**FORM10-Q—QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)**

**OF THESECURITIES EXCHANGE ACT OF 1934**

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM10-Q**

** **

**ý********Quarterly ReportPursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

 

**For thequarterly period ended  September 30, 2003**

 

**or**

 

o**TransitionReport Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**

 

**For thetransition period from                                      to                                **

 

**CommissionFile Number:   0-14745**

 

**SunBancorp, Inc.**

(Exact name of registrantas specified in its charter)

 

| **Pennsylvania**                                                                    |   | **23-2233584**                        |
|-------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)                    |   | (I.R.S. Employer  Identification No.) |
|                                                                                |   |                                  |
| **155  North 15th Street, Lewisburg, PA**                                           |   | **17837**                             |
| (Address of principal  executive offices)                                           |   | (Zip code)                            |
|                                                                                |   |                                  |
| **(570)  523-4300**                                                                 |
| (Registrant’s telephone  number, including area code)                          |
|                                                                                |
| **N/A**                                                                             |
| (Former name, former  address and former fiscal year, if changed since last report) |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 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   ý | No   o |
|-----------------------------|-----------------------|

 

Indicate by check mark whether theregistrant is an accelerated filer (as defined in Rule 12b-2 of the Act) 
| Yes   ý | No   o |
|-----------------------------|-----------------------|

 

APPLICABLE ONLY TOISSUERS INVOLVED IN BANKRUPTCYPROCEEDINGS DURING THE PRECEDING FIVE YEARS:

 

Indicate by check mark whether the registrant has filed all documentsand reports required to be filed by Sections 12, 13 or 15(d) of the SecuritiesExchange Act of 1934 subsequent to the distribution of securities under a planconfirmed by a court.
| Yes   o | No   o |
|------------------------|-----------------------|

 

APPLICABLE ONLY TOCORPORATE ISSUERS:

 

Indicate the number of shares outstanding of each of the issuer’sclasses of Common Stock, as of the latest practicable date.

 

| **Common  Stock, No Par Value** |   | **7,178,365**                           |
|---------------------------------|--------|-----------------------------------------|
| Class                           |   | Outstanding Shares At  November 7, 2003 |

 

 

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SUN BANCORP, INC.

FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2003

 

CONTENTS

 
| PART I  - FINANCIAL INFORMATION                                                                       |                                                                                                                         |
|-------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                  |                                                                                                                         |   |
| Item 1 - Financial  Statements:                                                                       |                                                                                                                         |
|                                                                                                  |                                                                                                                         |   |
|                                                                                                  | Consolidated Balance Sheet  as of September 30, 2003 (Unaudited) and December 31, 2002                                       |   |
|                                                                                                  |                                                                                                                         |   |
|                                                                                                  | Consolidated Statement  of Income for the Three and Nine Months Ended September 30, 2003 and  September 30, 2002 (Unaudited) |   |
|                                                                                                  |                                                                                                                         |   |
|                                                                                                  | Consolidated  Statement of Cash Flows for the Nine Months Ended September 30, 2003 and  September 30, 2002 (Unaudited)       |   |
|                                                                                                  |                                                                                                                         |   |
|                                                                                                  | Notes to the  Consolidated Financial Statements (Unaudited)                                                                  |   |
|                                                                                                  |                                                                                                                         |   |
| Item  2 - Management’s Discussion and Analysis of Financial Condition and Results  of Operations |                                                                                                                         |
|                                                                                                  |                                                                                                                         |   |
| Item  3 – Quantitative and Qualitative Disclosures about Market Risk                             |                                                                                                                         |
|                                                                                                  |                                                                                                                         |   |
| Item 4 – Controls and  Procedures                                                                |                                                                                                                         |
|                                                                                                  |                                                                                                                         |   |
| PART  II - OTHER INFORMATION                                                                          |                                                                                                                         |
|                                                                                                  |                                                                                                                         |   |
| Item 6 -  Exhibits and Reports on Form 8-K                                                            |                                                                                                                         |
|                                                                                                  |                                                                                                                         |
| SIGNATURES                                                                                            |                                                                                                                         |

 

2

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SUN BANCORP, INC.

FORM 10-Q

PART I

 

Item 1. Financial Statements

 

SUN BANCORP, INC.

CONSOLIDATED BALANCE SHEET

 
| **(In Thousands, Except Share Data)**       |   | **September  30, 2003** |      | **December  31, 2002** |   |
|---------------------------------------------|--------|-------------------------|-----------|------------------------|--------|
|                                        |   | **(Unaudited)**         |      |                   |   |
| ASSETS                                      |   |                    |      |                   |   |
|                                        |   |                    |      |                   |   |
| Cash and due  from banks                    |   | $                       | 30,760    |                   | $      | 21,399 |   |
| Interest-bearing  deposits in banks         |   | 1,665                   |      | 20,170                 |   |
| Total cash and  cash equivalents            |   | 32,425                  |      | 41,569                 |   |
|                                        |   |                    |      |                   |   |
| Investment  securities at fair market value |   | 228,553                 |      | 219,438                |   |
|                                        |   |                    |      |                   |   |
| Loans and  leases, net of unearned income   |   | 670,568                 |      | 608,601                |   |
| Less: allowance  for loan and lease losses  |   | 7,229                   |      | 6,206                  |   |
| Net loans and  leases                       |   | 663,339                 |      | 602,395                |   |
|                                        |   |                    |      |                   |   |
| Bank premises  and equipment, net           |   | 23,697                  |      | 15,809                 |   |
| Goodwill and  core deposit intangible       |   | 32,337                  |      | 22,924                 |   |
| Accrued interest                            |   | 3,523                   |      | 3,501                  |   |
| Bank owned life  insurance                  |   | 32,917                  |      | 30,800                 |   |
| Other assets                                |   | 16,502                  |      | 14,738                 |   |
| Total assets                                |   | $                       | 1,033,293 |                   | $      | 951,174 |   |

 

3

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SUN BANCORP, INC.

CONSOLIDATEDBALANCE SHEET

(Continued)

 
| **(In Thousands, Except Share Data)**                                                                                                    |   | **September  30,  2003** |      | **December  31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|-----------|-------------------------|--------|
|                                                                                                                                     |   | **(Unaudited)**          |      |                    |   |
|                                                                                                                                     |   |                     |      |                    |   |
| LIABILITIES  & SHAREHOLDERS’ EQUITY                                                                                             |   |                     |      |                    |   |
|                                                                                                                                     |   |                     |      |                    |   |
| Deposits                                                                                                                                 |   |                     |      |                    |   |
| Noninterest-bearing                                                                                                                      |   | $                        | 66,118    |                    | $      | 59,181 |   |
| Interest-bearing                                                                                                                         |   | 585,394                  |      | 528,299                 |   |
| Total deposits                                                                                                                           |   | 651,512                  |      | 587,480                 |   |
|                                                                                                                                     |   |                     |      |                    |   |
| Short-term  borrowings                                                                                                                   |   | 32,848                   |      | 29,682                  |   |
| Other borrowed  funds                                                                                                                    |   | 245,533                  |      | 220,000                 |   |
| Subordinated  debentures                                                                                                                 |   | 18,866                   |      | 19,655                  |   |
| Accrued interest  and other liabilities                                                                                                  |   | 5,519                    |      | 13,110                  |   |
| Total  liabilities                                                                                                                       |   | 954,278                  |      | 869,927                 |   |
|                                                                                                                                     |   |                     |      |                    |   |
| Commitments and  contingencies (note 11)                                                                                                 |   |                     |      |                    |   |
|                                                                                                                                     |   |                     |      |                    |   |
| Shareholders’  equity                                                                                                               |   |                     |      |                    |   |
|                                                                                                                                     |   |                     |      |                    |   |
| Preferred stock,  no par value per share, 10,000,000 authorized shares: no shares issued in  2003 and 2002                               |   | —                   |      | —                  |   |
| Common stock, no  par value per share; 50,000,000 authorized shares: issued  7,319,287 shares in 2003 and 7,299,446  shares in 2002 |   | 85,370                   |      | 84,591                  |   |
| Retained  earnings (deficit)                                                                                                             |   | (3,407                   | )         | (5,159                  | )      |
| Accumulated  other comprehensive income (loss)                                                                                           |   | (443                     | )         | 3,578                   |   |
| Less: Treasury  stock, at cost, 140,922 shares in 2003 and 126,717 shares in 2002                                                        |   | (2,505                   | )         | (1,763                  | )      |
| Total  shareholders’ equity                                                                                                         |   | 79,015                   |      | 81,247                  |   |
| Total  liabilities and shareholders’ equity                                                                                         |   | $                        | 1,033,293 |                    | $      | 951,174 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

4

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SUN BANCORP, INC.

CONSOLIDATED STATEMENT OF INCOME

(UNAUDITED)

 
|                                                              |   | **For the  Three Months  Ended September 30,** |   | **For the  Nine Months  Ended September 30,** |   |
|-------------------------------------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
| **(In Thousands, Except Share Data)**                             |   | **2003**                                       |   | **2002**                                      |   | **2003** |   | **2002** |   |
| Interest income:                                                  |   |                                           |   |                                          |   |   |   |   |   |
| Loans and  leases, including fees                                 |   | $                                              | 10,565 |                                          | $      | 10,364 |   | $ | 30,607 |   | $ | 30,262 |   |
| Available for  sale securities                                    |   |                                           |   |                                          |   |   |   |   |   |
| Taxable                                                           |   | 1,363                                          |   | 2,907                                         |   | 5,913 |   | 9,955 |   |
| Tax-exempt                                                        |   | 214                                            |   | 250                                           |   | 659 |   | 768 |   |
| Dividends                                                         |   | 99                                             |   | 112                                           |   | 305 |   | 358 |   |
| Deposits in  banks and other financial institutions               |   | 21                                             |   | 94                                            |   | 112 |   | 269 |   |
|                                                              |   |                                           |   |                                          |   |   |   |   |   |
| Total interest  and dividend income                               |   | 12,262                                         |   | 13,727                                        |   | 37,596 |   | 41,612 |   |
|                                                              |   |                                           |   |                                          |   |   |   |   |   |
| Interest  expense:                                                |   |                                           |   |                                          |   |   |   |   |   |
| Deposits                                                          |   | 2,749                                          |   | 3,605                                         |   | 8,947 |   | 11,289 |   |
| Short-term  borrowings                                            |   | 75                                             |   | 93                                            |   | 322 |   | 236 |   |
| Other borrowed  funds                                             |   | 3,010                                          |   | 3,181                                         |   | 9,494 |   | 9,514 |   |
| Subordinated  debentures                                          |   | 455                                            |   | 472                                           |   | 1,388 |   | 1,428 |   |
|                                                              |   |                                           |   |                                          |   |   |   |   |   |
| Total interest  expense                                           |   | 6,289                                          |   | 7,351                                         |   | 20,151 |   | 22,467 |   |
|                                                              |   |                                           |   |                                          |   |   |   |   |   |
| Net interest  income                                              |   | 5,973                                          |   | 6,376                                         |   | 17,445 |   | 19,145 |   |
|                                                              |   |                                           |   |                                          |   |   |   |   |   |
| Provision for  loan and lease losses                              |   | 405                                            |   | 450                                           |   | 1,215 |   | 1,260 |   |
|                                                              |   |                                           |   |                                          |   |   |   |   |   |
| Net interest  income, after provision for loan & lease losses |   | $                                              | 5,568  |                                          | $      | 5,926 |   | $ | 16,230 |   | $ | 17,885 |   |

 

5

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|                                  |   | **For the  Three Months  Ended September 30,** |   | **For the  Nine Months  Ended September 30,** |   |
|---------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
| **(In Thousands, Except Share Data)** |   | **2003**                                       |   | **2002**                                      |   | **2003** |   | **2002** |   |
| Non-interest  income:                 |   |                                           |   |                                          |   |   |   |   |   |
| Service charges  on deposit accounts  |   | $                                              | 1,137  |                                          | $      | 880 |   | $ | 2,965 |   | $ | 2,108 |   |
| Trust income                          |   | 171                                            |   | 222                                           |   | 593 |   | 563 |   |
| Net security  gains                   |   | 697                                            |   | 3                                             |   | 3,194 |   | 143 |   |
| Investment  product sales             |   | 142                                            |   | 90                                            |   | 244 |   | 350 |   |
| Bank owned life  insurance            |   | 314                                            |   | 187                                           |   | 956 |   | 393 |   |
| Insurance  subsidiary                 |   | 463                                            |   | 14                                            |   | 826 |   | 63 |   |
| Net gain on sale  of loans            |   | 60                                             |   | 63                                            |   | 364 |   | 136 |   |
| Leasing fees                          |   | 252                                            |   | —                                        |   | 815 |   | — |   |
| Other income                          |   | 492                                            |   | 171                                           |   | 1,208 |   | 570 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Total  non-interest income            |   | 3,728                                          |   | 1,630                                         |   | 11,165 |   | 4,326 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Non-interest  expense:                |   |                                           |   |                                          |   |   |   |   |   |
| Salaries and  employee benefits       |   | 3,330                                          |   | 2,991                                         |   | 9,911 |   | 8,624 |   |
| Net occupancy  expense                |   | 342                                            |   | 282                                           |   | 1,057 |   | 807 |   |
| Furniture and  equipment expenses     |   | 481                                            |   | 451                                           |   | 1,471 |   | 1,266 |   |
| Amortization of  intangibles          |   | 51                                             |   | —                                        |   | 89 |   | — |   |
| Other expenses                        |   | 2,951                                          |   | 1,927                                         |   | 8,331 |   | 5,282 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Total  non-interest expense           |   | 7,155                                          |   | 5,651                                         |   | 20,859 |   | 15,979 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Income before  income tax provision   |   | 2,141                                          |   | 1,905                                         |   | 6,536 |   | 6,232 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Income tax  provision                 |   | 320                                            |   | 210                                           |   | 991 |   | 1,044 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Net income                            |   | $                                              | 1,821  |                                          | $      | 1,695 |   | $ | 5,545 |   | $ | 5,188 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Net income per  share - Basic         |   | $                                              | 0.25   |                                          | $      | 0.24 |   | $ | 0.77 |   | $ | 0.73 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Net income per  share - Diluted       |   | $                                              | 0.25   |                                          | $      | 0.23 |   | $ | 0.77 |   | $ | 0.72 |   |
|                                  |   |                                           |   |                                          |   |   |   |   |   |
| Dividends declared                    |   | $                                              | 0.1815 |                                          | $      | 0.1650 |   | $ | 0.5280 |   | $ | 0.48 |   |

 

The accompanying notes are an integral part of these financialstatements.

 

6

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SUN BANCORP, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)

 
|                                                                           |   | **For the  Nine Months  Ended September 30,** |   |
|--------------------------------------------------------------------------------|--------|-----------------------------------------------|--------|
| **(In Thousands)**                                                             |   | **2003**                                      |   | **2002** |   |
| Cash flows from operating activities:                                          |   |                                          |   |   |   |
| Net income                                                                     |   | $                                             | 5,545  |   | $ | 5,188 |   |
| Adjustments to  reconcile net income to net cash used in operating activities: |   |                                          |   |   |   |
| Provision for  loan and lease losses                                           |   | 1,215                                         |   | 1,260 |   |
| Depreciation of  fixed assets                                                  |   | 956                                           |   | 769 |   |
| Amortization of  intangibles                                                   |   | 89                                            |   | — |   |
| Net amortization  and accretion of securities                                  |   | 1,483                                         |   | 807 |   |
| Net security  gains                                                            |   | (3,194                                        | )      | (143 | ) |
| Decrease  (increase) in accrued interest and other assets                      |   | 7,296                                         |   | (10,918 | ) |
| Net gain on  sales of loans                                                    |   | (364                                          | )      | (136 | ) |
| Loss (gain) on  sale of bank premises and equipment                            |   | 11                                            |   | (6 | ) |
| Decrease in  other assets and other liabilities                                |   | (11,563                                       | )      | (2,535 | ) |
| Net cash  provided by (used in) operating activities                           |   | 1,474                                         |   | (5,714 | ) |
|                                                                           |   |                                          |   |   |   |
| Cash flows from  investing activities:                                         |   |                                          |   |   |   |
| Proceeds from  sales of investment securities                                  |   | 83,316                                        |   | 1,081 |   |
| Proceeds from  maturities of investment securities                             |   | 101,784                                       |   | 89,867 |   |
| Purchase of bank  owned life insurance                                         |   | —                                        |   | 15,473 |   |
| Purchases of  investment securities                                            |   | (178,686                                      | )      | (11,309 | ) |
| Net cash paid  for acquisitions                                                |   | (131                                          | )      | — |   |
| Net increase in  loans                                                         |   | (56,825                                       | )      | (74,187 | ) |
| Proceeds from  sales of loans                                                  |   | 16,595                                        |   | 8,866 |   |
| Proceeds from  sales of bank premises and equipment                            |   | 14                                            |   | 6 |   |
| Capital  expenditures                                                          |   | (6,725                                        | )      | (1,030 | ) |
| Net cash used in  investing activities                                         |   | (40,658                                       | )      | (2,179 | ) |
|                                                                           |   |                                          |   |   |   |
| Cash flows from  financing activities:`                                        |   |                                          |   |   |   |
| Net increase in  deposits                                                      |   | 27,535                                        |   | 27,966 |   |
| Net increase in  short-term borrowings                                         |   | 2,745                                         |   | 1,200 |   |
| Net increase  (decrease) in long-term borrowings                               |   | 6,502                                         |   | (2,000 | ) |
| Repayment of  subordinated debt                                                |   | (789                                          | )      | (789 | ) |
| Cash dividends  paid                                                           |   | (3,793                                        | )      | (3,431 | ) |
| Proceeds from  sale of stock for employee benefits program                     |   | 262                                           |   | 608 |   |
| Purchase of  treasury stock                                                    |   | (2,422                                        | )      | (313 | ) |
| Net cash  provided by financing activities                                     |   | 30,040                                        |   | 23,247 |   |
|                                                                           |   |                                          |   |   |   |
| Net (decrease)  increase in cash and cash equivalents                          |   | (9,144                                        | )      | 15,484 |   |
| Cash and cash  equivalents at beginning of period                              |   | 41,569                                        |   | 44,983 |   |
| Cash and cash  equivalents at end of period                                    |   | 32,425                                        |   | 60,467 |   |
|                                                                           |   |                                          |   |   |   |
| Supplemental  disclosure of cash flow information:                             |   |                                          |   |   |   |
|                                                                           |   |                                          |   |   |   |
| Cash paid during  the period for:                                              |   |                                          |   |   |   |
|                                                                           |   |                                          |   |   |   |
| Interest                                                                       |   | $                                             | 20,842 |   | $ | 23,415 |   |
|                                                                           |   |                                          |   |   |   |
| Income taxes                                                                   |   | —                                        |   | $ | 1,950 |   |

 

Loans with an estimated value of $661,000 and $348,000 were reclassified to foreclosed assets held forsale during the nine-month periods ended September 30, 2003 and 2002,respectively.

 

The accompanyingnotes are an integral part of these financial statements.

 

7

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SUN BANCORP, INC.

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

(UNAUDITED)

 

Note 1 — Basis of Interim Presentation

 

The consolidated financial statements include theaccounts of Sun Bancorp, Inc. (“Sun”), the parent company, and its wholly-ownedsubsidiaries: SunBank, Mid-Penn Insurance Associates, Inc., SUBI InvestmentCompany, Beacon Life Insurance Company, and Sun Bancorp Statutory Trust I.  Sun also holds thirty percent ownership inSun Abstract and Settlement Services. The transactions of Beacon Life Insurance Company and Sun Abstract andSettlement Services are not material to the consolidated financial statements.  The parent and subsidiaries are reported asone unit within the financial statements. All significant intercompany balances and transactions have beeneliminated in consolidation.

 

The accompanying unaudited consolidated financialstatements for the interim periods do not include all of the information andfootnotes required by generally accepted accounting principles.  These statements should be read inconjunction with the notes to the audited financial statements contained in the2002 Annual Report to Shareholders. However, in the opinion of management, all adjustments necessary for afair presentation of the results of the interim period have been included.  Operating results for the three and ninemonths ended September 30, 2003 are not necessarily indicative of the resultsthat may be expected for the year ended December 31, 2003.

 

The accounting policies followed in the presentationof interim financial results are the same as those followed on an annualbasis.  These policies are presented onpages 18 thru 20 of the 2002 Annual Report to Shareholders with additionalpolicies listed in Note 1, Significant Accounting Policies.

 

Note 2 – Significant Accounting Policies

 

Lease Fee/Expense Recognition

Sun recognizes fees and expenses on direct financingleases using the implied interest rate, which results in a level yield.  Fees and expenses on operating leases arerecognized using the straight-line method.

 

Insurance Revenue Recognition

Sun recognizes revenue from the insurance subsidiaryas commissions become receivable.

 

Loans and Leases Available for Sale

Sun has contracted with a third party to purchasecertain new residential mortgages originated by Sun within seven days ofclosing.  The mortgages are selectedbased on predefined terms and conditions agreed upon by Sun and the thirdparty.  Due to the short holding periodand that the mortgage’s are booked at market rates, the market value and costbasis have not been deemed to be materially different.

 

8

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It is the intent of Sun to hold to maturity all otherloans and leases, except the mortgages noted above.  However, from time to time management may elect to sell certainloans or leases out of the portfolio.

 

Direct Financing Leases

Sun maintains residual value insurance with a $ 500deductible on each lease originated prior to April 1, 2003.  Leasesoriginated subsequent to April 1, 2003 are subject to an insurance policy witha deductible equal to 20% of the original residual value of each lease. Accordingly, substantially all of Sun’s leases qualify as directfinancing leases.

 

Residual Value Impairment

Sun tests residual values for impairmentannually.  Sun compares the portfolioagainst an equity table, which sets forth the insurance carrier’s projectionsof vehicle values based on how Automotive Lease Guide residual values measureto Black Book values.  The result ofthis comparison will be used by Sun in determining residual impairment, if any,so that any necessary write-downs may be taken.

 

Gains and Losses on Loans and Leases Sold

Sun recognizes gains or losses on the sale of loans orleases at the time of sale.  Theproceeds of the sale are first applied to accrued interest and fees receivablewith the remaining proceeds applied to principal.  Any remaining proceeds or deficit is recognized as a gain orloss.  Loans or leases are sold withoutrecourse; however, Sun does retain servicing rights, which is recorded as anasset at fair value and amortized over the weighted average life of theservicing asset.

 

Standby Letters of Credit

Sun enters into standby letters of credit with itscustomers to guarantee a customer’s performance to a third party.  These guarantees are primarily issued tosupport borrowing arrangements and related transactions.  Terms vary from one month to 24 months andmay have renewal features.  Feesassociated with standby letters of credit are deferred and recognized as aliability and amortized over the life of the standby letter of credit.

 

9

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Note 3 – Stock Options

 

Sun has three common stock plans for employees anddirectors.  The 1998 Stock IncentivePlan, administered by a Board of Directors committee of independent directors,allows for 716,625 shares of common stock to be issued for key officers andother management employees in the form of qualified options, non qualifiedoptions, stock appreciation rights, or restricted stock.  The 1998 Independent Directors Stock OptionPlan allows 115,763 shares of common stock to be issued for non-employeedirectors.  Options under those plansexpire ten years after the grant date. Both of these plans terminate in 2008.

 

The 1998 Employee Stock Purchase Plan, which permitsall employees to purchase common stock at a price per share not less than 85%of the market value on the exercise date was allocated 248,063 shares.  Options granted to date have been awarded at90% of the market value on the exercise date. Each option under the 1998 Employee Stock Purchase Plan expires no laterthan five years from the grant date. This plan terminates in 2008.

 

Sun applies Accounting Principles Board Opinion Number25 and related interpretations to account for its common stock plans.  Accordingly, Sun has not recognizedcompensation expense for the plans.  Hadcompensation expense been determined based on fair values at the grant dates(pursuant to SFAS 123), Sun’s net income and basic earnings per share for thethree and nine months ended September 30, 2003 and 2002 would have been:

 
|                        |   | **For the  Three Months Ended  September 30** |      | **For the  Nine Months Ended  September 30** |   |
|-----------------------------|--------|-----------------------------------------------|-----------|----------------------------------------------|--------|
|                        |   | **2003**                                      |      | **2002**                                     |   | **2003** |   | **2002** |   |
| Net income:                 |   |                                          |      |                                         |   |   |   |   |   |
| As reported                 |   | $                                             | 1,821,000 |                                         | $      | 1,695,000 |   | $ | 5,545,000 |   | $ | 5,188,000 |   |
| Pro forma                   |   | $                                             | 1,766,000 |                                         | $      | 1,605,000 |   | $ | 5,633,000 |   | $ | 5,012,000 |   |
|                        |   |                                          |      |                                         |   |   |   |   |   |
| Earnings per  share - Basic |   |                                          |      |                                         |   |   |   |   |   |
| As reported                 |   | $                                             | 0.25      |                                         | $      | 0.24 |   | $ | 0.77 |   | $ | 0.73 |   |
| Pro forma                   |   | $                                             | 0.25      |                                         | $      | 0.22 |   | $ | 0.78 |   | $ | 0.70 |   |

 

10

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Note 4 – Consolidated Statement of Changes in Shareholder’s Equity

 

The purpose of reporting comprehensive income is toreport a measure of all changes in Sun’s equity resulting from economic eventsother than transactions with shareholders acting in their normal capacity asshareholders.  For Sun, “comprehensiveincome” includes traditional income statement amounts as well as unrealizedgains and losses on certain investments in debt and equity securities (i.e.available-for-sale securities). Unrealized gains and losses are part of comprehensive income, thereforecomprehensive income may vary substantially between reporting periods due tofluctuations in the market prices of securities held.

 

**For the years ended December 31,2001, 2002 and the year to date ended September 30, 2003**

*(In Thousands, Except for ShareData)*

 
|                                                                                                     |   |              |       |       |       |                              |       | **Accumulated  Other  Comprehensive  Income(Loss)** |       |       |                                  |       |       |
|----------------------------------------------------------------------------------------------------------|--------|-------------------|------------|------------|------------|-----------------------------------|------------|-----------------------------------------------------|------------|------------|---------------------------------------|------------|------------|
|                                                                                                     |   |              |       |       |       | **Retained  Earnings  (Deficit)** |       |                                                |       |       | **Total  Shareholders’  Equity** |       |
|                                                                                                     |   | **Common  Stock** |       |       |       | **Treasury  Stock**               |       |                                                |
|                                                                                                     |   | **Shares**        |       | **Amount** |       |                              |       |                                                |       |
| Balance, December 31, 2000                                                                               |   | 7,227             |       | $          | 81,632     |                              | $          | (11,177                                             | )          | $          | (1,591                                | )          | $          | (6,337 | ) | $ | 62,527 |   |
| Comprehensive income:                                                                                    |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Net income                                                                                               |   | —            |       | —     |       | 8,350                             |       | —                                              |       | —     |                                  | 8,350      |       |
| Unrealized gains on  securities available for sale, net of reclassification adjustments and tax  effects |   | —            |       | —     |       | —                            |       | 3,660                                               |       | —     |                                  | 3,660      |       |
| Total comprehensive income                                                                               |   |              |       |       |       |                              |       |                                                |       |       |                                  | 12,010     |       |
|                                                                                                     |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Stock issued:                                                                                            |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Employee benefit plans                                                                                   |   | 9                 |       | 123        |       | —                            |       | —                                              |       | —     |                                  | 123        |       |
| Purchase of Guaranty Bank,  N.A. (553,558 treasury shares)                                               |   | —            |       | 1,810      |       | —                            |       | —                                              |       | 6,388      |                                  | 8,198      |       |
| Purchase of treasury stock  (80,535 shares)                                                              |   | —            |       | —     |       | —                            |       | —                                              |       | (1,213     | )                                     | (1,213     | )          |
| Cash dividends declared,  $.60 per share                                                                 |   | —            |       | —     |       | (4,134                            | )          | —                                              |       | —     |                                  | (4,134     | )          |
| Balance, December 31, 2001                                                                               |   | 7,236             |       | 83,565     |       | (6,961                            | )          | 2,069                                               |       | (1,162     | )                                     | 77,511     |       |
| Comprehensive income:                                                                                    |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Net income                                                                                               |   | —            |       | —     |       | 6,416                             |       | —                                              |       | —     |                                  | 6,416      |       |
| Unrealized gains on  securities available for sale, net of reclassification adjustments and tax  effects |   | —            |       | —     |       | —                            |       | 1,509                                               |       | —     |                                  | 1,509      |       |
| Total comprehensive income                                                                               |   |              |       |       |       |                              |       |                                                |       |       |                                  | 7,925      |       |
|                                                                                                     |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Stock issued:                                                                                            |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Employee benefit plans                                                                                   |   | 63                |       | 1,007      |       | —                            |       | —                                              |       | —     |                                  | 1,007      |       |
| Purchase of treasury stock  (33,300 shares)                                                              |   | —            |       | —     |       | —                            |       | —                                              |       | (601       | )                                     | (601       | )          |
| Cash dividends declared,  $.66 per share                                                                 |   | —            |       | —     |       | (4,614                            | )          | —                                              |       | —     |                                  | (4,614     | )          |
| Tax benefit of exercised  stock options                                                                  |   | —            |       | 19         |       | —                            |       | —                                              |       | —     |                                  | 19         |       |
| Balance, December 31, 2002                                                                               |   | 7,299             |       | 84,591     |       | (5,159                            | )          | 3,578                                               |       | (1,763     | )                                     | 81,247     |       |
| **Comprehensive  income:**                                                                               |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Net income                                                                                               |   | —            | ** ** | —     | ** ** | **5,545**                         | ** ** | —                                              | ** ** | —     | ** **                            | **5,545**  | ** ** |
| Unrealized gains on  securities available for sale, net of reclassification adjustments and tax  effects |   | —            | ** ** | —     | ** ** | —                            | ** ** | **(4,021**                                          | **)**      | —     | ** **                            | **(4,021** | **)**      |
| **Total  comprehensive income**                                                                          |   |              | ** ** |       | ** ** |                              | ** ** |                                                | ** ** |       | ** **                            | **1,524**  | ** ** |
|                                                                                                     |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Stock issued:                                                                                            |   |              |       |       |       |                              |       |                                                |       |       |                                  |       |       |
| Employee benefit plans                                                                                   |   | **20**            | ** ** | **262**    | ** ** | —                            | ** ** | —                                              | ** ** | —     | ** **                            | **262**    | ** ** |
| Purchase of Bank Capital  Services Corporation (25,109 treasury shares)                                  |   | —            | ** ** | **121**    | ** ** | —                            | ** ** | —                                              | ** ** | **351**    | ** **                            | **472**    | ** ** |
| Purchase of Mid-Penn  Insurance Associates, Inc. (85,936 treasury shares)                                |   | —            | ** ** | **396**    | ** ** | —                            | ** ** | —                                              | ** ** | **1,329**  | ** **                            | **1,725**  | ** ** |
| Purchase of treasury stock  (95,250 shares)                                                              |   | —            | ** ** | —     | ** ** | —                            | ** ** | —                                              | ** ** | **(2,422** | **)**                                 | **(2,422** | **)**      |
| Cash dividends declared,  $.528 per share                                                                |   | —            | ** ** | —     | ** ** | **(3,793**                        | **)**      | —                                              | ** ** | —     | ** **                            | **(3,793** | **)**      |
| **Balance,  September 30, 2003**                                                                         |   | **7,319**         | ** ** | **$**      | **85,370** | ** **                        | **$**      | **(3,407**                                          | **)**      | **$**      | **(443**                              | **)**      | **$**      | **(2,505** | **)** | **$** | **79,015** | ** ** |
|                                                                                                          |        |                   |            |            |            |                                   |            |                                                     |            |            |                                       |            |            |  |  |  |  |  |  |  |  |  |  |  |

 

11

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Note 5 – Investment Securities

 

The amortized cost and fair value of investmentsecurities available for sale, at September 30, 2003 and December 31, 2002,were as follows:

 
|                                              |   | **September 30, 2003** |    |
|---------------------------------------------------|--------|------------------------|---------|
| **(In  Thousands)**                               |   | **Amortized  Cost**    |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair Value** |   |
|                                              |   |                   |    |   |   |   |   |   |   |
| Debt Securities:                                  |   |                   |    |   |   |   |   |   |   |
| Mortgage - pass-through                           |   | $                      | 84,739  |   | $ | 354 |   | $ | (654 | ) | $ | 84,439 |   |
| Mortgage - other                                  |   | 98,103                 |    | 338 |   | (1,343 | ) | 97,098 |   |
| Agency obligations                                |   | 2,990                  |    | — |   | (90 | ) | 2,900 |   |
| Obligations of states and  political subdivisions |   | 18,380                 |    | 952 |   | (107 | ) | 19,225 |   |
| Other corporate                                   |   | 11,064                 |    | 36 |   | (157 | ) | 10,943 |   |
| Total debt securities                             |   | 215,276                |    | 1,680 |   | (2,351 | ) | 214,605 |   |
|                                              |   |                   |    |   |   |   |   |   |   |
| Equity securities:                                |   |                   |    |   |   |   |   |   |   |
| Marketable equity  securities                     |   | 330                    |    | — |   | — |   | 330 |   |
| Restricted equity  securities                     |   | 13,618                 |    | — |   | — |   | 13,618 |   |
| Total equity securities                           |   | 13,948                 |    | — |   | — |   | 13,948 |   |
|                                              |   |                   |    |   |   |   |   |   |   |
| Total                                             |   | $                      | 229,224 |   | $ | 1,680 |   | $ | (2,351 | ) | $ | 228,553 |   |

 
|                                              |   | **December 31, 2002** |    |
|---------------------------------------------------|--------|-----------------------|---------|
|                                              |   | **Amortized  Cost**   |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair Value** |   |
|                                              |   |                  |    |   |   |   |   |   |   |
| Debt Securities:                                  |   |                  |    |   |   |   |   |   |   |
| Mortgage - pass-through                           |   | $                     | 50,288  |   | $ | 2,371 |   | $ | — |   | $ | 52,659 |   |
| Mortgage - other                                  |   | 98,705                |    | 1,446 |   | (133 | ) | 100,018 |   |
| Agency obligations                                |   | 24,559                |    | 767 |   | — |   | 25,326 |   |
| Obligations of states and  political subdivisions |   | 19,767                |    | 836 |   | — |   | 20,603 |   |
| Other corporate                                   |   | 5,575                 |    | 388 |   | (75 | ) | 5,888 |   |
| Total debt securities                             |   | 198,894               |    | 5,808 |   | (208 | ) | 204,494 |   |
|                                              |   |                  |    |   |   |   |   |   |   |
| Equity securities:                                |   |                  |    |   |   |   |   |   |   |
| Marketable equity  securities                     |   | 3,111                 |    | 136 |   | (315 | ) | 2,932 |   |
| Restricted equity  securities                     |   | 12,012                |    | — |   | — |   | 12,012 |   |
| Total equity securities                           |   | 15,123                |    | 136 |   | (315 | ) | 14,944 |   |
|                                              |   |                  |    |   |   |   |   |   |   |
| Total                                             |   | $                     | 214,017 |   | $ | 5,944 |   | $ | (523 | ) | $ | 219,438 |   |

 

12

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Note 6 – Loans

 

The balances for principal loan categories were asfollows:

 
| **(In  Thousands)**                                 |   | **September 30, 2003** |    | **December 31, 2002**  |   |
|-----------------------------------------------------|--------|------------------------|---------|------------------------|--------|
|                                                |   |                   |    |                   |   |
| Real estate – mortgage                         |   | $                      | 399,760 |                   | $      | 404,350 |   |
| Real estate – construction                     |   | 26,952                 |    | 17,721                 |   |
| Agricultural                                        |   | 296                    |    | 138                    |   |
| Commercial and industrial                           |   | 71,509                 |    | 54,624                 |   |
| Lease – auto                                   |   | 72,921                 |    | 48,145                 |   |
| Lease – equipment                              |   | 8,080                  |    | 5,384                  |   |
| Individual                                          |   | 100,040                |    | 85,920                 |   |
| Other                                               |   | 393                    |    | 328                    |   |
| Total                                               |   | 679,951                |    | 616,610                |   |
|                                                |   |                   |    |                   |   |
| Less:                                               |   |                   |    |                   |   |
| Unearned income & deferred loan fees            |   | (9,878                 | )       | (7,945                 | )      |
| Unamortized net discount/premium on purchased loans |   | 495                    |    | (64                    | )      |
| ALLL                                                |   | (7,229                 | )       | (6,206                 | )      |
| Net Loans                                           |   | $                      | 663,339 |                   | $      | 602,395 |   |
|                                                |   |                   |    |                   |   |
| Net Investment in Direct  Financing Leases:         |   |                   |    |                   |   |
| (In Thousands)                                      |   |                   |    |                   |   |
|                                                |   |                   |    |                   |   |
|                                                |   | **September 30, 2003** |    | **December  31, 2002** |   |
| Minimum lease payments  receivable                  |   | $                      | 48,390  |                   | $      | 34,653 |   |
| Residual values                                     |   | 30,427                 |    | 18,876                 |   |
| Unearned income under  lease contracts              |   | (9,609                 | )       | (7,874                 | )      |
| Net Investment                                      |   | $                      | 69,208  |                   | $      | 45,655 |   |

 

13

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Note 7 — Net Income Per Share

 

Net income per share is computed based on the weightedaverage number of shares of stock outstanding for each period presented.  Statement of Financial Accounting StandardsNo. 128, “Earnings Per Share,” requires presentation of two amounts, basic anddiluted net income per share.  Basicearnings per share calculates net income divided by the average number of sharesoutstanding for the period.  Dilutedearnings per share calculates net income divided by the sum of the averagenumber of shares outstanding and the effect that, if all were exercised, thegranted stock options would have on the number of shares outstanding for theperiod.

 

The following data shows the amounts used in computingnet income per share and the weighted average number of shares of dilutivestock options for the three and nine-month periods ended September 30, 2003 and2002

 
|                                                                                            |   | **For the Three Months Ended  September 30** |      | **For the Nine Months Ended  September 30** |   |
|-------------------------------------------------------------------------------------------------|--------|----------------------------------------------|-----------|---------------------------------------------|--------|
|                                                                                            |   | **2003**                                     |      | **2002**                                    |   | **2003** |   | **2002** |   |
| Net income                                                                                      |   | $                                            | 1,821,000 |                                        | $      | 1,695,000 |   | $ | 5,545,000 |   | $ | 5,188,000 |   |
| Average number of common  shares oustanding                                                     |   | 7,189,319                                    |      | 7,164,910                                   |   | 7,193,995 |   | 7,149,568 |   |
| Effect of dilutive options                                                                      |   | 24,939                                       |      | 83,072                                      |   | 26,925 |   | 38,545 |   |
| Average number of common  shares oustanding used to calculate diluted earnings per common share |   | 7,214,258                                    |      | 7,247,982                                   |   | 7,220,920 |   | 7,188,113 |   |
|                                                                                                 |        |                                              |           |                                             |        |  |  |  |  |  |  |  |  |

 

Note 8 — Fixed Assets

 
| **(In  Thousands)**           |   | **September  2003** |   | **December  2002** |   |
|-------------------------------|--------|---------------------|--------|--------------------|--------|
| Land                          |   | $                   | 2,490  |               | $      | 2,046 |   |
| Building                      |   | 15,539              |   | 13,175             |   |
| Furniture and equipment       |   | 9,564               |   | 6,954              |   |
| Assets held for lease         |   | 3,893               |   | —             |   |
| Total cost                    |   | 31,486              |   | 22,175             |   |
|                          |   |                |   |               |   |
| Less: Accumulated deprecation |   | (7,789              | )      | (6,366             | )      |
| Fixed assets, net             |   | $                   | 23,697 |               | $      | 15,809 |   |

 

14

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Note 9 – Goodwill and Core Deposit Intangible

 

Following is a schedule of the intangibles acquired and theirassociated amortization for the nine month period ended September 30,2003.  The core deposit intangibleassociated with the Steelton Bancorp acquisition is being amortized over 10years and the customer list intangible associated with the Mid Penn Insuranceacquisition is being amortized over 15 years. There were no additions or amortization of intangibles recognized in2002.

 
|                    |   |                  |   | **Acquired**     |   |    |   |         |   |
|-------------------------|--------|-----------------------|--------|------------------|--------|---------|--------|--------------|--------|
| **(In  Thousands)**     |   | **December 31, 2002** |   | **Bank Capital** |   | **MPI** |   | **Steelton** |   | **Amortization** |   | **September 30, 2003** |   |
| Goodwill                |   | $                     | 22,924 |             | $      | 421     |   | $            | 612    |   | $ | 5,813 |   | $ | — |   | $ | 29,770 |   |
| Core Deposit Intangible |   | —                |   | —           |   | —  |   | 792          |   | (34 | ) | 758 |   |
| Customer List           |   | —                |   | —           |   | 1,864   |   | —       |   | (55 | ) | 1,809 |   |
| Total                   |   | $                     | 22,924 |             | $      | 421     |   | $            | 2,476  |   | $ | 6,605 |   | $ | (89 | ) | $ | 32,337 |   |

 

Note 10 – Borrowed Funds

 
| **(In  Thousands)**                             |   | **September 30, 2003** |    | **December 31, 2002** |   |
|-------------------------------------------------|--------|------------------------|---------|-----------------------|--------|
| Short-term Borrowings:                          |   |                   |    |                  |   |
| Securities sold under  agreements to repurchase |   | $                      | 32,723  |                  | $      | 29,557 |   |
| Treasury Tax and Loan Note  Option              |   | 125                    |    | 125                   |   |
| Total Short-term Borrowings                     |   | 32,848                 |    | 29,682                |   |
|                                            |   |                   |    |                  |   |
| Long-term Borrowings:                           |   |                   |    |                  |   |
| FHLB advances                                   |   | 233,633                |    | 220,000               |   |
| Other long term debt                            |   | 11,900                 |    | —                |   |
| Subordinated debentures                         |   | 18,866                 |    | 19,655                |   |
| Total Long-term Borrowings                      |   | 264,399                |    | 239,655               |   |
| Total Borrowed Funds                            |   | $                      | 297,247 |                  | $      | 269,337 |   |

 

The FHLB advances of $233,633 carry significant prepayment penaltiesthat limit the ability of Sun to reduce its debt level.  As of September 30, 2003, prepaymentpenalties totaled $33,031 as compared to $32,613 at December 31, 2002.

 

The following is a schedule of the rates and maturities for thelong-term borrowings identified above. The variable rate borrowings listedconsist entirely of FHLB advances that are fixed until the FHLB exercises theiroption to increase the rate charged when the then current rate surpasses therate set at contract inception.  Thefixed rate debt listed below consists of subordinated debentures and reverserepurchase agreements.

 

15

----

 

 
| **(In  Thousands)**                                    |   | **September 30, 2003** |    | **December 31, 2002** |   |
|--------------------------------------------------------|--------|------------------------|---------|-----------------------|--------|
| Variable rate of 1.99%,  maturity 2005                 |   | $                      | 2,000   |                  | $      | — |   |
| Variable rates between  4.63% and 5.04%, maturity 2008 |   | 26,000                 |    | 70,000                |   |
| Variable rates between  4.93% and 5.88%, maturity 2009 |   | 50,475                 |    | 50,000                |   |
| Variable rates between  5.86% and 6.36%, maturity 2010 |   | 105,908                |    | 100,000               |   |
| Variable rate of 5.24%,  maturity 2011                 |   | 3,000                  |    | —                |   |
| Variable rates between  5.08% and 5.15%, maturity 2013 |   | 46,250                 |    | —                |   |
| Fixed rate of 6.00%,  maturity 2003                    |   | —                 |    | 789                   |   |
| Fixed rate of 6.00%,  maturity 2004                    |   | 789                    |    | 789                   |   |
| Fixed rates between 1.90%  and 6.00%, maturity 2005    |   | 5,489                  |    | 789                   |   |
| Fixed rates between 2.42%  and 6.00%, maturity 2006    |   | 4,388                  |    | 788                   |   |
| Fixed rate of 2.84%,  maturity 2007                    |   | 3,600                  |    | —                |   |
| Fixed rate of 10.20%,  maturity 2031                   |   | 16,500                 |    | 16,500                |   |
| Total                                                  |   | $                      | 264,399 |                  | $      | 239,655 |   |

 

Note 11 – Off –Balance Sheet Risk

 

In the normal course of business, Sun is a party tofinancial instruments with off-balance sheet risk. These financial instrumentsinclude commitments to extend credit and standby letters of credit containing,in varying degrees, credit and interest rate risk exceeding the amountsrecognized in the balance sheet.

 

Credit risk from nonperformance by counterparties tocommitments to extend credit and standby letters of credit is represented bythe contractual amount of those instruments. Sun uses the same credit policiesto guide commitments and conditional obligations as it does for direct, fundedloans.

 

Commitments to extend credit are agreements to lend toa customer as long as no contract conditions are violated. Commitmentsgenerally include fixed expiration dates or other termination clauses andcertain fee payments. Since many commitments are expected to expire withoutbeing drawn upon, the total commitment amounts do not necessarily representfuture cash requirements. Each customer’s creditworthiness is evaluated on acase-by-case basis. The collateral amount obtained, if deemed necessary, isbased on management’s credit evaluation of the customer. Collateral types varybut may include accounts receivable, inventory, property, equipment, andincome-producing commercial properties.

 

Standby letters of credit are conditional commitmentsthat guarantee a customer’s performance to a third party. Those guarantees areprimarily issued to support borrowing arrangements and related transactions.Terms vary from one month to 24 months and may have renewal features.

 
| **(In Thousands)**                                |   | **September  2003** |    | **December  2002** |   |
|---------------------------------------------------|--------|---------------------|---------|--------------------|--------|
| Commitments to extend credit                      |   | $                   | 147,191 |               | $      | 128,796 |   |
| Standy letters of credit and financial guarantees |   | 10,283              |    | 10,577             |   |
| Total credit extension commitments                |   | $                   | 157,474 |               | $      | 139,373 |   |

 

16

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Note 12 – Hedging Activities

 

Sun maintains an overallinterest rate risk-management strategy that incorporates the use of derivativeinstruments to minimize significant unplanned fluctuations in earnings that arecaused by interest rate volatility. Sun’s goal is to manage interest rate sensitivity by modifying therepricing or maturity characteristics of certain balance sheet assets andliabilities so that movements in interest rates do not, on a material basis,adversely affect the net-interest margin. As a result of interest rate fluctuations, hedged fixed-rate liabilitieswill appreciate or depreciate in market value. The effect of this unrealized appreciation or depreciation is expectedto be substantially offset by Sun’s gains or losses on the derivativeinstruments that are linked to these hedged liabilities.  Another result of interest rate fluctuationsis that the interest expense of hedged variable-rate liabilities will increaseor decrease.  The effect of thisvariability in earnings is expected to be substantially offset by Sun’sderivative instruments that are linked to these hedged liabilities.  Sun considers its strategic use ofderivatives to be a prudent method of managing interest-rate sensitivity, as itreduces the exposure to earnings from undue risk posed by changes in interestrates.

 

Sun uses interest rateswaps as part of the interest rate risk-management strategy that have indicesrelated to the pricing of specific balance sheet liabilities.  As a matter of policy, Sun does not usehighly leveraged derivative instruments for interest rate risk management.  Interest rate swaps generally involve theexchange of fixed and variable-rate interest payments between two parties,based on a common notional principal amount and maturity date.  The derivative instruments entered into bySun give Sun the right to enter into additional interest rate swaps with thewriter of the option in the event that the liabilities are repriced by theissuer.

 

By using derivativeinstruments, Sun exposes itself to credit and market risk.   If a counterparty fails to fulfill itsperformance obligations under a derivative contract, Sun’s credit risk willequal the fair value gain in a derivative. Generally, when the fair value of a derivative contract is positive,this indicates that the counterparty owes Sun, thus creating a credit risk forSun.  When the fair value of aderivative contract is negative, Sun owes the counterparty and, therefore, assumesno credit risk.  Sun minimizes the credit(or repayment) risk in derivative instruments by entering into transactionswith high quality counterparties that are reviewed periodically by Sun’sAsset/Liability Committee.  Further,when the circumstances are deemed appropriate, Sun, may request that collateralbe provided by the counterparty.

 

Market risk is theadverse effect that a change in interest rates, currency, or implied volatilityrates might have on the value of a financial instrument.  Sun manages the market risk associated withinterest rate contracts by establishing and monitoring limits for the types anddegree of risk that may be undertaken. Sun’s derivative activities are monitored by its Asset/LiabilityCommittee as part of that committee’s oversight of Sun’s asset/liability position.  The Asset/Liability Committee is responsiblefor approving hedging strategies that are developed through its analysis ofdata derived from financial simulation models and other internal and industrysources.  The resulting hedgingstrategies are then incorporated into Sun’s overall interest raterisk-management strategy.

 

17

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Sun, as of September 30,2003 had entered into four pay-variable, receive-fixed interest rate swaps($100,000 total notional amount) to hedge changes in fair value of certainFederal Home Loan Bank long-term borrowings (other borrowed funds).  The swaps also contain an embedded option toreverse the swap to pay-fixed, receive-variable in the event that the FHLBlong-term borrowings reprice and become variable rate.  This occurrence would effectively fix therate being paid on the borrowings at approximately the original coupon andwould reduce the net interest volatility caused in a rising interest rateenvironment. Sun includes all components of each derivative gain or loss in theassessment of hedging effectiveness. Sun recognizes the change in fair value of the hedge and associatedborrowings through the other income line item of the income statement.  For the nine months ended September 30,2003, there was a change in value of $2,883 recognized in the hedge orassociated borrowing.  A summary ofSun’s fair value hedges at September 30, 2003 appears below:

 
|                                              |   |                 |    |      |   |          |   | **Weighted Average** |   |
|---------------------------------------------------|--------|----------------------|---------|-----------|--------|---------------|--------|----------------------|--------|
| **(In Thousands)**                                |   | **Notional  Amount** |    | **Asset** |   | **Liability** |   | **Receive  Rate**    |   | **Pay  Rate** |   | **Life  (Years)** |   |
| Fair Value  Hedges:                               |   |                 |    |      |   |          |   |                 |   |   |   |   |   |
| Receive fixed  - pay variable interest rate swaps |   | $                    | 100,000 |      | $      | 2,883         |   | $                    | — |   | 2.65 | % | 1.16 | % | 6.5 |   |
|                                                   |        |                      |         |           |        |               |        |                      |        |  |  |  |  |  |  |  |

 

Note 13 – Acquisitions

 

During2003 Sun has completed three acquisitions: Bank Capital Services Corporation (“Bank Capital”) in January, Mid Penn Insurance Associates (“Mid Penn Insurance”) in April, and Steelton Bancorp (“Steelton”) in April. Bank Capital, an auto and equipment lease broker andservicer, services Sun's leases and provides fee income due to theirpartnership with other financial institutions. Mid Penn Insurance, an insuranceagency located in central Pennsylvania, provides Sun with a respected Agencythat shares Sun's focus on customer service. Steelton, two branches in theHarrisburg market, provides Sun an entry into the capital region. Following isa summary of the purchases.

 
| ** **                       |   | **Bank  Capital** |   | **Mid Penn  Insurance** |   | **Steelton  Bancorp** |   | **Total** |   |
|----------------------------------|--------|-------------------|--------|-------------------------|--------|-----------------------|--------|-----------|--------|
| Assets                           |   | $                 | 223    |                    | $      | 875                   |   | $         | 63,589 |   | $ | 64,687 |   |
| Indentifiable  intangible assets |   | —            |   | 1,864                   |   | 792                   |   | 2,656     |   |
| Less:  liabilities assumed       |   | 54                |   | 977                     |   | 61,014                |   | 62,045    |   |
| Net assets  acquired             |   | 169               |   | 1,762                   |   | 3,367                 |   | 5,298     |   |
| Purchase price                   |   | 590               |   | 2,374                   |   | 9,180                 |   | 12,144    |   |
| Unidentifiable  assets           |   | $                 | 421    |                    | $      | 612                   |   | $         | 5,813  |   | $ | 6,846 |   |
|                             |   |              |   |                    |   |                  |   |      |   |
| Consideration  paid:             |   |              |   |                    |   |                  |   |      |   |
| Cash                             |   | $                 | 118    |                    | $      | 649                   |   | $         | 9,180  |   | $ | 9,947 |   |
| Stock                            |   | $                 | 472    |                    | $      | 1,725                 |   | $         | — |   | $ | 2,197 |   |

 

 

 

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Item 2.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations(in thousands, except per share amounts)

 

Forward Looking Statements (FLSs)

 

In addition to historical information, this report andthe reports and documents incorporated by reference in this report containstatements relating to future events and Sun’s future results. These statementsare “forward-looking” within the meaning of the Private Securities LitigationReform Act of 1995 and include, but are not limited to, statements that relateto projections of future results of operations, liquidity, capital expendituresor other financial items, discussions of estimated future revenue enhancementsand cost savings, and potential exposure to various types of market risk,including interest rate risk and credit risk. These statements may also relate to Sun’s business strategy, goals andexpectations concerning its market position, future operations, margins,profitability, liquidity and capital resources. Generally, words such as“anticipate”, “believe”, “continue”, “could”, “estimate”, “expect”, “intend”,“may”, “plan”, “predict”, “project”, “should”, “will” and similar terms andphrases are used to identify forward-looking statements in this report and inthe documents incorporated in this report by reference.   These forward-looking statements are madeas of the date of this report.

 

Readers should note that many factors, some of which are discussedelsewhere in this report and in the documents incorporated by reference in thisreport, could affect the future financial results of the Corporation and itssubsidiaries, both individually and collectively, and could cause those resultsto differ materially from those expressed in the forward-looking statementscontained or incorporated by reference in this Form 10-Q. These factorsinclude:

 

•        operating, legal andregulatory risks;

•        economic, political andcompetitive forces affecting banking, securities, asset management and creditservices businesses; and

•        the risk that management’sanalysis of these risks and forces could be incorrect and/or that thestrategies developed to address them could be unsuccessful.

 

Sun undertakes no obligation to publicly revise or update theseforward-looking statements to reflect events or circumstances that arise afterthe date of this report. Readers should carefully review the risk factorsdescribed in other documents that Sun files periodically with the Securitiesand Exchange Commission.

 

The following is management’s discussion and analysisof the significant changes in the results of operations, capital resources, andliquidity presented in its accompanying consolidated financial statements forSun, a financial holding company, and its wholly-owned subsidiaries, SunBank,Mid-Penn Insurance Associates, Inc., Beacon Life Insurance Company, and SunBancorp Statutory Trust I.  Sun Bancorp,Inc. also holds thirty percent ownership in Sun Abstract and SettlementServices.  Sun Bancorp, Inc.’sconsolidated financial condition and results of operations consist almostentirely of SunBank’s financial condition and results of operations.  This discussion should be read inconjunction with Sun’s 2002 Annual Report. Current performance does notguarantee or assure similar performance in the future, and may not beindicative of future results.

 

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Results of Operations – Three Months Ended September30, 2003 and 2002

 

Sun’s earnings of $1,821 or $0.25 per share basic anddiluted for the three months ended September 30, 2003 were $126 or $0.01 pershare basic and $0.02 per share diluted higher than the three months endedSeptember 30, 2002.

 

The earnings resulted in annualized return on averageassets for the three months ended September 30, 2003 of 0.70% compared to 0.73%for the same period in 2002.  Annualizedreturn on average equity for the three months ended September 30, 2003 was9.15% compared to 8.34% for the three months ended September 30, 2002.

 

Comparative information for the three months endedSeptember 30, 2003 and 2002 is impacted by the acquisition of Bank CapitalServices Corporation in January 2003, and the April 2003 acquisitions ofMid-Penn Insurance Associates, Inc. and Steelton Bancorp.

 

Net interest income decreased 6.32% to $5,973 for thethree months ended September 30, 2003 compared to $6,376 for the same period of2002.  Total interest and dividendincome decreased $1,465 to $12,262 for the three months ended September 30,2003.  Interest and fees on loans andleases remained relatively flat with a 1.94% increase to $10,565 for the threemonths ended September 30, 2003 compared to the corresponding period of 2002despite net loan and lease growth of $60,944 since December 31, 2002.  The limited growth in interest and fees onloans reflects the impact of significant loan prepayments, which partially offsetthe benefits of the overall loan growth. Interest and dividends on available for sale securities decreased $1,593or 48.73% to $1,676 for the three months ended September 30, 2003 due primarilyto accelerated amortization of premiums due to prepayments resulting from thelow interest rate environment during the period.   In addition, many of the higher coupon bonds in Sun’s investmentportfolio that were realizing accelerated prepayments and had have a shortenedaverage life of less than one year were sold and the proceeds were reinvestedin an effort to more appropriately distribute cash flows to meet futureliquidity needs.   Interest on depositsin banks decreased $73 or 77.66% to $21 for the three months ended September30, 2003, primarily due to decreased interest rates. Total interest expensedecreased 14.45% for the three months ended September 30, 2003, compared to thesame period of 2002.  This overalldecrease corresponds to a general decline in market rates.  Interest on deposits decreased 23.74%, or$856 primarily due to lowered offered rates in comparison to rates offeredduring the three months ended September 30, 2003 to the corresponding period2002.  The decrease in aggregateinterest expense did not keep pace with the decrease in interest income due tothe effect other borrowed funds that carried a weighted average cost of 4.90%for the three months ended September 2003 as compared to 5.74% for the sameperiod 2002.  To alleviate the impact ofthe Federal Home Loan Bank (FHLB) term borrowings, the Bank entered into$100,000 notional value swap arrangements in June of 2003.  In addition, the Bank restructured $46million of the FHLB term borrowings during the third quarter of 2003, loweringthe associated rate from 5.39% to 5.09% and prepaid $4,227 in FHLB debt thatcarried an aggregate rate of 6.64%.

 

Non-interest income,excluding security gains, increased $1,404 or 86.29% to $3,031 for the threemonths ended September 30, 2003 as compared to the corresponding period of2002.  Increased

 

20

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service charges on deposits accounted for $257 of the increase.  The increase in service charges wasprimarily the result of a program implemented during 2002 involving chargingfees for overdraft protection and the acquisition of Steelton Bancorp.  The addition of bank owned life insuranceduring March and October of 2002 represented $127 of the increase innon-interest income.  The bank ownedlife insurance was purchased to supplement future increases in employee benefitplans and is generating above market returns. Income from the leasing subsidiary, Bank Capital Services Corporationpurchased in January 2003, generated $252 in additional fees. In addition,income from the insurance subsidiary increased $449 as the result of theacquisition of Mid-Penn Insurance in April 2003.  Income from investment product sales increased $52 when comparingthe three months ended September 30, 2003 to the corresponding period of 2002as investor dollars began to move back into the stock/bond markets.  Other income increased $321 with $209 of theincrease resulting from Sun entering into operating lease agreements with itscustomers.  The rental income generatedfrom these leases is reported as other income. Sun recognized security gains of $697 for the three months endedSeptember 30, 2003, compared to $3 for the corresponding period of 2002 as Sunrealigned the investment portfolio to provide an even cash flow over the nextthirty months.

 

Non-interest expenses increased $1,504 or 26.61% to$7,155 for the three months ended September 30, 2003 as compared to thecorresponding period of 2002.  Allcategories of non-interest expense have been impacted by the acquisitions ofBank Capital Services Corporation, Mid-Penn Insurance Associates, Inc., andSteelton Bancorp during 2003.  Salariesand employee benefits increased $339 or 11.33% due to the acquisitions andincreased employee benefit costs.  Netoccupancy expense and furniture and equipment expenses increased $90 or 21.28%due to the acquisitions and infrastructure improvements.  Other expenses increased 53.14% or $1,024due to increases in normal business expenses, acquisitions, depreciationrelated to assets under operating lease, FHLB borrowing prepayment penalties, andthe outsourcing of operational processing and certain other supportfunctions.  The outsourcing ofoperational processing (daily computer processing of the days work andassociated reports), which increased our capabilities, and the depreciationassociated with operating leases increased other expenses $160 or 15.63% and$165 or 16.11%, respectively.  FHLBprepayment penalties of $133 were incurred as management prepaid $4,227 in FHLBborrowings that were acquired in the Steelton Bancorp acquisition.  In aggregate, Bank Capital and MPIrepresented $693 or 46.08% of the total increase in non-interest expenses.

 

Results of Operations – Nine Months Ended September30, 2003 and 2002

 

Sun’s earnings of $5,545 or $0.77 per share basic anddiluted for the nine months ended September 30, 2003 were $357 or $0.04 pershare basic and $0.05 per share diluted higher than the nine months ended 2002.

 

The earnings resulted in annualized return on averageassets for the nine months ended September 30, 2003 of 0.73% as compared to0.75% for the nine months ended September 30, 2002.

 

21

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Annualized return on average equity for the ninemonths ended September 30, 2003 was 9.05% as compared to 8.68% for the ninemonths ended September 30, 2002.

 

Comparative information for the nine months endedSeptember 30, 2003 and 2002 is impacted by the acquisition of Bank CapitalServices Corporation, Mid-Penn Insurance Associates, Inc. and Steelton Bancorp.

 

Net interest income decreased 8.88% to $17,445 for thenine months ended September 30, 2003 as compared to $19,145 for the same periodof 2002.  Total interest and dividendincome decreased $4,016 to $37,596 for the nine months ended September 30,2003.  Interest and fees on loans remainedlargely flat with a 1.14% increase to $30,607 for the nine months endedSeptember 30, 2003.  Interest anddividends on available for sale securities decreased $4,204 to $6,877 for thenine months ended September 30, 2003 due to accelerated prepayments and lowerreinvestment rates as a result of the current low interest rateenvironment.   Interest income ondeposits in banks decreased 58.36% for the nine months ended September 30,2003. Total interest expense decreased 10.31% for the nine months ended September30, 2003, as compared to the corresponding period of 2002.  Interest expense on deposits decreased20.75%, or $2,342 as a result of the interest rate decreases when comparing thenine months ended September 30, 2003 to the corresponding period of 2002.  The decrease in the aggregate interestexpense has not kept pace with the decrease in interest income due to theeffect of other borrowed funds that carried a weighted average cost of 5.36%for the nine months ended September 30, 2003 as compared to 5.75% for the ninemonths ended September 30, 2002.  Toalleviate the impact of the Federal Home Loan Bank (FHLB) term borrowings, Sunhad entered into $100,000 notional value swap arrangements effective June 30,2003.  In addition, Sun restructured $46million of the FHLB term borrowings lowering the associated rate from 5.39% to5.09%.  Readers are encouraged to referto the Net Interest Income and Net Interest Margin section of Management’sDiscussion and Analysis for further details, including average balance sheetand volume rate analysis.

 

Non-interest income, excluding security gains,increased $3,788 or 90.56% to $7,971 for the nine months ended September 30,2003 as compared to the corresponding period of 2002.  Increased service charges on deposits accounted for $857 of theincrease.  The addition of bank ownedlife insurance during March and October of 2002 represented $563 of theincrease.  Income from leasing fees fromBank Capital Services Corporation, purchased in January 2003, generated $815 inadditional fees.  In addition, incomefrom insurance increased $763 as the result of the acquisition of Mid-PennInsurance in April 2003. Gain on sale of loans increased $228 primarily fromthe sale of a pool of SBA loans.  Incomefrom investment product sales decreased $106 when comparing the nine monthsended September 30, 2003 to the corresponding period of 2002 as dollars haveprimarily flowed out of the stock/bond markets during the majority of2003.  Other income increased $638 with$209 of the increase the result of Sun entering into operating lease agreementswith its customers with the revenue generated being reported as rental incomewithin other income.  The majority ofthe remaining increase in other income was the result of increased fee incomefrom debit card usage.  Security gainsof $3,194 were recognized for the nine months ended September 30, 2003,compared to $143 for the corresponding period of 2002 as Sun realigned theinvestment

 

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portfolio to provide an even cash flow over the next thirty months andto reduce regulatory-defined risk-weighted assets.  Refer to non-interest income discussion in Management’sDiscussion and Analysis for additional information.

 

Non-interest expenses increased $4,880 or 30.54% to$20,859 for the nine months ended September 30, 2003 as compared to thecorresponding period of 2002.  Allcategories of non-interest expense have been impacted by the acquisitions ofBank Capital Services Corporation, Mid-Penn Insurance, and Steelton Bancorpduring 2003.  Salaries and employeebenefits increased $1,287 or 14.92% due to the acquisitions and increasedemployee benefit costs.  Net occupancyexpense and furniture and equipment expenses increased $455 or 21.95%.  Other expenses increased 57.72% or $3,049due to increases in normal business expenses, acquisitions, depreciationrelated to operating leases, and the outsourcing of operational processing(daily computer processing of the days work and associated reports) and certainother support functions.  Theoutsourcing of operational processing, which increased our capabilities, anddepreciation associated with operating leases increased other expenses $844 or27.68% and $165 or 5.41% of the total increase in other expenses,respectively.   In aggregate, BankCapital and Mid Penn Insurance represented $1,462 or 29.95% of the totalincrease in non-interest expenses. Readers are encouraged to refer to non-interest expense discussion inManagement’s Discussion and Analysis for additional information.

 

Balance Sheet – September 30, 2003 and December 31,2002

 

Total assets were $1,033,293 at September 30, 2003, anincrease of $82,119 or 8.63% from $951,174 at December 31, 2002.  Cash and cash equivalents decreased $9,144,or 22.00% from $41,569 at December 31, 2002. The decrease in cash and cash equivalents was the result of interestbearing cash deposits being used to fund loan growth.  The investment growth was primarily the result of the acquisitionof Steelton Bancorp, Inc. in April 2003. In addition, to the investment portfolio remaining constant, excludingacquisitions, the portfolio has been realigned in an attempt to provide anexpected even cash flow over the next thirty months and to maximize theregulatorily-defined risk-based capital levels.  A majority of theportfolio was projected to experience accelerated prepayments, which would haveresulted in excess of $100 million in principal payments to Sun during2003.  To combat the accelerated prepayments, Sun began a program duringlate 2002 to sell bonds with a weighted average life of less than oneyear and which are experiencing accelerated prepayments.  The reinvestmentof the proceeds of the sales has been primarily in CMOs and mortgage pass-throughsthat have an average life of under 3 years in a flat rate environment andextension of another 2 years in an upward rate environment of 200bp, which isexpected to provide a constant level of cash flow, as interest rates moveup.  A byproduct of this strategy has been the recognition of $3,194 ingains for the nine months ended September 30, 2003. The growth in the loanportfolio of $61,967  occurred in thecommercial/industrial category, auto and equipment leases, and residentialmortgages. The residential mortgage growth was a result of the Steelton Bancorpacquisition in which Sun acquired $22,231 in primarily residential loans.  Bank-owned life insurance of $30,000 wasadded to the balance sheet during 2002. These policies are used to offset future

 

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increases in employee benefit costs and have increased in value to$32,917 as a result of earnings.

 

Total liabilities increased $84,351 or 9.70% to$954,278 at September 30, 2003.  Totaldeposits increased $64,032 to $651,512, as core deposits (non-time deposits)increased $30,117.  Of the totalincrease, $38,601 or 38.63% is the result of the Steelton Bancorp acquisitionin which $36,497 in deposits were acquired. Since December 31, 2002, savings and NOW accounts have increased $11,394and $14,887 respectively, while money market accounts have decreased$3,101.  Since December 31, 2002,non-interest-bearing deposits have increased $6,937 or 11.72%.  Short-term borrowings increased $3,166 fromDecember 31, 2002, due to fluctuations in cash management accounts.  Other borrowed funds increased $25,533primarily as a result of the Steelton Bancorp acquisition.

 

Sun’s total shareholders’ equity decreased $2,232 fromDecember 31, 2002 to September 30, 2003. The decrease is the result of several factors.  First, Sun’s accumulated other comprehensive income resultingfrom the change in the market value of Sun’s investment portfolio decreased112.38%, or $4,021, to $(443) from $3,578, at December 31, 2002, because ofchanges in the market value of Sun’s investment securities and the gainsrecognized on the sale of securities. Second, while net income of $5,545 increased shareholders’ equity, theincrease was offset by the payment of $3,793 in dividends to shareholdersduring the nine months ended September 30, 2003.  Treasury stock increased $742, as Sun purchased 125,250 shares oftreasury stock, at an average cost of $19.33 per share, over the first ninemonths of 2003 and issued 111,045 shares from treasury for the purchase of BankCapital and Mid Penn Insurance.

 

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Allowance for Loan and Lease Losses 

 

SunBank’s allowance for loan and lease losses isincreased through periodic provisions for loan and lease losses. The provisionis reported as an expense in current income. Loan losses are charged against the allowance for loan and lease lossesin the period in which they are determined to be uncollectible.  Recoveries of previously charged-off loansare credited to the allowance, as they are received.  Management maintains the allowance for loan and lease losses at alevel it believes will be adequate to absorb probable credit losses in theexisting loan portfolio.  Managementbelieves the allowance for loan and lease losses is adequate at September 30,2003 and December 31, 2002.

 

Management’s analysis incorporates many factors,including current and anticipated economic conditions, loss experience, loanportfolio composition, anticipated losses, and unfunded commitments.  For significant real estate properties,management obtains independent appraisals. SunBank also retains consultants to conduct independent, periodic loanquality reviews, which management incorporates into its allowance for loan andlease losses analysis.

 

Management determines the allowance for loan and leaselosses based on criteria and analysis developed to evaluate credit risk withineach loan category.  Each loancategory’s unique risk characteristics guide management’s analysis anddetermination of an adequate specific reserve for that category.  For real estate loans, management considersfactors that include historical loss rates, past due levels, collateral values,and anticipated economic conditions. For commercial and industrial loans, management evaluates severalfactors including historical loss experience, current loan grades, expectedfuture cash flows, individual loan reviews, internal and external analysis, andanticipated economic conditions.  Forindividual (consumer) loans, management evaluates factors such as historicaland projected loss rates, past due levels, collateral values, and anticipatedeconomic conditions.

 

SunBank’s allowance for loan and lease lossescomponents is based on loss rates by loan grade, economic trends, and otherrisk factors.  Management determinesestimated loss rates by loan grade based on current loan grade, remaining term,loan type, periodic quantification of actual losses over a period of time, andother factors.  Management believes itsmethodology reasonably measures the credit risk not captured in specificallocations and provides for an adequate aggregate allowance for loan and leaselosses.

 

As management continued to closely monitor theallowance for loan and lease losses, the provision for these losses decreased$45 to $405 and $45 to $1,215 for the three and nine months ended September 30,2003, respectively, as compared to the same periods in 2002.  The decrease in provision expense was theresult of net charge-offs of $884, for the nine months ended September 30, 2003coupled with management’s assessment of the portfolio and economicconditions.  These factors resulted inan allowance for loan and lease losses of 1.08% of total loans and leases atSeptember 30, 2003, as compared to 1.19% at September 30, 2002, and 1.02% atDecember 31, 2002.  The allowance forloan and lease losses as a percent of total loans for prior periods has beenadjusted to reflect a reclassification of lease residuals from other assets toloans and leases.

 

 

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Management continues to enhance its methodology foranalyzing the allowance for loan and leases losses and for assigningreserves.  However, the allowance forloan and lease losses still only represents management’s estimate of an amountadequate to absorb probable loan losses due to credit quality.  Management cannot precisely quantify thatamount due to many uncertainties, including future global, national, and localeconomic conditions and other factors. As a result, unforeseen developments may require management to increasethe allowance for loan and lease losses. Such developments could include changing economic conditions or negativedevelopments with borrowers.  Inaddition, bank regulators periodically assess SunBank’s allowance for loan andlease losses and may, consistent with examination guidelines and currentinformation, require an increased allowance for loan and lease losses.  As a result, any number of factors maymaterially change management’s analysis in the future.

 

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Deposits

 

Sun’s total deposits increased $64,032 or 10.90%, to$651,512 at September 30, 2003, compared to $587,480, at December 31,2002.  This increase is the result ofSun’s focus on growing low cost core deposits (all deposits excluding timedeposits) and building relationships with local municipalities, colleges, andbusinesses.  In addition, $38,601 of thedeposit increase, including $25,952 in time deposits, is the result of theSteelton Bancorp acquisition that occurred in April 2003 in which Sun acquired$36,497 in total deposits, including $22,579 in time deposits.  The acquisition and the focus on obtainingcore deposits resulted in a core deposit increase of 9.39% or $30,117, to$350,951 at September 30, 2003, compared to $320,834, at December 31,2002.  A majority of the deposit growthis the result of NOW accounts increasing $14,887 or 9.60%, and time depositsincreasing $33,915 or 12.72% since December 31, 2002.   Over the same time period, demand deposit accounts increased$6,937, or 11.72%, to $66,118.

 
|             |   | **September 30, 2003** |   | **December 31, 2002** |   | **Change** |   |
|------------------|--------|------------------------|--------|-----------------------|--------|------------|--------|
|             |   | **Amount**             |   | **% Total**           |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Demand deposits  |   | 66,118                 |   | 10.15                 | %      | 59,181     |   | 10.07 | % | 6,937 |   | 11.72 | % |
| NOW accounts     |   | 170,001                |   | 26.09                 | %      | 155,114    |   | 26.40 | % | 14,887 |   | 9.60 | % |
| Insured MMDA     |   | 26,726                 |   | 4.10                  | %      | 29,827     |   | 5.08 | % | (3,101 | ) | -10.40 | % |
| Savings deposits |   | 88,106                 |   | 13.52                 | %      | 76,712     |   | 13.06 | % | 11,394 |   | 14.85 | % |
| Time deposits    |   | 300,561                |   | 46.14                 | %      | 266,646    |   | 45.39 | % | 33,915 |   | 12.72 | % |
| Total deposits   |   | 651,512                |   | 100.00                | %      | 587,480    |   | 100.00 | % | 64,032 |   | 10.90 | % |
|             |   |                   |   |                  |   |       |   |   |   |   |   |   |   |
| Core deposits*   |   | 350,951                |   | 53.87                 | %      | 320,834    |   | 54.61 | % | 30,117 |   | 9.39 | % |

 

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* Core deposits are defined as total deposits lesstime deposits.

 

The time deposit totals above include certificates of deposit and othertime deposits issued in amounts of $100,000 or more.  These deposits and their remaining maturities at September 30,2003 and December 31, 2002 are listed below.

 
|                      |   | **September 30, 2003** |   | **December 31, 2002** |   | **Change** |   |
|---------------------------|--------|------------------------|--------|-----------------------|--------|------------|--------|
|                      |   | **Amount**             |   | **% Total**           |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Three months or less      |   | 30,601                 |   | 40.41                 | %      | 6,301      |   | 13.51 | % | 24,300 |   | 385.65 | % |
| Three through six months  |   | 13,350                 |   | 17.63                 | %      | 4,593      |   | 9.85 | % | 8,757 |   | 190.66 | % |
| Six through twelve months |   | 7,655                  |   | 10.11                 | %      | 14,248     |   | 30.56 | % | (6,593 | ) | -46.27 | % |
| Over twelve months        |   | 24,121                 |   | 31.85                 | %      | 21,488     |   | 46.08 | % | 2,633 |   | 12.25 | % |
| Total                     |   | 75,727                 |   | 100.00                | %      | 46,630     |   | 100.00 | % | 29,097 |   | 62.40 | % |

 

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Other Funding

 

Sun continued using borrowed funds to supplementdeposits during 2003 and 2002.  AtSeptember 30, 2003, Sun had $245,533 in long term debt funding.  This funding consisted primarily of $233,633in variable Federal Home Loan Bank (FHLB) borrowings with maturities between2005 and 2013.  Sun also had $11,900 inlong-term repurchase agreements at September 30, 2003.

 

Sun had $18,866 in long term subordinated debentures,at September 30, 2003, that consisted of $16,500 in trust preferred securitieswith a maturity of February 22, 2031 and an initial call of February 22,2011.  The remaining $2,366 was theresult of a note issued for the purchase of Guaranty Bank, N.A., during 2001.

 

Other funding sources forshort-term money include deposit customers’ cash management accounts(classified as securities sold under agreements to repurchase), Treasury Taxand Loan Note Option, repurchase agreements, and FHLB overnightborrowings.  At September 30, 2003,Sun’s short-term borrowings consisted primarily of cash management accounts inthe amount of $32,298.

 

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Net Interest Income and Net Interest Margin

 

Net interest income, the difference between interestincome and interest expense, is the largest component of Sun’s earnings.  Net interest margin (NIM) measures thedifference between the yield on interest earning assets and the aggregatefunding cost.  NIM is calculated astaxable equivalent net interest income divided by average interest earningassets.

 

NIM decreased by 36 basis points to 2.70% for thethree months ended September 30, 2003, compared to 3.06%, for the same periodof 2002.  This decline in margin wasprimarily the result of significant increases in mortgage-backed investmentsecurity pre-payments, which were reinvested at lower investment securityyields during the current period. The stabilization of the NIM is the result ofSunBank lowering deposit rates at approximately the same rate of decline seenin the yield on earning assets.

 

For the nine months ended September 30, 2003, the NIMdecreased by 42 basis points to 2.70%, compared to 3.12% for the nine monthsended September 30, 2002.  The decreasewas primarily the result of decreased yield on the loan and investmentportfolios, which decreased greater than the cost of funds decreased.  The decreased yield of 198 basis points ontaxable investments is the result of accelerated prepayments coupled with lowreinvestment rates. In addition, many of the higher coupon bonds showingaccelerated prepayments with a remaining average life of less than one yearwere sold and the proceeds reinvested in a manner designed to spread the cashflow over the next thirty months.

 

To alleviate the compression in the NIM and constrainthe volatility in net interest income in an up or down interest rate environment,Sun has entered into $100 million in derivative contracts effective June 30,2003.  The contracts, which involve theFederal Home Loan Bank (FHLB) advances (other borrowings), increased netinterest income by $395 (NIM by 18 basis points) and $400 (NIM 6 basis points)for the three and nine months ended September 30, 2003, respectively.  Embedded in the swap is an option to reversethe original swap (receive fixed-pay variable), at any time, to pay fixed-receivevariable if the FHLB notifies the Bank that it is going to exercise the optionto increase the Bank’s interest rate on the debt.  Thus, in a rising rate environment the Bank has locked in a fixedrate.  Despite being able to lock in afixed rate, an upward movement in the 90-day LIBOR rate will reduce thepositive NIM impact of the swap and will cause a negative NIM impact during theperiod that 90-day LIBOR is above 2.65% and the point that the FHLB wouldreprice the debt.  Readers areencouraged to refer to Note 12 for further information on hedging activities.

 

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The followingtable sets forth comparative yields and rates paid for interest bearing assetsand liabilities:

 
|                                                                |   | **For the Three Months Ended** |          |
|---------------------------------------------------------------------|--------|--------------------------------|---------------|
|                                                                |   | **September 30, 2003**         |          | **September 30, 2002** |   |
| **(In  Thousands)**                                                 |   | **Average  Balance**           |          | **Interest** |   | **Rate** |   | **Average  Balance** |   | **Interest** |   | **Rate** |   |
| **ASSETS**                                                          |   |                           |          |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                            |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| Interest-bearing deposits                                           |   | **$**                          | **15,040**    | ** ** | **$** | **21** | ** ** | **0.55** | **%** | $ | 20,466 |   | $ | 94 |   | 1.82 | % |
| Loans (net of unearned income)                                      |   | **663,949**                    | ** **    | **10,684** | ** ** | **6.38** | **%** | 599,885 |   | 10,508 |   | 6.95 | % |
| Investments:                                                        |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| Taxable                                                             |   | **213,997**                    | ** **    | **1,462** | ** ** | **2.73** | **%** | 219,326 |   | 3,019 |   | 5.51 | % |
| Tax-exempt                                                          |   | **19,413**                     | ** **    | **324** | ** ** | **6.67** | **%** | 20,920 |   | 378 |   | 7.23 | % |
| **Total interest-earning assets**                                   |   | **912,398**                    | ** **    | **12,491** | ** ** | **5.44** | **%** | 860,597 |   | 13,999 |   | 6.47 | % |
|                                                                |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| **Noninterest-earning assets:**                                     |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| Cash and due from banks                                             |   | **28,009**                     |          |   |   |   | ** ** | 17,970 |   |   |   |   |   |
| Bank premises & equipment                                       |   | **20,811**                     |          |   |   |   | ** ** | 14,552 |   |   |   |   |   |
|                                                                |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| Accrued interest and other assets                                   |   | **79,424**                     |          |   |   |   | ** ** | 50,340 |   |   |   |   |   |
| Less: Allowance for loan losses                                     |   | **(7,188**                     | **)**         |   |   |   | ** ** | (7,010 | ) |   |   |   |   |
| Unamortized loan fees                                               |   | **369**                        |          |   |   |   | ** ** | 189 |   |   |   |   |   |
|                                                                |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| Total assets                                                        |   | **$**                          | **1,033,822** |   |   |   |   | ** ** | $ | 936,637 |   |   |   |   |   |
|                                                                |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                      |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| **Interest-bearing liabilities:**                                   |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| NOW Accounts                                                        |   | **$**                          | **170,085**   | ** ** | **$** | **239** | ** ** | **0.56** | **%** | $ | 152,334 |   | $ | 492 |   | 1.28 | % |
| Insured Money Market Accounts                                       |   | **27,366**                     | ** **    | **54** | ** ** | **0.78** | **%** | 22,538 |   | 106 |   | 1.87 | % |
| Savings deposits                                                    |   | **89,507**                     | ** **    | **122** | ** ** | **0.54** | **%** | 79,668 |   | 312 |   | 1.55 | % |
| Time deposits                                                       |   | **303,694**                    | ** **    | **2,334** | ** ** | **3.05** | **%** | 274,311 |   | 2,695 |   | 3.90 | % |
| Short-term borrowings                                               |   | **29,984**                     | ** **    | **75** | ** ** | **0.99** | **%** | 24,201 |   | 93 |   | 1.52 | % |
| Subordinated debentures                                             |   | **18,866**                     | ** **    | **455** | ** ** | **9.65** | **%** | 19,655 |   | 472 |   | 9.53 | % |
| Other borrowed funds                                                |   | **243,570**                    | ** **    | **3,010** | ** ** | **4.90** | **%** | 220,000 |   | 3,181 |   | 5.74 | % |
| **Total interest-bearing liabilities**                              |   | **883,073**                    | ** **    | **6,289** | ** ** | **2.83** | **%** | 792,708 |   | 7,351 |   | 3.68 | % |
|                                                                |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| **Noninterest-bearing liabilities and  shareholders’ equity:** |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| Demand deposits                                                     |   | **66,186**                     |          |   |   |   | ** ** | 58,060 |   |   |   |   |   |
| Accrued interest and other liabilities                              |   | **4,913**                      |          |   |   |   | ** ** | 4,606 |   |   |   |   |   |
| Shareholders’ equity                                           |   | **79,649**                     |          |   |   |   | ** ** | 81,263 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                     |   | **$**                          | **1,033,822** |   |   |   |   | ** ** | $ | 936,637 |   |   |   |   |   |
|                                                                |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| Interest rate spread                                                |   |                           |          |   |   | **2.61** | **%** |   |   |   |   | 2.79 | % |
|                                                                |   |                           |          |   |   |   | ** ** |   |   |   |   |   |   |
| Net interest income/margin                                          |   |                           | ** **    | **$** | **6,202** |   | **2.70** | **%** |   |   | $ | 6,648 |   | 3.06 | % |

 

----

* Average loan balances include non-accrual loans and interest incomeincludes fees on loans.

* Yields on tax-exempt loans and investments have been adjusted to afully taxable equivalent basis using a 34% federal income tax rate.

 

30

----

 

The followingtable sets forth comparative yields and rates paid for interest bearing assetsand liabilities:

 
|                                                                |   | **For the Nine Months Ended** |          |
|---------------------------------------------------------------------|--------|-------------------------------|---------------|
|                                                                |   | **September 30, 2003**        |          | **September 30, 2002** |   |
| **(In  Thousands)**                                                 |   | **Average  Balance**          |          | **Interest** |   | **Rate** |   | **Average  Balance** |   | **Interest** |   | **Rate** |   |
| **ASSETS**                                                          |   |                          |          |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                            |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| Interest-bearing deposits                                           |   | **$**                         | **14,713**    | ** ** | **$** | **112** | ** ** | **1.02** | **%** | $ | 16,520 |   | $ | 269 |   | 2.18 | % |
| Loans (net of unearned income)                                      |   | **638,449**                   | ** **    | **30,969** | ** ** | **6.49** | **%** | 574,371 |   | 30,673 |   | 7.14 | % |
| Investments:                                                        |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| Taxable                                                             |   | **225,570**                   | ** **    | **6,218** | ** ** | **3.68** | **%** | 242,838 |   | 10,313 |   | 5.66 | % |
| Tax-exempt                                                          |   | **19,438**                    | ** **    | **998** | ** ** | **6.85** | **%** | 21,102 |   | 1,163 |   | 7.35 | % |
| **Total interest-earning assets**                                   |   | **898,170**                   | ** **    | **38,297** | ** ** | **5.70** | **%** | 854,831 |   | 42,418 |   | 6.63 | % |
|                                                                |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| **Noninterest-earning assets:**                                     |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| Cash and due from banks                                             |   | **23,225**                    |          |   |   |   | ** ** | 19,229 |   |   |   |   |   |
| Bank premises & equipment                                       |   | **18,633**                    |          |   |   |   | ** ** | 14,472 |   |   |   |   |   |
|                                                                |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| Accrued interest and other assets                                   |   | **74,522**                    |          |   |   |   | ** ** | 46,054 |   |   |   |   |   |
| Less: Allowance for loan losses                                     |   | **(6,889**                    | **)**         |   |   |   | ** ** | (6,714 | )  |   |   |   |   |
| Unamortized loan fees                                               |   | **304**                       |          |   |   |   | ** ** | 102 |   |   |   |   |   |
|                                                                |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| Total assets                                                        |   | **$**                         | **1,007,965** |   |   |   |   | ** ** | $ | 927,974 |   |   |   |   |   |
|                                                                |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                      |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| **Interest-bearing liabilities:**                                   |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| NOW Accounts                                                        |   | **$**                         | **164,159**   | ** ** | **$** | **967** | ** ** | **0.79** | **%** | $ | 150,513 |   | $ | 1,501 |   | 1.33 | % |
| Insured Money Market Accounts                                       |   | **27,171**                    | ** **    | **251** | ** ** | **1.24** | **%** | 21,649 |   | 307 |   | 1.90 | % |
| Savings deposits                                                    |   | **85,238**                    | ** **    | **515** | ** ** | **0.81** | **%** | 76,960 |   | 945 |   | 1.64 | % |
| Time deposits                                                       |   | **290,559**                   | ** **    | **7,214** | ** ** | **3.32** | **%** | 275,004 |   | 8,536 |   | 4.15 | % |
| Short-term borrowings                                               |   | **37,076**                    | ** **    | **322** | ** ** | **1.16** | **%** | 21,956 |   | 236 |   | 1.44 | % |
| Subordinated debentures                                             |   | **19,387**                    | ** **    | **1,388** | ** ** | **9.55** | **%** | 20,112 |   | 1,428 |   | 9.47 | % |
| Other borrowed funds                                                |   | **236,955**                   | ** **    | **9,494** | ** ** | **5.36** | **%** | 221,136 |   | 9,514 |   | 5.75 | % |
| **Total interest-bearing liabilities**                              |   | **860,545**                   | ** **    | **20,151** | ** ** | **3.13** | **%** | 787,330 |   | 22,467 |   | 3.82 | % |
|                                                                |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| **Noninterest-bearing liabilities and  shareholders’ equity:** |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| Demand deposits                                                     |   | **60,749**                    |          |   |   |   | ** ** | 57,266 |   |   |   |   |   |
| Accrued interest and other liabilities                              |   | **4,984**                     |          |   |   |   | ** ** | 3,682 |   |   |   |   |   |
| Shareholders’ equity                                           |   | **81,687**                    |          |   |   |   | ** ** | 79,696 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                     |   | **$**                         | **1,007,965** |   |   |   |   | ** ** | $ | 927,974 |   |   |   |   |   |
|                                                                |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| Interest rate spread                                                |   |                          |          |   |   | **2.57** | **%** |   |   |   |   | 2.81 | % |
|                                                                |   |                          |          |   |   |   | ** ** |   |   |   |   |   |   |
| Net interest income/margin                                          |   |                          | ** **    | **$** | **18,146** |   | **2.70** | **%** |   |   | $ | 19,951 |   | 3.12 | % |

 

----

* Average loan balances include non-accrual loans and interest incomeincludes fees on loans.

* Yields on tax-exempt loans and investments have been adjusted to afully taxable equivalent basisusing a 34% federal income tax rate.

 

31

----

 

The following table represents the change in netinterest income due to changes in volume and interest rates for the threemonths ended September 30, 2003 and 2002 and the nine months ended September30, 2003 and 2002.

 
|                               |   | **Three Months Ended  Increase (Decrease)** |   | **Nine Months Ended  Increase (Decrease)** |   |
|------------------------------------|--------|---------------------------------------------|--------|--------------------------------------------|--------|
| **(In  Thousands)**                |   | **Volume**                                  |   | **Rate**                                   |   | **Net** |   | **Volume** |   | **Rate** |   | **Net** |   |
| Interest earned on:                |   |                                        |   |                                       |   |   |   |   |   |   |   |   |   |
| Interest -bearing deposits         |   | $                                           | (99    | )                                          | $      | 26 |   | $ | (73 | ) | $ | (39 | ) | $ | (118 | ) | $ | (157 | ) |
| Loans                              |   | 4,452                                       |   | (4,276                                     | )      | 176 |   | 4,575 |   | (4,279 | ) | 296 |   |
| Investments:                       |   |                                        |   |                                       |   |   |   |   |   |   |   |   |   |
| Taxable                            |   | (294                                        | )      | (1,263                                     | )      | (1,557 | ) | (977 | ) | (3,118 | ) | (4,095 | ) |
| Tax exempt                         |   | (109                                        | )      | 55                                         |   | (54 | ) | (122 | ) | (43 | ) | (165 | ) |
| Total interest-earning assets      |   | 3,950                                       |   | (5,458                                     | )      | (1,508 | ) | 3,437 |   | (7,558 | ) | (4,121 | ) |
|                               |   |                                        |   |                                       |   |   |   |   |   |   |   |   |   |
| Interest paid on:                  |   |                                        |   |                                       |   |   |   |   |   |   |   |   |   |
| NOW Accounts                       |   | 428                                         |   | (681                                       | )      | (253 | ) | 181 |   | (715 | ) | (534 | ) |
| Insured Money Market Accounts      |   | 131                                         |   | (183                                       | )      | (52 | ) | 105 |   | (161 | ) | (56 | ) |
| Savings deposits                   |   | 194                                         |   | (384                                       | )      | (190 | ) | 136 |   | (566 | ) | (430 | ) |
| Time deposits                      |   | 1,622                                       |   | (1,983                                     | )      | (361 | ) | 646 |   | (1,968 | ) | (1,322 | ) |
| Short-term borrowings              |   | 144                                         |   | (162                                       | )      | (18 | ) | 218 |   | (132 | ) | 86 |   |
| Subordinated debentures            |   | (78                                         | )      | 61                                         |   | (17 | ) | (69 | ) | 29 |   | (40 | ) |
| Other borrowed funds               |   | 1,358                                       |   | (1,529                                     | )      | (171 | ) | 910 |   | (930 | ) | (20 | ) |
| Total interest-bearing liabilities |   | 3,799                                       |   | (4,861                                     | )      | (1,062 | ) | 2,127 |   | (4,443 | ) | (2,316 | ) |
| Net interest income                |   | $                                           | 151    |                                       | $      | (597 | ) | $ | (446 | ) | $ | 1,310 |   | $ | (3,115 | ) | $ | (1,805 | ) |

 

----

* Income on tax exempt loans and investments have beenadjusted to a fully taxable equivalent basis using a 34% federal income taxrate.

 

32

----

 

Income and Expense Changes

 

The table below presents the consolidated comparativechanges in income and expense, and it reflects changes in average asset andliability volumes.  Tax-exempt income isnot shown on a tax equivalent basis.  The following table represents the three months ended September 30, 2003and 2002 and the nine months ended September 30, 2003 and 2002.

 
|                                                           |   | **Three Months Ended** |   | **Nine Months Ended** |   |
|----------------------------------------------------------------|--------|------------------------|--------|-----------------------|--------|
|                                                           |   | **Average  $ Change**  |   | **Volumes  % Change** |   | **Income/Expense** |   | **Average  $ Change** |   | **Volumes  % Change** |   | **Income/Expense** |   |
| **(In  Thousands)**                                            |   |                   |   | **$ Change**          |   | **% Change** |   |   |   | **$ Change** |   | **% Change** |   |
| Loans, net                                                     |   | $                      | 64,064 |                  | 10.68  | % | $ | 201 |   | 1.94 | % | $ | 64,078 |   | 11.16 | % | $ | 345 |   | 1.14 | % |
| Investment securities                                          |   | (6,836                 | )      | (2.85                 | )      | (1,593 | ) | (48.73 | ) | (18,932 | ) | (7.17 | ) | (4,204 | ) | (37.94 | ) |
| Interest-bearing deposits                                      |   | (5,426                 | )      | (26.51                | )      | (73 | ) | (77.66 | ) | (1,807 | ) | (10.94 | ) | (157 | ) | (58.36 | ) |
| Total interest-earning assets                                  |   | $                      | 51,802 |                  | 6.02   | % | $ | (1,465 | ) | (10.67 | )% | $ | 43,339 |   | 5.07 | % | $ | (4,016 | ) | (9.65 | )% |
|                                                           |   |                   |   |                  |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW Accounts                                                   |   | $                      | 17,751 |                  | 11.65  | % | $ | (253 | ) | (51.42 | )% | $ | 13,646 |   | 9.07 | % | $ | (534 | ) | (35.58 | )% |
| Insured Money Market  Accounts                                 |   | 4,828                  |   | 21.42                 |   | (52 | ) | (49.06 | ) | 5,522 |   | 25.51 |   | (56 | ) | (18.24 | ) |
| Savings deposits                                               |   | 9,839                  |   | 12.35                 |   | (190 | ) | (60.90 | ) | 8,278 |   | 10.76 |   | (430 | ) | (45.50 | ) |
| Time deposits                                                  |   | 29,383                 |   | 10.71                 |   | (361 | ) | (13.40 | ) | 15,555 |   | 5.66 |   | (1,322 | ) | (15.49 | ) |
| Short-term borrowings                                          |   | 5,783                  |   | 23.89                 |   | (18 | ) | (19.35 | ) | 15,120 |   | 68.87 |   | 86 |   | 36.44 |   |
| Subordinated debentures                                        |   | (789                   | )      | (4.01                 | )      | (17 | ) | (3.60 | ) | (725 | ) | (3.60 | ) | (40 | ) | (2.80 | ) |
| Other borrowed funds                                           |   | 23,570                 |   | 10.71                 |   | (171 | ) | (5.38 | ) | 15,819 |   | 7.15 |   | (20 | ) | (0.21 | ) |
| Total interest-bearing  liabilities                            |   | $                      | 90,366 |                  | 11.40  | % | $ | (1,062 | ) | (14.45 | )% | $ | 73,215 |   | 9.30 | % | $ | (2,316 | ) | (10.31 | )% |
|                                                           |   |                   |   |                  |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income                                            |   |                   |   |                  |   | $ | (403 | ) | (6.32 | )% |   |   |   |   | $ | (1,700 | ) | (8.88 | )% |
| Provision for loan and  lease losses                           |   |                   |   |                  |   | (45 | ) | (10.00 | ) |   |   |   |   | (45 | ) | (3.57 | ) |
| Net interest income after  provision for loan and lease losses |   |                   |   |                  |   | (358 | ) | (6.04 | ) |   |   |   |   | (1,655 | ) | (9.25 | ) |
| Service charges on deposit  accounts                           |   |                   |   |                  |   | 257 |   | 29.20 |   |   |   |   |   | 857 |   | 40.65 |   |
| Trust income                                                   |   |                   |   |                  |   | (51 | ) | (22.97 | ) |   |   |   |   | 30 |   | 5.33 |   |
| Net securities gains                                           |   |                   |   |                  |   | 694 |   | 23,133 |   |   |   |   |   | 3,051 |   | 2,134 |   |
| Investment sales                                               |   |                   |   |                  |   | 52 |   | 57.78 |   |   |   |   |   | (106 | ) | (30.29 | ) |
| Bank owned life insurance                                      |   |                   |   |                  |   | 127 |   | 67.91 |   |   |   |   |   | 563 |   | 143.26 |   |
| Insurance subsidiary                                           |   |                   |   |                  |   | 449 |   | 3,207 |   |   |   |   |   | 763 |   | 1,211 |   |
| Gain on sale of loans                                          |   |                   |   |                  |   | (3 | ) | (4.76 | ) |   |   |   |   | 228 |   | 167.65 |   |
| Leasing subsidiary                                             |   |                   |   |                  |   | 252 |   | N/A |   |   |   |   |   | 815 |   | N/A |   |
| Other income                                                   |   |                   |   |                  |   | 321 |   | 187.72 |   |   |   |   |   | 638 |   | 111.93 |   |
| Total other non-interest  income                               |   |                   |   |                  |   | 2,098 |   | 128.71 |   |   |   |   |   | 6,839 |   | 158.09 |   |
|                                                           |   |                   |   |                  |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Salaries and employee benefits                                 |   |                   |   |                  |   | 339 |   | 11.33 |   |   |   |   |   | 1,287 |   | 14.92 |   |
| Net occupancy expense                                          |   |                   |   |                  |   | 60 |   | 21.28 |   |   |   |   |   | 250 |   | 30.98 |   |
| Net furniture and equipment  expenses                          |   |                   |   |                  |   | 30 |   | 6.65 |   |   |   |   |   | 205 |   | 16.19 |   |
| Amortization of intangibles                                    |   |                   |   |                  |   | 51 |   | N/A |   |   |   |   |   | 89 |   | N/A |   |
| Other expenses                                                 |   |                   |   |                  |   | 1,024 |   | 53.14 |   |   |   |   |   | 3,049 |   | 57.72 |   |
| Total other non-interest  expense                              |   |                   |   |                  |   | 1,504 |   | 26.61 |   |   |   |   |   | 4,880 |   | 30.54 |   |
| Income before income tax  provision                            |   |                   |   |                  |   | 236 |   | 12.39 |   |   |   |   |   | 304 |   | 4.88 |   |
| Income tax provision                                           |   |                   |   |                  |   | 110 |   | 52.38 |   |   |   |   |   | (53 | ) | (5.08 | ) |
| Net income                                                     |   |                   |   |                  |   | $ | 126 |   | 7.43 | % |   |   |   |   | $ | 357 |   | 6.88 | % |

 

33

----

 

Non-interest Income

 

Non-interest income, excluding security gains,increased $1,404 or 86.3% to $3,031, for the three months ended September 30, 2003compared to the corresponding period of 2002. Increased service charges on deposits accounted for $257 of theincrease.  The increase in servicecharges was primarily the result of a program implemented during 2002 involvingoverdraft protection and the Steelton Bancorp acquisition.  The addition of bank owned life insuranceduring 2002 represented $127 of the increase. The bank owned life insurance was purchased to supplement futureincreases in employee benefit plan costs. Income from SunBank’s leasing subsidiary, Bank Capital ServicesCorporation, purchased in January 2003, generated $252 in additional fees. Inaddition, income from insurance fees increased $449, as the result of theacquisition of Mid-Penn Insurance in April 2003.  Income from investment product sales increased $52 as dollarsbegan to flow back into the stock/bond markets during the three-month periodended September 30, 2003.  Other incomeincreased $321 due to an increase in debit card interchange fees and rentalincome from operating leases. Trust income decreased $51 as the 2002 periodincluded nonrecurring estate fees.

 

Non-interest income, excluding security gains,increased $3,788 or 90.6% to $7,971 for the nine months ended September 30,2003 compared to the corresponding period of 2002.  The increases were driven by initiatives undertaken in 2002 andacquisitions in 2003, as noted in the above three-month discussion.

 
|                                 |   | **September 30, 2003** |   | **September 30, 2002** |   | **Change** |   |
|--------------------------------------|--------|------------------------|--------|------------------------|--------|------------|--------|
| **Three Months Ended**               |   | **Amount**             |   | **% Total**            |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Service charge on deposit accounts   |   | 1,137                  |   | 30.49                  | %      | 880        |   | 53.99 | % | 257 |   | 29.20 | % |
| Trust income                         |   | 171                    |   | 4.59                   | %      | 222        |   | 13.62 | % | (51 | ) | -22.97 | % |
| Net security gains                   |   | 697                    |   | 18.70                  | %      | 3          |   | 0.18 | % | 694 |   | 23133.33 | % |
| Income from investment product sales |   | 142                    |   | 3.81                   | %      | 90         |   | 5.52 | % | 52 |   | 57.78 | % |
| Bank owned life insurance            |   | 314                    |   | 8.42                   | %      | 187        |   | 11.47 | % | 127 |   | 67.91 | % |
| Income from insurance subsidiary     |   | 463                    |   | 12.42                  | %      | 14         |   | 0.86 | % | 449 |   | 3207.14 | % |
| Gain on sale of loans                |   | 60                     |   | 1.61                   | %      | 63         |   | 3.87 | % | (3 | ) | -4.76 | % |
| Income from leasing subsidiary       |   | 252                    |   | 6.76                   | %      | —     |   | 0.00 | % | 252 |   | N/A |   |
| Other income                         |   | 492                    |   | 13.20                  | %      | 171        |   | 10.49 | % | 321 |   | 187.72 | % |
| Total non-interest income            |   | 3,728                  |   | 100.00                 | %      | 1,630      |   | 100.00 | % | 2,098 |   | 128.70 | % |
|                                 |   |                   |   |                   |   |       |   |   |   |   |   |   |   |
|                                 |   | **September 30, 2003** |   | **September 30, 2002** |   | **Change** |   |
| **Nine Months Ended**                |   | **Amount**             |   | **% Total**            |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Service charge on deposit accounts   |   | 2,965                  |   | 26.56                  | %      | 2,108      |   | 48.73 | % | 857 |   | 40.65 | % |
| Trust income                         |   | 593                    |   | 5.31                   | %      | 563        |   | 13.01 | % | 30 |   | 5.33 | % |
| Net security gains                   |   | 3,194                  |   | 28.60                  | %      | 143        |   | 3.31 | % | 3,051 |   | 2133.57 | % |
| Income from investment product sales |   | 244                    |   | 2.19                   | %      | 350        |   | 8.09 | % | (106 | ) | -30.29 | % |
| Bank owned life insurance            |   | 956                    |   | 8.56                   | %      | 393        |   | 9.08 | % | 563 |   | 143.26 | % |
| Income from insurance subsidiary     |   | 826                    |   | 7.40                   | %      | 63         |   | 1.46 | % | 763 |   | 1211.11 | % |
| Gain on sale of loans                |   | 364                    |   | 3.26                   | %      | 136        |   | 3.14 | % | 228 |   | 167.65 | % |
| Income from leasing subsidiary       |   | 815                    |   | 7.30                   | %      | —     |   | 0.00 | % | 815 |   | N/A |   |
| Other income                         |   | 1,208                  |   | 10.82                  | %      | 570        |   | 13.18 | % | 638 |   | 111.93 | % |
| Total non-interest income            |   | 11,165                 |   | 100.00                 | %      | 4,326      |   | 100.00 | % | 6,839 |   | 158.10 | % |

 

34

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Non-interest Expenses

 

Non-interest expenses increased $1,504 or 26.61% to$7,155, for the three months ended September 30, 2003 compared to thecorresponding period of 2002.  Theacquisitions of Bank Capital, Mid-Penn Insurance, and Steelton Bancorp haveimpacted all categories of non-interest expense during 2003.  In the aggregate, Bank Capital and Mid PennInsurance represented $693 or 46.08% of the total increase.  The outsourcing of operational processingincreased expenses $160 or 10.64% of the total increase.  Salaries and employee benefits increased$339 or 11.33%, due to the acquisitions and increased employee benefit costs.  Net occupancy expense and furniture andequipment expenses increased $90 or 21.28% due to the acquisitions andinfrastructure improvements.  Otherexpenses increased 53.14% or $1,024 due to increases in normal businessexpenses, acquisitions, FHLB borrowing prepayment penalties, and theoutsourcing of operational processing (daily computer processing of the dayswork and associated reports) and certain other support functions.

 

Non-interest expenses increased $4,880 or 30.54% to$20,859 for the nine months ended September 30, 2003 as compared to 2002.  The increases were driven by initiativesundertaken in 2002 (i.e. operational outsourcing) and acquisitions in 2003, asnoted in the above three-month discussion.

 
|                             |   | **September 30, 2003** |   | **September 30, 2002** |   | **Change** |   |
|----------------------------------|--------|------------------------|--------|------------------------|--------|------------|--------|
| **Three Months Ended**           |   | **Amount**             |   | **% Total**            |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Salaries and employee benefits   |   | 3,330                  |   | 46.55                  | %      | 2,991      |   | 52.93 | % | 339 |   | 11.33 | % |
| Net occupancy expenses           |   | 342                    |   | 4.78                   | %      | 282        |   | 4.99 | % | 60 |   | 21.28 | % |
| Furniture and equipment expenses |   | 481                    |   | 6.72                   | %      | 451        |   | 7.98 | % | 30 |   | 6.65 | % |
| Amortization of intangibles      |   | 51                     |   | 0.71                   | %      | —     |   | 0.00 | % | 51 |   | N/A |   |
| Other expenses                   |   | 2,951                  |   | 41.24                  | %      | 1,927      |   | 34.10 | % | 1,024 |   | 53.14 | % |
| Total non-interest expense       |   | 7,155                  |   | 100.00                 | %      | 5,651      |   | 100.00 | % | 1,504 |   | 26.61 | % |
|                             |   |                   |   |                   |   |       |   |   |   |   |   |   |   |
|                             |   | **September 30, 2003** |   | **September 30, 2002** |   | **Change** |   |
| **Nine Months Ended**            |   | **Amount**             |   | **% Total**            |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Salaries and employee benefits   |   | 9,911                  |   | 47.51                  | %      | 8,624      |   | 53.97 | % | 1,287 |   | 14.92 | % |
| Net occupancy expenses           |   | 1,057                  |   | 5.07                   | %      | 807        |   | 5.05 | % | 250 |   | 30.98 | % |
| Furniture and equipment expenses |   | 1,471                  |   | 7.05                   | %      | 1,266      |   | 7.92 | % | 205 |   | 16.19 | % |
| Amortization of intangibles      |   | 89                     |   | 0.43                   | %      | —     |   | 0.00 | % | 89 |   | N/A |   |
| Other expenses                   |   | 8,331                  |   | 39.94                  | %      | 5,282      |   | 33.06 | % | 3,049 |   | 57.72 | % |
| Total non-interest expense       |   | 20,859                 |   | 100.00                 | %      | 15,979     |   | 100.00 | % | 4,880 |   | 30.54 | % |

 

35

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Capital Adequacy

 

Sun Bancorp and SunBank are subject to variousregulatory capital requirements administered by the federal bankingagencies.  Failure to meet minimumcapital requirements could prompt regulatory action that, if undertaken, mightmaterially affect Sun’s financial statements. Under regulatory capital adequacy guidelines, Sun Bancorp and SunBankmust meet specific capital requirements involving quantitative measures of assets,liabilities, and certain off-balance sheet items (calculated using regulatoryaccounting practices).  All relatedfactors are subject to qualitative judgments by the regulators.

 

Quantitative measures established by regulation toensure capital adequacy require the Bank to maintain minimum amounts and ratios(set forth in the table below) of total and Tier 1 capital (as defined in theregulations) to risk-weighted assets (as defined), and of Tier 1 capital (asdefined) to average assets (as defined). Management believes, as of September 30, 2003, that Sun Bancorp and theSunBank meet all capital adequacy requirements to which they are subject.

 

Sun is currently, and has been in the past, designateda well-capitalized institution. Shareholders’ equity decreased $2,232 to $79,015, at September 30, 2003,from $81,247, at December 31, 2002. Unrealized gains or losses, net of taxes on investment securities, arereported as accumulated other comprehensive income within shareholders’ equityare the cause of this decrease as accumulated other comprehensive incomedeclined $4,011 to $(433) from $3,578 at December 31, 2002.

 
|                        |   | **Actual** |   | **To Be Well Capitalized  Ratio** |   |
|-----------------------------|--------|------------|--------|-----------------------------------|--------|
| **(Dollars  in thousands)** |   | **Amount** |   | **Ratio**                         |   |
| As of September 30, 2003:   |   |       |   |                              |   |   |   |
| Total Risk-Based Capital    |   |       |   |                              |   |   |   |
| Sun Bancorp                 |   | $          | 73,213 |                              | 10.0   | % | 10.0 | % |
| SunBank                     |   | $          | 74,304 |                              | 10.2   | % | 10.0 | % |
| Tier I Risk-Based Capital   |   |       |   |                              |   |   |   |
| Sun Bancorp                 |   | $          | 63,618 |                              | 8.7    | % | 6.0 | % |
| SunBank                     |   | $          | 67,075 |                              | 9.2    | % | 6.0 | % |
| Leverage Ratio              |   |       |   |                              |   |   |   |
| Sun                         |   | $          | 63,618 |                              | 6.4    | % | 6.0 | % |
| SunBank                     |   | $          | 67,075 |                              | 6.7    | % | 6.0 | % |
|                        |   |       |   |                              |   |   |   |
| As of December 31, 2002:    |   |       |   |                              |   |   |   |
| Total Risk-Based Capital    |   |       |   |                              |   |   |   |
| Sun Bancorp                 |   | $          | 80,484 |                              | 12.6   | % | 10.0 | % |
| SunBank                     |   | $          | 77,175 |                              | 12.1   | % | 10.0 | % |
| Tier I Risk-Based Capital   |   |       |   |                              |   |   |   |
| Sun Bancorp                 |   | $          | 71,123 |                              | 11.1   | % | 6.0 | % |
| SunBank                     |   | $          | 70,969 |                              | 11.1   | % | 6.0 | % |
| Leverage Ratio              |   |       |   |                              |   |   |   |
| Sun Bancorp                 |   | $          | 71,123 |                              | 7.8    | % | 6.0 | % |
| SunBank                     |   | $          | 70,969 |                              | 7.9    | % | 6.0 | % |

 

36

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Liquidity

 

Management must ensure sufficient liquidity to meetcurrent and future business needs, including customer cash withdrawals and loanfundings. In addition, management must maintain additional contingencyliquidity sources to meet unexpected needs. Sun’s liquidity depends on itsability to acquire funds or convert assets to cash without material loss. Sun’sprimary liquidity sources include regular principal and interest payments onloans and securities, short-term securities, and various borrowing sources.Supplemental liquidity sources include longer-term securities, lines of credit,and additional sources for new deposits. Notably, management does not considercash and due from banks amounts to be liquidity sources. Those amounts aretypically needed by banks for daily operations.

 

Management believes that Sun has adequate financialresources to meet its ongoing cash requirements for operations and capitalexpenditures, as well as its other financial obligations.

 

Regulatory andIndustry Merger Activity

 

From time to time, various types of federal and statelegislation have been proposed that could result in additional regulation of,and restrictions on, the business of Sun and SunBank.  It cannot be predicted whether such legislation will be adoptedor, if adopted, how such legislation would affect the business of Sun.  As a consequence of the extensive regulationof commercial banking activities in the United States, Sun’s business isparticularly susceptible to being affected by federal legislation andregulations that may increase the costs of doing business.  Future legislation, rules or regulations ifimplemented, could have a material adverse effect upon the liquidity, capitalresources, or results of operations. The general cost of compliance withnumerous and multiple federal and state laws and regulations does have, and inthe future may have, a negative impact on Sun’s results of operations.

 

Further, the business of Sun is also affected by thestate of the financial services industry in general.  As a result of legal and industry changes, management expects theindustry to continue to experience an increase in consolidation as thefinancial services industry strives for greater cost efficiencies and firmsseek to gain market share.  Managementalso expects the financial services industry including Sun to increasediversification of financial products and services offered. Management believesthat industry consolidation and product and service diversification presentopportunities for Sun to enhance its competitive position.

 

37

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The following tables set forth Selected Financial Data for each of thepast five quarters:

 
|                                                |   | **Quarter  Ended (A)** |      |
|-----------------------------------------------------|--------|------------------------|-----------|
| **(Dollars in Thousands, Except Per Share Data)**   |   | **9/30/2003**          |      | **6/30/2003** |   | **3/31/2003** |   | **12/31/2002** |   | **9/30/2002** |   |
|                                                |   |                   |      |   |   |   |   |   |   |   |   |
| **Financial Condition  Data:**                      |   |                   |      |   |   |   |   |   |   |   |   |
| **General**                                         |   |                   |      |   |   |   |   |   |   |   |   |
| Total assets                                        |   | $                      | 1,033,293 |   | $ | 1,026,790 |   | $ | 1,004,753 |   | $ | 951,174 |   | $ | 949,563 |   |
| Loans, net                                          |   | 663,339                |      | 646,604 |   | 612,541 |   | 602,395 |   | 595,750 |   |
| Goodwill                                            |   | 32,337                 |      | 32,388 |   | 23,345 |   | 22,924 |   | 22,924 |   |
| Total deposits                                      |   | 651,512                |      | 648,429 |   | 598,067 |   | 587,480 |   | 601,843 |   |
| Non interest bearing                                |   | 66,118                 |      | 64,671 |   | 57,649 |   | 59,181 |   | 60,402 |   |
|                                                |   |                   |      |   |   |   |   |   |   |   |   |
| Savings                                             |   | 88,106                 |      | 89,806 |   | 81,321 |   | 76,712 |   | 79,588 |   |
| NOW                                                 |   | 170,001                |      | 163,018 |   | 156,649 |   | 155,114 |   | 157,806 |   |
| Money Market                                        |   | 26,726                 |      | 27,887 |   | 27,548 |   | 29,827 |   | 22,094 |   |
| Time Deposits                                       |   | 300,561                |      | 303,047 |   | 274,900 |   | 266,646 |   | 281,953 |   |
| Total interest bearing deposits                     |   | 585,394                |      | 583,758 |   | 540,418 |   | 528,299 |   | 541,441 |   |
|                                                |   |                   |      |   |   |   |   |   |   |   |   |
| Core deposits*                                      |   | 350,951                |      | 345,382 |   | 323,167 |   | 320,834 |   | 319,890 |   |
| Trust preferred securities &  subordinated debt |   | 18,866                 |      | 18,866 |   | 19,655 |   | 19,655 |   | 19,655 |   |
| Shareholders’ equity                           |   | 79,015                 |      | 81,037 |   | 80,035 |   | 81,247 |   | 81,868 |   |
| Trust assets under management                       |   | 148,144                |      | 148,156 |   | 151,065 |   | 157,667 |   | 158,155 |   |
|                                                |   |                   |      |   |   |   |   |   |   |   |   |
| **Asset Quality**                                   |   |                   |      |   |   |   |   |   |   |   |   |
|                                                |   |                   |      |   |   |   |   |   |   |   |   |
| Non-performing assets                               |   | $                      | 4,596     |   | $ | 4,592 |   | $ | 4,714 |   | $ | 4,115 |   | $ | 4,852 |   |
| Non-performing assets to total assets               |   | 0.44                   | %         | 0.45 | % | 0.47 | % | 0.43 | % | 0.51 | % |
| Allowance for loan losses                           |   | 7,229                  |      | 7,342 |   | 6,478 |   | 6,206 |   | 7,178 |   |
| Allowance for loan losses to total loans            |   | 1.08                   | %         | 1.12 | % | 1.05 | % | 1.02 | % | 1.19 | % |
| Allowance for loan losses to  non-performing loans  |   | 201.48                 | %         | 204.57 | % | 167.04 | % | 183.56 | % | 170.70 | % |
| Non-performing loans to total loans                 |   | 0.54                   | %         | 0.55 | % | 0.63 | % | 0.56 | % | 0.70 | % |
|                                                |   |                   |      |   |   |   |   |   |   |   |   |
| **Capitalization -  Bancorp**                       |   |                   |      |   |   |   |   |   |   |   |   |
|                                                |   |                   |      |   |   |   |   |   |   |   |   |
| Shareholders’ equity to total assets           |   | 7.65                   | %         | 7.89 | % | 7.97 | % | 8.54 | % | 8.62 | % |

 

----

*Core deposits are defined as total deposits less timedeposits

(A) 2002 quarters have been adjusted for SFAS No. 147impact.

 

38

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|                                               |   | **Quarter  Ended (A)** |   |
|----------------------------------------------------|--------|------------------------|--------|
| **(Dollars in Thousands,  Except Per Share Data)** |   | **9/30/2003**          |   | **6/30/2003** |   | **3/31/2003** |   | **12/31/2002** |   | **9/30/2002** |   |
|                                               |   |                   |   |   |   |   |   |   |   |   |   |
| **Operating Data**                                 |   |                   |   |   |   |   |   |   |   |   |   |
|                                               |   |                   |   |   |   |   |   |   |   |   |   |
| Net income                                         |   | $                      | 1,821  |   | $ | 1,690 |   | $ | 2,034 |   | $ | 1,228 |   | $ | 1,695 |   |
| Net interest income                                |   | 5,973                  |   | 5,924 |   | 5,548 |   | 5,750 |   | 6,376 |   |
| Provision for loan losses                          |   | 405                    |   | 405 |   | 405 |   | 200 |   | 450 |   |
| Non-interest income                                |   | 3,728                  |   | 3,547 |   | 3,890 |   | 2,342 |   | 1,630 |   |
| Non-interest expense                               |   | 7,155                  |   | 7,141 |   | 6,563 |   | 6,643 |   | 5,651 |   |
|                                               |   |                   |   |   |   |   |   |   |   |   |   |
| **Performance Statistics**                         |   |                   |   |   |   |   |   |   |   |   |   |
|                                               |   |                   |   |   |   |   |   |   |   |   |   |
| Net interest margin                                |   | 2.70                   | %      | 2.69 | % | 2.78 | % | 2.80 | % | 3.06 | % |
| Annualized return on average assets                |   | 0.70                   | %      | 0.66 | % | 0.84 | % | 0.51 | % | 0.73 | % |
| Annualized return on average equity                |   | 9.15                   | %      | 8.30 | % | 9.87 | % | 6.04 | % | 8.34 | % |
| Annualized net loan charge-offs to avg  loans      |   | 0.31                   | %      | 0.15 | % | 0.09 | % | 0.84 | % | 0.04 | % |
| Net charge-offs                                    |   | 517                    |   | 234 |   | 133 |   | 1,266 |   | 62 |   |
| Efficiency ratio                                   |   | 78.9                   |   | 83.7 |   | 82.6 |   | 87.2 |   | 70.6 |   |
| Net income per employee                            |   | 6                      |   | 6 |   | 7 |   | 4 |   | 6 |   |
|                                               |   |                   |   |   |   |   |   |   |   |   |   |
| **Per Share Data**                                 |   |                   |   |   |   |   |   |   |   |   |   |
|                                               |   |                   |   |   |   |   |   |   |   |   |   |
| Basic earnings per share                           |   | $                      | 0.25   |   | $ | 0.23 |   | $ | 0.28 |   | $ | 0.17 |   | $ | 0.24 |   |
| Diluted earnings per share                         |   | 0.25                   |   | 0.23 |   | 0.28 |   | 0.17 |   | 0.23 |   |
| Dividend declared per share                        |   | 0.1815                 |   | 0.1815 |   | 0.1650 |   | 0.1650 |   | 0.1650 |   |
| Book value                                         |   | 11.01                  |   | 11.24 |   | 11.17 |   | 11.33 |   | 11.43 |   |
| Common stock price:                                |   |                   |   |   |   |   |   |   |   |   |   |
| High                                               |   | 22.14                  |   | 22.48 |   | 20.50 |   | 23.20 |   | 23.98 |   |
| Low                                                |   | 17.80                  |   | 19.60 |   | 18.01 |   | 17.84 |   | 21.85 |   |
| Close                                              |   | 18.22                  |   | 20.13 |   | 19.51 |   | 18.26 |   | 22.48 |   |
| Weighted average common shares:                    |   |                   |   |   |   |   |   |   |   |   |   |
| Basic                                              |   | 7,189                  |   | 7,211 |   | 7,182 |   | 7,168 |   | 7,165 |   |
| Fully Diluted                                      |   | 7,214                  |   | 7,242 |   | 7,201 |   | 7,238 |   | 7,248 |   |
| End-of-period common shares:                       |   |                   |   |   |   |   |   |   |   |   |   |
| Issued                                             |   | 7,319                  |   | 7,319 |   | 7,317 |   | 7,299 |   | 7,276 |   |
| Treasury                                           |   | 141                    |   | 111 |   | 149 |   | 127 |   | 111 |   |

 

----

(A) 2002 quarters have been adjusted for SFAS No. 147 impact.

 

39

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Item 3 – Quantitative and Qualitative Disclosuresabout Market Risk

 

Market Risk

 

For Sun, market risk results predominantly frominterest rate risk and equity price risk. Although Sun’s market risks maychange in the future, management currently focuses its risk management effortson those two components.

 

Interest Rate Risk(IRR)

 

IRR represents the potential current or futureearnings and capital volatility due to interest rate changes. Interest ratefluctuations affect earnings by changing net interest income and otherinterest-sensitive income and expense levels. Interest rate changes affectcapital by altering banks’ economic value of equity (EVE). EVE represents thenet present value of all asset, liability, and off-balance sheet cash flows.Interest rate fluctuations change the present values of those cash flows.

 

As financial intermediaries, banks cannot completelyavoid IRR. However, excessive IRR can threaten earnings, capital, liquidity,and solvency. IRR has many components, including repricing risk, basis risk,yield curve risk, option risk, and price risk. Sun’s primary, but not sole, IRRsource is balance sheet optionality from residential mortgages andmortgage-backed securities. Those assets may prepay principal at changingspeeds depending on interest rate levels and other factors beyond Sun’scontrol. When prepayments occur, management must reinvest those cash flows atcurrent market rates (in loans or securities). Thus, future interest levels andpaths may negatively (or positively) affect Sun’s net interest income.

 

Sun seeks to minimize net interest income volatilityby carefully measuring, monitoring, and controlling IRR. Sun is implementing acomprehensive market risk management program to dramatically enhancemanagement’s ability to measure, monitor, and control risk. Market risk canresult in fluctuating net interest income due to interest rate and othereconomic changes. Using simulation models, Sun can measure market risk byforecasting net interest income volatility under various interest ratescenarios. However, these models depend on many significant assumptions thatmay not accurately reflect future conditions.

 

To minimize interest income volatility, on June 30,2003 Sun entered into four pay-variable receive-fixed interest rate swaps ($100,000notional total) to hedge changes in fair value of certain FHLB long-termborrowings (other borrowed funds).  Theswaps also contain an embedded option to reverse the swap to pay-fixedreceive-variable in the event that the FHLB long-term borrowings reprice andbecome variable rate.  The exercise ofthe option would effectively fix the rate Sun pays on the borrowings atapproximately the original coupon and would reduce the net interest incomevolatility caused in an increasing interest rate environment.  Sun includes all components of eachderivatives gain or loss in the assessment of hedge effectiveness.  Sun recognizes the change in fair value ofthe hedge and associated borrowings through the other income line item in theincome statement.  For the three andnine month periods ended September 30, 2003, there was a changes in value of$2,883 recognized in the hedge or associated borrowing.  A summary of Sun’s fair values hedgesappears below.

 

40

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|                                              |   |                 |    |      |       |          |       | **Weighted Average** |       |
|---------------------------------------------------|--------|----------------------|---------|-----------|------------|---------------|------------|----------------------|------------|
| **(In Thousands)**                                |   | **Notional  Amount** |    | **Asset** | ** ** | **Liability** | ** ** | **Receive  Rate**    | ** ** | **Pay  Rate** | ** ** | **Life  (Years)** |   |
| Fair Value Hedges:                                |   |                 |    |      |       |          |       |                 |       |   |   |   |   |
| Receive fixed - pay variable interest  rate swaps |   | $                    | 100,000 |      | $          | 2,883         |       | $                    | —     |   | 2.65 | % | 1.16 | % | 6.5 |   |
|                                                   |        |                      |         |           |            |               |            |                      |            |  |  |  |  |  |  |  |

 

Rate Shock at September 30, 2003:

 
|                      |   | **Parallel rate shock in  basis points (bp)** |   |
|---------------------------|--------|-----------------------------------------------|--------|
| **(In Thousands)**        |   | **-100bp**                                    |   | **0bp** |   | **+100bp** |   | **+200bp** |   | **+300bp** |   |
| Net interest income:      |   | $                                             | 21,657 |   | $ | 22,907 |   | $ | 23,231 |   | $ | 23,242 |   | $ | 23,110 |   |
| Percent change from flat: |   | -5.46                                         | %      | 0.00 | % | 1.41 | % | 1.46 | % | 0.89 | % |
|                           |        |                                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Equity Securities Risk

 

Sun’s equity securities consist of marketable equitiesand restricted stock.  Marketableequities consist entirely of common stock of bank and financial holdingcompanies.   Because Federal Home LoanBank stock is redeemable at par, Sun carries it at cost and periodicallyevaluates the stock for impairment. Possible impairment factors include potential dramatic changes to thehousing and residential mortgage industry or the related regulatoryenvironment.  Management currently doesnot believe any factors exist to suggest potential impairment.

 

Bank and financial holding company stocks are subjectto general industry risks, including competition from non-bank entities, creditrisk, interest rate risk, and other factors. Individual stocks could suffer price decreases due to circumstances atspecific banks.  In addition, Sun’s bankstock investments are concentrated in Pennsylvania entities, so theseinvestments could decline in value if there were a downturn in the state’seconomy.

 
|                                            |   | **September 30, 2003** |   |
|-------------------------------------------------|--------|------------------------|--------|
| **(In Thousands)**                              |   | **Book  Cost**         |   | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
| Banks and bank and financial holding  companies |   | $                      | 330    |   | $ | — |   | $ | — |   | $ | 330 |   |
| FHLB stock                                      |   | 13,618                 |   | — |   | — |   | 13,618 |   |
| Non-bank companies                              |   | —                 |   | — |   | — |   | — |   |
| Total                                           |   | $                      | 13,948 |   | $ | — |   | $ | — |   | $ | 13,948 |   |
|                                            |   |                   |   |   |   |   |   |   |   |
|                                            |   | **December 31, 2002**  |   |
|                                            |   | **Book  Cost**         |   | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair  Value** |   |
| Banks and bank and financial holding  companies |   | $                      | 3,035  |   | $ | 136 |   | $ | (293 | ) | $ | 2,878 |   |
| FHLB stock                                      |   | 12,012                 |   | — |   | — |   | 12,012 |   |
| Non-bank companies                              |   | 87                     |   |   |   | (22 | ) | 65 |   |
| Total                                           |   | $                      | 15,134 |   | $ | 136 |   | $ | (315 | ) | $ | 14,955 |   |

 

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Reference is also made to Item 7A. Quantitative and Qualitative DisclosureAbout Market Risk in Sun’s Annual Report on Form 10-K for the year 2002.

 

Item 4 – Controls and Procedures

 

Management maintains asystem of controls and procedures designed to provide reasonable assurance asto the reliability of the financial statements and other disclosures includedin this report, as well as to safeguard assets from unauthorized use ordisposition.  An evaluation was carriedout under the supervision and with the participation of the Sun’s management,including the Chief Executive Officer (“CEO”) and Chief Financial Officer(“CFO”), of the effectiveness of Sun’s disclosure controls and procedures as ofthe end of the period covered by this report.  Based on that evaluation,Sun’s management, including the CEO and CFO, has concluded that Sun’sdisclosure controls and procedures are effective.  No significant changes were made to Sun’s internal controls orother factors that could significantly affect these controls subsequent to thedate of their evaluation.

 

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SUN BANCORP, INC.

FORM 10-Q

PART II

 

Items 1, 2, 3, 4, and 5 – Omitted pursuant to instructions to Part II

 

Item 6 – Exhibits and Reports on Form 8-K

 
| a.     |   | On July 1, 2003, Sun Bancorp, Inc. filed a Current  Report on Form 8-K announcing an Employment Agreement between Wilmer D.  Leinbach, the Registrant, SunBank, and SUBI Services, dated January 28, 2003.                                                                                                                                                                                 |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                       |
| b.     |   | On July 17, 2003 Sun Bancorp, Inc. filed a Current  Report on Form 8-K announcing the operating results for the three and six  months ended June 30, 2003.                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                       |
| c.     |   | On August 27, 2003 Sun filed a Current Report on  Form 8-K announcing the election of John W. Rose to the Sun Bancorp, Inc. and  SunBank Board of Directors, H. David Padden to the Sun Bancorp, Inc. Board of  Directors, Amanda G. Kessler to the SunBank Board of Directors, and the  resignation of Gary L. Tice from the Sun Bancorp, Inc. and SunBank  Board of Directors. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                       |
| d.     |   | On September 19, 2003 Sun filed a Current Report on  Form 8-K announcing that James P. Radick had joined SunBank as a Senior Vice  President of Finance.                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                       |
| e.     |   | Exhibits                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   | 3(i)                                                                                                                                                                                                                                                                                                                                                                                       | The Articles of  Incorporation of the Registrant (Incorporated herein by reference to Exhibit  3(i) to the Registrant’s Current Report on Form 8-K filed with the Commission  on July 1, 2003). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                       |   |
|   |   | 3(ii)                                                                                                                                                                                                                                                                                                                                                                                      | The By-Laws, as  amended and restated (Incorporated herein by reference to Exhibit 3 to the  Registrant’s Current Report on Form 8-K filed with the Securities and  Exchange Commission on March 20, 2003). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                       |   |
|   |   | 10.1                                                                                                                                                                                                                                                                                                                                                                                       | Employment Agreement  between Robert J. McCormack, the Registrant and SunBank dated October 31,  2002.  (Incorporated by reference to  Exhibit 10.1 to the Registrant’s Current Report on Form 8-K filed with the  Commission on March 20, 2003). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                       |   |
|   |   | 10.2                                                                                                                                                                                                                                                                                                                                                                                       | Employment Agreement  between Thomas W. Bixler, the Registrant and SunBank dated November 3,  2002.  (Incorporated by reference to  Exhibit 10.2 to the Registrant’s Current Report on Form 8-K filed with the  Commission on March 20, 2003). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                       |   |
|   |   | 10.3                                                                                                                                                                                                                                                                                                                                                                                       | Employment  Agreement between Sandra Miller, the Registrant and SunBank dated October 24,  2002.  (Incorporated by reference to  Exhibit 10.3 to the Registrant’s Current Report on Form 8-K filed with the  Commission on March 20, 2003). |

 

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|   |   | 10.4   | Change of  Control Agreement between Maureen M. Bufalino, the Registrant and SunBank,  dated May 31, 2001.  (Incorporated by  reference to Exhibit 10.4 to the Registrant’s Current Report on Form 8-K  filed with the Commission on March 20, 2003). |
|--------|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 10.5   | Employment  Agreement between Wilmer D. Leinbach, the Registrant and SunBank dated  January 28, 2003.  (Incorporated by  reference to Exhibit 10.5 to the Registrant’s Current Report on Form 8-K  filed with the Commission on July 1, 2003).        |
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 10.6   | 1998 Stock  Incentive Plan.  (Incorporated by  reference to Exhibit 4.3 of Registration Statement No. 333-61237 on Form S-8  filed with the Commission on August 12, 1998).                                                                                |
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 10.7   | 1998 Independent  Directors Stock Option Plan.   (Incorporated by reference to Exhibit 4.3 of Registration Statement  No. 333-61241 on Form S-8 filed with the Commission on August 12, 1998).                                                             |
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 10.8   | 1998 Employee  Stock Purchase Plan.  (Incorporated by  reference to Exhibit 4.3 of Registration Statement No. 333-61249 on Form S-8  filed with the Commission on August 12, 1998).                                                                        |
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 11     | Statement re:  Computation of Earnings Per Share can be referenced in Note 7 of the  Consolidated Statements in this Report                                                                                                                                     |
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 31.1   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                       |
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 31.2   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                       |
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 32.1   | Certification of  principal executive officer or principal financial officer pursuant to 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                        |
|   |   |   |                                                                                                                                                                                                                                                            |
|   |   | 32.2   | Certification of  principal executive officer or principal financial officer pursuant to 18  U.S.C. Section 1350, as adopted pursuent to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                        |

 

44

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SIGNATURES

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|   |              | Sun Bancorp, Inc.                                                     |
|--------|-------------------|-----------------------------------------------------------------------|
|   |              |                                                                  |
| Date   | November 14, 2003 |                                                                  | /s/  Robert J. McCormack |
|   |              | Robert J. McCormack                                                   |
|   |              | President and Chief  Executive Officer  (Principal Executive Officer) |
|   |              |                                                                  |
|   |              |                                                                  |
|   |              | /s/  Wilmer D. Leinbach                                          |
|   |              | Wilmer D. Leinbach                                                    |
|   |              | Chief Financial Officer  (Principal Financial Officer)                |
|        |                   |                                                                       |  |

 

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