** **

**FORM 10-Q—QUARTERLY REPORT UNDER SECTION 13OR 15 (d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

 

| **ý****Quarterly Report  Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                                                       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **For the quarterly period ended March 31,  2004**                                                                                                                                                                                                                           |
|                                                                                                                                                                                                                                                                         |
| **or**                                                                                                                                                                                                                                                                       |
|                                                                                                                                                                                                                                                                         |
| **o****Transition Report  Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                                                           |
| **For the transition period from                                          to** |
|                                                                                                                                                                                                                                                                         |
| **Commission File Number: 0-14745**                                                                                                                                                                                                                                          |

 

| **Sun  Bancorp, Inc.**                                                              |
|-------------------------------------------------------------------------------------|
| (Exact name of registrant as 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 whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.

Yes  ý    No  o

 

Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Act)

Yes  ý    No  o

 

APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCYPROCEEDINGS DURING THE PRECEDING FIVE YEARS:

 

Indicate by check mark whetherthe registrant has filed all documents and reports required to be filed bySections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent tothe distribution of securities under a plan confirmed by a court.

Yes  o    No  o

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of Common Stock, as of the latestpracticable date.

 

| Common Stock, No Par Value |   | 7,684,848                            |
|----------------------------|--------|--------------------------------------|
| Class                      |   | Outstanding Shares At April 23, 2004 |

 

 

----

 

SUN BANCORP, INC.

FORM 10-Q

FOR THE QUARTER ENDED MARCH 31,2004

 
| CONTENTS                                                                                              |                                                                                                           |   |
|-------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                  |                                                                                                           |
| PART I - FINANCIAL INFORMATION                                                                        |                                                                                                           |   |
|                                                                                                  |                                                                                                           |   |
| Item 1 - Financial Statements:                                                                        |                                                                                                           |
|                                                                                                  |                                                                                                           |   |
|                                                                                                  | Consolidated Balance Sheet as of March 31, 2004 (Unaudited) and  December 31, 2003                             |   |
|                                                                                                  | Consolidated Statement of Income for the  Three Months Ended March 31, 2004 and March 31, 2003 (Unaudited)     |   |
|                                                                                                  | Consolidated Statement of Cash Flows for  the Three Months Ended March 31, 2004 and March 31, 2003 (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.

CONSOLIDATEDBALANCE SHEET

 
|                                                             |   | **(Unaudited)**     |      |                   |   |
|------------------------------------------------------------------|--------|---------------------|-----------|------------------------|--------|
| **(In  Thousands, Except Share Data)**                           |   | **March 31,  2004** |      | **December  31, 2003** |   |
|                                                             |   |                |      |                   |   |
| ASSETS                                                           |   |                |      |                   |   |
|                                                             |   |                |      |                   |   |
| Cash and due from other financial  institutions                  |   | $                   | 22,905    |                   | $      | 27,021 |   |
| Interest-bearing deposits in other  financial institutions       |   | 1,393               |      | 1,400                  |   |
| Total cash and cash equivalents                                  |   | 24,298              |      | 28,421                 |   |
|                                                             |   |                |      |                   |   |
| Investment securities, available for sale,  at fair market value |   | 213,988             |      | 223,209                |   |
|                                                             |   |                |      |                   |   |
| Loans and leases, net of unearned income                         |   | 684,226             |      | 679,977                |   |
| Less: allowance for loan and lease losses                        |   | 8,435               |      | 7,754                  |   |
| Loans and leases, net                                            |   | 675,791             |      | 672,223                |   |
|                                                             |   |                |      |                   |   |
| Bank premises and equipment, net                                 |   | 31,823              |      | 27,256                 |   |
| Goodwill                                                         |   | 36,163              |      | 29,848                 |   |
| Intangibles with finite lives                                    |   | 5,610               |      | 3,690                  |   |
| Intangibles, other                                               |   | 147                 |      | —                 |   |
| Accrued interest                                                 |   | 3,376               |      | 3,378                  |   |
| Bank-owned life insurance                                        |   | 33,485              |      | 33,174                 |   |
| Other assets                                                     |   | 12,537              |      | 7,054                  |   |
| Total assets                                                     |   | $                   | 1,037,218 |                   | $      | 1,028,253 |   |

 

3

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SUN BANCORP, INC.

CONSOLIDATED BALANCE SHEET

 
|                                                                                                                     |   | **(Unaudited)**     |      |                   |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|---------------------|-----------|------------------------|--------|
| **(In  Thousands, Except Share Data)**                                                                                   |   | **March 31,  2004** |      | **December  31, 2003** |   |
|                                                                                                                     |   |                |      |                   |   |
| LIABILITIES & SHAREHOLDERS’ EQUITY                                                                              |   |                |      |                   |   |
|                                                                                                                     |   |                |      |                   |   |
| Deposits                                                                                                                 |   |                |      |                   |   |
| Non-interest-bearing                                                                                                     |   | $                   | 69,794    |                   | $      | 69,640 |   |
| Interest-bearing                                                                                                         |   | 577,811             |      | 544,910                |   |
| Total deposits                                                                                                           |   | 647,605             |      | 614,550                |   |
|                                                                                                                     |   |                |      |                   |   |
| Short-term borrowings                                                                                                    |   | 26,788              |      | 65,388                 |   |
| Long-term borrowings, Federal Home Loan  Bank                                                                            |   | 229,000             |      | 226,236                |   |
| Long-term borrowings, other                                                                                              |   | 11,900              |      | 11,900                 |   |
| Subordinated debentures                                                                                                  |   | 18,866              |      | 18,866                 |   |
| Accrued interest and other liabilities                                                                                   |   | 13,520              |      | 12,131                 |   |
| Total liabilities                                                                                                        |   | 947,679             |      | 949,071                |   |
|                                                                                                                     |   |                |      |                   |   |
| Commitments and contingencies (note 10)                                                                                  |   |                |      |                   |   |
|                                                                                                                     |   |                |      |                   |   |
| Shareholders’ equity:                                                                                               |   |                |      |                   |   |
|                                                                                                                     |   |                |      |                   |   |
| Common stock, no par value; 50,000,000  authorized shares: issued 7,678,925 shares in 2004 and 7,320,225 shares in  2003 |   | 92,173              |      | 85,386                 |   |
| Retained earnings (deficit)                                                                                              |   | (3,613              | )         | (3,728                 | )      |
| Accumulated other comprehensive income, net  of taxes                                                                    |   | 979                 |      | 29                     |   |
| Less:   Treasury stock, at cost, 140,922 shares in 2003                                                             |   | —              |      | (2,505                 | )      |
| Total shareholders’ equity                                                                                          |   | 89,539              |      | 79,182                 |   |
| Total liabilities and shareholders’ equity                                                                          |   | $                   | 1,037,218 |                   | $      | 1,028,253 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

4

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SUN BANCORP, INC.

CONSOLIDATEDSTATEMENT OF INCOME

(UNAUDITED)

 
|                                                            |   | **For the  Three Months  Ended March 31,** |   |
|-----------------------------------------------------------------|--------|--------------------------------------------|--------|
| **(In  Thousands, Except Share Data)**                          |   | **2004**                                   |   | **2003** |   |
| Interest and dividend income:                                   |   |                                       |   |   |   |
| Loans and leases, including fees                                |   | $                                          | 9,892  |   | $ | 9,695 |   |
| Investment securities                                           |   |                                       |   |   |   |
| Taxable                                                         |   | 1,729                                      |   | 2,299 |   |
| Tax-exempt                                                      |   | 203                                        |   | 231 |   |
| Dividends                                                       |   | 46                                         |   | 111 |   |
| Deposits in other financial institutions                        |   | 13                                         |   | 52 |   |
|                                                            |   |                                       |   |   |   |
| Total interest and dividend income                              |   | 11,883                                     |   | 12,388 |   |
|                                                            |   |                                       |   |   |   |
| Interest expense:                                               |   |                                       |   |   |   |
| Deposits                                                        |   | 2,347                                      |   | 3,127 |   |
| Short-term borrowings                                           |   | 90                                         |   | 107 |   |
| Long-term borrowings                                            |   | 2,901                                      |   | 3,138 |   |
| Subordinated debentures                                         |   | 456                                        |   | 468 |   |
|                                                            |   |                                       |   |   |   |
| Total interest expense                                          |   | 5,794                                      |   | 6,840 |   |
|                                                            |   |                                       |   |   |   |
| Net interest income                                             |   | 6,089                                      |   | 5,548 |   |
|                                                            |   |                                       |   |   |   |
| Provision for loan and lease losses                             |   | 435                                        |   | 405 |   |
|                                                            |   |                                       |   |   |   |
| Net interest income, after provision for loan  and lease losses |   | $                                          | 5,654  |   | $ | 5,143 |   |

 

5

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|                                           |   | **For the  Three Months  Ended March 31,** |   |
|------------------------------------------------|--------|--------------------------------------------|--------|
| **(In Thousands, Except Share Data)**          |   | **2004**                                   |   | **2003** |   |
| Non-interest income:                           |   |                                       |   |   |   |
| Service charges on deposit accounts            |   | $                                          | 1,039  |   | $ | 845 |   |
| Trust income                                   |   | 332                                        |   | 219 |   |
| Net securities gains                           |   | 109                                        |   | 1,496 |   |
| Investment product sales                       |   | 165                                        |   | 24 |   |
| Bank-owned life insurance                      |   | 312                                        |   | 325 |   |
| Insurance subsidiary                           |   | 661                                        |   | 23 |   |
| Net gain on sale of loans                      |   | 34                                         |   | 261 |   |
| Leasing fees                                   |   | 272                                        |   | 301 |   |
| Other income                                   |   | 671                                        |   | 396 |   |
|                                           |   |                                       |   |   |   |
| Total non-interest income                      |   | 3,595                                      |   | 3,890 |   |
|                                           |   |                                       |   |   |   |
| Non-interest expense:                          |   |                                       |   |   |   |
| Salaries and employee benefits                 |   | 3,493                                      |   | 3,166 |   |
| Net occupancy expenses                         |   | 438                                        |   | 383 |   |
| Furniture and equipment expenses               |   | 530                                        |   | 487 |   |
| Amortization of intangibles with finite  lives |   | 108                                        |   | — |   |
| Other expenses                                 |   | 2,950                                      |   | 2,527 |   |
|                                           |   |                                       |   |   |   |
| Total non-interest expense                     |   | 7,519                                      |   | 6,563 |   |
|                                           |   |                                       |   |   |   |
| Income before income tax provision             |   | 1,730                                      |   | 2,470 |   |
|                                           |   |                                       |   |   |   |
| Income tax provision                           |   | 221                                        |   | 436 |   |
|                                           |   |                                       |   |   |   |
| Net income                                     |   | $                                          | 1,509  |   | $ | 2,034 |   |
|                                           |   |                                       |   |   |   |
| Net income per share - Basic                   |   | $                                          | 0.21   |   | $ | 0.28 |   |
|                                           |   |                                       |   |   |   |
| Net income per share - Diluted                 |   | $                                          | 0.21   |   | $ | 0.28 |   |
|                                           |   |                                       |   |   |   |
| Dividends  declared                            |   | $                                          | 0.1815 |   | $ | 0.1650 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

6

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SUN BANCORP, INC.FORM 10-QPART I

 

Item 1. Financial Statements

 

SUN BANCORP, INC.CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY(UNAUDITED)

 
|                                                                                                    |   |              |       |         |       |              |       | **Accumulated**  |       |                   |       |       |       |
|---------------------------------------------------------------------------------------------------------|--------|-------------------|------------|--------------|------------|-------------------|------------|------------------|------------|------------------------|------------|------------|------------|
|                                                                                                    |   |              |       |         |       | **Retained**      |       | **Other**        |       |                   |       | **Total**  |       |
|                                                                                                    |   | **Common  Stock** |       | **Earnings** |       | **Comprehensive** |       | **Treasury**     |       | **Shareholders’** |       |
| **(In Thousands**                                                                                       |   | **Shares**        |       | **Amount**   |       | **(Deficit)**     |       | **Income(Loss)** |       | **Stock**              |       | **Equity** |       |
| **Balance, December 31, 2003**                                                                          |   | **7,320**         | ** ** | **$**        | **85,386** | ** **        | **$**      | **(3,728**       | **)**      | **$**                  | **29**     | ** ** | **$**      | **(2,505** | **)** | **$** | **79,182** | ** ** |
| **Comprehensive income:**                                                                               |   |              | ** ** |         | ** ** |              | ** ** |             | ** ** |                   | ** ** |       | ** ** |
| Net income                                                                                              |   | **—**        | ** ** | **—**   | ** ** | **1,509**         | ** ** | **—**       | ** ** | **—**             | ** ** | **1,509**  | ** ** |
| Unrealized gains on securities available  for sale, net of reclassification adjustments and tax effects |   | **—**        | ** ** | **—**   | ** ** | **—**        | ** ** | **950**          | ** ** | **—**             | ** ** | **950**    | ** ** |
| **Total comprehensive income**                                                                          |   |              | ** ** |         | ** ** |              | ** ** |             | ** ** |                   | ** ** | **2,459**  | ** ** |
|                                                                                                    |   |              | ** ** |         | ** ** |              | ** ** |             | ** ** |                   | ** ** |       | ** ** |
| Stock issued:                                                                                           |   |              | ** ** |         | ** ** |              | ** ** |             | ** ** |                   | ** ** |       | ** ** |
| Employee benefit plans                                                                                  |   | **—**        | ** ** | **2**        | ** ** | **—**        | ** ** | **—**       | ** ** | **—**             | ** ** | **2**      | ** ** |
| Purchase of Sentry Trust Company (141  treasury shares)                                                 |   | **359**           | ** ** | **6,785**    | ** ** | **—**        | ** ** | **—**       | ** ** | **2,505**              | ** ** | **9,290**  | ** ** |
| Cash dividends declared, $.1815 per share                                                               |   | **—**        | ** ** | **—**   | ** ** | **(1,394**        | **)**      | **—**       | ** ** | **—**             | ** ** | **(1,394** | **)**      |
| **Balance, March 31, 2004**                                                                             |   | **7,679**         | ** ** | **$**        | **92,173** | ** **        | **$**      | **(3,613**       | **)**      | **$**                  | **979**    | ** ** | **$**      | **—** | ** ** | **$** | **89,539** | ** ** |

 
|                                                                                                    |   |              |       |         |       |              |       | **Accumulated**  |       |                   |       |       |       |
|---------------------------------------------------------------------------------------------------------|--------|-------------------|------------|--------------|------------|-------------------|------------|------------------|------------|------------------------|------------|------------|------------|
|                                                                                                    |   |              |       |         |       | **Retained**      |       | **Other**        |       |                   |       | **Total**  |       |
|                                                                                                    |   | **Common  Stock** |       | **Earnings** |       | **Comprehensive** |       | **Treasury**     |       | **Shareholders’** |       |
|                                                                                                    |   | **Shares**        |       | **Amount**   |       | **(Deficit)**     |       | **Income(Loss)** |       | **Stock**              |       | **Equity** |       |
| Balance, December 31, 2002                                                                              |   | 7,299             |       | $            | 84,591     |              | $          | (5,159           | )          | $                      | 3,578      |       | $          | (1,763 | ) | $ | 81,247 |   |
| **Comprehensive income:**                                                                               |   |              |       |         |       |              |       |             |       |                   |       |       |       |
| Net income                                                                                              |   | **—**        | ** ** | **—**   | ** ** | **2,034**         | ** ** | **—**       | ** ** | **—**             | ** ** | **2,034**  | ** ** |
| Unrealized gains on securities available  for sale, net of reclassification adjustments and tax effects |   | **—**        | ** ** | **—**   | ** ** | **—**        | ** ** | **(1,855**       | **)**      | **—**             | ** ** | **(1,855** | **)**      |
| **Total comprehensive income**                                                                          |   |              | ** ** |         | ** ** |              | ** ** |             | ** ** |                   | ** ** | **179**    | ** ** |
| Stock issued:                                                                                           |   |              | ** ** |         | ** ** |              | ** ** |             | ** ** |                   | ** ** |       | ** ** |
| Employee benefit plans                                                                                  |   | **18**            | ** ** | **342**      | ** ** | **—**        | ** ** | **—**       | ** ** | **—**             | ** ** | **342**    | ** ** |
| Purchase of treasury stock  (95 shares)                                                                 |   | **—**        | ** ** | **—**   | ** ** | **—**        | ** ** | **—**       | ** ** | **(547**               | **)**      | **(547**   | **)**      |
| Cash dividends declared,  $.165 per share                                                               |   | **—**        | ** ** | **—**   | ** ** | **(1,186**        | **)**      | **—**       | ** ** | **—**             | ** ** | **(1,186** | **)**      |
| **Balance, March 31, 2003**                                                                             |   | **7,317**         | ** ** | **$**        | **84,933** | ** **        | **$**      | **(4,311**       | **)**      | **$**                  | **1,723**  | ** ** | **$**      | **(2,310** | **)** | **$** | **80,035** | ** ** |

 

 

7

----

 

 

SUN BANCORP, INC.

CONSOLIDATEDSTATEMENT OF CASH FLOWS

(UNAUDITED)

 
|                                                                                             |   | **For the  Three Months  Ended March 31,** |   |
|--------------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                             |   | **2004**                                   |   | **2003** |   |
| Cash flows from operating activities:                                                            |   |                                       |   |   |   |
| Net income                                                                                       |   | $                                          | 1,509  |   | $ | 2,034 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities:     |   |                                       |   |   |   |
| Provision for loan and lease losses                                                              |   | 435                                        |   | 405 |   |
| Depreciation                                                                                     |   | 381                                        |   | 257 |   |
| Amortization of intangibles                                                                      |   | 56                                         |   | — |   |
| Amortization and accretion of premium and  discounts on investment securities available for sale |   | 278                                        |   | 263 |   |
| Net gain on sale of investment securities  available for sale                                    |   | (109                                       | )      | (1,496 | ) |
| Proceeds from loan sales                                                                         |   | 2,221                                      |   | 10,427 |   |
| Mortgage loans orginated for resale                                                              |   | (2,112                                     | )      | (10,620 | ) |
| Net gain on sale of loans                                                                        |   | 34                                         |   | 261 |   |
| Decrease in other assets and liabilities,  net                                                   |   | (2,523                                     | )      | (5,872 | ) |
| Net cash provided by (used in) operating  activities                                             |   | 170                                        |   | (4,341 | ) |
|                                                                                             |   |                                       |   |   |   |
| Cash flows from investing activities:                                                            |   |                                       |   |   |   |
| Proceeds from sales of investment  securities available for sale                                 |   | 38,247                                     |   | 37,782 |   |
| Proceeds from maturities, calls, and  prepayments of investment securities available for sale    |   | 9,822                                      |   | 24,814 |   |
| Purchases of investment securities  available for sale                                           |   | (32,993                                    | )      | (123,902 | ) |
| Net cash used in acquisitions                                                                    |   | (5,888                                     | )      | (36 | ) |
| Net increase in loans and leases                                                                 |   | (4,146                                     | )      | (6,115 | ) |
| Capital expenditures                                                                             |   | (2,398                                     | )      | (974 | ) |
| Net cash provided by (used in) investing  activities                                             |   | 2,644                                      |   | (68,431 | ) |
|                                                                                             |   |                                       |   |   |   |
| Cash flows from financing activities:                                                            |   |                                       |   |   |   |
| Net increase in deposits                                                                         |   | 33,055                                     |   | 10,587 |   |
| Net (decrease) increase in short-term  borrowings                                                |   | (38,600                                    | )      | 36,675 |   |
| Proceeds from long-term borrowings, other                                                        |   | —                                     |   | 11,900 |   |
| Cash dividends paid                                                                              |   | (1,394                                     | )      | (1,186 | ) |
| Proceeds from sale of stock for employee  benefits program                                       |   | 2                                          |   | 221 |   |
| Purchase of treasury stock                                                                       |   | —                                     |   | (898 | ) |
| Net cash (used in) provided by financing  activities                                             |   | (6,937                                     | )      | 57,299 |   |
|                                                                                             |   |                                       |   |   |   |
| Net decrease in cash and cash equivalents                                                        |   | (4,123                                     | )      | (15,473 | ) |
| Cash and cash equivalents at beginning of  period                                                |   | 28,421                                     |   | 41,569 |   |
| Cash and cash equivalents at end of period                                                       |   | $                                          | 24,298 |   | $ | 26,096 |   |

 

8

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|                                               |   | **For the  Three Months  Ended March 31,** |   |
|----------------------------------------------------|--------|--------------------------------------------|--------|
| **(In Thousands)**                                 |   | **2004**                                   |   | **2003** |   |
|                                               |   |                                       |   |   |   |
| Supplemental disclosure of cash flow  information: |   |                                       |   |   |   |
|                                               |   |                                       |   |   |   |
| Cash paid during the period for:                   |   |                                       |   |   |   |
|                                               |   |                                       |   |   |   |
| Interest                                           |   | $                                          | 6,210  |   | $ | 7,199 |   |
|                                               |   |                                       |   |   |   |
| Income taxes                                       |   | —                                     |   | — |   |
|                                                    |        |                                            |        |  |  |  |  |

 

Loans with an estimated value of $147 were reclassified to foreclosedassets held for sale during the three-month period ended March 31, 2003 with noloans reclassified during the three-month period ended March 31, 2004.

 

The accompanying notes are an integral part of these financialstatements.

 

9

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SUN BANCORP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

Note 1 — Basis of InterimPresentation

 

Theconsolidated financial statements include the accounts of Sun Bancorp, Inc.(“Sun”), the parent company, and its wholly-owned subsidiaries: SunBank,Mid-Penn Insurance Associates, Inc., Sentry Trust Company, 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 financialstatements.  The parent and subsidiariesare reported as one unit within the financial statements.  All significant intercompany balances andtransactions have been eliminated in consolidation.

 

Theaccompanying unaudited consolidated financial statements for the interimperiods do not include all of the information and footnotes required bygenerally accepted accounting principles. These statements should be read in conjunction with the notes to theaudited financial statements contained in the 2003 Annual Report toShareholders.  However, in the opinionof management, all adjustments necessary for a fair presentation of the resultsof the interim period have been included. Operating results for the three months ended March 31, 2004 are notnecessarily indicative of the results that may be expected for the year endedDecember 31, 2004.

 

The accountingpolicies followed in the presentation of interim financial results are the sameas those followed on an annual basis. These policies are presented on pages 18 through 21 of the 2003 AnnualReport to Shareholders.

 

10

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Note 2 – Stock Options

 

Sun has threecommon stock plans for employees and directors.  The 1998 Stock Incentive Plan, administered by a Board ofDirectors committee of independent directors, allows for 716,625 shares ofcommon stock to be issued for key officers and other management employees inthe form of qualified options, non qualified options, stock appreciationrights, or restricted stock.  The 1998Independent Directors Stock Option Plan allows 115,763 shares of common stockto be issued for non-employee directors. Options under those plans expire ten years after the grant date.  Both of these plans terminate in 2008.

 

The 1998Employee Stock Purchase Plan, which permits all employees to purchase commonstock at a price per share not less than 85% of the market value on theexercise date was allocated 248,063 shares. Options granted to date have been awarded at 90% of the market value onthe exercise date.  Each option underthe 1998 Employee Stock Purchase Plan expires no later than five years from thegrant date.  This plan terminates in2008.

 

Sun appliesAccounting Principles Board Opinion Number 25 and related interpretations toaccount for its common stock plans. Accordingly, Sun does not recognize compensation expense under theseplans when the options are granted.  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 months ended March 31, 2004 and 2003 would have been:

 
|                                       |   | **For the  Three Months Ended  March 31** |   |
|--------------------------------------------|--------|-------------------------------------------|--------|
| **(In Thousands, Except per Share  Data)** |   | **2004**                                  |   | **2003** |   |
| Net income:                                |   |                                      |   |   |   |
| As reported                                |   | $                                         | 1,509  |   | $ | 2,034 |   |
| Pro forma                                  |   | $                                         | 1,776  |   | $ | 2,031 |   |
|                                       |   |                                      |   |   |   |
| Earnings per share - Basic                 |   |                                      |   |   |   |
| As reported                                |   | $                                         | 0.21   |   | $ | 0.28 |   |
| Pro forma                                  |   | $                                         | 0.24   |   | $ | 0.28 |   |

 

 

11

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Note 3 – InvestmentSecurities

 

SunBank holdsone bond within other corporate obligations that has experienced a 10%unrealized loss at March 31, 2004 and a 12% unrealized loss at December 31,2003.  The amortized cost of the bondwas $223 and $236 at March 31, 2004 and December 31, 2003, respectively.  Management believes this loss is temporary,due to the continued AAA rating of the bond and the continued receipt ofprincipal and interest payments.  Thereare no other investments with an unrealized loss greater than one year as ofMarch 31, 2004.

 

The amortizedcost and fair value of investment securities available for sale, at March 31,2004 and December 31, 2003, were as follows:

 
|                                              |   | **March 31,  2004** |    |
|---------------------------------------------------|--------|---------------------|---------|
| **(In Thousands)**                                |   | **Amortized  Cost** |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair Value** |   |
|                                              |   |                |    |   |   |   |   |   |   |
| Debt Securities:                                  |   |                |    |   |   |   |   |   |   |
| Mortgage - Pass through                           |   | $                   | 77,459  |   | $ | 401 |   | $ | (191 | ) | $ | 77,669 |   |
| Mortgage - Other                                  |   | 82,519              |    | 479 |   | (412 | ) | 82,586 |   |
| Agency obligations                                |   | 11,514              |    | 31 |   | (13 | ) | 11,532 |   |
| Obligations of states and political  subdivisions |   | 17,222              |    | 1,277 |   | (31 | ) | 18,468 |   |
| Other corporate                                   |   | 10,398              |    | 36 |   | (94 | ) | 10,340 |   |
| Total debt securities                             |   | 199,112             |    | 2,224 |   | (741 | ) | 200,595 |   |
|                                              |   |                |    |   |   |   |   |   |   |
| Equity securities:                                |   |                |    |   |   |   |   |   |   |
| Marketable equity securities                      |   | 330                 |    | — |   | — |   | 330 |   |
| Restricted equity securities                      |   | 13,063              |    | — |   | — |   | 13,063 |   |
| Total equity securities                           |   | 13,393              |    | — |   | — |   | 13,393 |   |
|                                              |   |                |    |   |   |   |   |   |   |
| Total                                             |   | $                   | 212,505 |   | $ | 2,224 |   | $ | (741 | ) | $ | 213,988 |   |

 
|                                              |   | **December  31, 2003** |    |
|---------------------------------------------------|--------|------------------------|---------|
|                                              |   | **Amortized  Cost**    |    | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  Losses** |   | **Fair Value** |   |
|                                              |   |                   |    |   |   |   |   |   |   |
| Debt Securities:                                  |   |                   |    |   |   |   |   |   |   |
| Mortgage - Pass through                           |   | $                      | 84,935  |   | $ | 407 |   | $ | (559 | ) | $ | 84,783 |   |
| Mortgage - Other                                  |   | 101,393                |    | 263 |   | (992 | ) | 100,664 |   |
| Agency obligations                                |   | 3,190                  |    | 11 |   | (73 | ) | 3,128 |   |
| Obligations of states and political  subdivisions |   | 17,654                 |    | 1,030 |   | (62 | ) | 18,622 |   |
| Other corporate                                   |   | 1,206                  |    | 19 |   | — |   | 1,225 |   |
| Total debt securities                             |   | 208,378                |    | 1,730 |   | (1,686 | ) | 208,422 |   |
|                                              |   |                   |    |   |   |   |   |   |   |
| Equity  securities:                               |   |                   |    |   |   |   |   |   |   |
| Marketable equity securities                      |   | 330                    |    | — |   | — |   | 330 |   |
| Restricted equity securities                      |   | 14,457                 |    | — |   | — |   | 14,457 |   |
| Total equity securities                           |   | 14,787                 |    | — |   | — |   | 14,787 |   |
|                                              |   |                   |    |   |   |   |   |   |   |
| Total                                             |   | $                      | 223,165 |   | $ | 1,730 |   | $ | (1,686 | ) | $ | 223,209 |   |

 

12

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Note 4 – Loans

 

   The balances for principal loan categorieswere as follows:

 

 
| **(In Thousands)**                                   |   | **March 31,  2004** |    | **December  31, 2003** |   |
|------------------------------------------------------|--------|---------------------|---------|------------------------|--------|
|                                                 |   |                |    |                   |   |
| Real estate – mortgage                          |   | $                   | 326,955 |                   | $      | 373,068 |   |
| Real estate - construction                           |   | 14,403              |    | 32,157                 |   |
| Agricultural                                         |   | 276                 |    | 268                    |   |
| Commercial and industrial                            |   | 150,973             |    | 96,028                 |   |
| Lease – auto                                    |   | 87,743              |    | 80,582                 |   |
| Lease – equipment                               |   | 9,962               |    | 9,404                  |   |
| Individual                                           |   | 104,257             |    | 98,193                 |   |
| Other                                                |   | 241                 |    | 321                    |   |
| Total                                                |   | 694,810             |    | 690,021                |   |
|                                                 |   |                |    |                   |   |
| Less:                                                |   |                |    |                   |   |
| Unearned income & deferred loan fees             |   | (10,914             | )       | (10,541                | )      |
| Unamortized net discount/premium on  purchased loans |   | 330                 |    | 497                    |   |
| ALLL                                                 |   | (8,435              | )       | (7,754                 | )      |
| Net Loans                                            |   | $                   | 675,791 |                   | $      | 672,223 |   |

 

Net Investment in DirectFinancing Leases:

 
| **(In Thousands)**                    |   | **March 31,  2004** |   | **December  31, 2003** |   |
|---------------------------------------|--------|---------------------|--------|------------------------|--------|
| Minimum lease payments receivable     |   | $                   | 59,655 |                   | $      | 55,685 |   |
| Residual values                       |   | 38,050              |   | 34,301                 |   |
| Unearned income under lease contracts |   | (10,868             | )      | (10,488                | )      |
| Net Investment                        |   | $                   | 86,837 |                   | $      | 79,498 |   |

 

13

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Note 5 – Net Income PerShare

 

Net income pershare is computed based on the weighted average number of shares of stockoutstanding for each period presented. Statement of Financial Accounting Standards No. 128, “Earnings PerShare,” requires presentation of two amounts, basic and diluted net income pershare.  Basic earnings per sharecalculates net income divided by the average number of shares outstanding forthe period.  Diluted earnings per sharecalculates net income divided by the sum of the average number of sharesoutstanding and the number of shares of common stock which would be issued,assuming the exercise of stock options during each period using the treasurymethod.

 

The followingdata shows the amounts used in computing net income per share and the weightedaverage number of shares of dilutive stock options for the three-month periodsended March 31, 2004 and 2003:

 
|                                                                                             |   | **For the  Three Months Ended  March 31** |   |
|--------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
| **(In Thousands, Except Share  Data)\**                                                          |   | **2004**                                  |   | **2003** |   |
| Net income                                                                                       |   | $                                         | 1,509  |   | $ | 2,034 |   |
| Average number of common shares oustanding                                                       |   | 7,333,058                                 |   | 7,182,149 |   |
| Effect of dilutive options                                                                       |   | 24,060                                    |   | 18,821 |   |
| Average number of common shares oustanding  used  to calculate diluted earnings per common share |   | 7,357,118                                 |   | 7,200,970 |   |
|                                                                                                  |        |                                           |        |  |  |  |  |

 

Note 6 – Bank Premises and Equipment 

 
| **(In Thousands)**               |   | **March 31,  2004** |   | **December  31,  2003** |   |
|----------------------------------|--------|---------------------|--------|-------------------------|--------|
| Land                             |   | $                   | 3,801  |                    | $      | 3,631 |   |
| Buildings                        |   | 17,234              |   | 15,033                  |   |
| Furniture and equipment          |   | 9,839               |   | 9,455                   |   |
| Autos under operating lease      |   | 9,682               |   | 7,195                   |   |
| Total cost                       |   | 40,556              |   | 35,314                  |   |
|                             |   |                |   |                    |   |
| Less: Accumulated deprecation    |   | (8,733              | )      | (8,058                  | )      |
| Bank premises and equipment, net |   | $                   | 31,823 |                    | $      | 27,256 |   |

 

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Note 7 – Goodwill and CoreDeposit Intangible

 

In February2004, Sun acquired Sentry Trust Company. The acquisition of Sentry included identifiable intangible assets in theform of a trade name intangible and customer relationship intangible which werevalued by a third party.  Assumptionsused in the valuation of the customer relationship intangible included, but werenot limited to (1) an attrition rate of 5.0%, (2) a discount rate of 15.0%, and(3) an effective tax rate of 35%. Assumptions used in the valuation of the trade name intangible included,but were not limited to (1) a royalty rate of 1.5%, (2) a growth rate of 3.0%,and (3) a discount rate of 20%.  Thecustomer relationship was classified as an identifiable intangible of $2,028,while the trade name was classified as an identifiable intangible of $147.  The annual amortization for the customerrelationship intangible amounts to $107 using a 19-year amortization, while thetrade name intangible has been determined to have an indefinite life.

 

The following is a scheduleof intangibles acquired and associated amortization for the three months endedMarch 31, 2004.

 
| **(In Thousands)**      |   | **December  31, 2003** |   | **Sentry** |   | **Amortization** |   | **March 31,  2004** |   |
|-------------------------|--------|------------------------|--------|------------|--------|------------------|--------|---------------------|--------|
| Goodwill                |   | $                      | 29,848 |       | $      | 6,315            |   | $                   | — |   | $ | 36,163 |   |
| Core Deposit Intangible |   | 1,912                  |   | —     |   | (68              | )      | 1,844               |   |
| Customer Relationship   |   | 1,778                  |   | 2,028      |   | (40              | )      | 3,766               |   |
| Trade Name              |   | —                 |   | 147        |   | —           |   | 147                 |   |
| Total                   |   | $                      | 33,538 |       | $      | 8,490            |   | $                   | (108   | ) | $ | 41,920 |   |

 

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Note 8 – Borrowed Funds

 
| **(In Thousands)**                              |   | **March 31,  2004** |    | **December  31, 2003** |   |
|-------------------------------------------------|--------|---------------------|---------|------------------------|--------|
| Short-term Borrowings:                          |   |                |    |                   |   |
| FHLB repurchase agreements                      |   | $                   | 4,900   |                   | $      | 17,570 |   |
| FHLB advances                                   |   | —              |    | 20,000                 |   |
| Securities sold under agreements to  repurchase |   | 21,763              |    | 27,693                 |   |
| Treasury Tax and Loan Note Option               |   | 125                 |    | 125                    |   |
| Total Short-term Borrowings                     |   | 26,788              |    | 65,388                 |   |
|                                            |   |                |    |                   |   |
| Long-term Borrowings:                           |   |                |    |                   |   |
| FHLB advances                                   |   | 229,000             |    | 226,236                |   |
| Subordinated debentures                         |   | 18,866              |    | 18,866                 |   |
| Other borrowings                                |   | 11,900              |    | 11,900                 |   |
| Total Long-term Borrowings                      |   | 259,766             |    | 257,002                |   |
| Total Borrowed Funds                            |   | $                   | 286,554 |                   | $      | 322,390 |   |

 

The long-termFHLB advances carry significant prepayment penalties that limit the ability ofSun to reduce its debt level.  As ofMarch 31, 2004, prepayment penalties totaled $31,643 as compared to $29,418 atDecember 31, 2003.

 

The followingis a schedule of the rates and maturities for the long-term borrowingsidentified above. The variable rate borrowings listed consist entirely of FHLBadvances that are fixed until the FHLB exercises their option to increase therate charged when the then current rate surpasses the rate set at contractinception.  The fixed rate debt listedbelow also consists of subordinated debentures and reverse repurchaseagreements.

 
| **(In Thousands)**                                     |   | **March 31,  2004** |    | **December  31, 2003** |   |
|--------------------------------------------------------|--------|---------------------|---------|------------------------|--------|
| Variable rate of 1.99%, maturity 2005                  |   | $                   | 2,040   |                   | $      | 2,044 |   |
| Variable rates between 4.63% and 5.04%,  maturity 2008 |   | 26,058              |    | 26,063                 |   |
| Variable rates between 4.93% and 5.88%,  maturity 2009 |   | 53,043              |    | 49,360                 |   |
| Variable rates between 5.86% and 6.36%,  maturity 2010 |   | 98,369              |    | 99,258                 |   |
| Variable rate of 5.24%, maturity 2011                  |   | 3,240               |    | 3,261                  |   |
| Variable rates between 5.08% and 5.15%,  maturity 2013 |   | 46,250              |    | 46,250                 |   |
| Fixed rate of 6.00%, maturity 2004                     |   | 789                 |    | 789                    |   |
| Fixed rates between 1.90% and 6.00%,  maturity 2005    |   | 5,489               |    | 5,489                  |   |
| Fixed rates between 2.42% and 6.00%,  maturity 2006    |   | 4,388               |    | 4,388                  |   |
| Fixed rate of 2.84%, maturity 2007                     |   | 3,600               |    | 3,600                  |   |
| Fixed rate of 10.20%, maturity 2031                    |   | 16,500              |    | 16,500                 |   |
| Total                                                  |   | $                   | 259,766 |                   | $      | 257,002 |   |

 

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Note 9 – Employee BenefitPlans

 

Sun provides adefined contribution pension plan that covers substantially all employees.  Sun’s contributions are based on employeecontribution and compensation.  Thecontributions are accrued and funded to the employee’s account once a year withthe employee’s accounts once a year with a employee maintaining control overthe allocation of the funds between stock and bonds.

 

In additiontot he defined contribution plan, Sun also has a defined benefit plan, whichprovides supplemental payments to certain key employees upon retirement.  The supplemental payment expense includedinterest of $1 for each of the three-month periods ended March 31, 2004 and2003, respectively.  With the Guarantyacquisition in 2001 and the Steclton acquisition in 2003, Sun will also providesupplemental payments to certain former directors.  Life insurance contracts are being used to fund this supplementalpayment to the former directors. Expenses related to these plans and the carrying value of the definedplan for the three-months ended March 31, 2004 and 2003 were:

 

(In Thousands)

 
|                                                   |   | **2004** |   | **2003** |   |
|--------------------------------------------------------|--------|----------|--------|----------|--------|
| Defined pension contributions                          |   | $        | 221    |     | $      | 238 |   |
| Supplemental payment expense for defined  benefit plan |   | $        | 3      |     | $      | 9 |   |
| Defined benefit plan, carrying value                   |   | $        | 130    |     | $      | 349 |   |

 

The estimatedpayments under the defined contribution pension plan and defined benefit planfor the each of the next five years ended December 31 are as follows:

 

(In Thousands)

 
| **December  31,** |   | **2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   |
|-------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Defined pension   |   | $        | 595    |     | $      | 613      |   | $        | 632    |     | $      | 651 |   | $ | 670 |   |
| Defined benefit   |   | $        | 12     |     | $      | 12       |   | $        | 12     |     | $      | 12 |   | $ | 12 |   |

 

Note 10 – Off –Balance SheetRisk

 

In the normal course ofbusiness, Sun is a party to financial instruments with off-balance sheet risk.These financial instruments include commitments to extend credit and standbyletters of credit containing, in varying degrees, credit and interest rate riskexceeding the amount recognized in the balance sheet.  There were no material loss contingencies at March 31, 2004 orDecember 31, 2003.

 

Credit risk fromnonperformance by counterparties to commitments to extend credit and standbyletters of credit is represented by the contractual amount of thoseinstruments. Sun uses the same credit policies to guide commitments andconditional obligations as it does for direct, funded loans.

 

Commitments to extend creditare agreements to lend to a customer as long as no contract conditions areviolated. Commitments generally include fixed expiration dates or othertermination clauses and certain fee payments. Since many commitments areexpected to expire without being drawn upon, the total commitment amounts donot necessarily represent future cash requirements. Each customer’screditworthiness is evaluated on a case-by-case basis. The collateral amountobtained, if deemed necessary, is based on management’s credit evaluation ofthe customer. Collateral types vary but may include accounts receivable,inventory, property, equipment, and income-producing commercial properties.

 

Standby letters of credit areconditional commitments that guarantee a customer’s performance to a thirdparty. Those guarantees are primarily issued to support borrowing arrangementsand related transactions. Terms vary from one month to 24 months and may haverenewal features.   Credit risk differslittle from direct loans to customers. When warranted, Sun holds collateral against those commitments.  Sun recognizes a liability for financialguarantees at the inception of the contract. This liability is equivalent to the premium received and is amortizedover the life of the guarantee.

 

The following representsoutstanding commitments to extend credit and standby letters of credit as ofMarch 31, 2004 and December 31, 2003:

 
| **(In Thousands)**                                 |   | **March 31,  2004** |    | **December  31,  2003** |   |
|----------------------------------------------------|--------|---------------------|---------|-------------------------|--------|
| Commitments to extend credit                       |   | $                   | 140,766 |                    | $      | 158,291 |   |
| Standy letters of credit and financial  guarantees |   | 11,675              |    | 11,356                  |   |
| Total credit extension commitments                 |   | $                   | 152,441 |                    | $      | 169,647 |   |

 

17

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Note 11 – Hedging Activities

 

Sun maintainsan overall interest rate risk-management strategy that incorporates the use ofderivative instruments to minimize significant unplanned fluctuations inearnings that are caused by interest rate volatility. Sun’s goal is to manageinterest rate sensitivity by modifying the repricing or maturitycharacteristics of certain balance sheet liabilities so that movements ininterest rates do not, on a material basis, adversely affect the fair values ofthese liabilities. As a result of interest rate fluctuations, hedged fixed-rateliabilities will appreciate or depreciate in market value. The effect of thisunrealized appreciation or depreciation is expected to be substantially offsetby Sun’s gains or losses on the derivative instruments that are linked to thesehedged liabilities. Another result of interest rate fluctuations is that theinterest expense of hedged variable-rate liabilities will increase or decrease.The effect of this variability in earnings is expected to be substantiallyoffset by Sun’s derivative instruments that are linked to these hedgedliabilities. Sun considers its strategic use of derivatives to be a prudentmethod of managing interest-rate sensitivity, as it reduces the exposure toearnings from undue risk posed by changes in interest rates.

 

Sun uses interest rate swaps as part of theinterest rate risk-management strategy. These interest rate swaps have indicesrelated to the pricing of specific balance sheet liabilities. As a matter ofpolicy, Sun does not use highly leveraged derivative instruments for interest raterisk management. Interest rate swaps generally involve the exchange of fixedand variable-rate interest payments between two parties, based on a commonnotional principal amount and maturity date. The derivative instruments enteredinto by Sun gives Sun the right to enter into additional interest rate swapswith the writer of the option in the event that the liabilities are repriced bythe issuer.

 

By usingderivative instruments, Sun exposes itself to credit and market risk. If acounterparty fails to fulfill its performance obligations under a derivativecontract, Sun’s credit risk will equal the fair value gain in a derivative.Generally, when the fair value of a derivative contract is positive, thisindicates that the counterparty owes Sun, thus creating a credit risk for Sun.When the fair value of a derivative contract is negative, Sun owes thecounterparty and, therefore, assumes no credit risk. Sun minimizes the credit(or repayment) risk in derivative instruments by entering into transactions withhigh quality counterparties that are reviewed periodically by Sun’sAsset/Liability Committee.

 

Market risk is the adverse effect that achange in interest rates, currency, or implied volatility might have on thevalue 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 aremonitored by its Asset/Liability Committee as part of that committee’soversight of Sun’s asset/liability position. The Asset/Liability Committee isresponsible for approving hedging strategies that are developed through itsanalysis of data derived from financial simulation models and other internaland industry sources. The resulting hedging strategies are then incorporatedinto Sun’s overall interest rate risk-management strategy.

 

As of March 31, 2004, Sun has used fourpay-variable, receive-fixed interest rate swaps with a $100,000 total notionalamount to hedge changes in the fair value of certain Federal Home Loan Bank(FHLB) long-term borrowings. The swaps also contain an embedded option to enterinto an interest rate swap with opposite terms in the event the FHLB long-termborrowings convert to a

 

18

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variable rate. This occurrencewould effectively fix the rate being paid on the borrowings at approximatelythe original coupon and would reduce the net interest volatility caused in arising interest rate environment. Sun includes all components of eachderivative gain or loss in the assessment of hedge effectiveness. Sunrecognizes the change in fair value of the hedge and associated borrowingsthrough the income statement within other income. The cost of the swaption isembedded within the rate of its host, the fixed to variable swap. The cost ofthe swaption will increase interest expense. Premiums/discounts are reflectedin the rates received/paid and thus reflected in interest expense. Because thisswaption is a fair value hedge, Sun reports changes in the fair value of theswaption in other income/other expense during the applicable period. For thethree months ended March 31, 2004, there was a change in value recognized inthe hedge and associated long-term FHLB borrowings of $2,816 to $2,340 at March31, 2004 from $5,156 at December 31, 2003 due to the change in interest rates.Sun also recognized a reduction of $372 in interest expense on long-term FHLBborrowings as a result of the hedge transaction during the three months endedMarch 31, 2004.  Sun had no hedgetransactions outstanding as of March 31, 2003. A summary of Sun’s fair value hedges at March 31, 2004 follows:

 
|                                              |   |         |    |      |   |          |   | **Weighted  Average** |   |
|---------------------------------------------------|--------|--------------|---------|-----------|--------|---------------|--------|-----------------------|--------|
|                                              |   | **Notional** |    |      |   |          |   | **Receive**           |   | **Pay** |   | **Life** |   |
| **(In Thousands)**                                |   | **Amount**   |    | **Asset** |   | **Liability** |   | **Rate**              |   | **Rate** |   | **(Years)** |   |
| March 31, 2004                                    |   |         |    |      |   |          |   |                  |   |   |   |   |   |
| Fair Value Hedges:                                |   |         |    |      |   |          |   |                  |   |   |   |   |   |
| Receive fixed - pay variable interest rate  swaps |   | $            | 100,000 |      | $      | —        |   | $                     | 2,340  |   | 2.65 | % | 1.12 | % | 6.0 |   |
|                                                   |        |              |         |           |        |               |        |                       |        |  |  |  |  |  |  |  |

 

Note 12 – Acquisitions

 

DuringFebruary 2004 Sun completed the acquisition of Sentry Trust Company.  Sentry provides Sun an entry into southcentral Pennsylvania, while further diversifying Sun’s revenue stream.  As of March 31, 2004, Sentry hadapproximately $460,162 in assets under management.  Based on the guidance provided by FASB 141, BusinessCombinations, management believes that this transaction did not have a materialeffect on consolidated financial results and, therefore, does not requirepro-forma presentation at this time.

 

The following is a summary ofthe purchase:

 
| **(In Thousands)**             |   | **Sentry  Trust** |   |
|--------------------------------|--------|-------------------|--------|
| Assets acquired                |   | $                 | 7,661  |   |
| Identifiable intangible assets |   | 2,175             |   |
| Less: liabilities assumed      |   | 186               |   |
| Net assets acquired            |   | 9,650             |   |
| Less: purchase price           |   | 15,965            |   |
| Goodwill                       |   | $                 | 6,315  |   |
|                           |   |              |   |
| Consideration paid:            |   |              |   |
| Cash                           |   | $                 | 6,674  |   |
| Stock                          |   | $                 | 9,291  |   |

 

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Note 13 – Subsequent Event

 

On April 20,2004, Sun announced that a definitive merger agreement was unanimously approvedby the Boards of Directors of both Sun and Omega Financial Corporation(Omega).  The agreement provides thatSun be merged with and into Omega (which would survive the merger as thesurviving corporation).  Pursuant tothis agreement, each share of Sun common stock would be converted into either..664 shares of Omega common stock or cash in the amount of $23.25.  Holders of Sun common stock will be entitledto elect their preference, subject to prorata allocation, such that 20% of thetotal deal consideration will be paid in cash, and 80% will be paid in the formof Omega common stock. The transaction is anticipated to close late in thethird quarter or early in the fourth quarter of 2004.

 

20

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

 

ForwardLooking Statements (FLSs)

 

In addition tohistorical information, this report and the reports and documents incorporatedby reference in this report contain statements relating to future events andSun’s future results. These statements are “forward-looking” within the meaningof the Private Securities Litigation Reform Act of 1995 and include, but arenot limited to, statements that relate to projections of future results ofoperations, liquidity, capital expenditures or other financial items,discussions of estimated future revenue enhancements and cost savings, andpotential exposure to various types of market risk, including interest raterisk and credit risk.  These statementsmay also relate to Sun’s business strategy, goals and expectations concerningits market position, future operations, margins, profitability, liquidity andcapital resources. Generally, words such as “anticipate”, “believe”, “continue”,“could”, “estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”,“should”, “will” and similar terms and phrases are used to identifyforward-looking statements in this report and in the documents incorporated inthis report by reference.   Theseforward-looking statements are made as of the date of this report.

 

Readers should note that manyfactors, some of which are discussed elsewhere in this report and in thedocuments incorporated by reference in this report, could affect the future financialresults of Sun and its subsidiaries, both individually and collectively, andcould cause those results to differ materially from those expressed in theforward-looking statements contained or incorporated by reference in this Form10-Q. These factors include:

 

•                                          operating,legal and regulatory risks;

•                                          economic,political and competitive forces affecting banking, securities, assetmanagement and credit services businesses; and

•                                          therisk that management’s analysis of these risks and forces could be incorrectand/or that the strategies developed to address them could be unsuccessful.

 

Sun undertakes no obligation topublicly revise or update these forward-looking statements to reflect events orcircumstances that arise after the date of this report. Readers shouldcarefully review the risk factors described in other documents that Sun filesperiodically with the Securities and Exchange Commission.

 

The following is management’s discussion and analysis of thesignificant 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., Sentry Trust Company, Beacon LifeInsurance Company, SUBI Investment Company, and Sun Bancorp Statutory TrustI.  Sun Bancorp, Inc. also holds thirtypercent ownership in Sun Abstract and Settlement Services.  Sun Bancorp, Inc.’s consolidated financialcondition and results of operations consist almost entirely of SunBank’sfinancial condition and results of operations. This discussion should be read in conjunction with Sun’s 2003 AnnualReport. Current performance does not guarantee or assure similar performance inthe future, and may not be indicative of future results.

 

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Results ofOperations – Three Months Ended March 31, 2004 and 2003

 

Sun’s earnings of $1,509 or $0.21 per sharebasic and diluted for the three months ended March 31, 2004 were $525 or $0.07per share basic and diluted lower than the three months ended March 31,2003.  Excluding security gains, netincome for the three months ended March 31, 2004 would have increased $390 or$0.05 per share basic from the three months ended March 31, 2003.

 

 The earnings resulted in annualized return onaverage assets for the three months ended March 31, 2004 of 0.59% compared to0.84% for the same period in 2003. Annualized return on average equity for the three months ended March 31,2003 was 6.87% compared to 9.87% for the three months ended March 31, 2003.

 

Comparativeinformation for the three months ended March 31, 2004 and 2003 is impacted bythe acquisitions of Mid-Penn Insurance Associates, Inc. in April 2003, SteeltonBancorp in April 2003, and Sentry Trust Company in February 2004.

 

Net interestincome increased 9.8% to $6,089 for the three months ended March 31, 2004compared to $5,548 for the same period of 2003.  Total interest and dividend income decreased $505 to $11,883 forthe three months ended March 31, 2004. Interest and fees on loans and leases remained relatively flat with a2.0% increase to $9,892 for the three months ended March 31, 2004 compared tothe corresponding period of 2003 despite net loan and lease growth of $63,250since March 31, 2003.  The limitedgrowth in interest and fees on loans reflects the impact of significant loanprepayments with higher coupons and the scheduled principal payments.  Interest and dividends on available for salesecurities decreased $663 or 25.1% to $1,978 for the three months ended March31, 2004 due in part to accelerated amortization of premiums on assetbacked securities caused by prepayments on the underlying assets and loweroutstanding balances.   Inaddition, many of the higher coupon bonds in Sun’s investment portfolio thatwere realizing accelerated prepayments and that had a shortened average life ofless than one year were sold during 2003 and the proceeds were reinvested todistribute cash flows evenly over the next three years.   Interest on deposits in banks decreased $39or 75.0% to $13 for the three months ended March 31, 2004, primarily due todecreased interest rates. Total interest expense decreased 15.3% for the three monthsended March 31, 2004, compared to the same period of 2003.  This overall decrease corresponds to ageneral decline in market rates and the maturity of certificates of deposits,which were written during a period of higher interest rates.  Interest on deposits decreased 24.9%, or$780 primarily due to lowered offered rates for the three months ended March31, 2004 in comparison to rates offered during the three months ended March 31,2003.  The decrease in aggregateinterest expense outpaced the decrease in interest income.   Other borrowed funds that carried aweighted average cost of 4.90% for the three months ended March 31, 2004 ascompared to 5.69% for 2003 limited the decrease in aggregate interestexpense.  To alleviate the impact of theFederal Home Loan Bank (FHLB) term borrowings, the Bank entered into $100,000total notional value interest rate swap agreements in June of 2003.

 

Non-interestincome, excluding security gains, increased $1,092 or 45.6% to $3,486 for thethree months ended March 31, 2004 as compared to the corresponding period of2003.  Increased service

 

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charges on deposits accounted for $194 of the increase.  The increase in service charges wasprimarily the result of improved performance related to SunBank’s overdrafthonor program, which provides overdraft protection.  This increase was also attributable to service fees on accountsobtained through the April 2003 acquisition of Steelton Bancorp.  Income from Sun’s insurance subsidiaryincreased $638 primarily resulting from the acquisition of Mid-Penn Insurancein April 2003.  The acquisition ofSentry Trust Company and Sun’s focus on increasing fee income resulted ingrowth of $113 in trust income and $141 in investment product sales. Otherincome increased $275 with the increase resulting from Sun entering intooperating lease agreements with its customers. The rental income generated from these leases is reported as otherincome.  Gains on the sale of loansdecreased $227 to $34 for the three months ended March 31, 2004 as the threemonths ended March 31, 2003 included a gain of $160 related to a sale of a poolof SBA loans.  Sun recognized securitygains of $109 for the three months ended March 31, 2004, compared to $1,496 forthe corresponding period of 2003 as Sun continued to restructure the investmentportfolio composition.

 

Non-interestexpenses increased $956 or 14.6% to $7,519 for the three months ended March 31,2004 compared to the corresponding period of 2003.  All categories of non-interest expense have been impacted by theacquisitions of Mid-Penn Insurance Associates, Inc. and Steelton Bancorp inApril 2003 and Sentry Trust Company during 2004.  Salaries and employee benefits increased $327 or 10.3% due to theacquisitions and increased employee benefit costs.  Net occupancy expense and furniture and equipment expensesincreased $98 or 11.3% due to acquisitions and, to a lesser extent,infrastructure improvements.  Other expensesincreased 16.7% or $423 due to increases in normal business expenses, acquisitions,and depreciation related to operating leases. The depreciation related to the operating leases accounted for $287 or67.8% of the increase in other expenses. Amortization of intangibles increased $108 due to the amortization ofcustomer relationship intangibles from the Mid Penn Insurance and Sentryacquisitions and the amortization of core deposit intangibles from the Steeltonand Mellon branch acquisition.  Refer toNote 7 for additional information regarding intangibles.

 

Balance Sheet– March 31, 2004 and December 31, 2003

 

Total assetsremained relatively constant at $1,037,218 at March 31, 2004, an increase of$8,965 from $1,028,253 at December 31, 2003. Cash and cash equivalents decreased $4,123, or 14.5% from $28,421 atDecember 31, 2003 as cash was utilized as a component of the consideration paidfor Sentry Trust Company (cash $6,674, stock $9,291).  The investment portfolio decreased $9,221 or 4.1%, as cash flowsfrom the portfolio were used to reduce short-term borrowing levels and also toprovide cash for the Sentry acquisition. The growth in net loans outstanding of $3,568 occurred primarily in theauto and equipment lease categories. The allowance for loan and lease losses increased $681 and is discussedin greater detail in the Allowance for Loan and Lease Losses section ofManagement’s Discussion and Analysis. The increases in fixed assets, intangibles, and other assets are theresult of the previously mentioned acquisitions.

 

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Total liabilities remained relatively constant at $947,679 at March 31,2004 compared to $949,071 at December 31, 2003.  Total deposits increased $33,055 to $647,605, with core deposits(non-time deposits) contributing $10,900 to the increase.  Since December 31, 2003, savings and moneymarket accounts have increased $2,162 and $12,011 respectively, while NOWaccounts have decreased $3,427.  Theincrease in money market accounts is the result of a deposit gathering campaignthat places particular emphasis on money market accounts.  Time deposit increased $22,155 from December31, 2003 as Sun has placed emphasis on gathering time deposit with a maturitygreater than two years.  Since December31, 2003, non-interest-bearing deposits have remained stable at $69,794.  Short-term borrowings decreased $38,600 fromDecember 31, 2003, due to the payoff of short-term FHLB borrowings.  The funds used to payoff the short-termborrowings were from the increase in deposits and a reduction of investmentsecurities available for sale.

 

Sun’s total shareholders’ equity increased$10,357 from December 31, 2003 to March 31, 2004.  The increase is the result of several factors.  First, accumulated other comprehensiveincome increased $950 to $979 at March 31, 2004 due to an increase in themarket value of Sun’s investment portfolio. Second, while net income of $1,509increased shareholders’ equity, the increase was offset by the payment of$1,394 in dividends to shareholders during the three months ended March 31,2004.  The final cause of the increasewas the acquisition of Sentry Trust Company. The acquisition resulted in an increase of $9,291 as Sun issuedapproximately a half million shares in total from authorized, non-issued, andtreasury as a component of the purchase price.

 

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Allowance for Loan and Lease Losses 

 

Sun maintainsan Allowance for Loan and Lease Losses (ALLL) in an effort to provide forlosses inherent in its loan and lease portfolio. Loan and lease losses arecharged against the ALLL in the period in which they have been determineduncollectible. Recoveries of previously charged-off loans and leases arecredited to the ALLL when received. Management believes the ALLL is adequate asof March 31, 2004.

 

Sun’s methodologyfor calculating its ALLL consists of three components:

•  specific allocations for loans evaluated bymanagement and deemed to have an increased level of inherent risks;

 

•  a general allocation, which varies for eachtype of homogenous loan pool within the portfolio; and qualitative factorswhich are discussed below.

 

Specificreserves are established for loans of all types that management deems to berisk-rated as Other Assets Especially Mentioned (OAEM) or lower. The allocationbased on specific risk-rated credits is calculated by applying a risk factor(from 3% to 100%) against the loan based on the severity of risk-rating.  All loans are risk-rated; however, consumerloans and residential mortgages generally receive a favorable rating unless anduntil a history of delinquency becomes evident. Commercial loans arecontinuously reviewed and a specific reserve is allocated once a loan hasfallen to OAEM or lower status.

 

Loans of alltypes, for which there are no specific reserves, are evaluated as a homogeneousgroup based on common characteristics. Management determines the generalallocation by applying Sun’s charge-off rate for each loan group based on theexperience of the previous five complete years and the current partial year.

 

Sun’s assessmentof the ALLL also considers additional qualitative factors reflective ofeconomic conditions, management’s lending policies, the nature and volume ofloan portfolio changes, credit management, credit review, risk profile,classified assets, historic collection and charge-off practices, portfolioconcentrations, and external factors such as competition, legal and regulatoryrequirements.

 

Sun’s loanreview and underwriting process includes risk-based pricing in the loanstructuring process.  Sun also utilizesa loan quality committee, comprised of members of senior management andrepresentatives of the Board of Directors, that meets monthly overseeingoverall credit quality.

 

Managementcontinued to closely monitor credit quality during the first quarter of 2004.The ALLL, as a percentage of total loans and leases, increased to 1.23% atMarch 31, 2004 from 1.14% of total loans at December 31, 2003. The increase wasdue to the changing mix of loans within the portfolio and an increase inspecific reserve for several watch list loans. A significant improvement in net charge-offs compared to prior periodslimited the increase in the provision for loan and lease losses.  Changes in the composition of the loan andlease portfolio affected the allocation within

 

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ALLL. Most notably, commercialand industrial loans and real estate collateralized commercial loans, includedwithin the real estate category, have become an increasing percentage of theoverall loan portfolio as Sun has been selling new residential mortgages on thesecondary market within seven days of closing. Accordingly, because commercialand industrial loans and real estate collateralized commercial loans aregenerally associated with a higher element of risk compared to residentialmortgages, a higher percentage of the ALLL is directed toward commercial andindustrial loans. Moreover, increases in auto leases have required a highergeneral allocation in the ALLL because of the historically higher industry wideloss rates on this type asset.

 

Sun’s ALLLreflects periodic provisions for loan and lease losses determined through theapplication of Sun’s ALLL methodology discussed above. The provision for loanand lease losses is the expense necessary to maintain the ALLL at a leveladequate to encompass management’s best estimate of possible losses in the loanand lease portfolio. Management increased the provision for loan and leaselosses to $435 for the three months ended March 31, 2004 compared to $405 in2003. The provision was increased in 2004 based on a larger loan portfolio, inpart due to a merger with Steelton Bancorp during 2003, due to the changing mixof loans within the portfolio as discussed above, and several watch list loansrequiring an increase specific reserve.

 

Determiningthe level of the ALLL at any given period is difficult, particularly duringdeteriorating or uncertain economic periods. Management must make estimatesusing information and assumptions that are often subjective and rapidlychanging. Management continues to review the loan and lease portfolios in lightof a changing economy and the dynamics of the banking and regulatoryenvironment.

 

Management cannot precisely quantify that amount due to manyuncertainties, including future global, national, and local economic conditionsand other factors. As a result, unforeseen developments may require managementto increase the ALLL. Such developments could include changing economicconditions or negative developments with borrowers. In addition, bankregulators periodically assess Sun’s ALLL and may, consistent with examinationguidelines and current information, require an increased ALLL. As a result, anynumber of factors may materially change management’s analysis in the future.

 

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Deposits

 

Sun’s totaldeposits increased $33,055 or 5.4%, to $647,605 at March 31, 2004, compared to$614,550, at December 31, 2003.  Thisincrease is the result of Sun’s focus on growing low cost core deposits (alldeposits excluding time deposits) and building relationships with localmunicipalities, colleges, and businesses. The focus on obtaining core deposits resulted in a core deposit increaseof 3.2% or $10,900, to $350,220 at March 31, 2004, compared to $339,320, atDecember 31, 2003.  As part of thisprocess, Sun began a marketing and pricing program to attract money marketaccounts during the first quarter of 2004. The result was a $12,011 or 53.5% increase in money market accountssince December 31, 2003.  Sun alsoinitiated a time deposit gathering campaign that places emphasis on attractingtime deposits, which have a maturity greater than two years. The net result ofthis campaign was $22,155 or 8.0% increase during the first quarter of2004.  Over the same time period, demanddeposit, savings, and NOW accounts have remained constant with each categoryhaving less than a 3% balance fluctuation.

 
|               |   | **March 31,  2004** |    | **December  31, 2003** |   | **Change** |   |
|--------------------|--------|---------------------|---------|------------------------|--------|------------|--------|
| **(In Thousands)** |   | **Amount**          |    | **% Total**            |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Demand deposits    |   | $                   | 69,794  |                   | 10.8   | %          | $      | 69,640 |   | 11.3 | % | $ | 154 |   | 0.2 | % |
| NOW accounts       |   | 161,376             |    | 24.9                   | %      | 164,803    |   | 26.8 | % | (3,427 | ) | -2.1 | % |
| Insured MMDA       |   | 34,472              |    | 5.3                    | %      | 22,461     |   | 3.7 | % | 12,011 |   | 53.5 | % |
| Savings deposits   |   | 84,578              |    | 13.1                   | %      | 82,416     |   | 13.4 | % | 2,162 |   | 2.6 | % |
| Time deposits      |   | 297,385             |    | 45.9                   | %      | 275,230    |   | 44.8 | % | 22,155 |   | 8.0 | % |
| Total deposits     |   | $                   | 647,605 |                   | 100.0  | %          | $      | 614,550 |   | 100.0 | % | $ | 33,055 |   | 5.4 | % |
|               |   |                |    |                   |   |       |   |   |   |   |   |   |   |
| Core deposits*     |   | $                   | 350,220 |                   | 54.1   | %          | $      | 339,320 |   | 55.2 | % | $ | 10,900 |   | 3.2 | % |

 

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* Core deposits are defined as total deposits less time deposits

 

Time deposittotals above include certificates of deposit and other time deposits issued inamounts of $100,000 or more.  Thesedeposits and their remaining maturities, at March 31, 2004 and December 31,2003, are listed below:

 
|                      |   | **March 31,  2004** |   | **December  31, 2003** |   | **Change** |   |
|---------------------------|--------|---------------------|--------|------------------------|--------|------------|--------|
| **(In Thousands)**        |   | **Amount**          |   | **% Total**            |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Three months or less      |   | $                   | 26,828 |                   | 36.5   | %          | $      | 20,487 |   | 35.6 | % | $ | 6,341 |   | 39.6 | % |
| Three through six months  |   | 6,359               |   | 8.6                    | %      | 12,818     |   | 22.2 | % | (6,459 | ) | -40.3 | % |
| Six through twelve months |   | 14,239              |   | 19.3                   | %      | 8,515      |   | 14.8 | % | 5,724 |   | 35.7 | % |
| Over twelve months        |   | 26,233              |   | 35.6                   | %      | 15,817     |   | 27.4 | % | 10,416 |   | 65.0 | % |
| Total                     |   | $                   | 73,659 |                   | 100.0  | %          | $      | 57,637 |   | 100.0 | % | $ | 16,022 |   | 27.8 | % |

 

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Other Funding

 

Sun continuedusing borrowed funds to supplement deposits during 2004 and 2003.  At March 31, 2004, Sun had $259,766 in longterm debt funding.  This fundingconsisted primarily of $229,000 in variable rate FHLB borrowings withmaturities between 2005 and 2013.  Sunalso had $11,900 in long-term repurchase agreements at March 31, 2004.  In addition, Sun had $18,866 in long termsubordinated debentures, at March 31, 2004, that consisted of $16,500 in trustpreferred securities with a maturity of February 22, 2031 and an initial callof February 22, 2011.  The issuer ofthese securities, Sun Bancorp Statutory Trust I, is a wholly owned subsidiaryof the parent company and as such, Sun Bancorp fully and unconditionallyguarantees these securities.  Theremaining $2,366 was the result of a note issued for the purchase of GuarantyBank, N.A., during 2001 and carries a rate of 6% and matures in 2006.

 

Other fundingsources for short-term money include deposit customers’ cash managementaccounts (classified as securities sold under agreements to repurchase),Treasury Tax and Loan Note Option, repurchase agreements, and FHLB overnightborrowings.  At March 31, 2004, Sun’sshort-term borrowings consisted primarily of cash management accounts in theamount of $21,763.

 

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#### **Net Interest Income and Net Interest Margin**

 

Net interestincome, the difference between interest income and interest expense, is thelargest component of Sun’s earnings. Net interest margin (NIM) measures the difference between the yield oninterest earning assets and the aggregate funding cost.  NIM is calculated as taxable equivalent netinterest income divided by average interest earning assets.

 

Sun’s NIMincreased by 7 basis points to 2.85% for the three months ended March 31, 2004,compared to 2.78%, for the same period of 2003.  Theincrease is primarily the result of two actions.  The first action was the entering into four swap contracts onJune 30, 2003, involving the FHLB advances. The second action centered around Sun’s evaluation of the rates beingpaid on deposit accounts.  These actionscountered a continued decline in yield of the loan and investment portfolios,which declined due to prepayments and scheduled payments of higher couponpaper.  As rates continued to declinethroughout 2003, these payments have been reinvested in lower yielding loansand investments.

 

The previouslymentioned swaps were entered into to partially remediate the volatility in netinterest income in an up or down interest rate environment.  The contracts, which involve the FHLBadvances, increased net interest income by $372 (NIM by 16 basis points) forthe three months ended March 31, 2004 as compared to the three months endedMarch 31, 2003.  Embedded in each swapis an option to reverse the original swap (receive fixed-pay variable), at anytime, to pay fixed-receive variable if the FHLB notifies the Bank that it isgoing to exercise the option to increase the Bank’s interest rate on thedebt.  Thus, in a rising rateenvironment the Bank has locked in a fixed rate.  Despite being able to lock in a fixed rate, an upward movement inthe 90-day LIBOR rate will reduce the positive NIM impact of the swap and willcause a negative NIM impact during the period that 90-day LIBOR is above 2.65%and the point at which the FHLB would reprice the debt.  Readers are encouraged to refer to Note 11for further information on Sun’s hedging activities.

 

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The following table sets forth comparative yields and rates paid forinterest bearing assets and liabilities:

 
|                                                                |   | **For the  Three Months Ended** |          |
|---------------------------------------------------------------------|--------|---------------------------------|---------------|
|                                                                |   | **March 31,  2004**             |          | **March 31,  2003** |   |
| **(In Thousands)**                                                  |   | **Average  Balance (1)**        |          | **Interest** |   | **Rate (2)** |   | **Average  Balance (1)** |   | **Interest** |   | **Rate (2)** |   |
| **ASSETS**                                                          |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| Interest-earning assets:                                            |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits                                           |   | **$**                           | **5,997**     | ** ** | **$** | **13** | ** ** | **0.87** | **%** | $ | 17,477 |   | $ | 52 |   | 1.21 | % |
| Loans (net of unearned income)                                      |   | **679,420**                     | ** **    | **10,025** | ** ** | **5.93** | **%** | 605,474 |   | 9,939 |   | 6.67 | % |
| Investments:                                                        |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
| Taxable                                                             |   | **187,511**                     | ** **    | **1,775** | ** ** | **3.79** | **%** | 219,027 |   | 2,410 |   | 4.40 | % |
| Tax-exempt                                                          |   | **18,524**                      | ** **    | **308** | ** ** | **6.65** | **%** | 19,306 |   | 351 |   | 7.26 | % |
| **Total interest-earning assets**                                   |   | **891,452**                     | ** **    | **12,121** | ** ** | **5.46** | **%** | 861,284 |   | 12,752 |   | 5.99 | % |
|                                                                |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| **Noninterest-earning assets:**                                     |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
|                                                                |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks                                             |   | **24,542**                      | ** **    |   |   |   | ** ** | 19,260 |   |   |   |   |   |
| Bank premises & equipment                                       |   | **29,180**                      | ** **    |   |   |   | ** ** | 16,147 |   |   |   |   |   |
|                                                                |   |                            | ** **    |   |   |   | ** ** |   |   |   |   |   |   |
| Accrued interest and other assets                                   |   | **85,017**                      | ** **    |   |   |   | ** ** | 70,261 |   |   |   |   |   |
| Less: Allowance for loan losses                                     |   | **(7,952**                      | **)**         |   |   |   | ** ** | (6,368 | ) |   |   |   |   |
| Unamortized loan fees                                               |   | **338**                         | ** **    |   |   |   | ** ** | 205 |   |   |   |   |   |
|                                                                |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| Total assets                                                        |   | **$**                           | **1,022,577** | ** ** |   |   |   | ** ** | $ | 960,789 |   |   |   |   |   |
|                                                                |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                       |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
|                                                                |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| **Interest-bearing liabilities:**                                   |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
|                                                                |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| NOW Accounts                                                        |   | **$**                           | **162,313**   | ** ** | **$** | **198** | ** ** | **0.49** | **%** | $ | 156,497 |   | $ | 378 |   | 0.98 | % |
| Insured Money Market Accounts                                       |   | **26,493**                      | ** **    | **63** | ** ** | **0.96** | **%** | 25,761 |   | 99 |   | 1.56 | % |
| Savings deposits                                                    |   | **83,280**                      | ** **    | **80** | ** ** | **0.39** | **%** | 78,920 |   | 192 |   | 0.99 | % |
| Time deposits                                                       |   | **287,247**                     | ** **    | **2,006** | ** ** | **2.81** | **%** | 275,963 |   | 2,458 |   | 3.61 | % |
| Short-term borrowings                                               |   | **40,796**                      | ** **    | **90** | ** ** | **0.89** | **%** | 33,245 |   | 107 |   | 1.31 | % |
| Subordinated debentures                                             |   | **18,866**                      | ** **    | **456** | ** ** | **9.67** | **%** | 19,655 |   | 468 |   | 9.52 | % |
| Other borrowed funds                                                |   | **238,158**                     | ** **    | **2,901** | ** ** | **4.90** | **%** | 223,702 |   | 3,138 |   | 5.69 | % |
|                                                                |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| **Total interest-bearing liabilities**                              |   | **857,153**                     | ** **    | **5,794** | ** ** | **2.72** | **%** | 813,743 |   | 6,840 |   | 3.41 | % |
|                                                                |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
| **Noninterest-bearing  liabilities and shareholders’ equity:** |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
|                                                                |   |                            |          |   |   |   |   |   |   |   |   |   |   |
| Demand deposits                                                     |   | **67,045**                      | ** **    |   |   |   | ** ** | 56,204 |   |   |   |   |   |
| Accrued interest and other liabilities                              |   | **10,478**                      | ** **    |   |   |   | ** ** | 8,440 |   |   |   |   |   |
| Shareholders’ equity                                           |   | **87,901**                      | ** **    |   |   |   | ** ** | 82,402 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                     |   | **$**                           | **1,022,577** | ** ** |   |   |   | ** ** | $ | 960,789 |   |   |   |   |   |
|                                                                |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
| Interest rate spread                                                |   |                            |          |   |   | **2.74** | **%** |   |   |   |   | 2.58 | % |
|                                                                |   |                            | ** **    |   | ** ** |   | ** ** |   |   |   |   |   |   |
| Net interest income/margin                                          |   |                            |          | **$** | **6,327** | ** ** | **2.85** | **%** |   |   | $ | 5,912 |   | 2.78 | % |
|                                                                     |        |                                 |               |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) Averageloan balances include non-accrual loans and interest income includes fees onloans.

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

 

30

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The followingrate/volume analysis represents the portions of the net change in interestincome due to changes in volume or rate on a tax equivalent basis using afederal income tax rate of 34%.  Changesin net interest income, for the three months ended March 31, 2004 compared tothe same period in 2003, due to rate and volume have been allocated to changesdue to volume and rate in proportion to the absolute amount of change in each.

 
|                               |   | **Three  Months Ended March 31, 2004 Compared to 2003  Increase (Decrease)** |   |
|------------------------------------|--------|------------------------------------------------------------------------------|--------|
| **(In Thousands)**                 |   | **Volume**                                                                   |   | **Rate** |   | **Net Change** |   |
| Interest earned on:                |   |                                                                         |   |   |   |   |   |
| Interest -bearing deposits         |   | $                                                                            | (34    | ) | $ | (5 | ) | $ | (39 | ) |
| Loans                              |   | 1,369                                                                        |   | (1,283 | ) | 86 |   |
| Investments:                       |   |                                                                         |   |   |   |   |   |
| Taxable                            |   | (347                                                                         | )      | (288 | ) | (635 | ) |
| Tax exempt                         |   | (14                                                                          | )      | (29 | ) | (43 | ) |
| Total interest-earning assets      |   | 974                                                                          |   | (1,605 | ) | (631 | ) |
|                               |   |                                                                         |   |   |   |   |   |
| Interest paid on:                  |   |                                                                         |   |   |   |   |   |
| NOW Accounts                       |   | 19                                                                           |   | (199 | ) | (180 | ) |
| Insured Money Market Accounts      |   | 4                                                                            |   | (40 | ) | (36 | ) |
| Savings deposits                   |   | 13                                                                           |   | (125 | ) | (112 | ) |
| Time deposits                      |   | 136                                                                          |   | (588 | ) | (452 | ) |
| Short-term borrowings              |   | 26                                                                           |   | (43 | ) | (17 | ) |
| Subordinated debentures            |   | (19                                                                          | )      | 7 |   | (12 | ) |
| Other borrowed funds               |   | 249                                                                          |   | (486 | ) | (237 | ) |
| Total interest-bearing liabilities |   | 428                                                                          |   | (1,474 | ) | (1,046 | ) |
| Net interest income                |   | $                                                                            | 546    |   | $ | (131 | ) | $ | 415 |   |

 

31

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Income andExpense Changes

 

The tablebelow presents consolidated comparative changes in income and expense, and alsopresents changes in average asset and liability volumes.  Tax-exempt income is not shown on a taxequivalent basis.   The following tablerepresents the three months ended March 31, 2004 and March 31, 2003:

 
|                                                           |   | **Three  Months Ended March 31, 2004 Compared to 2003** |   |
|----------------------------------------------------------------|--------|---------------------------------------------------------|--------|
|                                                           |   | **Average**                                             |   | **Volume** |   | **Income/Expense** |   |
| **(In Thousands)**                                             |   | **$ Change**                                            |   | **% Change** |   | **$ Change** |   | **% Change** |   |
| Loans, net                                                     |   | $                                                       | 73,946 |   | 12.21 | % | $ | 197 |   | 2.03 | % |
| Investment securities                                          |   | (32,298                                                 | )      | (13.55 | ) | (663 | ) | (25.10 | ) |
| Interest-bearing deposits                                      |   | (11,480                                                 | )      | (65.69 | ) | (39 | ) | (75.00 | ) |
| Total interest-earning assets                                  |   | $                                                       | 30,168 |   | 3.50 | % | $ | (505 | ) | (4.08 | )% |
|                                                           |   |                                                    |   |   |   |   |   |   |   |
| NOW Accounts                                                   |   | $                                                       | 5,816  |   | 3.72 | % | $ | (180 | ) | (47.62 | )% |
| Insured Money Market Accounts                                  |   | 732                                                     |   | 2.84 |   | (36 | ) | (36.36 | ) |
| Savings deposits                                               |   | 4,360                                                   |   | 5.52 |   | (112 | ) | (58.33 | ) |
| Time deposits                                                  |   | 11,284                                                  |   | 4.09 |   | (452 | ) | (18.39 | ) |
| Short-term borrowings                                          |   | 7,551                                                   |   | 22.71 |   | (17 | ) | (15.89 | ) |
| Subordinated debentures                                        |   | (789                                                    | )      | (4.01 | ) | (12 | ) | (2.56 | ) |
| Other borrowed funds                                           |   | 14,456                                                  |   | 6.46 |   | (237 | ) | (7.55 | ) |
| Total interest-bearing liabilities                             |   | $                                                       | 43,410 |   | 5.33 | % | $ | (1,046 | ) | (15.29 | )% |
|                                                           |   |                                                    |   |   |   |   |   |   |   |
| Net interest income                                            |   |                                                    |   |   |   | $ | 541 |   | 9.75 | % |
| Provision for loan and lease losses                            |   |                                                    |   |   |   | 30 |   | 7.41 |   |
| Net interest income after provision for  loan and lease losses |   |                                                    |   |   |   | 511 |   | 9.94 |   |
| Service charges on deposit accounts                            |   |                                                    |   |   |   | 194 |   | 22.96 |   |
| Trust income                                                   |   |                                                    |   |   |   | 113 |   | 51.60 |   |
| Net securities gains                                           |   |                                                    |   |   |   | (1,387 | ) | (92.71 | ) |
| Investment sales                                               |   |                                                    |   |   |   | 141 |   | 587.50 |   |
| Bank owned life insurance                                      |   |                                                    |   |   |   | (13 | ) | (4.00 | ) |
| Insurance subsidiary                                           |   |                                                    |   |   |   | 638 |   | 2,773.91 |   |
| Gain on sale of loans                                          |   |                                                    |   |   |   | (227 | ) | (86.97 | ) |
| Leasing subsidiary                                             |   |                                                    |   |   |   | (29 | ) | (9.63 | ) |
| Other income                                                   |   |                                                    |   |   |   | 275 |   | 69.44 |   |
| Total other non-interest income                                |   |                                                    |   |   |   | (295 | ) | (7.58 | ) |
|                                                           |   |                                                    |   |   |   |   |   |   |   |
| Salaries and employee benefits                                 |   |                                                    |   |   |   | 327 |   | 10.33 |   |
| Net occupancy expense                                          |   |                                                    |   |   |   | 55 |   | 14.36 |   |
| Net furniture and equipment expenses                           |   |                                                    |   |   |   | 43 |   | 8.83 |   |
| Amortization of intangibles                                    |   |                                                    |   |   |   | 108 |   | N/A |   |
| Other expenses                                                 |   |                                                    |   |   |   | 423 |   | 16.74 |   |
| Total other non-interest expense                               |   |                                                    |   |   |   | 956 |   | 14.57 |   |
| Income before income tax provision                             |   |                                                    |   |   |   | (740 | ) | (29.96 | ) |
| Income tax provision                                           |   |                                                    |   |   |   | (215 | ) | (49.31 | ) |
| Net income                                                     |   |                                                    |   |   |   | $ | (525 | ) | (25.81 | )% |

 

32

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#### **Non-interest Income**

 

Non-interestincome, excluding security gains, increased $1,092 or 45.6% to $3,486, for thethree months ended March 31, 2004 compared to the corresponding period of2003.  Increased service charges ondeposits accounted for $194 of the increase. Improved performance related to Sun’s overdraft honor program, whichprovides overdraft protection, was the main source of the growth.  The increase was also attributable toincreased service fees from deposit accounts resulting from the April 2003Steelton Bancorp acquisition.  In addition,income from insurance fees increased $638 primarily as the result of Sun’sacquisition of Mid-Penn Insurance in April 2003.  Income from investment product sales and trust income increased$141 and $113, respectively due in part to the acquisition of Sentry TrustCompany during the first quarter of 2004 and a focus on increasing feeincome.  Other income increased $275principally due to rental income from operating leases.  Gains on sales of loans decreased $227 asthe three months ended March 31, 2003 included $160 from the sale of a pool ofSBA loans.  Net security gains decreased$1,387, compared to the three months ended March 31, 2003.  During the first quarter of 2003, Sunrealigned its portfolio to better serve its needs in the current interest rateenvironment resulting in significant gains on sales during that period.

 
|                                 |   | **For The  Three Months Ended** |   |
|--------------------------------------|--------|---------------------------------|--------|
|                                 |   | **March 31,  2004**             |   | **March 31,  2003** |   | **Change** |   |
| **(In Thousands)**                   |   | **Amount**                      |   | **% Total** |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Service charge on deposit accounts   |   | $                               | 1,039  |   | 27.9 | % | $ | 845 |   | 51.7 | % | $ | 194 |   | 23.0 | % |
| Trust income                         |   | 332                             |   | 8.9 | % | 219 |   | 13.4 | % | 113 |   | 51.6 | % |
| Net security gains                   |   | 109                             |   | 2.9 | % | 1,496 |   | 91.8 | % | (1,387 | ) | -92.7 | % |
| Income from investment product sales |   | 165                             |   | 4.4 | % | 24 |   | 1.5 | % | 141 |   | 587.5 | % |
| Bank owned life insurance            |   | 312                             |   | 8.4 | % | 325 |   | 19.9 | % | (13 | ) | -4.0 | % |
| Income from insurance subsidiary     |   | 661                             |   | 17.7 | % | 23 |   | 1.4 | % | 638 |   | 2773.9 | % |
| Gain on sale of loans                |   | 34                              |   | 0.9 | % | 261 |   | 16.0 | % | (227 | ) | -87.0 | % |
| Income from leasing subsidiary       |   | 272                             |   | 7.3 | % | 301 |   | 18.5 | % | (29 | ) | N/A |   |
| Other income                         |   | 671                             |   | 18.0 | % | 396 |   | 24.3 | % | 275 |   | 69.4 | % |
| Total non-interest income            |   | $                               | 3,595  |   | 96.4 | % | $ | 3,890 |   | 238.5 | % | $ | (295 | ) | -7.6 | % |

 

33

----

 

#### **Non-interest Expenses**

 

Non-interestexpenses increased $956 or 14.6% to $7,519, for the three months ended March31, 2004 compared to the corresponding period of 2003.  The acquisitions of Mid-Penn Insurance,Steelton Bancorp, and Sentry significantly impacted all categories of non-interestexpense for the three months ended March 31, 2004 as compared to 2003.  In the aggregate, MPI and Sentry represented$593 or 62.0% of the total increase. Salaries and employee benefits increased $327 or 10.3%, primarily due tothe acquisitions and increased employee benefit costs.  Net occupancy expense and furniture andequipment expenses increased $98 or 11.3% due to the acquisitions and certaininfrastructure improvements.  Otherexpenses increased $423 or 16.7% due to increases in normal business expenses,acquisitions, and depreciation expense related to Sun’s auto leaseprogram.  Intangible amortization of$108 for the three months ended March 31, 2004 is the result of the creation ofcustomer relationship intangibles and core deposit intangibles related to theacquisitions (Refer to Note 7 for additional information).

 
|                             |   | **For The  Three Months Ended** |   |
|----------------------------------|--------|---------------------------------|--------|
|                             |   | **March 31,  2004**             |   | **March 31,  2003** |   | **Change** |   |
| **(In Thousands)**               |   | **Amount**                      |   | **% Total** |   | **Amount** |   | **% Total** |   | **Amount** |   | **%** |   |
| Salaries and employee benefits   |   | $                               | 3,493  |   | 46.5 | % | $ | 3,166 |   | 48.2 | % | $ | 327 |   | 10.3 | % |
| Net occupancy expenses           |   | 438                             |   | 5.8 | % | 383 |   | 5.8 | % | 55 |   | 14.4 | % |
| Furniture and equipment expenses |   | 530                             |   | 7.1 | % | 487 |   | 7.4 | % | 43 |   | 8.8 | % |
| Amortization of intangibles      |   | 108                             |   | 1.4 | % | — |   | 0.0 | % | 108 |   | N/A |   |
| Other expenses                   |   | 2,950                           |   | 39.2 | % | 2,527 |   | 38.5 | % | 423 |   | 16.7 | % |
| Total non-interest expense       |   | $                               | 7,519  |   | 100.0 | % | $ | 6,563 |   | 100.0 | % | $ | 956 |   | 14.6 | % |

 

34

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Capital Adequacy

 

Sun Bancorp and SunBank are subject to various regulatory capitalrequirements administered by the federal banking agencies.  Failure to meet minimum capital requirementscould prompt regulatory action that, if undertaken, might materially affectSun’s financial statements.  Under regulatorycapital adequacy guidelines, Sun Bancorp and SunBank must meet specific capitalrequirements involving quantitative measures of assets, liabilities, andcertain off-balance sheet items (calculated using regulatory accountingpractices).  All related factors aresubject to qualitative judgments by the regulators.

 

Quantitative measures established by regulation to ensure capitaladequacy require the Bank to maintain minimum amounts and ratios (set forth inthe table below) of total and Tier 1 capital (as defined in the regulations) torisk-weighted assets (as defined), and of Tier 1 capital (as defined) toaverage assets (as defined).  Managementbelieves, as of March 31, 2004, that Sun Bancorp and the SunBank meet allcapital adequacy requirements to which they are subject.

 

     Sun is currently, and hasbeen in the past, designated as a well-capitalized institution.  Shareholders’ equity increased $10,357 to$89,539, at March 31, 2004, from $79,182, at December 31, 2003.  This increase is attributable to theacquisition of Sentry Trust Company which resulted in an increase of $9,291 asSun issued approximately a half million shares from treasury and authorizedshares as a component of the purchase.

 
|                       |   | **Actual** |   | **To Be Well  Capitalized** |   |
|----------------------------|--------|------------|--------|-----------------------------|--------|
| **(Dollars in thousands)** |   | **Amount** |   | **Ratio**                   |   | **Ratio** |   |
| As of March 31, 2004:      |   |       |   |                        |   |   |   |
| Total Risk-Based Capital   |   |       |   |                        |   |   |   |
| Sun Bancorp                |   | $          | 73,940 |                        | 9.6    | % | N/A |   |
| SunBank                    |   | $          | 83,802 |                        | 10.9   | % | 10.0 | % |
| Tier I Risk-Based Capital  |   |       |   |                        |   |   |   |
| Sun Bancorp                |   | $          | 63,139 |                        | 8.2    | % | N/A |   |
| SunBank                    |   | $          | 75,367 |                        | 9.8    | % | 6.0 | % |
| Leverage Ratio             |   |       |   |                        |   |   |   |
| Sun                        |   | $          | 63,139 |                        | 6.4    | % | N/A |   |
| SunBank                    |   | $          | 75,367 |                        | 7.7    | % | 5.0 | % |
|                       |   |       |   |                        |   |   |   |
| As of December 31, 2003:   |   |       |   |                        |   |   |   |
| Total Risk-Based Capital   |   |       |   |                        |   |   |   |
| Sun Bancorp                |   | $          | 73,984 |                        | 9.9    | % | N/A |   |
| SunBank                    |   | $          | 76,880 |                        | 10.3   | % | 10.0 | % |
| Tier I Risk-Based Capital  |   |       |   |                        |   |   |   |
| Sun Bancorp                |   | $          | 63,864 |                        | 8.5    | % | N/A |   |
| SunBank                    |   | $          | 69,126 |                        | 9.2    | % | 6.0 | % |
| Leverage Ratio             |   |       |   |                        |   |   |   |
| Sun Bancorp                |   | $          | 63,864 |                        | 6.4    | % | N/A |   |
| SunBank                    |   | $          | 69,126 |                        | 6.9    | % | 5.0 | % |

 

35

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Liquidity

 

Management must ensure sufficient liquidity tomeet current and future business needs, including customer cash withdrawals andloan fundings. 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 adequatefinancial resources to meet its ongoing cash requirements for operations andcapital expenditures, as well as its other financial obligations.

 

Regulatory andIndustry Merger Activity

 

From time totime, various types of federal and state legislation have been proposed thatcould result in additional regulation of, and restrictions on, the business ofSun and SunBank.  It cannot be predictedwhether such legislation will be adopted or, if adopted, how such legislationwould affect the business of Sun.  As aconsequence of the extensive regulation of commercial banking activities in theUnited States, Sun’s business is particularly susceptible to being affected byfederal legislation and regulations that may increase the costs of doingbusiness.  Future legislation, rules orregulations if implemented, could have a material adverse effect upon theliquidity, capital resources, or results of operations. The general cost ofcompliance with numerous and multiple federal and state laws and regulations doeshave, and in the future may have, a negative impact on Sun’s results ofoperations.

 

Further, thebusiness of Sun is also affected by the state of the financial servicesindustry in general.  As a result oflegal and industry changes, management expects the industry to continue toexperience an increase in consolidation as the financial services industrystrives for greater cost efficiencies and firms seek to gain market share.  Management also expects the financialservices industry including Sun to increase diversification of financialproducts and services offered. Management believes that industry consolidationand product and service diversification present opportunities for Sun toenhance its competitive position.

 

On April 20,2004, Sun announced that a definitive merger agreement was unanimously approvedby the Boards of Directors of both Sun and Omega Financial Corporation.  Please refer to Note 13 for furtherinformation on Sun’s merger with Omega Financial Corporation.

 

36

----

 

The followingtables set forth Selected Financial Data for each of the past five quarters:

 
|                                                |   | **Quarter  Ended** |      |
|-----------------------------------------------------|--------|--------------------|-----------|
| **(Dollars in Thousands, Except Per  Share Data)**  |   | **3/31/2004**      |      | **12/31/2003** |   | **9/30/2003** |   | **6/30/2003** |   | **3/31/2003** |   |
| **Financial Condition Data:**                       |   |               |      |   |   |   |   |   |   |   |   |
| **General**                                         |   |               |      |   |   |   |   |   |   |   |   |
| Total assets                                        |   | $                  | 1,037,218 |   | $ | 1,028,253 |   | $ | 1,033,917 |   | $ | 1,027,414 |   | $ | 1,004,753 |   |
| Loans, net                                          |   | 675,791            |      | 672,223 |   | 663,339 |   | 646,604 |   | 612,541 |   |
| Intangibles                                         |   | 41,920             |      | 33,538 |   | 33,981 |   | 34,032 |   | 23,345 |   |
| Total deposits                                      |   | 647,605            |      | 614,550 |   | 651,512 |   | 648,429 |   | 598,067 |   |
| Non interest bearing                                |   | 69,794             |      | 69,640 |   | 66,118 |   | 64,671 |   | 57,649 |   |
|                                                |   |               |      |   |   |   |   |   |   |   |   |
| Savings                                             |   | 84,578             |      | 82,416 |   | 88,106 |   | 89,806 |   | 81,321 |   |
| NOW                                                 |   | 161,376            |      | 164,803 |   | 170,001 |   | 163,018 |   | 156,649 |   |
| Money Market                                        |   | 34,472             |      | 22,461 |   | 26,726 |   | 27,887 |   | 27,548 |   |
| Time Deposits                                       |   | 297,385            |      | 275,230 |   | 300,561 |   | 303,047 |   | 274,900 |   |
| Total interest bearing deposits                     |   | 577,811            |      | 544,910 |   | 585,394 |   | 583,758 |   | 540,418 |   |
|                                                |   |               |      |   |   |   |   |   |   |   |   |
| Core deposits*                                      |   | 350,220            |      | 339,320 |   | 350,951 |   | 345,382 |   | 323,167 |   |
| Trust preferred securities &  subordinated debt |   | 18,866             |      | 18,866 |   | 18,866 |   | 18,866 |   | 19,655 |   |
| Shareholders’ equity                           |   | 89,539             |      | 79,182 |   | 79,015 |   | 81,037 |   | 80,035 |   |
| Trust assets under management                       |   | 588,642            |      | 162,150 |   | 148,144 |   | 148,156 |   | 151,065 |   |
|                                                |   |               |      |   |   |   |   |   |   |   |   |
| **Asset Quality**                                   |   |               |      |   |   |   |   |   |   |   |   |
|                                                |   |               |      |   |   |   |   |   |   |   |   |
| Non-performing assets                               |   | $                  | 6,033     |   | $ | 5,203 |   | $ | 4,596 |   | $ | 4,592 |   | $ | 4,714 |   |
| Non-performing assets to total assets               |   | 0.58               | %         | 0.51 | % | 0.44 | % | 0.45 | % | 0.47 | % |
| Allowance for loan losses                           |   | 8,435              |      | 7,754 |   | 7,229 |   | 7,342 |   | 6,478 |   |
| Allowance for loan losses to total loans            |   | 1.23               | %         | 1.14 | % | 1.08 | % | 1.12 | % | 1.05 | % |
| Allowance for loan losses to non-performing  loans  |   | 175.77             | %         | 194.97 | % | 201.48 | % | 204.57 | % | 167.04 | % |
| Non-performing loans to total loans                 |   | 0.70               | %         | 0.58 | % | 0.54 | % | 0.55 | % | 0.63 | % |
|                                                |   |               |      |   |   |   |   |   |   |   |   |
| **Capitalization - Bancorp**                        |   |               |      |   |   |   |   |   |   |   |   |
|                                                |   |               |      |   |   |   |   |   |   |   |   |
| Shareholders’ equity to total assets           |   | 8.63               | %         | 7.70 | % | 7.64 | % | 7.89 | % | 7.97 | % |

 

----

*Core deposits are defined as total deposits less time deposits

 

37

----

 
|                                               |   | **Quarter  Ended** |   |
|----------------------------------------------------|--------|--------------------|--------|
| **(Dollars in Thousands, Except Per  Share Data)** |   | **3/31/2004**      |   | **12/31/2003** |   | **9/30/2003** |   | **6/30/2003** |   | **3/31/2003** |   |
|                                               |   |               |   |   |   |   |   |   |   |   |   |
| **Operating Data**                                 |   |               |   |   |   |   |   |   |   |   |   |
|                                               |   |               |   |   |   |   |   |   |   |   |   |
| Net income                                         |   | $                  | 1,509  |   | $ | 983 |   | $ | 1,821 |   | $ | 1,690 |   | $ | 2,034 |   |
| Net interest income                                |   | 6,089              |   | 5,829 |   | 5,973 |   | 5,924 |   | 5,548 |   |
| Provision for loan losses                          |   | 435                |   | 405 |   | 405 |   | 405 |   | 405 |   |
| Non-interest income                                |   | 3,595              |   | 3,065 |   | 3,728 |   | 3,547 |   | 3,890 |   |
| Non-interest expense                               |   | 7,519              |   | 7,634 |   | 7,155 |   | 7,141 |   | 6,563 |   |
|                                               |   |               |   |   |   |   |   |   |   |   |   |
| **Performance Statistics**                         |   |               |   |   |   |   |   |   |   |   |   |
|                                               |   |               |   |   |   |   |   |   |   |   |   |
| Net interest margin                                |   | 2.85               | %      | 2.69 | % | 2.70 | % | 2.69 | % | 2.78 | % |
| Annualized return on average assets                |   | 0.59               | %      | 0.38 | % | 0.70 | % | 0.66 | % | 0.84 | % |
| Annualized return on average equity                |   | 6.87               | %      | 4.99 | % | 9.15 | % | 8.30 | % | 9.87 | % |
| Annualized net loan charge-offs to avg loans       |   | -0.14              | %      | -0.07 | % | 0.31 | % | 0.15 | % | 0.09 | % |
| Net charge-offs (recoveries)                       |   | (246               | )      | (120 | ) | 517 |   | 234 |   | 133 |   |
| Efficiency ratio                                   |   | 77.4               |   | 80.9 |   | 78.9 |   | 83.7 |   | 82.6 |   |
| Net income per employee                            |   | 5                  |   | 3 |   | 6 |   | 6 |   | 7 |   |
|                                               |   |               |   |   |   |   |   |   |   |   |   |
| **Per Share Data**                                 |   |               |   |   |   |   |   |   |   |   |   |
|                                               |   |               |   |   |   |   |   |   |   |   |   |
| Basic earnings per share                           |   | $                  | 0.21   |   | $ | 0.14 |   | $ | 0.25 |   | $ | 0.23 |   | $ | 0.28 |   |
| Diluted earnings per share                         |   | 0.21               |   | 0.14 |   | 0.25 |   | 0.23 |   | 0.28 |   |
| Dividend declared per share                        |   | 0.1815             |   | 0.1815 |   | 0.1815 |   | 0.1815 |   | 0.1650 |   |
| Book value                                         |   | 11.66              |   | 11.03 |   | 11.01 |   | 11.24 |   | 11.17 |   |
| Common stock price:                                |   |               |   |   |   |   |   |   |   |   |   |
| High                                               |   | 20.28              |   | 21.29 |   | 22.14 |   | 22.48 |   | 20.50 |   |
| Low                                                |   | 17.87              |   | 18.36 |   | 17.80 |   | 19.60 |   | 18.01 |   |
| Close                                              |   | 19.50              |   | 18.96 |   | 18.22 |   | 20.13 |   | 19.51 |   |
| Weighted average common shares:                    |   |               |   |   |   |   |   |   |   |   |   |
| Basic                                              |   | 7,333              |   | 7,179 |   | 7,189 |   | 7,211 |   | 7,182 |   |
| Fully Diluted                                      |   | 7,357              |   | 7,203 |   | 7,214 |   | 7,242 |   | 7,201 |   |
| End-of-period common shares:                       |   |               |   |   |   |   |   |   |   |   |   |
| Issued                                             |   | 7,679              |   | 7,320 |   | 7,319 |   | 7,319 |   | 7,317 |   |
| Treasury                                           |   | —             |   | 141 |   | 141 |   | 111 |   | 149 |   |

 

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Item 3 – Quantitative and Qualitative Disclosures about Market Risk

 

Market Risk

 

For Sun, market risk results predominantlyfrom interest 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.

 

InterestRate Risk (IRR)

 

IRR represents the potentialcurrent or future earnings and capital volatility due to interest rate changes.Interest rate fluctuations affect earnings by changing net interest income andother interest-sensitive income and expense levels. Interest rate changesaffect capital by altering banks’ economic value of equity (EVE). EVErepresents the net present value of all asset, liability, and off-balance sheetcash flows. Interest rate fluctuations change the present values of those cashflows.

 

As financial intermediaries,banks cannot completely avoid IRR. However, excessive IRR can threatenearnings, capital, liquidity, and solvency. IRR has many components, includingrepricing risk, basis risk, yield curve risk, option risk, and price risk.Sun’s primary, but not sole, IRR source is balance sheet optionality fromresidential mortgages and mortgage-backed securities. Those assets may prepayprincipal at changing speeds depending on interest rate levels and otherfactors beyond Sun’s control. When prepayments occur, management must reinvestthose cash flows at current market rates (in loans or securities). Thus, futureinterest levels and paths may negatively (or positively) affect Sun’s netinterest income.

 

Sun seeks to minimize net interest incomevolatility by carefully measuring, monitoring, and controlling IRR. Sun isimplementing a comprehensive market risk management program to dramaticallyenhance management’s ability to measure, monitor, and control risk. Market riskcan result 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 enteredinto four pay-variable receive-fixed interest rate swaps ($100,000 notionaltotal) to hedge changes in fair value of certain FHLB long-term borrowings(other borrowed funds).  The swaps alsocontain an embedded option to reverse the swap to pay-fixed receive-variable inthe event that the FHLB long-term borrowings reprice and become variable rate.  The exercise of the option would effectivelyfix the rate Sun pays on the borrowings at approximately the original couponand would reduce the net interest income volatility caused in an increasinginterest rate environment.  Sun includesall components of each derivatives gain or loss in the assessment of hedgeeffectiveness.  Sun recognizes thechange in fair value of the hedge and associated borrowings through the incomestatement.  There was a change in valuerecognized in the hedge and associated long-term FHLB borrowings of $2,816 to$2,340 at March 31, 2004 from $5,156 at December 31, 2003, due to the mark tomarket adjustment. The change in value of the FHLB borrowings is includedwithin long-term borrowings, while the change in the swap value is includedwithin accrued interest and other liabilities.   Sun also

 

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recognized areduction of $372 in interest expense on long-term FHLB borrowings during thethree months ended March 31, 2004 as a result of the hedge transaction.  A summary of Sun’s fair value hedges appearsbelow:

 

(In Thousands)

 
|                                              |   |         |    |      |   |          |   | **Weighted  Average** |   |
|---------------------------------------------------|--------|--------------|---------|-----------|--------|---------------|--------|-----------------------|--------|
|                                              |   | **Notional** |    |      |   |          |   | **Receive**           |   | **Pay** |   | **Life** |   |
| **March 31, 2004**                                |   | **Amount**   |    | **Asset** |   | **Liability** |   | **Rate**              |   | **Rate** |   | **(Years)** |   |
| Fair Value Hedges:                                |   |         |    |      |   |          |   |                  |   |   |   |   |   |
| Receive fixed - pay variable interest rate  swaps |   | $            | 100,000 |      | $      | —        |   | $                     | 2,340  |   | 2.65 | % | 1.12 | % | 6.0 |   |
|                                                   |        |              |         |           |        |               |        |                       |        |  |  |  |  |  |  |  |

 
|                                              |   |         |    |      |   |          |   | **Weighted  Average** |   |
|---------------------------------------------------|--------|--------------|---------|-----------|--------|---------------|--------|-----------------------|--------|
|                                              |   | **Notional** |    |      |   |          |   | **Receive**           |   | **Pay** |   | **Life** |   |
| **December 31, 2003**                             |   | **Amount**   |    | **Asset** |   | **Liability** |   | **Rate**              |   | **Rate** |   | **(Years)** |   |
| Fair Value Hedges:                                |   |         |    |      |   |          |   |                  |   |   |   |   |   |
| Receive fixed - pay variable interest rate  swaps |   | $            | 100,000 |      | $      | —        |   | $                     | 5,156  |   | 2.65 | % | 1.13 | % | 6.3 |   |
|                                                   |        |              |         |           |        |               |        |                       |        |  |  |  |  |  |  |  |

 

Rate Shock at March31, 2004 for the Next Twelve Months:

 
|                      |   | **Parallel  rate shock in basis points (bp)** |   |
|---------------------------|--------|-----------------------------------------------|--------|
| **(In Thousands)**        |   | **-100bp**                                    |   | **0bp** |   | **+100bp** |   | **+200bp** |   | **+300bp** |   |
| Net interest income:      |   | $                                             | 19,433 |   | $ | 21,561 |   | $ | 22,389 |   | $ | 22,805 |   | $ | 23,078 |   |
| Percent change from flat: |   | -9.87                                         | %      | 0.00 | % | 3.84 | % | 5.77 | % | 7.04 | % |
|                           |        |                                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Rate Shock atDecember 31, 2003 for the Next Twelve Months:

 
|                      |   | **Parallel  rate shock in basis points (bp)** |   |
|---------------------------|--------|-----------------------------------------------|--------|
| **(In Thousands)**        |   | **-100bp**                                    |   | **0bp** |   | **+100bp** |   | **+200bp** |   | **+300bp** |   |
| Net interest income:      |   | $                                             | 19,695 |   | $ | 21,947 |   | $ | 22,520 |   | $ | 22,561 |   | $ | 22,475 |   |
| Percent change from flat: |   | -10.26                                        | %      | 0.00 | % | 2.61 | % | 2.80 | % | 2.41 | % |
|                           |        |                                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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#### **Equity Securities Risk**

 

Sun’s equitysecurities consist of marketable equities and restricted stock.  Marketable equities consist entirely ofcommon stock of bank and financial holding companies.   Because Federal Home Loan Bank stock is redeemable at par, Suncarries it at cost and periodically evaluates the stock for impairment.  Possible impairment factors includepotential dramatic changes to the housing and residential mortgage industry orthe related regulatory environment. Management currently does not believe any factors exist to suggestpotential impairment.

 

Bank andfinancial holding company stocks are subject to general industry risks,including competition from non-bank entities, credit risk, interest rate risk,and other factors.  Individual stockscould suffer price decreases due to circumstances at specific banks.  In addition, Sun’s bank stock investmentsare concentrated in Pennsylvania entities, so these investments could declinein value if there were a downturn in the state’s economy.

 

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Reference is also made to Item 7A. Quantitative and QualitativeDisclosure About Market Risk in Sun’s Annual Report on Form 10-K for the year2003.

 

Item 4 – Controls and Procedures

 

Management maintains a system of controls andprocedures designed to provide reasonable assurance as to the reliability ofthe financial statements and other disclosures included in this report, as wellas to safeguard assets from unauthorized use or disposition.  An evaluation was carried out under thesupervision and with the participation of the Sun’s management, including thePrincipal Executive Officer and Principal Financial Officer of theeffectiveness of Sun’s disclosure controls and procedures as of the end of theperiod covered by this report.  Based on that evaluation, Sun’smanagement, including the Principal Executive Officer and Principal FinancialOfficer has concluded that Sun’s disclosure controls and procedures areeffective.  No significant changes weremade to Sun’s internal controls or other factors that could significantlyaffect these controls subsequent to the date of their evaluation.

 

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SUN BANCORP,INC.

FORM 10-Q

PART II

 

Items 1, 3, and 4 – Omittedpursuant to instructions to Part II

 

Item 2 – Changes in Securities, Use of Proceeds and Issuer Purchases ofEquity Securities

 

There were nopurchases of Sun’s common stock conducted by Sun during the three months endedMarch 31, 2004.  During this period, Sunutilized its treasury stock holding as a portion of the consideration paid forthe acquisition of Sentry Trust Company.

 

Item 5 – Other Information

 

There were no material changes to theprocedures by which a shareholder may recommend nominees to Sun’s Board ofDirectors.

 

Item 6 – Exhibitsand Reports on Form 8-K

 

a.                                 On January 21, 2004,Sun Bancorp, Inc. filed a Current Report on Form 8-K announcing the operating results for the three and twelve months endedDecember 31, 2003

 

b.                                OnJanuary 30, 2004, Sun Bancorp, Inc. filed a Current Report on Form 8-K announcingthe declaration of the first quartercash dividend of $0.1815 per share.

 

c.                                 On March 1, 2004, SunBancorp, Inc. filed a Current Report on Form 8-K announcing the completion ofthe acquisition of Sentry Trust Company.

 

d.                                On March 26, 2004, SunBancorp, Inc. filed a Current Report on Form 8-K announcing an Employment Agreement between Maureen M. Bufalino, theRegistrant, SunBank, and SUBI Services, dated January 12, 2004.

 

e.                                 Exhibits

 

2                                    Agreementand Plan of Merger by and between Omega Financial Corporation and Sun Bancorp,Inc. dated April 20, 2004 is incorporated by reference to Exhibit 2.1 to theForm 8-K filed April 22, 2003 (Commission File Number 0-14745)

 

3(i)                         The Articles ofIncorporation of the Registrant are incorporated herein by reference to Exhibit3(i) to the Form 8-K filed July 1, 2003 (Commission File Number 0-14745).

 

3(ii)                      The By-Laws, as amended andrestated are incorporated herein by reference to Exhibit 3 (iii) to the Form8-K filed March 20, 2003 (Commission File Number 0-14745).

 

10.1               Employment Agreementbetween Robert J. McCormack, the Registrant and SunBank dated October 31, 2002is incorporated by reference to Form 8-K filed March 20, 2003 (Commission FileNumber 0-14745).

 

10.2               Employment Agreementbetween Thomas W. Bixler, the Registrant and SunBank dated November 3, 2002 isincorporated by reference to Form 8-K filed March 20, 2003 (Commission FileNumber 0-14745).

 

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10.3               Employment Agreementbetween Sandra Miller, the Registrant and SunBank dated October 24, 2002 isincorporated by reference to Form 8-K filed March 20, 2003 (Commission FileNumber 0-14745).

 

10.4               Employment Agreementbetween Maureen M. Bufalino, the Registrant, SunBank, and SUBI Services, LLCdated January 12, 2004 is incorporated by reference to Form 8-K filed March 26,2004 (Commission File Number 0-14745).

 

10.5               Employment Agreementbetween Wilmer D. Leinbach, the Registrant, SunBank, and SUBI Services, LLCdated January 28, 2003 is incorporated by reference to Form 8-K filed July 1,2003 (Commission File Number 0-14745).

 

10.6               Employment Agreementbetween David M. Diffenderffer, the Registrant, SunBank, and SUBI Services, LLCdated January 12, 2004 is incorporated by reference to Form 10-K filed March15, 2004 (Commission File Number 0-14745).

 

10.7               Employment Agreementbetween James P. Radick, the Registrant, SunBank, and SUBI Services, LLC datedJanuary 12, 2004 is incorporated by reference to Form 10-K filed March 15, 2004(Commission File Number 0-14745).

 

10.8               Employment Agreementbetween Byron M. Mertz III, the Registrant, SunBank, and SUBI Services, LLCdated January 12, 2004 is incorporated by reference to Form 10-K filed March15, 2004 (Commission File Number 0-14745).

 

10.9               Employment Agreement betweenGary Cook, the Registrant, SunBank, and Bank Capital Services Corporation datedDecember 17, 2002 is incorporated by reference to Form 10-K filed March 15,2004 (Commission File Number 0-14745).

 

10.10         Employment Agreement between CarolPhillips, the Registrant, SunBank, and Bank Capital Services Corporation datedDecember 17, 2002 is incorporated by reference to Form 10-K filed March 15,2004 (Commission File Number 0-14745).

 

10.11         Employment Agreement betweenChristopher J. Fellon, the Registrant, SunBank, and Mid-Penn InsuranceAssociates dated December 23, 2002 is incorporated by reference to Form 10-Kfiled March 15, 2004 (Commission File Number 0-14745).

 

10.12         Employment Agreement between Cheryl A.Zellers, the Registrant, SunBank, and Mid-Penn Insurance Associates datedDecember 23, 2002 is incorporated by reference to Form 10-K filed March 15,2004 (Commission File Number 0-14745).

 

10.13         Employment Agreement between Daniel R.Geise, the Registrant, SunBank, and Mid-Penn Insurance Associates datedDecember 23, 2002 is incorporated by reference to Form 10-K filed March 15,2004 (Commission File Number 0-14745).

 

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10.14         Employment Agreement between Charles E.Nelson, the Registrant, SunBank, SUBI Services, LLC, and Sentry Trust Companydated April 23, 2003 is incorporated by reference to Exhibit 2 to Appendix A tothe proxy statement prospectus on Sun’s Registration Statement on Form S-4filed January 23, 2004 (Registration Statement no. 333-107944).

 

10.15         Employment Agreement between Carole L.Crist, the Registrant, SunBank, SUBI Services, LLC, and Sentry Trust Companydated April 23, 2003 is incorporated by reference to Exhibit 3 to Appendix A ofthe proxy statement prospectus on Sun’s Registration Statement on Form S-4filed January 23, 2004 (Registration Statement no. 333-107944).

 

10.16         Employment Agreement between Randy L.Martin, the Registrant, SunBank, SUBI Services, LLC, and Sentry Trust Companydated April 23, 2003 is incorporated by reference to Exhibit 4 to Appendix A ofthe proxy statement prospectus on Sun’s Registration Statement on Form S-4filed January 23, 2004 (Registration Statement no. 333-107944).

 

10.17         1998 Stock Incentive Plan isincorporated by reference to Exhibit 4.3 of Sun’s Registration Statement onForm S-8 filed on August 12, 1998 (Registration Statement No. 333-61237).

 

10.18         1998 Independent Directors Stock OptionPlan is incorporated by reference to Exhibit 4.3 of Sun’s RegistrationStatement on Form S-8 filed on August 12, 1998 (Registration Statement No.333-61241).

 

10.19         1998Employee Stock Purchase Plan isincorporated by reference to Exhibit 4.3 of Sun’s Registration Statement onForm S-8 filed on August 12, 1998 (Registration Statement No. 333-61249).

 

10.20         Consulting Agreement between SunBancorp, Inc. and Sidney M Palmer is incorporated by reference to Appendix B tothe proxy statement prospectus on Sun’s Registration Statement on Form S-4filed on January 23, 2004 (Registration Statement No. 333-107944)

 

11                        Statement re: Computationof Earnings Per Share can be referenced in Note 5 of the ConsolidatedStatements in this Report

 

31.1               Certification pursuant toSection 302 of the Sarbanes-Oxley Act of 2002.

 

31.2               Certification pursuant toSection 302 of the Sarbanes-Oxley Act of 2002.

 

32.1               Certification of principalexecutive officer or principal financial officer pursuant to 18U.S.C. Section1350.

 

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32.2               Certification of principalexecutive officer or principal financial officer pursuant to 18U.S.C. Section1350.

 

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SIGNATURES

 

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

 

 
|   | Sun Bancorp, Inc.                     |   |
|--------|---------------------------------------|--------|
|   |                                  |   |
| Date   | May 7, 2004                           |   | /s/  Robert J. McCormack |   |
|   | Robert J. McCormack                   |   |
|   | President and Chief Executive Officer |   |
|   | (Principal Executive Officer)         |   |
|   |                                  |   |
|   | /s/  James P. Radick             |   |
|   | James P. Radick                       |   |
|   | Senior Vice President of Finance      |   |
|   | (Principal Financial Officer)         |   |
|        |                                       |        |  |  |

 

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