by realestate, construction loans secured by real estate, 1-4 family residential realestate, and commercial loans. The growth in the Bank’s commercial loanportfolio is a result of the increased commercial activity in the Bank’s localmarket.  Commercial loans secured by realestate increased $8,789,000. Construction loans secured by real estateincreased $4,736,000 and 1-4 family residential real estate loans increased$2,990,000.  Commercial loans increased$2,970,000.  As of September 30, 2004,$38,221,000 or 31% of total loans were commercial loans secured by realestate.  Commercial loans were$32,743,000 or 27% of total loans.  Loanssecured by 1-4 family residential real estate were $23,792,000 or 19% of totalloans.  Construction loans secured byreal estate were $21,241,000 or 17% of total loans.  Consumer loans were $5,207,000 or 4% of totalloans.  Other loans were $2,464,000 or 2%of total loans.

There was $238,000 inmortgage loans held for sale at September 30, 2004, compared with $278,000 atDecember 31, 2003.  The decrease inmortgage loans held for sale was primarily due to timing issues related tosecondary market investor funding.

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION**

**AND RESULTS OF OPERATIONS**

**September 30, 2004**

# **FINANCIAL CONDITION (continued)**

Managementanticipates that loan demand will continue to be strong.  The loan-to-deposit ratio as of September 30,2004, was 89.2%, compared to 88.9% at December 31, 2003, and the loan-to-assetsratio was 81.7% at September 30, 2004, compared to 79.8% at December 31,2003.  Management expects that theloan-to-deposit ratio for the remainder of 2004 will remain in the range ofapproximately 85% - 90% and the loans-to-assets ratio will be between 75% -80%.

As ofSeptember 30, 2004, the company owned $15,783,000 of securitiesavailable-for-sale, an increase of $129,000 or .8%.  The small increase in securitiesavailable-for-sale is primarily due to the principal payments ofmortgage-backed securities and the funding of loan growth.

Deposits whichare the Bank’s primary source of funds, totaled $138,604,000 at September 30,2004, for  an increase of $22,904,000, or19.8%, compared to the $115,700,000 at December 31, 2003.  Deposits at September 30, 2004 consisted of$24,796,000 or 17.9% in non-interest bearing demand deposits, $38,932,000 or28.0% in interest-bearing demand deposits, $69,032,000 or 49.8% in timecertificates of deposit and $5,845,000 or 4.3% in savings accounts.  The Bank has targeted local consumers,professionals, and small businesses as its central clientele.  These customers are being offered variousdeposit instruments such as demand deposits, savings accounts, money marketaccounts, certificates of deposit and IRAs.  The Bankbelieves it has a competitive advantage by being a  locally owned financial institutionwhich will contribute to increased market share.  However, no assurance of market growth can begiven.

The majorityof the deposits continue to be CDs, which increased $8,077,000 in the firstnine months of 2004.  At September 30,2004, the weighted average rate on CDs was 2.71% compared to 2.79% for the ninemonths ended September 30, 2003. The Bank has time deposits maturing within oneyear of $31,599,000 or 45.7% of total time deposits.  Time deposits maturing greater than one yearis $37,433,000 or 54.3% of total time deposits. Interest-bearing accounts, other than CDs, increased $5,372,000 in thefirst nine months of 2004.  Noninterestbearing deposits increased $9,455,000 for the nine months ended September 30,2004.  The weighted average cost of alldeposit accounts during the first nine months of 2004 was 1.75% compared to1.90% for the same period in 2003.  

Total shareholders’ equity increased $1,042,000, to $12,115,000 atSeptember 30, 2004, from $11,073,000 at December 31, 2003.  This increase was due to the Company’s netincome of $1,031,000 for the first nine months of 2004 along with a netincrease in unrealized gains on securities available for sale of $11,000, netof tax.

# **RESULTS OF OPERATIONS**

For the firstnine months of 2004, net income after tax was $1,031,000, compared to $782,000for the same period in 2003, an increase of 31.7%.  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 2004 was $3,814,000, an increase of $685,000 or 21.9% from $3,129,000 forthe first nine months of 2003.

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION**

**AND RESULTS OF OPERATIONS**

**September 30, 2004**

RESULTS OFOPERATIONS (continued)

Interest andfee income on loans for the first nine months of 2004 was $5,057,000, anincrease of $782,000 or 18.3% from $4,275,000 for the nine months endedSeptember 30, 2003.  The increase ininterest and fee income on loans is primarily due to increased volume incommercial and real estate loans.  

Interestincome from securities and short-term funds increased to $462,000 in the firstnine months of 2004, from $346,000 in the same period of 2003.  The increase in 2004 was due to an increasein the average dollar amount of securities and short-term funds outstanding;$18,793,000 at September 30, 2004 compared to $15,142,000 at September 30,2003.

Interestexpense totaled $1,705,000 in the first nine months of 2004, compared to$1,492,000 for the same period of 2003. The increase in interest expense in 2004 was due to the significantgrowth of deposits.  Total depositsoutstanding at September 30, 2004 were $138,604,000 compared to $115,700,000 atSeptember 30, 2003.

The Bank’s net interest margin for the first nine months of 2004 was4.14% compared to 4.59% for the nine months ended September 30, 2003.

The Bank’s yield on earning assets has decreased to 4.94%, for thefirst nine months of 2004 from 5.28% for the first nine months of 2003.  The cost of interest-bearing funds hasfollowed the same trend, decreasing to 2.09% for the first nine months of 2004,down from 2.19% for the same period in 2003.

In the first nine months of 2004, the Bank provided $362,000 forprobable incurred loan losses, compared to $219,000 for the same period of2003.  Management’s determination of theappropriate level of the provision for loan losses and the adequacy of theallowance for loan losses is based, in part, on an evaluation of specificloans, as well as a conservative 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 2004 were $91,000 compared to $106,000 for the same period in 2003.

At September 30, 2004, the Bank had three loans totaling $53,000 innonaccrual status.  This compares withDecember 31, 2003, where there was one loan for $5,000 in nonaccrual.  The bank had one loan totaling $36,000 thatwas more than 90 days delinquent on September 30, 2004 compared to two loanstotaling $80,000 as of December 31, 2003. In the first nine months of 2004, loans totaling $96,000 were chargedoff and $5,000 was recovered on loans previously charged off.  Management believes the allowance for loanlosses at September 30, 2004, is adequate to absorb probable incurred losses inthe loan portfolio.

Total noninterest income for the first nine months of 2004 was$1,316,000 compared to $1,138,000 for the same period in 2003.  The Bank originates and sells long-term fixedrate mortgages and the related servicing. Mortgage loans originated and sold generated $295,000 of fees as ofSeptember 30, 2004 compared to $556,000 for the nine months ended September 30,2003.  The actual dollars of mortgageloans originated for sale declined $11,187,000 over the same period in2003.  There were 113 loans closed andsold for a total of $15,578,000 as of September 30, 2004 compared to 218 loansand $26,765,000 for the same period in 2003. The decline is due primarily to the slow down in the refinancemarket.  The other large component ofnon-interest income is service charges on deposit accounts which totaled$838,000 as of September 30, 2004 compared to $476,000 for the same period in2003.  The 

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION**

**AND RESULTS OF OPERATIONS**

**September 30, 2004**

# **RESULTS OF OPERATIONS (continued)**

increase here isprimarily due to the new “bounce protection” overdraft product introduced inMay 2004 and overall deposit growth of the bank.

# **Noninterest expenses were $3,156,000 for thefirst nine months of 2004, compared with $2,903,000 for the same period of2003; an increase of $253,000 or 8.7%. The growth in noninterest expenses in the first nine months of 2004 isattributable primarily to the increase in salaries and benefits expense whichincreased $111,000 or 7.5% increase over the same period in 2003.  As of September 30, 2004, the bank had 48full-time equivalent employees compared to 41 for the same period of 2003.Occupancy expenses increased $10,000 or 4.1% over the same period in 2003 to$254,000.  The increase was primarily dueto increased utilities, $6,000 and property taxes of $3,000.  Other operating expenses increased $132,000or 11.1% to $1,319,000 for the first nine months of 2004 compared to $1,187,000for the same period in 2003.  Theincrease was primarily in marketing and advertising ($27,000 increase), outsidefees, which includes director fees, audit, legal, FDIC & State Assessment,consultants, etc.($67,000 increase), loss on the saleof foreclosed property ($13,000 increase), postage($6,000 increase) andprofessional dues and subscriptions (6,000 increase).  These increases are a result of the continuedgrowth of the bank.**

Managementexpects that noninterest expenses will increase moderately in 2004 inconjunction with the growth of the Bank but the overhead costs as a percentageof both interest income and total assets will continue to decrease.  At September 30, 2004 noninterest expense asa percentage of interest income and total assets was 57.2% and 2.1% compared to62.8% and 2.3% for the same period in 2003.

The Bank became fully taxable beginning the second quarter of2003.  The provision for income taxes was$581,000 at September 30, 2004 compared to $363,000 for the same period in2003.

The results of operations for the three months ended September 30, 2004were influenced by the same factors as discussed in the results of operationsfor the nine months ended September 30, 2004.

# **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 itscustomers, and to a lesser extent, repayment of loan principal and interestincome on loans and investments.  TheCompany has access to additional funding in the form of borrowings ofapproximately $10,000,000 if needed for liquidity purposes.  The Company currently has $13,600,000 inbrokered certificates of deposit.

The primaryuses of cash are lending to the Company’s borrowers, and investing insecurities and short-term interest-earning assets.  In the first nine months of 2004, loan demandkept pace with deposit growth.  Otherpotential sources of liquidity include the sale of available-for-salesecurities from the Bank’s portfolio, the sale of loans, the purchase offederal funds, or repurchase agreements.

** **

**SOUTHERN HERITAGE BANCSHARES, INC.**

**MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION**

**AND RESULTS OF OPERATIONS**

**September 30, 2004**

**RESULTSOF OPERATIONS (continued)**

At September30, 2004 and December 31, 2003, Southern Heritage 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, 2004*  *Dec. 31,2003*   *Well-capitalized*

Tier 1 capital to risk-weighted assets                          8.97%               9.80%                6.0%

Total capital to risk-weighted assets                         10.19%             11.01%              10.0%

Tier 1 leverage ratio                                                  8.11%               8.54%                5.0%

 

 

** **

As discussedabove, total shareholders’ equity increased $1,042,000, to $12,115,000 atSeptember 30, 2004 from $11,073,000 at December 31, 2003.  This increase was due to the Company’s netincome of $1,031,000 for the first nine months of 2004 along with a netincrease in unrealized gains on securities available for sale of $11,000, netof tax.

# **INTEREST RATE SENSITIVITY**

One of management’s objectives in managing the Bank’s balance sheet forinterest rate 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.  Management believes that, as of year-end 2003and in the first nine months of 2004, interest rates have reached their lowpoint and are beginning to move upward. Management’s strategy has been to be in a positive one year gap positionwhich will normally result in an increase in net interest margin as rates beginto rise.  However, due to the maturitiesand repricing of a portion of the loan portfolio during the period of low ratesthe interest margins have declined. Management believes this should improve as rates continue toincrease.  Many of the Bank’s loans are commercial real estate loans with ratesthat are tied to New York Prime or that are fixed for up to three years, andthis strategy allows the Bank to match longer-term funding with these loans,thus minimizing volatility in the net interest margin.

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**DISCLOSURE CONTROLS AND PROCEDURES REPORT**

**September 30, 2004**

**Item3.****  Controls and Procedures**

As ofSeptember 30, 2004, an evaluation was carried out under the supervision andwith the participation of the registrant's management, including our Presidentand Chief Financial Officer, of the effectiveness of our disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities 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 havebeen no changes in the registrant's internal controls over financial reportingor in other factors that has materially affected, oris reasonably likely to materially affect, the registrant's internal controlover financial reporting.

 

**SOUTHERN HERITAGE BANCSHARES, INC.**

**FORM 10-QSB**

**Quarter ended September 30, 2004**

**PART II - OTHER INFORMATION**

**Item1.****  Legal Proceedings**

None

**Item2.****  Unregistered Sales of Equity Securities andUse of Proceeds**

(a)  On May 20, 2004 the shareholders of SouthernHeritage Bank approved a Plan of Share Exchange (the “Plan”) between SouthernHeritage Bancshares, Inc. and Southern Heritage Bank.  Southern Heritage Bancshares is a corporationformed in 2004 under the laws of the State of Tennessee for the purpose ofacquiring Southern Heritage Bank, a Tennessee banking corporation, by means ofa share exchange and becoming a registered bank holding company under theFederal Reserve Act.  Under the Plan, thecommon shares of Southern Heritage Bank were exchanged, on a one-for-one basis,for common shares of Southern Heritage Bancshares, Inc.  The share exchange was effective on August 31,2004.  The exchangewas exempt from the registration requirements under the Securities Act of 1933,as amended, pursuant to Section 3(a)(12).

(b)  Not applicable.

(c)  No repurchase of our securities were madeduring the quarter ended September 30, 2004. The only restrictions on working capital and dividends are thosereported in Part I of this Report.

**Item3.****  Default Upon Senior Securities**

None

**Item4.****  Submission of Matters to a Vote of SecurityHolders**

None

**Item5.****  Other Information**

None

**Item6.****  Exhibits**

Rule 13a-14(a) Certifications.

Section 1350Certifications.

 

# **SOUTHERNHERITAGE BANCSHARES, INC.**

# **FORM 10-QSB**

#### Quarter endedSeptember 30, 2004

# ** **

# **SIGNATURES**

 

 

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

 

 
|     |   |   | Southern Heritage Bancshares, Inc. |   |   |   |
|----------|--------|--------|------------------------------------|--------|--------|--------|
|     |   |   | (Registrant)                       |   |   |   |   |   |
|     |   |   |                               |   |   |   |   |   |
| 11/10/04 |   |   | /s/ J. Lee Stewart                 |   |   |   |
| (Date)   |   |   | J. Lee  Stewart                    |   |   |   |   |   |
|     |   |   | President                          |   |   |   |   |   |
|     |   |   |                               |   |   |   |   |   |
| 11/10/04 |   |   | /s/ Steven  W. Ledbetter           |   |   |   |
| (Date)   |   |   | Steven W.  Ledbetter,              |   |   |   |   |   |
|     |   |   | Chief  Financial Officer           |   |   |   |   |   |