** **

**UNITED STATES**

**SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM 10-Q**

**(Mark One)**

 

ý                                    **QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

 

**For the quarterly period ended March 31,2005**

 

**OR**

 

o                                    **TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.******

** **

**CommissionFile Number 0-18832**

 

**First FinancialService Corporation**

(ExactName of Registrant as specified in its charter)

 

| **Kentucky**                      | ** ** | **61-1168311**                    |
|-----------------------------------|------------|-----------------------------------|
| (State or other jurisdiction      |       | (IRS Employer Identification No.) |
| of incorporation or organization) |       |                              |
|                              |       |                              |

**2323 Ring Road**

**Elizabethtown, Kentucky 42701**

(Addressof principal executive offices)

(ZipCode)

 

**(270)765-2131**

(Registrant’s telephonenumber, including area code)

 

Indicate by check mark whether the registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 isan accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes ý  No o

 

Indicate the number of shares outstanding of each of theissuer’s classes of common stock, as of the latest practicable date.

 

| **Class**    | ** ** | **Outstanding as of April 30, 2005** |
|--------------|------------|--------------------------------------|
|         |       |                                 |
| Common Stock |       | 3,648,188** **shares            |
|         |       |                                 |

 

 

 

----

 

## ** **

 

 

 

## **FIRST FINANCIAL SERVICE CORPORATION**

 

**TABLE OF CONTENTS**

 

 
| **PART I** — FINANCIAL INFORMATION | ** **                                                                                                                  |
|-----------------------------------------|-----------------------------------------------------------------------------------------------------------------------------|
|                                    |                                                                                                                        |   |
| **Item 1.**                             | Consolidated Financial  Statements and Notes to Consolidated Financial Statements                                           | ** ** |
|                                    |                                                                                                                        |   |
| **Item 2.**                             | Management’s Discussion and  Analysis of the Consolidated Statements 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 1.**                       | Legal Proceedings                                                                                                           |   |
|                                    |                                                                                                                        |   |
|  **Item 2.**                       | Changes In Securities, Use of Proceeds and Issuer Purchases of Equity Securities                                            |   |
|                                    |                                                                                                                        |   |
|  **Item 3.**                       | Defaults upon Senior Securities                                                                                             |   |
|                                    |                                                                                                                        |   |
|  **Item 4.**                       | Submission of Matters to a Vote of Security Holders                                                                         |   |
|                                    |                                                                                                                        |   |
|  **Item 5.**                       | Other Information                                                                                                           |   |
|                                    |                                                                                                                        |   |
|  **Item 6.**                       | Exhibits                                                                                                                    |   |
|                                    |                                                                                                                        |   |
| SIGNATURES                              |                                                                                                                        |
|                                    |                                                                                                                        |   |
| CERTIFICATIONS                          |                                                                                                                        |
|                                    |                                                                                                                        |   |

 

** **

 

2

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** **

**Item 1.FIRST FINANCIAL SERVICECORPORATION**

**ConsolidatedStatements****of Financial Condition**

 
| ** **                                                                                                                                                 | ** ** | **(Unaudited)** | ** ** | ** ** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                                                                                                 | ** ** | **March  31,**  | ** ** | ** ** | ** ** |
| **(Dollars  in thousands, except share data)**                                                                                                             | ** ** | **2005**        | ** ** | **2004**   | ** ** |
| **ASSETS**                                                                                                                                                 |       |            |       |       |       |
| Cash and due  from banks                                                                                                                                   |       | $               | 18,900     |       | $          | 27,910 |   |
| Federal funds  sold                                                                                                                                        |       | 10,000          |       | 8,000      |       |
| Cash and cash  equivalents                                                                                                                                 |       | 28,900          |       | 35,910     |       |
|                                                                                                                                                       |       |            |       |       |       |
| Securities  available-for-sale                                                                                                                             |       | 38,130          |       | 21,928     |       |
| Securities  held-to-maturity, fair value of $33,794 Mar (2005)                                                                                             |       |            |       |       |       |
| and $34,557 Dec  (2004)                                                                                                                                    |       | 34,539          |       | 34,915     |       |
| Total securities                                                                                                                                           |       | 72,669          |       | 56,843     |       |
|                                                                                                                                                       |       |            |       |       |       |
| Loans held for  sale                                                                                                                                       |       | 721             |       | 1,219      |       |
| Loans  receivable, net of unearned fees                                                                                                                    |       | 599,846         |       | 604,698    |       |
| Allowance for  loan losses                                                                                                                                 |       | (6,701          | )          | (6,489     | )          |
| Net loans  receivable                                                                                                                                      |       | 593,866         |       | 599,428    |       |
|                                                                                                                                                       |       |            |       |       |       |
| Federal Home  Loan Bank stock                                                                                                                              |       | 6,921           |       | 6,845      |       |
| Cash surrender  value of life insurance                                                                                                                    |       | 7,425           |       | 7,353      |       |
| Premises and  equipment, net                                                                                                                               |       | 18,080          |       | 17,469     |       |
| Real estate  owned:                                                                                                                                        |       |            |       |       |       |
| Acquired through  foreclosure                                                                                                                              |       | 913             |       | 681        |       |
| Held for  development                                                                                                                                      |       | 389             |       | 389        |       |
| Other  repossessed assets                                                                                                                                  |       | 59              |       | 40         |       |
| Goodwill                                                                                                                                                   |       | 8,384           |       | 8,384      |       |
| Accrued interest  receivable                                                                                                                               |       | 2,563           |       | 2,487      |       |
| Other assets                                                                                                                                               |       | 2,302           |       | 1,817      |       |
|                                                                                                                                                       |       |            |       |       |       |
| **TOTAL ASSETS**                                                                                                                                           |       | $               | 742,471    |       | $          | 737,646 |   |
|                                                                                                                                                       |       |            |       |       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY LIABILITIES:**                                                                                                 |       |            |       |       |       |
| Deposits:                                                                                                                                                  |       |            |       |       |       |
| Non-interest  bearing                                                                                                                                      |       | $               | 39,961     |       | $          | 38,441 |   |
| Interest bearing                                                                                                                                           |       | 549,088         |       | 547,945    |       |
| Total deposits                                                                                                                                             |       | 589,049         |       | 586,386    |       |
|                                                                                                                                                       |       |            |       |       |       |
| Advances from  Federal Home Loan Bank                                                                                                                      |       | 78,860          |       | 78,904     |       |
| Subordinated  debentures                                                                                                                                   |       | 10,000          |       | 10,000     |       |
| Accrued interest  payable                                                                                                                                  |       | 393             |       | 413        |       |
| Accounts payable  and other liabilities                                                                                                                    |       | 1,943           |       | 637        |       |
| Deferred income  taxes                                                                                                                                     |       | 1,291           |       | 1,505      |       |
|                                                                                                                                                       |       |            |       |       |       |
| **TOTAL  LIABILITIES**                                                                                                                                     |       | 681,536         |       | 677,845    |       |
|                                                                                                                                                       |       |            |       |       |       |
| **STOCKHOLDERS’  EQUITY:**                                                                                                                            |       |            |       |       |       |
| Serial preferred  stock, 5,000,000 shares                                                                                                                  |       |            |       |       |       |
| authorized and  unissued                                                                                                                                   |       | —          |       | —     |       |
| Common stock, $1  par value per share; authorized 10,000,000 shares; issued and outstanding,  3,648,188 shares Mar (2005), and 3,645,438 shares Dec (2004) |       | 3,648           |       | 3,645      |       |
| Additional  paid-in capital                                                                                                                                |       | 8,280           |       | 8,226      |       |
| Retained  earnings                                                                                                                                         |       | 48,666          |       | 47,174     |       |
| Accumulated  other comprehensive                                                                                                                           |       |            |       |       |       |
| income, net of  tax                                                                                                                                        |       | 341             |       | 756        |       |
|                                                                                                                                                       |       |            |       |       |       |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                                                                                       |       | 60,935          |       | 59,801     |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                       |       | $               | 742,471    |       | $          | 737,646 |   |

 

***See notes to the unaudited consolidated financialstatements.***

## ** **

 

3

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Income**

**(Unaudited)**

## ** **

 
| ** **                                           | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|
| ** **                                           | ** ** | **March 31,**          | ** ** |
| **(Dollars in thousands, except per share data)**    | ** ** | **2005**               | ** ** | **2004** | ** ** |
| **Interest  Income:**                                |       |                   |       |   |   |
| Interest and  fees on loans                          |       | $                      | 9,954      |   | $ | 9,107 |   |
| Interest and  dividends on investments and deposits  |       | 676                    |       | 443 |   |
| Total interest  income                               |       | 10,630                 |       | 9,550 |   |
|                                                 |       |                   |       |   |   |
| **Interest  Expense:**                               |       |                   |       |   |   |
| Deposits                                             |       | 2,892                  |       | 2,725 |   |
| Federal Home  Loan Bank advances                     |       | 944                    |       | 928 |   |
| Subordinated  debentures                             |       | 158                    |       | 124 |   |
| Total interest  expense                              |       | 3,994                  |       | 3,777 |   |
|                                                 |       |                   |       |   |   |
| Net interest  income                                 |       | 6,636                  |       | 5,773 |   |
| Provision for  loan losses                           |       | 275                    |       | 389 |   |
| Net interest  income after provision for loan losses |       | 6,361                  |       | 5,384 |   |
|                                                 |       |                   |       |   |   |
| **Non-interest  Income:**                            |       |                   |       |   |   |
| Customer service  fees on deposit accounts           |       | 1,120                  |       | 1,135 |   |
| Gain on sale of  mortgage loans                      |       | 184                    |       | 218 |   |
| Brokerage  commissions                               |       | 78                     |       | 94 |   |
| Gain on sale of  investments                         |       | 381                    |       | — |   |
| Other income                                         |       | 258                    |       | 324 |   |
| Total  non-interest income                           |       | 2,021                  |       | 1,771 |   |
|                                                 |       |                   |       |   |   |
| **Non-interest  Expense:**                           |       |                   |       |   |   |
| Employee  compensation and benefits                  |       | 2,778                  |       | 2,398 |   |
| Office occupancy  expense and equipment              |       | 494                    |       | 408 |   |
| Marketing and  advertising                           |       | 188                    |       | 139 |   |
| Outside services  and data processing                |       | 597                    |       | 514 |   |
| Bank franchise  tax                                  |       | 203                    |       | 212 |   |
| Other expense                                        |       | 884                    |       | 768 |   |
| Total  non-interest expense                          |       | 5,144                  |       | 4,439 |   |
|                                                 |       |                   |       |   |   |
| Income before  income taxes                          |       | 3,238                  |       | 2,716 |   |
| Income taxes                                         |       | 1,052                  |       | 878 |   |
| **Net  Income**                                      |       | $                      | 2,186      |   | $ | 1,838 |   |
|                                                 |       |                   |       |   |   |
| Shares  applicable to basic income per share         |       | 3,647,500              |       | 3,690,438 |   |
| **Basic  income per share**                          |       | $                      | 0.60       |   | $ | 0.50 |   |
|                                                 |       |                   |       |   |   |
| Shares applicable  to diluted income per share       |       | 3,665,496              |       | 3,708,063 |   |
| **Diluted  income per share**                        |       | $                      | 0.60       |   | $ | 0.50 |   |

 

***Seenotes to the unaudited consolidated financial statements.***

 

 

4

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**FIRST  FINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Comprehensive Income**

**(Unaudited)**

 
| ** **                                | ** ** | **Three Months Ended**

**March 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|
| **(Dollars in thousands)**                | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                      |       |                                  |       |   |   |
| **Net  Income**                           |       | $                                     | 2,186      |   | $ | 1,838 |   |
| Other  comprehensive income (loss):       |       |                                  |       |   |   |
| Change in  unrealized gain (loss)         |       |                                  |       |   |   |
| on securities                             |       | (248                                  | )          | 41 |   |
| Reclassification  of realized amount      |       | (381                                  | )          | — |   |
| Net unrealized  gain (loss) recognized in |       |                                  |       |   |   |
| comprehensive  income                     |       | (629                                  | )          | 41 |   |
| Tax effect                                |       | 214                                   |       | (14 | ) |
| Total other  comphrehensive income (loss) |       | (415                                  | )          | 27 |   |
|                                      |       |                                  |       |   |   |
| **Comphrehensive  Income**                |       | $                                     | 1,771      |   | $ | 1,865 |   |

 

***See notes to the unaudited consolidated financialstatements.***

 

5

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Changes in Stockholders’ Equity**

**ThreeMonths Ended March 31, 2005**

**(DollarsIn Thousands, Except Per Share Amounts)**

**(Unaudited)**

 
| ** **                                                                             | ** ** | ** **       | ** ** | ** **  | ** ** | ** **     | ** ** | ** **         | ** ** | **Accumulated Other  ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------|------------|-------------|------------|----------------|------------|--------------------|------------|-----------------------------------|------------|------------|------------|
| ** **                                                                             | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **         | ** ** | **Comprehensive**                 | ** ** | ** ** | ** ** |
| ** **                                                                             | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Retained**   | ** ** | **Income, Net of** | ** ** | ** **                        | ** ** |
| ** **                                                                             | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Earnings**       | ** ** | **Tax**                           | ** ** | **Total**  | ** ** |
|                                                                                   |       |             |       |        |       |           |       |               |       |                              |       |       |       |
| **Balance,  December 31, 2004**                                                        |       | 3,645            |       | $           | 3,645      |           | $          | 8,226              |       | $                                 | 47,174     |       | $          | 756 |   | $ | 59,801 |   |
| Net income                                                                             |       |             |       |        |       |           |       | 2,186              |       |                              |       | 2,186      |       |
| Exercise of  stock options                                                             |       | 3                |       | 3           |       | 54             |       |               |       |                              |       | 57         |       |
| Net change in  unrealized gains (losses) on securities available- for-sale, net of tax |       |             |       |        |       |           |       |               |       | (415                              | )          | (415       | )          |
| Cash dividends  declared ($.19 per share)                                              |       | —           |       | —      |       | —         |       | (694               | )          | —                            |       | (694       | )          |
| Stock  repurchased                                                                     |       |             |       |        |       |           |       |               |       |                              |       |       |       |
| **Balance,  March 31, 2005**                                                           |       | 3,648            |       | $           | 3,648      |           | $          | 8,280              |       | $                                 | 48,666     |       | $          | 341 |   | $ | 60,935 |   |

 

***Seenotes to the unaudited consolidated financial statements.***

 

 

 

6

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Cash Flows**

**(DollarsIn Thousands)**

 
| ** **                                                                         | ** ** | **Three Months Ended**

**March  31,** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| **Operating  Activities:**                                                         |       |                                   |       |   |   |
| Net income                                                                         |       | $                                      | 2,186      |   | $ | 1,838 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                                   |       |   |   |
| Provision for  loan losses                                                         |       | 275                                    |       | 389 |   |
| Depreciation on  premises and equipment                                            |       | 301                                    |       | 244 |   |
| Federal Home  Loan Bank stock dividends                                            |       | (76                                    | )          | (66 | ) |
| Net amortization  (accretion)                                                      |       | 106                                    |       | 9 |   |
| Gain on sale of  investments available-for-sale                                    |       | (381                                   | )          | — |   |
| Gain on sale of  mortgage loans                                                    |       | (184                                   | )          | (218 | ) |
| Origination of  loans held for sale                                                |       | (9,758                                 | )          | (11,893 | ) |
| Proceeds on sale  of loans held for sale                                           |       | 10,440                                 |       | 11,769 |   |
| Changes in:                                                                        |       |                                   |       |   |   |
| Cash surrender  value of life insurance                                            |       | (72                                    | )          | (70 | ) |
| Interest  receivable                                                               |       | (76                                    | )          | 167 |   |
| Other assets                                                                       |       | (486                                   | )          | (994 | ) |
| Interest payable                                                                   |       | (20                                    | )          | (18 | ) |
| Accounts payable  and other liabilities                                            |       | 1,306                                  |       | 566 |   |
| Net cash from  operating activities                                                |       | 3,561                                  |       | 1,723 |   |
|                                                                               |       |                                   |       |   |   |
| **Investing  Activities:**                                                         |       |                                   |       |   |   |
| Sales of  securities available-for-sale                                            |       | 1,431                                  |       | — |   |
| Purchases of  securities available-for-sale                                        |       | (18,185                                | )          | — |   |
| Purchases of  securities held-to-maturity                                          |       | —                                 |       | (10,000 | ) |
| Maturities of  securities held-to-maturity                                         |       | 574                                    |       | 16,365 |   |
| Net change in  loans                                                               |       | 4,539                                  |       | (15,278 | ) |
| Net purchases of  premises and equipment                                           |       | (912                                   | )          | (1,335 | ) |
| Net cash from  investing activities                                                |       | (12,553                                | )          | (10,248 | ) |
|                                                                               |       |                                   |       |   |   |
| **Financing  Activities**                                                          |       |                                   |       |   |   |
| Net change in  deposits                                                            |       | 2,663                                  |       | 11,685 |   |
| Repayments to  Federal Home Loan Bank                                              |       | (44                                    | )          | (73 | ) |
| Proceeds from  stock options exercised                                             |       | 57                                     |       | — |   |
| Dividends paid                                                                     |       | (694                                   | )          | (667 | ) |
| Common stock  repurchased                                                          |       | —                                 |       | (1,560 | ) |
| Net cash from  financing activities                                                |       | 1,982                                  |       | 9,385 |   |
|                                                                               |       |                                   |       |   |   |
| **(Decrease)  Increase in cash and cash equivalents**                              |       | (7,010                                 | )          | 860 |   |
| **Cash  and cash equivalents, beginning of period**                                |       | 35,910                                 |       | 48,030 |   |
| **Cash  and cash equivalents, end of period**                                      |       | $                                      | 28,900     |   | $ | 48,890 |   |

 

***Seenotes to the unaudited consolidated financial statements.***

 

 

7

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** **

**Notes To Unaudited Consolidated Financial Statements**

 

**1.****                                     ****BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

***Basis of Presentation*** — The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation and its wholly owned subsidiary, First Federal Savings Bank.  First Federal Savings Bank has three wholly owned subsidiaries, First Service Corporation of Elizabethtown, First Heartland Mortgage Company and First Federal Office Park, LLC.  Unless the text clearly suggests otherwise, references to “us,” “we,” or “our” include First Financial Service Corporation and its wholly-owned subsidiary.  All significant intercompany transactions and balances have been eliminated.

 

The accompanying unauditedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and with the instructions to Form 10-Q and Rule10-01 of Regulation S-X.  Accordingly,they do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been included.  Operating results for the three-month periodending March 31, 2005 are not necessarily indicative of the results that mayoccur for the year ending December 31, 2005. For further information, refer to the consolidated financial statementsand footnotes thereto included in the Corporation’s annual report on Form 10-Kfor the period ended December 31, 2004.

 

***Stock Option Plans*** — Employee compensationexpense under stock option plans is reported using the intrinsic valuemethod.  No stock-based compensation costis reflected in net income, as all options granted had an exercise price equalto the market price of the underlying common stock at date of grant.  The following table illustrates the effect onnet income and earnings per share if expense was measured using the fair valuerecognition provisions of FASB Statement No. 123, Accounting for Stock-BasedCompensation.

* *
| ** **                                                  | ** ** | **Three Months Ended**

**March 31,**             | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                  | ** ** | **2005**                                          | ** ** | **2004** | ** ** |
| ** **                                                  | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Net income:                                                 |       |                                              |       |   |   |
| As reported                                                 |       | $                                                 | 2,186      |   | $ | 1,838 |   |
| Deduct: Stock-based  compensation expense                   |       |                                              |       |   |   |
| determined under  fair value based method                   |       | (33                                               | )          | (31 | ) |
| Pro-forma                                                   |       | $                                                 | 2,153      |   | $ | 1,807 |   |
| Earnings per  share:                                        |       |                                              |       |   |   |
| Basic        As Reported |       | $                                                 | 0.60       |   | $ | 0.50 |   |
| Pro-forma                                                   |       | 0.59                                              |       | 0.49 |   |
| Diluted    As Reported                       |       | $                                                 | 0.60       |   | $ | 0.50 |   |
| Pro-forma                                                   |       | 0.59                                              |       | 0.49 |   |

 

 

** ****Effect ofNewly Issued But Not Yet Effective Accounting Standards** — In December2004, the Financial Accounting Standards Board (“FASB”) issued Statement ofFinancial Accounting Standard (“SFAS”) No. 123 (Revised 2004) (“SFAS No. 123R”),“Share-Based Payment.”  SFAS No. 123R isa revision of FASB Statement 123, “Accounting for Stock-Based Compensation” andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” andits related implementation guidance. SFAS No. 123R requires all public companies to record compensation costfor stock options provided to employees in return for employee service. Thecost is measured at the fair value of the options when granted, and this costis expensed over the employee service period, which is normally the vestingperiod of the options.  This will applyto awards granted or modified for the year beginning January 1, 2006.** **Compensationcost will also be recorded for prior option grants that vest after the date ofadoption.  The effect on results ofoperations will depend on the level of future option grants and the calculationof the fair value of the options granted at such future date, as well as thevesting periods provided, and so they cannot currently be predicted. ** **Existingoptions that will vest after adoption date are expected to result in additionalcompensation expense of approximately $66,000 in 2006, $60,000 in 2007, $60,000in 2008 and $45,000 in 2009.  There willbe no significant effect on financial position as total equity will not change.

 

8

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***Reclassifications*** — Certainamounts have been reclassified in the prior period financial statements toconform to the current period classifications.

 

 

**2.**             **SECURITIES**

 

The amortized cost basis and fair values ofsecurities are as follows:

 
| **(Dollars in thousands)**          | ** ** | **Amortized**

**Cost** | ** ** | **Gross**

**Unrealized**

**Gains** | ** ** | **Gross**

**Unrealized**

**Losses** | ** ** | **Fair  Value** | ** ** |
|-------------------------------------|------------|-------------------------|------------|--------------------------------------|------------|---------------------------------------|------------|-----------------|------------|
| **Securities  available-for-sale:** |       |                    |       |                                 |       |                                  |       |            |       |
| **March  31, 2005:**                |       |                    |       |                                 |       |                                  |       |            |       |
| U. S. Treasury  and agencies        |       | $                       | 31,861     |                                 | $          | —                                |       | $               | (117       | ) | $ | 31,744 |   |
| Mortgage-backed                     |       | 1,764                   |       | —                               |       | (52                                   | )          | 1,712           |       |
| Equity                              |       | 1,033                   |       | 653                                  |       | —                                |       | 1,686           |       |
| State and  municipal                |       | 924                     |       | 32                                   |       | —                                |       | 956             |       |
| Corporate                           |       | 2,032                   |       | —                               |       | —                                |       | 2,032           |       |
|                                |       |                    |       |                                 |       |                                  |       |            |       |
| Total                               |       | $                       | 37,614     |                                 | $          | 685                                   |       | $               | (169       | ) | $ | 38,130 |   |
|                                |       |                    |       |                                 |       |                                  |       |            |       |
| **December  31, 2004:**             |       |                    |       |                                 |       |                                  |       |            |       |
| U. S. Treasury  and agencies        |       | $                       | 15,985     |                                 | $          | —                                |       | $               | (56        | ) | $ | 15,929 |   |
| Mortgage-backed                     |       | 1,901                   |       | —                               |       | (22                                   | )          | 1,879           |       |
| Equity                              |       | 1,898                   |       | 1,181                                |       | —                                |       | 3,079           |       |
| State and  municipal                |       | 999                     |       | 42                                   |       | —                                |       | 1,041           |       |
|                                |       |                    |       |                                 |       |                                  |       |            |       |
| Total                               |       | $                       | 20,783     |                                 | $          | 1,223                                 |       | $               | (78        | ) | $ | 21,928 |   |
|                                     |            |                         |            |                                      |            |                                       |            |                 |            |  |  |  |  |  |

 
| ** **                        | ** ** | **Amortized**

**Cost** | ** ** | **Gross**

**Unrecognized**

**Gains** | ** ** | **Gross**

**Unrecognized**

**Losses** | ** ** | **Fair  Value** | ** ** |
|-----------------------------------|------------|-------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|-----------------|------------|
| **Securities  held-to-maturity:** |       |                    |       |                                   |       |                                    |       |            |       |
| **March  31, 2005:**              |       |                    |       |                                   |       |                                    |       |            |       |
| U.S. Treasury  and agencies       |       | $                       | 26,094     |                                   | $          | —                                  |       | $               | (582       | ) | $ | 25,512 |   |
| Mortgage-backed                   |       | 6,445                   |       | 6                                      |       | (169                                    | )          | 6,282           |       |
| Corporate                         |       | 2,000                   |       | —                                 |       | —                                  |       | 2,000           |       |
|                              |       |                    |       |                                   |       |                                    |       |            |       |
| Total                             |       | $                       | 34,539     |                                   | $          | 6                                       |       | $               | (751       | ) | $ | 33,794 |   |
|                              |       |                    |       |                                   |       |                                    |       |            |       |
| **December  31, 2004:**           |       |                    |       |                                   |       |                                    |       |            |       |
| U.S. Treasury  and agencies       |       | $                       | 26,095     |                                   | $          | 3                                       |       | $               | (244       | ) | $ | 25,854 |   |
| Mortgage-backed                   |       | 6,820                   |       | 7                                      |       | (124                                    | )          | 6,703           |       |
| Corporate                         |       | 2,000                   |       | —                                 |       | —                                  |       | 2,000           |       |
|                              |       |                    |       |                                   |       |                                    |       |            |       |
| Total                             |       | $                       | 34,915     |                                   | $          | 10                                      |       | $               | (368       | ) | $ | 34,557 |   |

 

 

9

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**3.             LOANS RECEIVABLE**

 

Loans receivable are summarized as follows:

** **
| **(Dollars in thousands)**          | ** ** | **March 31,**

**2005** | ** ** | **December 31,**

**2004** | ** ** |
|-------------------------------------|------------|-------------------------|------------|----------------------------|------------|
|                                |       |                    |       |                       |       |
| Commercial                          |       | $                       | 32,616     |                       | $          | 32,228 |   |
| Real estate  commercial             |       | 305,840                 |       | 302,567                    |       |
| Real estate  construction           |       | 9,515                   |       | 10,850                     |       |
| Residential mortgage                |       | 153,942                 |       | 159,550                    |       |
| Consumer and  home equity           |       | 68,071                  |       | 70,143                     |       |
| Indirect  consumer                  |       | 31,167                  |       | 30,798                     |       |
| Loans held for  sale                |       | 721                     |       | 1,219                      |       |
|                                |       | 601,872                 |       | 607,355                    |       |
| Less:                               |       |                    |       |                       |       |
| Net deferred  loan origination fees |       | (1,305                  | )          | (1,438                     | )          |
| Allowance for loan  losses          |       | (6,701                  | )          | (6,489                     | )          |
|                                |       | (8,006                  | )          | (7,927                     | )          |
|                                |       |                    |       |                       |       |
| Loans Receivable                    |       | $                       | 593,866    |                       | $          | 599,428 |   |

 

 

**           **The allowancefor losses on loans is summarized as follows:

 
| ** **                    | ** ** | **As of and For the**

**Three Months Ended**

**March 31,** | ** ** |
|-------------------------------|------------|--------------------------------------------------------------|------------|
| **(Dollars in thousands)**    | ** ** | **2005**                                                     | ** ** | **2004** | ** ** |
|                          |       |                                                         |       |   |   |
| Balance,  beginning of period |       | $                                                            | 6,489      |   | $ | 5,568 |   |
| Provision for  loan losses    |       | 275                                                          |       | 389 |   |
| Charge-offs                   |       | (140                                                         | )          | (271 | ) |
| Recoveries                    |       | 77                                                           |       | 47 |   |
| Balance, end of  period       |       | $                                                            | 6,701      |   | $ | 5,733 |   |

 

 

Investmentin impaired loans is summarized below. There were no impaired loans for the periods presented without anallowance allocation.

 

 
| **(Dollars in thousands)**    | ** ** | **As of and For the Three Months Ended March 31, 2005** | ** ** | **As of and For the Year Ended December 31, 2004** | ** ** |
|-------------------------------|------------|---------------------------------------------------------|------------|----------------------------------------------------|------------|
|                          |       |                                                    |       |                                               |       |
| End of period  impaired loans |       | $                                                       | 5,418      |                                               | $          | 5,240 |   |
| Amount of  allowance for loan |       |                                                    |       |                                               |       |
| loss allocated                |       | 1,022                                                   |       | 928                                                |       |
|                               |            |                                                         |            |                                                    |            |  |  |

 

 

 

10

----

 

 

We report non-performing loans as impaired.  Our non-performing loans are as follows:

 
| **(Dollars in thousands)**                    | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|-----------------------|------------|
|                                          |       |               |       |                  |       |
| Restructured                                  |       | $                  | 3,185      |                  | $          | 3,218 |   |
| Loans past due  over 90 days still on accrual |       | —             |       | —                |       |
| Non accrual  loans                            |       | 2,233              |       | 2,022                 |       |
| Total                                         |       | $                  | 5,418      |                  | $          | 5,240 |   |

 

 

**4.             EARNINGS PER SHARE**

 

**            **The reconciliationof the numerators and denominators of the basic and diluted EPS is as follows:

 
| ** **                                           | ** ** | **Three Months Ended**

**March 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|
| **(Dollars in thousands,****except per share data)** | ** ** | **2005**                              | ** ** | **2004** | ** ** |
|                                                 |       |                                  |       |   |   |
| Net income  available to common shareholders         |       | $                                     | 2,186      |   | $ | 1,838 |   |
| Basic EPS:                                           |       |                                  |       |   |   |
| Weighted average  common shares                      |       | 3,647                                 |       | 3,690 |   |
| Diluted EPS:                                         |       |                                  |       |   |   |
| Weighted average  common shares                      |       | 3,647                                 |       | 3,690 |   |
| Dilutive effect  of stock options                    |       | 18                                    |       | 18 |   |
| Weighted average  common and incremental shares      |       | 3,665                                 |       | 3,708 |   |
| Earnings Per  Share:                                 |       |                                  |       |   |   |
| Basic                                                |       | $                                     | 0.60       |   | $ | 0.50 |   |
| Diluted                                              |       | $                                     | 0.60       |   | $ | 0.50 |   |

 

 

Stockoptions for 10,000 shares of common stock were not included in the 2004computation of diluted earnings per share because their impact wasanti-dilutive.

 

**Item 2.**

## **MANAGEMENT’SDISCUSSION** AND ANALYSIS OF FINANCIALCONDITION

**AND RESULTSOF OPERATIONS**

##### ** **

##### **GENERAL**

 

We conduct operations in 14 full-servicebanking centers in six contiguous counties in Central Kentucky along theInterstate 65 corridor.  Our marketpresence ranges from the major metropolitan market of Louisville in JeffersonCounty, Kentucky approximately 40 miles north of our headquarters inElizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles southof Elizabethtown.  Our market issupported by a diversified industry base and consists of a regional populationof over 1 million.

 

We serve the needs and caterto the economic strengths of the local communities in which we operate andstrive to provide a high level of personal and professional customer service.We offer a variety of financial services to our retail and commercial bankingcustomers. These services include personal and corporate banking services andpersonal investment financial counseling services.

 

Through****our personal investment financial counselingservices, we offer a wide variety of mutual funds, equity investments, andfixed and variable annuities.

 

 

11

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We invest in the wholesalecapital markets through the management of our security portfolio and usevarious forms of wholesale funding. The security portfolio contains a varietyof instruments, including callable debentures, taxable and non-taxabledebentures, fixed and adjustable rate mortgage backed securities, andcollateralized mortgage obligations.

 

Our results of operationsdepend primarily on net interest income, which is the difference betweeninterest income we earn on loans, investment securities and otherinterest-earning assets and interest expense we pay on deposits and other interest-bearingliabilities. Our operations are also affected by non-interest income, such asservice charges, insurance agency revenue, loan fees, gains and losses from thesale of mortgage loans and gains from the sale of real estate held for development.Our principal operating expenses, aside from interest expense, consist ofcompensation and employee benefits, occupancy costs, data processing expenseand provisions for loan losses.

 

This discussion andanalysis covers material changes in the financial condition since December 31,2004 and material changes in the results of operations for the three-monthperiod ending, March 31, 2005 as compared to 2004.  It should be read in conjunction with “ManagementDiscussion and Analysis of Financial Condition and Results of Operations”included in the Annual Report on Form 10-K for the period ended December 31,2004.

 

# **BusinessRisk**

 

We,like other financial companies, are subject to a number of risks, many of whichare outside of management’s control, though we strive to manage those riskswhile optimizing returns.  Among therisks assumed are: (a) credit risk, which is the risk that loan and leasecustomers or other counter parties will be unable to perform their contractualobligations, (b) market risk, which is the risk that changes in market ratesand prices will adversely affect our financial condition or results ofoperation, (c) liquidity risk, which is the risk that we will have insufficientcash or access to cash to meet our operating needs, and (d) operational risk,which is the risk of loss resulting from inadequate or failed internalprocesses, people, and systems, or from external events.

 

Inaddition to the other information included or incorporated by reference intothis report, readers should consider that the following important factors,among others, could materially impact our business, future results ofoperations, and future cash flows.

 

**(a)****         ****Credit Risk**

 

Weextend credit to a variety of customers based on internally set standards andthe judgment of management.  We managethe credit risk it takes through a program of underwriting standards that wefollow, the review of certain credit decisions, and an on-going process ofassessment of the quality of the credit we have already extended.  There can be no assurance that our creditstandards and our on-going process of credit assessment will protect us fromsignificant credit losses.

 

Ourloans and deposits are focused in central Kentucky and adverse economicconditions in that state, in particular, could negatively impact results fromoperations, cash flows, and financial condition.  Adverse economic conditions and otherfactors, such as political or business development or natural hazards that mayaffect Kentucky, may reduce demand for credit or fee-based products and couldnegatively affect real estate and other collateral values, interest ratelevels, and the availability of credit to refinance loans at or prior tomaturity.

 

**(b)****         ****Market Risk**

 

Changesin interest rates could negatively impact our financial condition or results ofoperations.

 

Ourresults of operations depend substantially on net interest income, thedifference between interest earned on interest-earning assets (such asinvestments and loans) and interest paid on interest-bearing liabilities (suchas deposits and borrowings).  Interestrates are highly sensitive to many factors, including governmental monetarypolicies and domestic and international economic and political conditions.  Conditions such as inflation, recession,unemployment, money supply, and other factors beyond our control may alsoaffect interest rates.  If ourinterest-earning assets mature or reprice more quickly than interest-bearingliabilities in a given period, a decrease in market rates could adverselyaffect net interest income.  Likewise, ifinterest-bearing liabilities mature or reprice more quickly thaninterest-earning assets in a given period, an increase in market rates couldadversely affect net interest income.

 

Fixed-rateloans increase our exposure to interest rate risk in a rising rate environmentbecause interest-bearing liabilities would be subject to repricing beforeassets become subject to repricing. Adjustable-rate loans decrease the 

 

 

12

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riskassociated with changes in interest rates but involve other risks, such as theinability of borrowers to make higher payments in an increasing interest rateenvironment.  At the same time, forsecured loans, the marketability of the underlying collateral may be adverselyaffected by higher interests rates.  In adeclining interest rate environment, there may be an increase in prepayments onloans as the borrowers refinance their loans at lower interest rates.  Under these circumstances, our results ofoperations could be negatively impacted.

 

Whenevaluating short-term interest rate risk exposure, the primary measurementrepresents scenarios that model a 200 basis point increasing (decreasing)parallel shift in rates over the next twelve-month period versus rates impliedby the current yield curve.  For thequarter ended March 31, 2005, that scenario modeled net interest income to beapproximately 12.5% lower than the internal forecast of net interest incomeusing the baseline scenario if rates were to decrease 200 basis points in aparallel shift and 9.3% higher than the internal forecast of net interestincome using the baseline scenario if rates were to increase 200 basis pointsin a parallel shift.

 

Althoughfluctuations in market interest rates are neither completely predictable norcontrollable, our Asset Liability Committee meets periodically to monitor ourinterest rate sensitivity position and oversee its financial risk management byestablishing policies and operating limits. For further discussion, see the “Asset/Liability Management and MarketRisk” section of Management’s Discussion and Analysis of Financial Conditionand Results of Operations.

 

**(c)****         ****LiquidityRisk**

 

Ifwe are unable to borrow funds through access to the capital markets, we may notbe able to meet the cash flow requirements of our depositors and borrowers, ormeet the operating cash needs of the Corporation to fund corporate expansion orother activities.

 

Liquiditypolicies and limits are established by the board of directors, with operatinglimits set by the Asset Liability Committee (“ALCO”), based upon analyses ofthe ratio of loans to deposits, the percentage of assets funded with non-coreor wholesale funding.  ALCO regularlymonitors the overall liquidity position of the Bank and holding company toensure that various alternative strategies exist to cover unanticipated eventsthat could affect liquidity.  Liquidityis the ability to meet cash flow needs on a timely basis at a reasonable cost.  The liquidity of the Bank is used to makeloans and to repay deposit liabilities as they become due or are demanded bycustomers.  The ALCO establishes boardapproved policies and monitors guidelines to diversify our wholesale fundingsources to avoid concentrations in any one-market source.  Wholesale funding sources include Federalfunds purchased, securities sold under repurchase agreements, non-core brokereddeposits, and medium and long-term debt, which includes Federal Home Loan Bank(FHLB) advances that are collateralized with mortgage-related assets.

 

Wemaintain a portfolio of securities that can be used as a secondary source ofliquidity. There are other sources of liquidity should they be needed.  These include the sale or securitization ofloans, the ability to acquire additional non-core brokered deposits, additionalcollateralized borrowings such as FHLB advances, the issuance of debtsecurities, and the issuance of preferred or common securities in public orprivate transactions.

 

Ifwe were unable to access any of these funding sources when needed, we might beunable to meet the needs of our customers, which could adversely impact ourfinancial condition, our results of operations, cash flows, and our level ofregulatory-qualifying capital.  Forfurther discussion, see the “Liquidity” section of Management’s Discussion andAnalysis of Financial Condition and Results of Operations.

 

**(d)****         ****OperationalRisk**

 

Wehave significant competition in both attracting and retaining deposits and inoriginating loans.

 

Competitionis intense in most of the markets we serve. We compete on price and service with other banks and financial companiessuch as savings and loans, credit unions, finance companies, mortgage bankingcompanies, and brokerage firms. Competition could intensify in the future as a result of industryconsolidation, the increasing availability of products and services fromnon-banks, greater technological developments in the industry, and bankingreform.

 

Managementmaintains internal operational controls and we have invested in technology tohelp us process large volumes of transactions. However, there can be no assurance that we will be able to continueprocessing at the same or higher levels of transactions.  If our systems of internal controls shouldfail to work as expected, if our systems were to be used in an unauthorizedmanner, or if employees were to subvert the system of internal controls,significant losses could occur.

 

 

13

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Weprocess large volumes of transactions on a daily basis and are exposed tonumerous types of operation risk. Operational risk resulting from inadequate or failed internal processes,people, and systems includes the risk of fraud by employees or persons outsideof our company, the execution of unauthorized transactions by employees, errorsrelating to transaction processing and systems, and breaches of the internalcontrol system and compliance requirements. This risk of loss also includes potential legal actions that could ariseas a result of the operational deficiency or as a result of noncompliance withapplicable regulatory standards.

 

Weestablish and maintain systems of internal operational controls that providemanagement with timely and accurate information about our level of operationalrisk.  While not foolproof, these systemshave been designed to manage operational risk at appropriate, cost effectivelevels.  We have also establishedprocedures that are designed to ensure that policies relating to conduct,ethics, and business practices are followed. From time to time, we experience loss from operational risk, includingthe effects of operational errors.

 

Whilemanagement continually monitors and improves our system of internal controls,data processing systems, and corporate wide processes and procedures, there canbe no assurance that we will not suffer such losses in the future.  New, or changes in existing tax, accounting,are regulatory laws, regulations, rules, standards, policies, and interpretationscould significantly impact strategic initiatives, results of operations, cashflows, and financial condition.

 

The financial services industry isextensively regulated.  Federal and statebanking regulations are designed primarily to protect deposit insurance fundsand consumers, not to benefit a financial company’s shareholders.  These regulations may sometimes imposesignificant limitations on operations. The significant federal and state banking regulations that affect us aredescribed in this report under the heading “Regulation”.  These regulations, along with currentlyexisting tax, accounting, and monetary laws, regulations, rules, standards,policies and interpretations control the methods by which financialinstitutions conduct business, implement strategic initiatives and tax compliance,and govern financial reporting and disclosures. These laws, regulations, rules, standards, policies, and interpretationsare constantly evolving and may change significantly over time.  Events that may not have a direct impact onus, such as the bankruptcy of U.S. companies, have resulted in legislators,regulators, and authoritative bodies, such as the Financial AccountingStandards Board, the Securities and Exchange Commission, the Public CompanyAccounting Oversight Board, and other various taxing authorities responding byadopting and or proposing substantive revisions to laws, regulations, rules,standards, policies, and interpretations. The nature, extent, and timing of the adoption of significant new lawsand regulations, or changes in or repeal of existing laws and regulations mayhave a material impact on our business and results of operations.  However, it is impossible to predict at thistime, the extent to which any such adoption, change, or repeal would impact us.

 

**OVERVIEW**

 

During the quarter, we completed the redesign of our Mt.Washington facility in Bullitt County. This follows the redesign of one of our Hardin County facilities and theopening of two new full-service facilities in the growing Louisvillemarket.  We intend to start constructionon a new full-service banking center in Elizabethtown during 2005 with plans ofopening in early 2006.  The design of thenew and enhanced facilities represents our state of the art prototype branchwith a retail focused design, complimenting our commitment to providingsuperior customer service. We believe these facilities will allow us tomore effectively support our lending relationships and to develop a largerpresence within these markets in the future. While we anticipate these facilities will significantly enhance thevalue of our franchise in the near future, the additional expense in operatingthese new facilities will continue to place pressure on earnings for a periodof time.  We are optimistic that ourexpansion strategy will minimize this period and the long-term benefits willoutweigh the initial investment.

 

Whilethe commercial loan growth in the first quarter of 2005 was slower than recentquarters, our emphasis on commercial lending continued to produce positiveresults generating a $2.3 million increase in commercial loans to $348 millionat March 31, 2005, compared to $346 million at December 31, 2004.** **Thisfavorable trend has resulted in a 34% annual compound growth rate over the pastfour years.** **The percentage of commercial loans in our portfolio hasincreased from 57% at December 31, 2004, to 58% at March 31, 2005.  We intend to continue this commercial lendingemphasis and anticipate continued increases in the commercial and commercialreal estate portfolios.

 

In January 2003, we implemented a strategy todevelop a bank-wide service and sales culture emphasizing expanded accountrelationships.  To achieve this goal, weincreased the number of associates in banking centers, relationship bankers,business development officers, stockbrokers, and loan officers with experiencein commercial lending.  The results ofthis effort as well as our transition from a federally chartered thrift to astate-chartered commercial bank in January 2003, have contributed to ourgrowth.  The resulting increase in staff 

 

 

14

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along with the expansion into the Louisvillemarket have contributed to a $380,000, or 16%****increase in employee compensation expense for the quarter endedMarch 31, 2005, compared to the quarter ended March 31, 2004.  We expect a continued increase in employeecompensation expense in the 2005 calendar year as we continue our expansioninto our current markets.

 

###### **CRITICAL ACCOUNTING POLICIES**

 

Our accounting and reportingpolicies comply with accounting principles generally accepted in the UnitedStates of America and conform to general practices within the bankingindustry.  The accounting policy relatingto the allowance for loan losses is critical to the understanding of our resultsof operations since the application of this policy requires significantmanagement assumptions and estimates that could result in materially differentamounts to be reported if conditions or underlying circumstances were tochange.

 

**Allowance for Loan Losses —**We maintain an allowancesufficient to absorb probable incurred credit losses existing in the loanportfolio, and our Executive Loan Committee evaluates the adequacy of theallowance for loan losses on a quarterly basis.  We estimate the allowancerequired using past loan loss experience, known and inherent risks in theportfolio, adverse situations that may affect the borrower’s ability to repay,estimated value of the underlying collateral, and current economicconditions.  While we estimate the allowance for loan losses, in part,based on historical losses within each loan category, estimates for losseswithin the commercial real estate portfolio depend more on credit analysis andrecent payment performance. Allocations of the allowance may be made forspecific loans or loan categories, but the entire allowance is available forany loan that, in management’s judgment, should be charged off.

 

Theallowance consists of specific and general components.  The specific component relates to loans thatare individually classified as impaired or loans otherwise classified assubstandard or doubtful.  The generalcomponent covers non-classified loans and is based on historical lossexperience adjusted for current factors. The methodology for allocating the allowancefor loan and lease losses takes into account our strategic plan to increase ouremphasis on commercial and consumer lending. We increase the amount of theallowance allocated to commercial loans and consumer loans in response to thegrowth of the commercial and consumer loan portfolios and management’srecognition of the higher risks and loan losses in these lending areas.Allowance estimates are developed in consultation with regulatory authoritiesand actual loss experience adjusted for current economic conditions.  Allowance estimates are considered a prudentmeasurement of the risk in the loan portfolio and are applied to individualloans based on loan type.

 

Based on our calculation, anallowance of $6.7 million or 1.12% of total loans was reserved for potentiallosses within the loan portfolio as of March 31, 2005.  This estimateresulted in a provision for loan losses on the income statement of $275,000during the quarter. ****If themix and amount of future charge off percentages differ significantly from thoseassumptions used by management in making its determination, the allowance forloan losses and provision for loan losses on the income statement could bematerially and adversely affected.

 

##### **RESULTS OF OPERATIONS**

 

Net income for the quarterended March 31, 2005 was $2.2 million or $0.60 per share diluted compared to$1.8 million or $0.50 per share diluted for the same period in 2004. ** **Theincrease in diluted earnings per share was the result of an increase innet-interest income of $863,000, a decrease in provision for loan loss expenseand a $250,000 increase in non-interest income.** **Our book value percommon share increased from $15.35 at March 31, 2004 to $16.70 at March 31,2005.  Annualized net income for 2005generated a return on average assets of 1.18% and a return on average equity of14.35%.  These compare with a return onaverage assets of 1.07% and a return on average equity of 12.99% for the 2004period also annualized.

 

***Net Interest Income***-On anannualized basis, the net interest margin as a percent of average earningassets increased 26 basis points to 3.90% for the quarter ended March 31, 2005compared to 3.64% for the 2004 period. We were able to increase our net interest margin through an increase inthe yield on earning assets, which increased 23 basis points from 6.02% for the2004 quarter to 6.25% for the 2005 period. We have been successful inincreasing the percentage of variable rate loans in the loan portfolio, whichwe expect to increase the yield in an increasing interest rateenvironment.  The prime lending rateincreased 175 basis points since the Federal Open Market Committee beganincreasing short-term interest rates in June 2004.  Management expects its yield on loans toimprove with additional increases in the prime-lending rate.

 

Our cost of funds averaged2.53% during the 2005 quarter, a decrease of 2 basis points from the 2004average cost of funds of 2.55%.  Goingforward, our cost of funds is expected to increase as the general market depositrates have become increasingly competitive with the recent upward trend ininterest rates.

 

 

15

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The net result of theabove factors was an increase in net interest income of $863,000 for thequarter ended March 31, 2005 compared to the same three-month period a yearago.

 

**AVERAGE BALANCE SHEET**

 

Thefollowing table sets forth information relating to the Bank’s average balancesheet and reflects the average yield on assets and average cost of liabilitiesfor the periods indicated.  Dividingincome or expense by the average monthly balance of assets or liabilities,respectively, derives such yields and costs for the periods presented.

 
| ** **                                           | ** ** | **Quarter Ended March 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                           | ** ** | **2005**                    | ** ** | **2004** | ** ** |
| **(Dollars in thousands)**                           | ** ** | **Average Balance**         | ** ** | **Interest** | ** ** | **Average Yield/Cost (5)** | ** ** | **Average Balance** | ** ** | **Interest** | ** ** | **Average Yield/Cost (5)** | ** ** |
|                                                 |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning  assets:                            |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and  agencies                          |       | $                           | 49,623     |   | $ | 324 |   | 2.65 | % | $ | 17,168 |   | $ | 149 |   | 3.49 | % |
| Mortgage-backed  securities                          |       | 8,445                       |       | 80 |   | 3.84 |   | 8,751 |   | 84 |   | 3.86 |   |
| Equity securities                                    |       | 2,673                       |       | 40 |   | 6.07 |   | 2,950 |   | 33 |   | 4.50 |   |
| State and  political subdivision securities (1)      |       | 991                         |       | 15 |   | 6.14 |   | 1,071 |   | 18 |   | 6.76 |   |
| Corporate bonds                                      |       | 2,065                       |       | 23 |   | 4.52 |   | 2,000 |   | 15 |   | 3.02 |   |
| Loans receivable (2) (3) (4)                         |       | 599,006                     |       | 9,954 |   | 6.74 |   | 562,049 |   | 9,108 |   | 6.52 |   |
| FHLB stock                                           |       | 6,846                       |       | 76 |   | 4.50 |   | 6,571 |   | 65 |   | 3.98 |   |
| Interest bearing  deposits                           |       | 20,409                      |       | 123 |   | 2.44 |   | 38,145 |   | 85 |   | 0.90 |   |
| **Total  interest earning assets**                   |       | 690,058                     |       | 10,635 |   | 6.25 |   | 638,705 |   | 9,557 |   | 6.02 |   |
| Less: Allowance  for loan losses                     |       | (6,502                      | )          |   |   |   |   | (5,581 | ) |   |   |   |   |
| Non-interest  earning assets                         |       | 59,880                      |       |   |   |   |   | 54,059 |   |   |   |   |   |
| **Total  assets**                                    |       | $                           | 743,436    |   |   |   |   |   | $ | 687,183 |   |   |   |   |   |
|                                                 |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**       |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing  liabilities:                       |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                     |       | $                           | 78,122     |   | $ | 222 |   | 1.15 | % | $ | 91,137 |   | $ | 188 |   | 0.83 | % |
| NOW and money  market                                |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| accounts                                             |       | 155,938                     |       | 512 |   | 1.33 |   | 121,619 |   | 221 |   | 0.73 |   |
| Certificates of  deposit and                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| other time  deposits                                 |       | 316,494                     |       | 2,158 |   | 2.77 |   | 294,471 |   | 2,316 |   | 3.16 |   |
| FHLB advances                                        |       | 78,877                      |       | 944 |   | 4.85 |   | 78,243 |   | 928 |   | 4.77 |   |
| Trust preferred  securities                          |       | 10,000                      |       | 158 |   | 6.41 |   | 10,000 |   | 124 |   | 4.99 |   |
| **Total  interest bearing liabilities**              |       | 639,431                     |       | 3,994 |   | 2.53 |   | 595,470 |   | 3,777 |   | 2.55 |   |
| Non-interest  bearing liabilities:                   |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest  bearing deposits                       |       | 39,442                      |       |   |   |   |   | 31,918 |   |   |   |   |   |
| Other liabilities                                    |       | 3,617                       |       |   |   |   |   | 3,200 |   |   |   |   |   |
| **Total  liabilities**                               |       | 682,490                     |       |   |   |   |   | 630,588 |   |   |   |   |   |
|                                                 |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’  equity                           |       | 60,946                      |       |   |   |   |   | 56,595 |   |   |   |   |   |
| **Total  liabilities and stockholders’ equity** |       | $                           | 743,436    |   |   |   |   |   | $ | 687,183 |   |   |   |   |   |
|                                                 |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| **Net  interest income**                             |       |                        |       | $ | 6,641 |   |   |   |   |   | $ | 5,780 |   |   |   |
| **Net interest  spread**                             |       |                        |       |   |   | 3.72 | % |   |   |   |   | 3.47 | % |
| **Net  interest margin**                             |       |                        |       |   |   | 3.90 | % |   |   |   |   | 3.64 | % |
|                                                      |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**(****1)****Taxable equivalent yields arecalculated assuming a 34% federal income tax rate.**

**(2)****Includesloan fees, immaterial in amount, in both interest income and the calculation ofyield on loans.**

**(3)****Calculationsinclude non-accruing loans in the average loan amounts outstanding.**

**(4)****Includesloans held for sale.**

**(5)****Annualized**

 

 

16

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 **RATE/VOLUMEANALYSIS**

 

The table below sets forth certaininformation regarding changes in interest income and interest expense of theBank for the periods indicated.  For eachcategory of interest-earning assets and interest-bearing liabilities, informationis provided on changes attributable to (1) changes in rate (changes in ratemultiplied by old volume); (2) changes in volume (change in volume multipliedby old rate); and (3) changes in rate-volume (change in rate multiplied bychange in volume).  Changes inrate-volume are proportionately allocated between rate and volume variance.

 
| ** **                              | ** ** | **Three  Months Ended**

**March  31,**

**2005 vs.  2004** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------------------|------------|
| **(Dollars  in thousands)**             | ** ** | **Increase  (decrease)**

**Due to  change in**             | ** ** |
| ** **                              | ** ** | **Rate**                                                    | ** ** | **Volume** | ** ** | **Net**

**Change** | ** ** |
| **Interest  income:**                   |       |                                                        |       |   |   |   |   |
| U.S. Treasury  and agencies             |       | $                                                           | (44        | ) | $ | 219 |   | $ | 175 |   |
| Mortgage-backed  securities             |       | (1                                                          | )          | (3 | ) | (4 | ) |
| Equity  securities                      |       | 10                                                          |       | (3 | ) | 7 |   |
| State and  political subdivision        |       |                                                        |       |   |   |   |   |
| securities                              |       | (2                                                          | )          | (1 | ) | (3 | ) |
| Corporate bonds                         |       | 8                                                           |       | — |   | 8 |   |
| Loans                                   |       | 239                                                         |       | 607 |   | 846 |   |
| FHLB stock                              |       | 8                                                           |       | 3 |   | 11 |   |
| Interest bearing  deposits              |       | 92                                                          |       | (54 | ) | 38 |   |
|                                    |       |                                                        |       |   |   |   |   |
| **Total  interest earning assets**      |       | 310                                                         |       | 768 |   | 1,078 |   |
|                                    |       |                                                        |       |   |   |   |   |
| **Interest  expense:**                  |       |                                                        |       |   |   |   |   |
| Savings accounts                        |       | 63                                                          |       | (29 | ) | 34 |   |
| NOW and money  market accounts          |       | 216                                                         |       | 75 |   | 291 |   |
| Certificates of  deposit and other      |       |                                                        |       |   |   |   |   |
| time deposits                           |       | (322                                                        | )          | 164 |   | (158 | ) |
| FHLB advances                           |       | 9                                                           |       | 7 |   | 16 |   |
| Trust Preferred  Securities             |       | 34                                                          |       | — |   | 34 |   |
|                                    |       |                                                        |       |   |   |   |   |
| **Total  interest bearing liabilities** |       | —                                                      |       | 217 |   | 217 |   |
|                                    |       |                                                        |       |   |   |   |   |
| **Net  change in net interest income**  |       | $                                                           | 310        |   | $ | 551 |   | $ | 861 |   |

 

 

***Non-Interest Income***-Non-interest incomeincreased $250,000, or 14% for the quarter ended March 31, 2005 to $2.0 millioncompared to $1.8 million for the same quarter in 2004.  The increased level of non-interest incomeduring 2005 was primarily related to a $381,000 gain on the sale of investmentsecurities.  Offsetting this increasewere decreases in customer service fees on deposit accounts, gain on sale ofmortgage loans, brokerage and insurance commissions and other income.

 

Customer service fees on deposit accountsdecreased $15,000 for the first quarter of 2005 due to a decline in the numberof non-sufficient fund charges.  Gain onsale of mortgage loans decreased $34,000 for the 2004 quarter, resulting fromlower origination volume.  Othernon-interest income decreased during the 2005 period by $66,000 primarily dueto losses on repossessed assets.

 

***Non-Interest Expense -*** Non-interest expenseincreased $705,000 or 16% during the quarter ended March 31, 2005 compared tothe same period in 2004.  The primaryfactors impacting non-interest expense include additional operating andemployee compensation expenses relating to the recent retail expansionefforts.  Employee compensation andbenefits, the largest component of non-interest expense, increased 380,000 or16% for 2005.  Twenty-one retail staffpositions were added for the expansion into the Louisville market, coupled withexpanded facilities in Hardin County and Bullitt County, Kentucky.  Additional increases in staff have

 

17

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taken place during 2004 and 2005 as westrengthen our retail sales culture and provide expanded products and servicesto our retail and commercial customers.

 

The two full service branch openings havecontributed to higher operating costs including an increase in office occupancyand equipment expense of $86,000, an increase in promotions and enhanced radioand newspaper marketing of $49,000, and an increase in data processing andoutside service fees of $83,000.

 

We anticipate the increased level onnon-interest expense to continue during 2005 with continued retail expansionand market share protection efforts.  Weintend to start construction on a new full service-banking center in Elizabethtown,KY during 2005 with plans of opening in early 2006.  We are also considering other possiblelocations within the core market area to protect and grow our 21% market share.

 

Despite the increase in non-interest expensefor 2005, we maintained an efficiency ratio of 59% for the quarters ended March31, 2005 and 2004.

 

**ANALYSIS OF FINANCIAL CONDITION**

 

Totalassets at March 31, 2005 were $742.5 million compared to $737.6 million atDecember 31, 2004, an increase of $4.9 million. The increase was primarily related to an increase in investmentsecurities of $15.8 million and an increase in deposits of $2.7 million.  These increases were offset by a decrease innet loans receivable of $5.6 million and a decrease in cash and cashequivalents of $7.0 million.

 

##### **Loans Receivable**

 

Net loans receivable decreased $5.5 million to$593.9 million at March 31, 2005 compared to $599.4 million at December 31,2004.  Our commercial and commercial realestate portfolios increased $2.3 million to $348 million at March 31,2005.  For the 2005 period, these loanscomprised 58% of the total loan portfolio compared to 57% at December 31, 2004,and 51% at March 31, 2004.  While theloan growth in the first quarter of 2005 was slower than recent quarters, weexpect the favorable trend, which has generated a 4% compound annual growthrate in the total loan portfolio to continue for 2005.

 

Offsetting this growth was a $5.6 million, or3.5% decrease in the residential mortgage loan portfolio to $153.9 million atMarch 31, 2005, compared to $159.5 million at December 31, 2004.  For 2005, the decline in mortgage loans isexpected to slow from the decreases experienced in 2003 and early 2004.  Also, contributing to the decrease was a $1.7million decline in consumer loans.

 

**Allowance and Provision for LoanLosses**

 

Our financial performance depends on the quality of the loans weoriginate and management’s ability to assess the degree of risk in existingloans when it determines the allowance for loan losses.  An increase in loan charge-offs ornon-performing loans or an inadequate allowance for loan losses could reducenet interest income, net income and capital and limit the range of products andservices we can offer.

 

The Executive Loan Committee evaluates the allowance for loan lossesquarterly to maintain a level sufficient to absorb probable incurred creditlosses existing in the loan portfolio. Periodic provisions to the allowance are made as needed.  The allowance is determined based on the applicationof loss estimates to graded loans by categories.  The amount of the provision for loan lossesnecessary to maintain an adequate allowance is also based upon an analysis ofsuch factors as changes in lending policies and procedures; underwritingstandards; collection; charge-off and recovery history; changes in national andlocal economic business conditions and developments; changes in thecharacteristics of the portfolio; ability and depth of lending management andstaff; changes in the trend of the volume and severity of past due, non-accrualand classified loans; troubled debt restructuring and other loan modifications;and results of regulatory examinations.

 

Themethodology for allocating the allowance for loan and lease losses takes intoaccount our strategic plan to increase our emphasis on commercial and consumerlending.  We increase the amount of theallowance allocated to commercial loans and consumer loans in response to thegrowth of the commercial and consumer loan portfolios and management’srecognition of the higher risks and loan losses in these lending areas.  The indirect consumer loan program iscomprised of new and used automobile, motorcycle and all terrain vehicle loansoriginated on our behalf by a select group of auto dealers within our servicearea.   The indirect loan programinvolves a greater degree of risk and is evaluated quarterly and monitored bythe Board of Directors.  In light of thegreater charge-offs from indirect consumer loans compared to direct consumerloans, proportionally more of the allowance for consumer loans is allocated forindirect loans than direct loans.  As theindirect loan program has evolved, dealer analysis and

 

 

18

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 underwriting standards have been refined toimprove the loan loss experience of the program.  Estimating the allowance is a continuousprocess.  In this regard, the ExecutiveLoan Committee continues to monitor the performance of indirect consumer loansas well as our other loan products and updates estimates as the evidencewarrants.

 

The following table sets forthan analysis of the Bank’s loan loss experience for the periods indicated.

 
| ** **                                                                | ** ** | **Three  Months Ended**

**March  31,** | ** ** |
|---------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| **(Dollars  in thousands)**                                               | ** ** | **2005**                                | ** ** | **2004** | ** ** |
|                                                                      |       |                                    |       |   |   |
| **Balance  at beginning of period**                                       |       | $                                       | 6,489      |   | $ | 5,568 |   |
| Loans  charged-off:                                                       |       |                                    |       |   |   |
| Real estate mortgage                                                      |       | 4                                       |       | 41 |   |
| Consumer                                                                  |       | 136                                     |       | 230 |   |
| Commercial                                                                |       | —                                  |       | — |   |
| Total  charge-offs                                                        |       | 140                                     |       | 271 |   |
| Recoveries:                                                               |       |                                    |       |   |   |
| Real estate  mortgage                                                     |       | 1                                       |       | — |   |
| Consumer                                                                  |       | 76                                      |       | 47 |   |
| Commercial                                                                |       | —                                  |       | — |   |
| Total recoveries                                                          |       | 77                                      |       | 47 |   |
|                                                                      |       |                                    |       |   |   |
| **Net  loans charged-off**                                                |       | 63                                      |       | 224 |   |
|                                                                      |       |                                    |       |   |   |
| Provision for  loan losses                                                |       | 275                                     |       | 389 |   |
|                                                                      |       |                                    |       |   |   |
| **Balance  at end of period**                                             |       | $                                       | 6,701      |   | $ | 5,733 |   |
|                                                                      |       |                                    |       |   |   |
| Allowance for  loan losses to total loans (excluding loans held for sale) |       | 1.12                                    | %          | 1.01 | % |
| Net charge-offs  to average loans outstanding                        | ** ** | 0.01                                    | %          | 0.04 | % |
| Allowance for  loan losses to                                             | ** ** | ** **                              | ** ** | ** ** | ** ** |
| total  non-performing loans                                               |       | 124                                     | %          | 131 | % |

 

The provision for loan losses decreased $114,000,or 29% to $275,000 for the quarter ended March 31, 2005, compared to the 2004period due to slower loan growth during the 2005 quarter.  The total allowance for loan losses increased$968,000 to $6.7 million from March 31, 2004 to March 31, 2005.  The increase in the allowance was related toa $30.0 million increase in loans receivable at March 31, 2005, compared toMarch 31, 2004, in conjunction with a $2.6 million increase in classified loansfor the 2005 period compared to the 2004 period.  Net loan charge-offs decreased $161,000 to$63,000 during 2005 compared to $224,000 during 2004.  The decrease in charge-offs is primarilyrelated to a decrease in charge-offs of indirect consumer loans during theperiod.

 

Federal regulationsrequire insured institutions to classify their own assets on a regularbasis.  The regulations provide for threecategories of classified loans — substandard, doubtful and loss.  Assets classified as substandard or doubtfulrequire the institution to establish general allowances for loan losses. If anasset or portion thereof is classified as loss, the insured institution musteither establish specified allowances for loan losses in the amount of 100% ofthe portion of the asset classified loss, or charge off such amount.  At March 31, 2005, on the basis of management’sreview of the loan portfolio, we had $8.0 million of assets classifiedsubstandard, $970,000 classified as doubtful, and $89,000 of assets classifiedas loss.  At March 31, 2004, on the basisof management’s review of the loan portfolio, we had $5.2 million assetsclassified substandard,  $1.2 millionclassified as doubtful, and $106,000 of assets classified as loss.

 

Loans are classified according to estimatedloss as follows:  Substandard-2.5% to35%; Doubtful-5% to 50%; and Loss-100%;. We additionally provide a reserveestimate for probable incurred losses in non-classified loans ranging from .20%to 3.50%.  Although we may allocate aportion of the allowance to specific loans or loan categories, the entireallowance is available for active charge-offs. Allowance estimates are developed in consultation with regulatory authoritiesand actual loss experience adjusted for current economic conditions.  Allowance estimates are considered a prudentmeasurement of the risk in the loan portfolio and are applied to individualloans based on loan type.

 

 

19

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##### **Non-Performing Assets**

 

Non-performingassets consist of certain restructured loans for which interest rate or otherterms have been renegotiated, loans on which interest is no longer accrued,real estate acquired through foreclosure and repossessed assets.   We do not have any loans greater than 90days past due still on accrual.  Loans,including impaired loans under SFAS 114, are placed on non-accrual status whenthey become past due 90 days or more as to principal or interest, unless theyare adequately secured and in the process of collection.  Loans are considered impaired if fullprincipal or interest payments are not anticipated in accordance with thecontractual loan terms.  Impaired loansare carried at the present value of expected future cash flows discounted atthe loan’s effective interest rate or at the fair value of the collateral ifthe loan is collateral dependent.

 

Loans are reviewed on aregular basis and normal collection procedures are implemented when a borrowerfails to make a required payment on a loan. If the delinquency on a mortgage loan exceeds 90 days and is not curedthrough normal collection procedures or an acceptable arrangement is not workedout with the borrower, we institute measures to remedy the default, includingcommencing a foreclosure action. Consumer loans generally are charged off when a loan is deemeduncollectible by management and any available collateral has been disposed of.  Commercial business and real estate loandelinquencies are handled on an individual basis by management with the adviceof legal counsel.

 

     Interest income on loans is recognized onthe accrual basis except for those loans in a non-accrual of income status. Theaccrual of interest on impaired loans is discontinued when management believes,after consideration of economic and business conditions and collection effortsthat the borrowers’ financial condition is such that collection of interest isdoubtful, typically after the loan becomes 90 days delinquent.  When interest accrual is discontinued,existing accrued interest is reversed and interest income is subsequentlyrecognized only to the extent cash payments are received.

 

Real estate acquired as a result of foreclosureor by deed in lieu of foreclosure is classified as real estate owned until suchtime as it is sold. New and used automobile, motorcycle and all terrainvehicles acquired as a result of foreclosure are classified as repossessedassets until they are sold. When such property is acquired it is recorded atthe lower of the unpaid principal balance of the related loan or its fairmarket value.  Any write-down of theproperty at the time of acquisition is charged to the allowance for loanlosses.  Subsequent gains and losses areincluded in non-interest income and non-interest expense.

 

The following table sets forth informationwith respect to non-performing assets for the periods indicated.

 
| **(Dollar  in thousands)**                                                   | ** ** | **March  31,**

**2005** | ** ** | **December  31,**

**2004** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Restructured                                                                 |       | $                        | 3,185      |                        | $          | 3,218 |   |
| Past due 90 days  still on accrual                                           |       | —                   |       | —                      |       |
| Loans on  non-accrual status                                                 |       | 2,233                    |       | 2,022                       |       |
|                                                                         |       |                     |       |                        |       |
| Total  non-performing loans                                                  |       | 5,418                    |       | 5,240                       |       |
| Real estate  acquired through foreclosure                                    |       | 913                      |       | 681                         |       |
| Other  repossessed assets                                                    |       | 59                       |       | 40                          |       |
| Total  non-performing assets                                                 |       | $                        | 6,390      |                        | $          | 5,961 |   |
|                                                                         |       |                     |       |                        |       |
| Interest income  that would have been earned on non-performing loans         |       | $                        | 365        |                        | $          | 336 |   |
| Interest income  recognized on non-performing loans                          |       | 209                      |       | 197                         |       |
| Ratios:  Non-performing loans to total loans (excluding loans held for sale) |       | 0.90                     | %          | 0.87                        | %          |
| Non-performing  assets to total loans  (excluding loans  held for sale) |       | 1.07                     | %          | 0.99                        | %          |

 

Included in non-performing assets for the 2005period is $3.2 million in restructured commercial and residential mortgageloans.** **The restructured loans primarily consist of three creditrelationships aggregating $3.0 million, including a $2.3 million commercialrelationship, a $215,000 commercial relationship and a $459,000 residentialmortgage relationship.   The terms ofthese loans have been renegotiated to reduce the rate of interest and extendthe term thus reducing the amount of cash flow required from the borrower toservice the loans.  The terms of therestructured loans are currently being met.

 

 

20

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**Investment Securities**

 

Interest on securities provides us ourlargest source of interest income after interest on loans, constituting 6.3% ofthe total interest income for the quarter ended March 31, 2005.  Thesecurities portfolio serves as a source of liquidity and earnings andcontributes to the management of interest rate risk.  We have the authority to invest invarious types of liquid assets, including short-term United States Treasuryobligations and securities of various federal agencies, obligations of statesand political subdivisions, corporate bonds, certificates of deposit at insuredsavings and loans and banks, bankers’ acceptances, and federal funds.  We may also invest a portion of our assets incertain commercial paper and corporate debt securities.  We are also authorized to invest in mutualfunds and stocks whose assets conform to the investments that we are authorizedto make directly. The available-for-sale and held-to-maturity investmentportfolios increased by $15.8 million or 28% during the 2005 period due toinvestments in U.S. agencies and a corporate bond.  We also sold$1.4 million in securities available-for-sale during the 2005quarter due to ofone of our equity investments de-listing from the NASDAQ National MarketSystem.

 

###### **Deposits**

 

We rely primarily on customer service and long-standingrelationships with customers to attract and retain deposits. Market interestrates and rates on deposit products offered by competing financial institutionscan significantly affect our ability to attract and retain deposits. During thequarter ended March 31, 2005, total deposits increased by $2.7 million comparedto December 31, 2004. The increase in retail deposits was primarily incertificate of deposit balances.  We plan to continue our deposit gatheringinitiatives by utilizing pricing strategies and offering competitive productsin our existing markets.

 

The following table breaksdown our deposits.

##### ** **

| ** **               | ** ** | **March  31,**

**2005** | ** ** | **December  31,**

**2004** | ** ** |
|--------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **               | ** ** | **(In  Thousands)**      | ** ** |
|                     |       |                     |       |                        |       |
| Non-interest  bearing    |       | $                        | 39,961     |                        | $          | 38,441 |   |
| NOW demand               |       | 73,299                   |       | 73,801                      |       |
| Savings                  |       | 69,657                   |       | 78,499                      |       |
| Money market             |       | 84,340                   |       | 85,418                      |       |
| Certificates of  deposit |       | 321,792                  |       | 310,227                     |       |
|                     |       | $                        | 589,049    |                        | $          | 586,386 |   |

##### ** **

 

##### **LIQUIDITY**

##### ** **

Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that the cash flow requirements of depositors and borrowers, as well as our operating cash needs, are met, taking into account all on- and off-balance sheet funding demands. Liquidity risk management also includes ensuring cash flow needs are met at a reasonable cost. We maintain an investment and funds management policy, which identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The liquidity position is continually monitored and reviewed by the Asset Liability Committee.

 

Funds are available from a number of sources, including the sale of securities in the available-for-sale portion of the investment portfolio, principal paydowns on loans and mortgage-backed securities, proceeds realized from loans held for sale, brokered deposits and other wholesale funding. ** **At March 31, 2005, we had brokered deposits totaling $500,000.  We also have secured federal funds borrowing lines from two of our correspondent banks totaling $10 million and $15 million respectively.** **Our banking centers also provide access to retail deposit markets.** **If large certificate depositors shift to our competitors or the stock market in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources.** **Traditionally, we have also utilized borrowings from the FHLB to supplement our funding requirements.  At March 31, 2005, we had an unused approved line of credit in the amount of $97.1 million****and sufficient collateral available to borrow, approximately, an additional****$28 million in advances from the FHLB.** **We believe our sources of liquidity are adequate to meet expected cash needs for the foreseeable future.

 

 

21

 

 

 

At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the holding company include dividends and returns of investment from the Bank, a revolving credit agreement with an unaffiliated bank, and access to the capital markets.

 

##### **CAPITAL**

 

Stockholders’ equity increased $1.1 millionfor the quarter ended March 31, 2005 compared to December 31, 2004.**** Theincrease in capital was primarily attributable to net income during the quarterand stock options exercised by our employees. These increases were offset by a decline in accumulated othercomprehensive income, a result of temporary unrealized losses recorded onsecurities. ** **Average stockholders’ equity toaverage assets ratio declined to 8.20% for the quarter ended March 31, 2005compared to 8.23% for 2004.

### ** **

In March 2002, a trust formed by First FinancialService Corporation completed the private placement of 10,000 shares of cumulativetrust preferred securities with a liquidation preference of $1,000 persecurity.  The proceeds of the offeringwere loaned to us in exchange for floating rate junior subordinated deferrableinterest debentures.  Distributions onthe securities are payable quarterly at a rate per annum equal to the 3-monthLIBOR plus 3.60%.  We undertook theissuance of these securities to enhance our regulatory capital position, as thesecurities are considered as Tier I capital under current regulatory guidelines.

 

###### **Kentucky banking laws limit the amount of dividendsthat may be paid to First Financial Service Corporation by First FederalSavings Bank without prior approval of the Kentucky Office of FinancialInstitutions.  Under these laws, theamount of dividends that may be paid in any calendar year is limited to currentyear’s net income, as defined in the laws, combined with the retained netincome of the preceding two years, less any dividends declared during thoseperiods.**  At March 31, 2005, without prior regulatory approval, we hadapproximately $7.7 million of retained earnings that could be utilized forpayment of dividends if authorized by our board of directors.

 

Each of the federal bank regulatory agencies hasestablished minimum leverage capital requirements for banking organizations.Banking organizations must maintain a minimum ratio of Tier 1 capital toadjusted average quarterly assets equal to 3% to 5% subject to federal bankregulatory evaluation of an organization’s overall safety and soundness.  We intend to maintain a capital position thatmeets or exceeds the “well capitalized” requirements as defined by theFDIC.  The following table shows theratios of Tier 1 capital and total capital to risk-adjusted assets and theleverage ratios for the Corporation and the Bank as of March 31, 2005.

 

 

22

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| **(Dollars  in thousands)**                          | ** ** | **Actual** | ** ** | **For  Capital Adequacy Purposes** | ** ** | **To Be  Considered Well Capitalized Under Prompt Correction Action Provisions** | ** ** |
|------------------------------------------------------|------------|------------|------------|------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| **As of  March 31, 2005:**                           | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                                       | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total risk-based  capital (to risk- weighted assets) |       |       |       |                               |       |                                                                             |       |   |   |   |   |   |   |
| Consolidated                                         |       | $          | 69,205     |                               | 11.7       | %                                                                                | $          | 47,263 |   | 8.0 | % | $ | 59,078 |   | 10.0 | % |
| Bank                                                 |       | 67,296     |       | 11.4                               |       | 47,138                                                                           |       | 8.0 |   | 58,922 |   | 10.0 |   |
| Tier I capital  (to risk-weighted assets)       | ** ** | ** ** | ** ** | ** **                         | ** ** | ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 62,210     |       | 10.5                               |       | 23,631                                                                           |       | 4.0 |   | 35,447 |   | 6.0 |   |
| Bank                                                 |       | 60,346     |       | 10.2                               |       | 23,569                                                                           |       | 4.0 |   | 35,353 |   | 6.0 |   |
| Tier I capital  (to average assets)                  | ** ** | ** ** | ** ** | ** **                         | ** ** | ** **                                                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 62,210     |       | 8.4                                |       | 29,526                                                                           |       | 4.0 |   | 36,907 |   | 5.0 |   |
| Bank                                                 |       | 60,346     |       | 8.2                                |       | 29,306                                                                           |       | 4.0 |   | 36,632 |   | 5.0 |   |
|                                                      |            |            |            |                                    |            |                                                                                  |            |  |  |  |  |  |  |  |  |  |

 
| **(Dollars in thousands)**                           | ** ** | **Actual** | ** ** | **For Capital Adequacy Purposes** | ** ** | **To Be Considered Well Capitalized Under Prompt Correction Action  Provision** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------------------|------------|---------------------------------------------------------------------------------|------------|
| **As of  December 31, 2004:**                        | ** ** | **Amount** | ** ** | **Ratio**                         | ** ** | **Amount**                                                                      | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total risk-based  capital (to risk- weighted assets) |       |       |       |                              |       |                                                                            |       |   |   |   |   |   |   |
| Consolidated                                         |       | $          | 67,798     |                              | 11.6       | %                                                                               | $          | 46,793 |   | 8.0 | % | $ | 58,492 |   | 10.0 | % |
| Bank                                                 |       | 65,087     |       | 11.2                              |       | 46,600                                                                          |       | 8.0 |   | 58,250 |   | 10.0 |   |
| Tier I capital  (to risk-weighted assets)            |       |       |       |                              |       |                                                                            |       |   |   |   |   |   |   |
| Consolidated                                         |       | 61,029     |       | 10.4                              |       | 23,397                                                                          |       | 4.0 |   | 35,095 |   | 6.0 |   |
| Bank                                                 |       | 58,318     |       | 10.0                              |       | 23,300                                                                          |       | 4.0 |   | 34,950 |   | 6.0 |   |
| Tier I capital  (to average assets)                  |       |       |       |                              |       |                                                                            |       |   |   |   |   |   |   |
| Consolidated                                         |       | 61,029     |       | 8.5                               |       | 28,860                                                                          |       | 4.0 |   | 36,075 |   | 5.0 |   |
| Bank                                                 |       | 58,318     |       | 8.1                               |       | 28,762                                                                          |       | 4.0 |   | 35,953 |   | 5.0 |   |
|                                                      |            |            |            |                                   |            |                                                                                 |            |  |  |  |  |  |  |  |  |  |

 

 

### **FORWARD-LOOKING STATEMENTS**

 

Statements contained in this report that arenot statements of historical fact constitute forward-looking statements withinthe meaning of Section 21E of the Securities Exchange Act of 1934, asamended.  In addition, the Corporationmay make forward-looking statements in future filings with the Securities andExchange Commission, in press releases, and in oral and written statements madeby or with the approval of the Corporation. Forward-looking statements include, but are not limited to: (1)projections of revenues, income or loss, earnings or loss per share, capitalstructure and other financial items; (2) statements of plans and objectives ofthe Corporation or its management or Board of Directors; (3) statementsregarding future events, actions or economic performance; and (4) statements ofassumptions underlying such statements. Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,”“intends,” “plans,” “targeted,” and similar expressions are intended toidentify forward-looking statements, but are not the exclusive means ofidentifying such statements.

 

Forward-looking statementsinvolve risks and uncertainties that may cause actual results to differmaterially from those indicated by the forward-looking statements.  Some of the events or circumstances thatcould cause such differences include the following: changes in general economicconditions and economic conditions in Kentucky and the markets served by theCorporation any of which may affect, among other things, the level ofnon-performing assets, charge-offs, and provision expense; changes in theinterest rate environment which may reduce interest margins and impact fundingsources; changes in market rates and prices which may adversely impact thevalue of financial products including securities, loans and deposit; changes intax laws, rules and regulations; various monetary and fiscal policies andregulations, including those determined by the Federal Reserve Board, theFederal Deposit Insurance Corporation and the Kentucky Office of FinancialInstitutions; competition with other local and regional commercial banks,savings banks, credit unions and other non-bank financial institutions; abilityto grow core businesses; ability to develop and introduce new banking-related 

 

 

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products, services andenhancements and gain market acceptance of such products; and management’sability to manage these and other risks.

 

###### **Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

###### **Asset/Liability Management and Market Risk**

 

To minimize the volatility of net interest incomeand exposure to economic loss that may result from fluctuating interest rates,we manage our exposure to adverse changes in interest rates through asset andliability management activities within guidelines established by our AssetLiability Committee (“ALCO”).  The ALCO,which includes senior management representatives, has the responsibility forapproving and ensuring compliance with asset/liability management polices.  Interest rate risk is the exposure to adversechanges in the net interest income as a result of market fluctuations ininterest rates.  The ALCO, on an ongoingbasis, monitors interest rate and liquidity risk in order to implementappropriate funding and balance sheet strategies.  Management considers interest rate risk to beour most significant market risk.

 

Weutilize an earnings simulation model to analyze net interest incomesensitivity.  Potential changes in marketinterest rates and their subsequent effects on net interest income are thenevaluated.  The model projects the effectof instantaneous movements in interest rates of both 100 and 200 basispoints.  Assumptions based on thehistorical behavior of our deposit rates and balances in relation to changes ininterest rates are also incorporated into the model.  These assumptions are inherently uncertainand, as a result, the model cannot precisely measure future net interest incomeor precisely predict the impact of fluctuations in market interest rates on netinterest income.  Actual results willdiffer from the model’s simulated results due to timing, magnitude andfrequency of interest rate changes as well as changes in market conditions andthe application and timing of various management strategies.

 

Ourinterest sensitivity profile was asset sensitive at both March 31, 2005 andDecember 31, 2004.  Given a sustained 100basis point decrease in rates, our base net interest income would decrease byan estimated 5.29% at March 31, 2005 compared to a decrease of 2.38% atDecember 31, 2004.  Given a 100 basispoint increase in interest rates our base net interest income would increase byan estimated 4.76% at March 31, 2005 compared to an increase of 2.19% atDecember 31, 2004.

 

Ourinterest sensitivity at any point in time will be affected by a number offactors.  These factors include the mixof interest sensitive assets and liabilities as well as their relative pricingschedules.  It is also influenced bymarket interest rates, deposit growth, loan growth, decay rates and prepaymentspeed assumptions.

 

Asdemonstrated by the March 31, 2005 and December 31, 2004 sensitivity tablespresented below, we are continuing to transition away from a liabilitysensitive to an asset sensitive position as compared to prior periods inanticipation of rising interest rates for the next several months. The changein our asset sensitivity is a result of changes in the loan portfolio to agreater extent than changes in the investment portfolio.  While lending practices have shifted toshorter term, variable rate commercial and consumer loans, that impact will beevidenced in smaller degrees over time.

 

Oursensitivity to interest rate changes is presented based on data as of March 31,2005 and December 31, 2004 annualized to a one year period.

 

 

24

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** **
| ** **                      | ** ** | **March 31, 2005**        | ** ** |
|---------------------------------|------------|---------------------------|------------|
| ** **                      | ** ** | **Decrease in Rates**     | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| **(Dollars in thousands)**      | ** ** | **200**

**Basis Points** | ** ** | **100**

**Basis Points** | ** ** | **Base** | ** ** | **100**

**Basis Points** | ** ** | **200**

**Basis Points** | ** ** |
| ** **                      |
|                            |       |                      |       |   |   |   |   |   |   |   |   |
| **Projected  interest income**  |       |                      |       |   |   |   |   |   |   |   |   |
| Loans                           |       | $                         | 37,473     |   | $ | 40,130 |   | $ | 42,639 |   | $ | 45,061 |   | $ | 47,407 |   |
| Investments                     |       | 1,893                     |       | 2,800 |   | 3,336 |   | 3,806 |   | 4,296 |   |
| **Total  interest income**      |       | 39,366                    |       | 42,930 |   | 45,975 |   | 48,867 |   | 51,703 |   |
|                            |       |                      |       |   |   |   |   |   |   |   |   |
| **Projected  interest expense** |       |                      |       |   |   |   |   |   |   |   |   |
| Deposits                        |       | 9,713                     |       | 11,095 |   | 12,518 |   | 13,941 |   | 15,364 |   |
| Borrowed funds                  |       | 4,253                     |       | 4,339 |   | 4,425 |   | 4,511 |   | 4,597 |   |
| **Total  interest expense**     |       | 13,966                    |       | 15,434 |   | 16,943 |   | 18,452 |   | 19,961 |   |
|                            |       |                      |       |   |   |   |   |   |   |   |   |
| **Net  interest income**        |       | $                         | 25,400     |   | $ | 27,496 |   | $ | 29,032 |   | $ | 30,415 |   | $ | 31,742 |   |
| Change from base                |       | $                         | (3,632     | ) | $ | (1,536 | ) |   |   | $ | 1,383 |   | $ | 2,710 |   |
| % Change from  base             |       | (12.51%                   | )          | (5.29% | ) |   |   | 4.76 | % | 9.33 | % |
|                                 |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                      | ** ** | **December 31, 2004**     | ** ** |
|---------------------------------|------------|---------------------------|------------|
| ** **                      | ** ** | **Decrease in Rates**     | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| **(Dollars in thousands)**      | ** ** | **200**

**Basis Points** | ** ** | **100**

**Basis Points** | ** ** | **Base** | ** ** | **100**

**Basis Points** | ** ** | **200**

**Basis Points** | ** ** |
|                            |       |                      |       |   |   |   |   |   |   |   |   |
| **Projected  interest income**  |       |                      |       |   |   |   |   |   |   |   |   |
| Loans                           |       | $                         | 38,503     |   | $ | 39,834 |   | $ | 40,943 |   | $ | 41,960 |   | $ | 42,995 |   |
| Investments                     |       | 1,963                     |       | 2,332 |   | 2,517 |   | 2,667 |   | 2,820 |   |
| **Total  interest income**      |       | 40,466                    |       | 42,166 |   | 43,460 |   | 44,627 |   | 45,815 |   |
|                            |       |                      |       |   |   |   |   |   |   |   |   |
| **Projected  interest expense** |       |                      |       |   |   |   |   |   |   |   |   |
| Deposits                        |       | 10,215                    |       | 10,805 |   | 11,395 |   | 11,914 |   | 12,433 |   |
| Borrowed funds                  |       | 4,262                     |       | 4,307 |   | 4,352 |   | 4,393 |   | 4,434 |   |
| **Total  interest expense**     |       | 14,477                    |       | 15,112 |   | 15,747 |   | 16,307 |   | 16,867 |   |
|                            |       |                      |       |   |   |   |   |   |   |   |   |
| **Net  interest income**        |       | $                         | 25,989     |   | $ | 27,054 |   | $ | 27,713 |   | $ | 28,320 |   | $ | 28,948 |   |
| Change from base                |       | $                         | (1,724     | ) | $ | (659 | ) |   |   | $ | 607 |   | $ | 1,235 |   |
| % Change from  base             |       | (6.22%                    | )          | (2.38% | ) |   |   | 2.19 | % | 4.46 | % |
|                                 |            |                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

###### ** **

###### **Item 4.  CONTROLS AND PROCEDURES**

 

*Evaluation of disclosure controls and procedures*

 

Our management evaluated,with the participation of our Chief Executive Officer and our Chief FinancialOfficer, the effectiveness of our disclosure controls and procedures as of theend of the period covered by this Quarterly Report on Form 10-Q. Based onthis evaluation, our Chief Executive Officer and our Chief Financial Officerhave concluded that our disclosure controls and procedures are effective as ofthe end of the period covered by this Quarterly Report on Form 10-Q toensure that information we are required to disclose in reports that we file orsubmit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in Securities andExchange Commission rules and forms.

 

*Changes in internal control over financial reporting*

 

There was no change in ourinternal control over financial reporting that occurred during the periodcovered by this Quarterly Report on Form 10-Q that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

 

25

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##### **Part II -  OTHERINFORMATION**

 

###### **Item1.  LegalProceedings**

 

Although, from time to time, we are involved invarious legal proceedings in the normal course of business, there are nomaterial pending legal proceedings to which we are a party, or to which any ofour property is subject.

 

###### **Item2.  Changesin Securities, Use of Proceeds and Issuer Purchases of Equity Securities**

(e)  Issuer Purchases of Equity Securities

We repurchased no shares of our common stock during the quarter ended March 31, 2005.

 

###### **Item3.  DefaultsUpon Senior Securities**

 

Not Applicable

 

###### **Item4.  Submissionof Matters to a Vote of Security Holders**

 

Not Applicable

 

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

###### ** **

None

 

###### **Item6.  Exhibits:**

 

31.1  Certificationof Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act

 

31.2 Certification of Chief Financial Officer Pursuant to Section 302 ofSarbanes-Oxley Act

 

32 Certification of Chief Executive Officer and Chief Financial OfficerPursuant to Section 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906of the Sarbanes-Oxley Act of 2002)

 

26

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**FIRST FINANCIAL SERVICE CORPORATION**

 

## **SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

 

 

 
| DATE: May 9, 2005 | BY: (S) |  B. Keith  Johnson               |
|-------------------|---------|---------------------------------------|
|              |    | B. Keith Johnson                      |
|              |    | President and Chief Executive Officer |
|              |    |                                  |
| DATE: May 9, 2005 | BY: (S) | Gregory S. Schreacke                  |
|              |    | Gregory S.  Schreacke                 |
|              |    | Chief Financial Officer               |
|              |    | Principal Accounting Officer          |

 

 

 

27

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## **INDEX TO EXHIBITS**

 

 

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                   |   |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|            |       |                                                                                                                                                                              |   |
| 31.1            |       | Certification  of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                           |   |
|            |       |                                                                                                                                                                              |   |
| 31.2            |       | Certification  of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                           |   |
|            |       |                                                                                                                                                                              |   |
| 32              |       | Certification  of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of  2002) |   |

 

 

 

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