**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM10-Q**

 
| **(Mark One)**                                   |
|--------------------------------------------------|
|                                             |   |
| **ý**                                       | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934.** |
| ** **                                       | ** ** |
| **For the quarterly period ended June 30, 2004** |
|                                             |   |
| **OR**                                           |
|                                             |   |
| **o**                                            | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |
| ** **                                       | ** ** |
| **Commission File Number 0-18832**               |

 

**FirstFinancial Service Corporation**

(Exact Name of Registrant as specified in its charter)

 
| **Kentucky**                                                    | ** ** | **61-1168311**                    |
|-----------------------------------------------------------------|------------|-----------------------------------|
| (State or other jurisdiction  of incorporation or organization) |       | (IRS Employer Identification No.) |
|                                                            |       |                              |
| **2323 Ring Road  Elizabethtown, Kentucky  42701**         |
| (Address of principal executive offices)  (Zip Code)            |
|                                                            |       |                              |
| **(270) 765-2131**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes**ý**  No o

 

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

 

Yes **ý**  Noo

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

| **Class**    | ** ** | **Outstanding as of July 31, 2004** |
|--------------|------------|-------------------------------------|
| Common Stock |       | 3,645,438 shares                    |

 

 

----

 

## **FIRST FINANCIAL SERVICECORPORATION**

## ** **

**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 and Reports on Form 8-K                                                                                           |   |
|                                    |                                                                                                                       |   |
|                                    | SIGNATURES                                                                                                                 |   |
|                                    |                                                                                                                       |   |
|                                    | CERTIFICATIONS                                                                                                             |   |

 

2

----

 
| **Item 1.** | ** ** | **FIRST FINANCIAL SERVICE CORPORATION** |
|-------------|------------|-----------------------------------------|

**Consolidated Statements ofFinancial Condition**

 
| ** **                                                                                                                                                 | ** ** | **(Unaudited)**    | ** ** | ** **             | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| **(Dollars In Thousands, Except  Share Data)**                                                                                                             | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
| **ASSETS**                                                                                                                                                 |       |               |       |                   |       |
| Cash and due from banks                                                                                                                                    |       | $                  | 25,219     |                   | $          | 28,030 |   |
| Federal funds sold                                                                                                                                         |       | —             |       | 20,000                 |       |
| Cash and cash equivalents                                                                                                                                  |       | 25,219             |       | 48,030                 |       |
|                                                                                                                                                       |       |               |       |                   |       |
| Securities available-for-sale                                                                                                                              |       | 4,023              |       | 4,009                  |       |
| Securities held-to-maturity, fair value of  $41,183 Jun (2004) and $30,919 Dec (2003)                                                                      |       | 41,908             |       | 30,929                 |       |
| Total securities                                                                                                                                           |       | 45,931             |       | 34,938                 |       |
|                                                                                                                                                       |       |               |       |                   |       |
| Loans held for sale                                                                                                                                        |       | 1,231              |       | 1,021                  |       |
| Loans receivable, net of unearned fees                                                                                                                     |       | 580,221            |       | 554,700                |       |
| Allowance for loan losses                                                                                                                                  |       | (5,822             | )          | (5,568                 | )          |
| Net loans receivable                                                                                                                                       |       | 575,630            |       | 550,153                |       |
|                                                                                                                                                       |       |               |       |                   |       |
| Federal Home Loan Bank stock                                                                                                                               |       | 6,702              |       | 6,570                  |       |
| Cash surrender value of life insurance                                                                                                                     |       | 7,209              |       | 7,067                  |       |
| Premises and equipment, net                                                                                                                                |       | 17,104             |       | 15,466                 |       |
| Real estate owned:                                                                                                                                         |       |               |       |                   |       |
| Acquired through foreclosure                                                                                                                               |       | 568                |       | 387                    |       |
| Held for development                                                                                                                                       |       | 446                |       | 446                    |       |
| Other repossessed assets                                                                                                                                   |       | 60                 |       | 62                     |       |
| Goodwill                                                                                                                                                   |       | 8,384              |       | 8,384                  |       |
| Accrued interest receivable                                                                                                                                |       | 1,948              |       | 1,931                  |       |
| Other assets                                                                                                                                               |       | 2,487              |       | 2,901                  |       |
|                                                                                                                                                       |       |               |       |                   |       |
| **TOTAL ASSETS**                                                                                                                                           |       | $                  | 691,688    |                   | $          | 676,335 |   |
|                                                                                                                                                       |       |               |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       |               |       |                   |       |
| **LIABILITIES:**                                                                                                                                           |       |               |       |                   |       |
| Deposits:                                                                                                                                                  |       |               |       |                   |       |
| Non-interest bearing                                                                                                                                       |       | $                  | 34,694     |                   | $          | 28,632 |   |
| Interest bearing                                                                                                                                           |       | 491,633            |       | 500,530                |       |
| Total deposits                                                                                                                                             |       | 526,327            |       | 529,162                |       |
|                                                                                                                                                       |       |               |       |                   |       |
| Advances from Federal Home Loan Bank                                                                                                                       |       | 95,865             |       | 78,283                 |       |
| Subordinated debentures                                                                                                                                    |       | 10,000             |       | 10,000                 |       |
| Accrued interest payable                                                                                                                                   |       | 390                |       | 416                    |       |
| Accounts payable and other liabilities                                                                                                                     |       | 764                |       | 1,027                  |       |
| Deferred income taxes                                                                                                                                      |       | 1,130              |       | 1,126                  |       |
|                                                                                                                                                       |       |               |       |                   |       |
| **TOTAL LIABILITIES**                                                                                                                                      |       | 634,476            |       | 620,014                |       |
|                                                                                                                                                       |       |               |       |                   |       |
| **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, 3,645,438 shares Jun  (2004), and 3,705,438 shares Dec (2003) |       | 3,645              |       | 3,705                  |       |
| Additional paid-in capital                                                                                                                                 |       | 8,226              |       | 9,726                  |       |
| Retained earnings                                                                                                                                          |       | 44,534             |       | 42,092                 |       |
| Accumulated other comprehensive income, net  of tax                                                                                                        |       | 807                |       | 798                    |       |
|                                                                                                                                                       |       |               |       |                   |       |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                                                                        |       | 57,212             |       | 56,321                 |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                        |       | $                  | 691,688    |                   | $          | 676,335 |   |

 

***See notes to theunaudited consolidated financial statements.***

 

3

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**FIRST FINANCIAL SERVICECORPORATION**

**Consolidated Statements of Income**

**(Dollars In Thousands, Except PerShare Data)**

**(Unaudited)**

** **
| ** **                                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Interest Income:**                                 |       |                             |       |                           |       |   |   |   |   |
| Interest and fees on loans                           |       | $                                | 9,021      |                           | $          | 9,451 |   | $ | 18,129 |   | $ | 19,089 |   |
| Interest and dividends on investments and  deposits  |       | 419                              |       | 520                            |       | 862 |   | 1,006 |   |
| Total interest income                                |       | 9,440                            |       | 9,971                          |       | 18,991 |   | 20,095 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| **Interest Expense:**                                |       |                             |       |                           |       |   |   |   |   |
| Deposits                                             |       | 2,528                            |       | 3,113                          |       | 5,253 |   | 6,358 |   |
| Federal Home Loan Bank advances                      |       | 923                              |       | 932                            |       | 1,851 |   | 1,855 |   |
| Subordinated debentures                              |       | 124                              |       | 129                            |       | 248 |   | 257 |   |
| Total interest expense                               |       | 3,575                            |       | 4,174                          |       | 7,352 |   | 8,470 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Net interest  income                                 |       | 5,865                            |       | 5,797                          |       | 11,639 |   | 11,625 |   |
| Provision for loan losses                            |       | 259                              |       | 420                            |       | 648 |   | 749 |   |
| Net interest income after provision for  loan losses |       | 5,606                            |       | 5,377                          |       | 10,991 |   | 10,876 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| **Non-interest Income:**                             |       |                             |       |                           |       |   |   |   |   |
| Customer service fees on deposit accounts            |       | 1,268                            |       | 1,133                          |       | 2,403 |   | 2,133 |   |
| Gain on sale of mortgage loans                       |       | 244                              |       | 431                            |       | 462 |   | 838 |   |
| Brokerage and insurance commissions                  |       | 116                              |       | 101                            |       | 228 |   | 197 |   |
| Gain on sale of real estate held for  development    |       | 371                              |       | —                         |       | 376 |   | — |   |
| Other income                                         |       | 262                              |       | 217                            |       | 563 |   | 432 |   |
| Total non-interest income                            |       | 2,261                            |       | 1,882                          |       | 4,032 |   | 3,600 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| **Non-interest Expense:**                            |       |                             |       |                           |       |   |   |   |   |
| Employee compensation and benefits                   |       | 2,657                            |       | 2,433                          |       | 5,055 |   | 4,669 |   |
| Office occupancy expense and equipment               |       | 482                              |       | 379                            |       | 891 |   | 747 |   |
| Marketing and advertising                            |       | 213                              |       | 150                            |       | 352 |   | 298 |   |
| Outside services and data processing                 |       | 551                              |       | 464                            |       | 1,065 |   | 931 |   |
| Bank franchise tax                                   |       | 207                              |       | 141                            |       | 419 |   | 282 |   |
| Other expense                                        |       | 906                              |       | 766                            |       | 1,673 |   | 1,450 |   |
| Total non-interest expense                           |       | 5,016                            |       | 4,333                          |       | 9,455 |   | 8,377 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Income before income taxes                           |       | 2,851                            |       | 2,926                          |       | 5,568 |   | 6,099 |   |
| Income taxes                                         |       | 925                              |       | 976                            |       | 1,803 |   | 2,027 |   |
| **Net Income**                                       |       | $                                | 1,926      |                           | $          | 1,950 |   | $ | 3,765 |   | $ | 4,072 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Shares applicable to basic income per share          |       | 3,645,438                        |       | 3,715,065                      |       | 3,671,152 |   | 3,858,713 |   |
| **Basic income per share**                           |       | $                                | 0.53       |                           | $          | 0.52 |   | $ | 1.03 |   | $ | 1.06 |   |
|                                                 |       |                             |       |                           |       |   |   |   |   |
| Shares applicable to diluted income per  share       |       | 3,659,274                        |       | 3,754,950                      |       | 3,688,193 |   | 3,877,278 |   |
| **Diluted income per share**                         |       | $                                | 0.53       |                           | $          | 0.52 |   | $ | 1.02 |   | $ | 1.05 |   |

 

***See notes to theunaudited consolidated financial statements.***

 

4

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**FIRST  FINANCIAL SERVICE CORPORATION**

**Consolidated Statements ofComprehensive Income**

**(Dollars In Thousands)**

**(Unaudited)**

 
| ** **                                                     | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                     | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                           |       |                             |       |                           |       |   |   |   |   |
| **Net Income**                                                 |       | $                                | 1,926      |                           | $          | 1,950 |   | $ | 3,765 |   | $ | 4,072 |   |
| Other comprehensive income (loss):                             |       |                             |       |                           |       |   |   |   |   |
| Change in unrealized gain (loss) on  securities                |       | (27                              | )          | 226                            |       | 14 |   | 220 |   |
| Reclassification of realized amount                            |       | —                           |       | —                         |       | — |   | — |   |
| Net unrealized gain (loss) recognized in  comprehensive income |       | (27                              | )          | 226                            |       | 14 |   | 220 |   |
| Tax effect                                                     |       | 9                                |       | (77                            | )          | (5 | ) | (75 | ) |
| Total other comphrehensive income (loss)                       |       | (18                              | )          | 149                            |       | 9 |   | 145 |   |
|                                                           |       |                             |       |                           |       |   |   |   |   |
| **Comphrehensive Income**                                      |       | $                                | 1,908      |                           | $          | 2,099 |   | $ | 3,774 |   | $ | 4,217 |   |

 

***See notes to theunaudited consolidated financial statements.***

 

5

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**FIRST FINANCIAL SERVICECORPORATION**

**Consolidated Statements of Changesin Stockholders’ Equity**

**Six Months Ended June 30, 2004**

**(Dollars In Thousands, Except PerShare Amounts)**

**(Unaudited)**

 

 
| ** **                                                                             | ** ** | **Common  Shares** | ** ** | **Stock  Amount** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income, Net of  Tax** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|------------------------------------------------------------|------------|-----------|------------|
|                                                                                   |       |               |       |              |       |                             |       |                   |       |                                                       |       |      |       |
| **Balance, December 31, 2003**                                                         |       | 3,705              |       | $                 | 3,705      |                             | $          | 9,726                  |       | $                                                          | 42,092     |      | $          | 798 |   | $ | 56,321 |   |
| Net income                                                                             |       |               |       |              |       |                             |       | 3,765                  |       |                                                       |       | 3,765     |       |
| Net change in unrealized gains (losses) on  securities available- for-sale, net of tax |       |               |       |              |       |                             |       |                   |       | 9                                                          |       | 9         |       |
| Cash dividends declared ($.36 per share)                                               |       |               |       |              |       |                             |       | (1,323                 | )          |                                                       |       | (1,323    | )          |
| Stock repurchased                                                                      |       | (60                | )          | (60               | )          | (1,500                           | )          |                   |       |                                                       |       | (1,560    | )          |
|                                                                                   |       |               |       |              |       |                             |       |                   |       |                                                       |       |      |       |
| **Balance, June 30, 2004**                                                             |       | 3,645              |       | $                 | 3,645      |                             | $          | 8,226                  |       | $                                                          | 44,534     |      | $          | 807 |   | $ | 57,212 |   |

 

***See notes to theunaudited consolidated financial statements.***

 

6

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**FIRST FINANCIAL SERVICE CORPORATION**

**Consolidated Statements of CashFlows**

**(Dollars In Thousands)**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                       | ** ** | **2003** | ** ** |
| **Operating Activities:**                                                          |       |                           |       |   |   |
| Net income                                                                         |       | $                              | 3,765      |   | $ | 4,072 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                           |       |   |   |
| Provision for loan losses                                                          |       | 648                            |       | 749 |   |
| Depreciation on premises and equipment                                             |       | 524                            |       | 496 |   |
| Federal Home Loan Bank stock dividends                                             |       | (132                           | )          | (126 | ) |
| Net amortization (accretion)                                                       |       | 20                             |       | (219 | ) |
| Gain on sale of mortgage loans                                                     |       | (462                           | )          | (838 | ) |
| Gain on sale of real estate held for  development                                  |       | (376                           | )          | — |   |
| Origination of loans held for sale                                                 |       | (29,060                        | )          | (49,991 | ) |
| Proceeds on sale of loans held for sale                                            |       | 29,312                         |       | 49,398 |   |
| Changes in:                                                                        |       |                           |       |   |   |
| Interest receivable                                                                |       | (17                            | )          | (67 | ) |
| Other assets                                                                       |       | 267                            |       | 774 |   |
| Interest payable                                                                   |       | (26                            | )          | (23 | ) |
| Accounts payable and other liabilities                                             |       | (23                            | )          | 70 |   |
| Net cash from operating activities                                                 |       | 4,440                          |       | 4,295 |   |
|                                                                               |       |                           |       |   |   |
| **Investing Activities:**                                                          |       |                           |       |   |   |
| Purchases of securities available-for-sale                                         |       | —                         |       | (1,415 | ) |
| Purchases of securities held-to-maturity                                           |       | (28,100                        | )          | (29,978 | ) |
| Maturities of securities held-to-maturity                                          |       | 17,101                         |       | 22,257 |   |
| Net change in loans                                                                |       | (26,089                        | )          | 10,065 |   |
| Net purchases of premises and equipment                                            |       | (2,027                         | )          | (2,683 | ) |
| Net cash from investing activities                                                 |       | (39,115                        | )          | (1,754 | ) |
|                                                                               |       |                           |       |   |   |
| **Financing Activities**                                                           |       |                           |       |   |   |
| Net change in deposits                                                             |       | (2,835                         | )          | 9,349 |   |
| Advances from Federal Home Loan Bank                                               |       | 57,100                         |       | 132 |   |
| Repayments to Federal Home Loan Bank                                               |       | (39,518                        | )          | (128 | ) |
| Dividends paid                                                                     |       | (1,323                         | )          | (1,321 | ) |
| Common stock repurchased                                                           |       | (1,560                         | )          | (9,032 | ) |
| Net cash from financing activities                                                 |       | 11,864                         |       | (1,000 | ) |
|                                                                               |       |                           |       |   |   |
| **(Decrease) Increase in cash and cash  equivalents**                              |       | (22,811                        | )          | 1,541 |   |
| **Cash and cash equivalents, beginning of  period**                                |       | 48,030                         |       | 91,776 |   |
| **Cash and cash equivalents, end of period**                                       |       | $                              | 25,219     |   | $ | 93,317 |   |

 

***See notes to the unaudited consolidatedfinancial statements.***

 

7

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## **FIRST FINANCIAL SERVICECORPORATION**

**Notes To Unaudited Consolidated Financial Statements**

 

**1.****                                     ****BASIS OF PRESENTATION ANDSUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

***Basis of Presentation*** – The accompanyingunaudited consolidated financial statements include the accounts of FirstFinancial Service Corporation (the Corporation) and its wholly ownedsubsidiary, First Federal Savings Bank of Elizabethtown (the Bank).  As further discussed in Note 7 of theCorporation’s annual report on Form 10-K for the period ended December 31,2003, a trust that had previously been consolidated with the Bank is nowreported separately.  The Bank has threewholly owned subsidiaries, First Service Corporation of Elizabethtown, FirstHeartland Mortgage Company and First Federal Office Park, LLC.  All significant intercompany transactions andbalances 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 six-month periodending June 30, 2004 are not necessarily indicative of the results that may occurfor the year ending December 31, 2004. 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, 2003.

 

***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  June 30,**                  | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------|-------------|---------------------------------------------------|------------|--------------------------------|------------|
| ** **          | ** **  | **2004**                                          | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **          | ** **  | **(Dollars In Thousands, Except Per Share Data)** | ** ** |
| Net income:         |        |                                              |       |                           |       |   |   |   |   |
| As reported         |        | $                                                 | 1,926      |                           | $          | 1,950 |   | $ | 3,765 |   | $ | 4,072 |   |
| Pro-forma           |        | 1,896                                             |       | 1,923                          |       | 3,703 |   | 4,016 |   |
| Earnings per share: |        |                                              |       |                           |       |   |   |   |   |
| Basic               | As Reported |                                              | $          | 0.53                           |       | $ | 0.52 |   | $ | 1.03 |   | $ | 1.06 |   |
|                | Pro-forma   |                                              | 0.52       |                           | 0.52       |   | 1.01 |   | 1.05 |   |
| Diluted             | As Reported |                                              | $          | 0.53                           |       | $ | 0.52 |   | $ | 1.02 |   | $ | 1.05 |   |
|                | Pro-forma   |                                              | 0.52       |                           | 0.51       |   | 1.01 |   | 1.04 |   |

 

***Reclassifications*** – Certain amounts have been reclassified inthe prior period financial statements to conform to the current periodclassifications.

 

8

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**2.**             **SECURITIES**

 

Theamortized cost basis and fair values of securities are as follows:

 
| **(Dollars  in thousands)**        | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair Value** | ** ** |
|------------------------------------|------------|---------------------|------------|------------------------------|------------|-------------------------------|------------|----------------|------------|
| **Securities available-for-sale:** |       |                |       |                         |       |                          |       |           |       |
| **June 30, 2004:**                 |       |                |       |                         |       |                          |       |           |       |
| Equity                             |       | $                   | 1,801      |                         | $          | 1,175                         |       | $              | —     |   | $ | 2,976 |   |
| State and municipal                |       | 999                 |       | 48                           |       | —                        |       | 1,047          |       |
|                               |       |                |       |                         |       |                          |       |           |       |
| Total                              |       | $                   | 2,800      |                         | $          | 1,223                         |       | $              | —     |   | $ | 4,023 |   |
|                               |       |                |       |                         |       |                          |       |           |       |
| **December 31, 2003:**             |       |                |       |                         |       |                          |       |           |       |
| Equity                             |       | $                   | 1,801      |                         | $          | 1,138                         |       | $              | —     |   | $ | 2,939 |   |
| State and municipal                |       | 999                 |       | 71                           |       | —                        |       | 1,070          |       |
|                               |       |                |       |                         |       |                          |       |           |       |
| Total                              |       | $                   | 2,800      |                         | $          | 1,209                         |       | $              | —     |   | $ | 4,009 |   |

 
| ** **                       | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrecognized  Gains** | ** ** | **Gross  Unrecognized  Losses** | ** ** | **Fair Value** | ** ** |
|----------------------------------|------------|---------------------|------------|--------------------------------|------------|---------------------------------|------------|----------------|------------|
| **Securities held-to-maturity:** |       |                |       |                           |       |                            |       |           |       |
| **June 30, 2004:**               |       |                |       |                           |       |                            |       |           |       |
| U.S. Treasury and agencies       |       | $                   | 30,096     |                           | $          | —                          |       | $              | (473       | ) | $ | 29,623 |   |
| Corporate                        |       | 2,000               |       | —                         |       | —                          |       | 2,000          |       |
| Mortgage-backed                  |       | 9,812               |       | 9                              |       | (261                            | )          | 9,560          |       |
|                             |       |                |       |                           |       |                            |       |           |       |
| Total                            |       | $                   | 41,908     |                           | $          | 9                               |       | $              | (734       | ) | $ | 41,183 |   |
|                             |       |                |       |                           |       |                            |       |           |       |
| **December 31, 2003:**           |       |                |       |                           |       |                            |       |           |       |
| U.S. Treasury and agencies       |       | $                   | 19,999     |                           | $          | 77                              |       | $              | —     |   | $ | 20,076 |   |
| Corporate                        |       | 2,000               |       | —                         |       | —                          |       | 2,000          |       |
| Mortgage-backed                  |       | 8,930               |       | 9                              |       | (96                             | )          | 8,843          |       |
|                             |       |                |       |                           |       |                            |       |           |       |
| Total                            |       | $                   | 30,929     |                           | $          | 86                              |       | $              | (96        | ) | $ | 30,919 |   |

 

9

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**3.****            ****LOANS RECEIVABLE**

 

Loansreceivable are summarized as follows:

** **
| **(Dollars  in thousands)**        | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------|------------|--------------------|------------|------------------------|------------|
|                               |       |               |       |                   |       |
| Commercial                         |       | $                  | 30,978     |                   | $          | 30,943 |   |
| Real estate commercial             |       | 278,789            |       | 239,406                |       |
| Real estate construction           |       | 6,523              |       | 9,952                  |       |
| Residential mortgage               |       | 176,921            |       | 194,000                |       |
| Consumer and home equity           |       | 58,932             |       | 53,566                 |       |
| Indirect consumer                  |       | 29,467             |       | 28,279                 |       |
| Loans held for sale                |       | 1,231              |       | 1,021                  |       |
|                               |       | 582,841            |       | 557,167                |       |
| Less:                              |       |               |       |                   |       |
| Net deferred loan origination fees |       | (1,389             | )          | (1,446                 | )          |
| Allowance for loan losses          |       | (5,822             | )          | (5,568                 | )          |
|                               |       | (7,211             | )          | (7,014                 | )          |
|                               |       |               |       |                   |       |
| Loans Receivable                   |       | $                  | 575,630    |                   | $          | 550,153 |   |

 

The allowance for losses on loans is summarized as follows:

 
| ** **                   | ** ** | **As of and For the  Three Months Ended  June 30,** | ** ** | **As of and For the  Six Months Ended  June 30,** | ** ** |
|------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **(Dollars in thousands)**   | ** ** | **2004**                                            | ** ** | **2003**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
|                         |       |                                                |       |                                              |       |   |   |   |   |
| Balance, beginning of period |       | $                                                   | 5,733      |                                              | $          | 4,679 |   | $ | 5,568 |   | $ | 4,576 |   |
| Provision for loan losses    |       | 259                                                 |       | 420                                               |       | 648 |   | 749 |   |
| Charge-offs                  |       | (219                                                | )          | (224                                              | )          | (490 | ) | (483 | ) |
| Recoveries                   |       | 49                                                  |       | 60                                                |       | 96 |   | 93 |   |
| Balance, end of period       |       | $                                                   | 5,822      |                                              | $          | 4,935 |   | $ | 5,822 |   | $ | 4,935 |   |

 

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

 
| **(Dollars in thousands)**                  | ** ** | **As of the  Six Months Ended  June 30,  2004** | ** ** | **As of the  Year Ended  December 31,  2003** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
|                                        |       |                                            |       |                                          |       |
| End of period impaired loans                |       | $                                               | 4,338      |                                          | $          | 5,318 |   |
| Amount of allowance for loan loss allocated |       | 795                                             |       | 911                                           |       |
|                                             |            |                                                 |            |                                               |            |  |  |

 

10

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Non-performingloans were as follows:

 
| **(Dollars in thousands)**                    | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|------------------------|------------|
|                                          |       |               |       |                   |       |
| Restructured                                  |       | $                  | 3,063      |                   | $          | 3,037 |   |
| Loans past due over 90 days still on  accrual |       | —             |       | —                 |       |
| Non accrual loans                             |       | 1,275              |       | 2,281                  |       |
|                                               |            |                    |            |                        |            |  |  |

 

**4.             EARNINGS PER SHARE**

 

The reconciliation of the numerators and denominators of the basic anddiluted EPS is as follows:

 
| ** **                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **(Dollars in thousands,  except per share data)** | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                               |       |                             |       |                           |       |   |   |   |   |
| Net income available to common shareholders        |       | $                                | 1,926      |                           | $          | 1,950 |   | $ | 3,765 |   | $ | 4,072 |   |
| Basic EPS:                                         |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares                     |       | 3,645                            |       | 3,710                          |       | 3,671 |   | 3,835 |   |
| Diluted EPS:                                       |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares                     |       | 3,645                            |       | 3,710                          |       | 3,671 |   | 3,835 |   |
| Dilutive effect of stock options                   |       | 14                               |       | 44                             |       | 17 |   | 42 |   |
| Weighted average common and incremental  shares    |       | 3,659                            |       | 3,754                          |       | 3,688 |   | 3,877 |   |
| Earnings Per Share:                                |       |                             |       |                           |       |   |   |   |   |
| Basic                                              |       | $                                | 0.53       |                           | $          | 0.52 |   | $ | 1.03 |   | $ | 1.06 |   |
| Diluted                                            |       | $                                | 0.53       |                           | $          | 0.52 |   | $ | 1.02 |   | $ | 1.05 |   |

 

Stock options for 10,000 shares of common stock were not included inthe 2004 computations of diluted earnings per share because their impact wasanti-dilutive.

 

**Item 2****.**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITIONAND RESULTS OF OPERATIONS**

** **

##### **GENERAL**

##### ** **

The Corporation, through its subsidiary,First Federal Savings Bank conducts operations in 14 full-service bankingcenters in six contiguous counties in Kentucky along the Interstate 65corridor.  The Corporation’s marketpresence ranges from the major metropolitan market of Louisville in JeffersonCounty, Kentucky approximately 40 miles north of its headquarters inElizabethtown, Kentucky, to Hart County, Kentucky approximately 30 miles southof Elizabethtown.

 

The Bank serves the needsand caters to the economic strengths of the local communities in which itoperates, and strives to provide a high level of personal and professionalcustomer service. The Bank offers a variety of financial services to its retailand commercial banking customers. These services include personal and corporatebanking services, trust and estate planning, and personal investment financialcounseling services.

 

Through the Bank’s trust andestate planning and personal investment financial counseling services, itoffers a wide variety of mutual funds, equity investments, and fixed andvariable annuities.

 

The principal source of the Bank’s revenue is net interest income.  Net interest income is the difference betweeninterest income on interest-earning assets, such as loans and securities andthe interest expense on liabilities used to fund those assets, such asinterest-bearing deposits and borrowings. Net interest income is impacted by both changes in the amount andcomposition of interest-earning assets and interest-bearing liabilities as wellas market

 

11

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interest rates. The Bank’s other source of revenue is non-interestincome, such as service charges, insurance agency revenue, loan fees, gains andlosses from the sale of mortgage loans and gains from the sale of real estateheld for development. Its principal operating expenses, aside from interestexpense, consist of compensation and employee benefits, occupancy costs, dataprocessing expense and provisions for loan losses.

 

This discussion and analysis covers material changes in the financialcondition since December 31, 2003 and material changes in the results ofoperations for the three and six-month periods ending, June 30, 2004 ascompared to 2003.  It should be read inconjunction with “Management Discussion and Analysis of Financial Condition andResults of Operations” included in the Annual Report on Form 10-K for theperiod ended December 31, 2003.

 

**OVERVIEW**

 

During the quarter, the Corporation opened its second new full-servicefacility in the growing Metro Louisville market.  The facility represents the Corporation’s newprototype branch with a retail focused design, including an internet café.  The facility is the Corporation’s second fullservice location opened in the Metro Louisville market this year.  The branch replaces its former locationinside a Wal-Mart super store. Management believes these facilities will allowthe Bank to more effectively support its lending relationships in MetroLouisville, and in 2002 and 2003 the Bank closed over $95 million in commercialloans, primarily commercial real estate, as a result of the customer contactsmade within Metro Louisville to develop a larger presence within that market inthe future.  While management fullyanticipate these facilities to significantly enhance the value of its franchisein the near future, the additional expense in operating these new facilitieswill continue to place pressure on earnings for a period of time.  Management is optimistic that its expansionstrategy for Metro Louisville will minimize this period of time and thelong-term benefits will outweigh the initial investment.

 

The Corporation’s emphasis on commercial lending continued to producepositive results for the six-month period generating a $39 million, or 14%increase in commercial loans to $310 million at June 30 2004, compared to $270million at December 31, 2003.  Thisfavorable trend has resulted in an annual compound growth rate of 38% over thepast three years.  The percentage ofcommercial loans in the Bank’s portfolio has increased from 49% at December 31,2003, to 53% at June 30, 2004, while residential loans declined from 35% atDecember 31, 2003, to 30% at June 30, 2004. Management intends to continue this commercial lending emphasis andanticipates continued increases in the commercial and commercial real estateportfolios.

 

In January 2003, the Corporation implemented an effort to develop abank-wide service and sales culture emphasizing expanded accountrelationships.  To achieve this goal, theCorporation increased the number of associates in banking centers, relationshipbankers, business development officers, stockbrokers, and loan officers withexperience in commercial lending.  Theresults of this effort as well as its transition from a federally charteredthrift to a Kentucky state-chartered commercial bank in January 2003 havecontributed to the growth in the Corporation. The resulting increase in staff along with the expansion into the MetroLouisville market have contributed to a $386,000, or 8% increase in employeecompensation expense for the six-months ended June 30, 2004, compared to theperiod ended June 30, 2003.  Managementexpects a continued increase in employee compensation expense in the 2004calendar year as it continues its expansion into Metro Louisville.

 

12

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

 

The Corporation’sapplication of accounting and reporting policies are in accordance withaccounting principles generally accepted in the United States of America andconform to general practices within the banking industry.  In preparing the consolidated financialstatements, management is required to make estimates and assumptions thataffect the reported amounts of assets and liabilities as of the date of thestatement of financial condition and revenues and expenses for the period.  Actual results could differ significantlydepending on the accuracy of those estimates.

 

***Allowance for Loan Losses*****-**The applicationof the Corporation’s accounting policy relating to the allowance for loanlosses requires management to make significant assumptions and estimates thatcould result in materially different amounts to be reported if conditions orunderlying circumstances were to change. See “Allowance and Provision for LoanLosses” herein for a complete discussion of the First Federal FinancialCorporation’s accounting methodologies related to the allowance.  Also refer to Note 1 in the “Notes toConsolidated Financial Statements” in the 2003 10-K for details regarding allof the Corporation’s critical and significant accounting policies.

 

##### **RESULTSOF OPERATIONS**

##### ** **

Net income for the quarter ended June 30, 2004 was $1.9 million or$0.53 per share diluted compared to $2.0 million or $0.52 per share diluted forthe same period in 2003.  Net income forthe six-month period ended June 30, 2004 was $3.8 million or $1.02 per sharediluted compared to $4.1 million or $1.05 per share diluted for the same perioda year ago.  The decrease in dilutedearnings per share for the six month period was primarily the result of anincrease in non-interest expense of $1.1 million for 2004 compared to 2003.** **TheBank’s book value per common share increased from $14.48 at June 30, 2003 to$15.69 at June 30, 2004.** **Annualized net income for 2004generated a return on average assets of 1.10% and a return on average equity of13.27%.  These compare with a return onaverage assets of 1.20% and a return on average equity of 14.48% for the 2003period also annualized.

 

On an annualized basis, the net interestmargin as a percent of average earning assets increased to 3.69% for thequarter ended June 30, 2004 and 3.65% for the six months ended June 30, 2004compared to 3.63% and 3.64% for the respective three-month and six-monthperiods ended June 30, 2003.  Netinterest margin continued to benefit from a decrease in interest expense ondeposits.  The Bank’s cost of fundsaveraged 2.41% and 2.47% for the respective three-month and six-month 2004periods compared to an average cost of funds of 2.86% and 2.90% for the sameperiods in 2003.  The improvement was theresult of the continued re-pricing of certificate of deposit maturities rollingoff at higher rates into current lower interest rates, as well as the continueddecrease in certificate of deposit balances as a percentage of total deposits.  Going forward, the Bank’s cost of funds isexpected to increase as the general market deposit rates have becomeincreasingly competitive with the recent upward trend in interest rates.

 

The yield on earning assets continued todecline for the quarter and the six months ended June 30, 2004 to 5.93% and5.96% respectively, a decrease from 6.24% and 6.28% for the same periods a yearago.  The decrease in the yield onearning assets was primarily the result of a decrease in mortgage loans ascustomers refinanced their mortgage loans elsewhere, or the loans were sold tothe secondary market.  The Bank wassuccessful in increasing the balance of commercial loans over that same timeframe.  In addition to changing the mixof assets in the loan portfolio, the shift also increased the percentage ofvariable rate loans in the portfolio, which will increase the yield in anincreasing interest rate environment. The Bank increased its prime lending rate 25 basis points after the June2004 Federal Open Market Committee meeting. Management anticipates the prime lending rate to increase over the nextyear, which is expected to increase the Bank’s yield on earning assets.

 

The net result of the above factors was anincrease in net interest income of $68,000 for the quarter ended and $14,000 forthe six months ended June 30, 2004 compared to the same three and six monthperiods a year ago.

 

13

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**AVERAGEBALANCE SHEET**

 

The following table sets forth information relating to the Bank’saverage balance sheet and reflects the average yield on assets and average costof liabilities for the periods indicated. Dividing income or expense by the average monthly balance of assets orliabilities, respectively, derives such yields and costs for the periods presented.

 
| ** **                                          | ** ** | **Quarter Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|----------------------------|------------|
| ** **                                          | ** ** | **2004**                   | ** ** | **2003** | ** ** |
| **(Dollars in thousands)**                          | ** ** | **Average  Balance**       | ** ** | **Interest** | ** ** | **Average  Yield/Cost (5)** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/Cost (5)** | ** ** |
|                                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                          |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets: Equity securities          |       | $                          | 2,966      |   | $ | 31 |   | 4.18 | % | $ | 2,056 |   | $ | 18 |   | 3.50 | % |
| State and political subdivision securities **(1)**  |       | 1,071                      |       | 15 |   | 5.60 |   | 1,086 |   | 16 |   | 5.89 |   |
| U.S. Treasury and agencies                          |       | 26,922                     |       | 188 |   | 2.79 |   | 12,999 |   | 81 |   | 2.49 |   |
| Corporate bond                                      |       | 2,000                      |       | 15 |   | 3.00 |   | 2,000 |   | 16 |   | 3.20 |   |
| Mortgage-backed securities                          |       | 10,087                     |       | 86 |   | 3.41 |   | 8,126 |   | 80 |   | 3.94 |   |
| Loans receivable **(2) (3) (4)**                    |       | 575,987                    |       | 9,021 |   | 6.26 |   | 524,656 |   | 9,452 |   | 7.21 |   |
| FHLB stock                                          |       | 6,637                      |       | 66 |   | 3.98 |   | 6,392 |   | 64 |   | 4.01 |   |
| Interest bearing deposits                           |       | 11,076                     |       | 23 |   | 0.83 |   | 82,055 |   | 250 |   | 1.22 |   |
| **Total interest earning assets**                   |       | 636,746                    |       | 9,445 |   | 5.93 |   | 639,370 |   | 9,977 |   | 6.24 |   |
| Less:   Allowance for loan losses              |       | (5,724                     | )          |   |   |   |   | (4,830 | ) |   |   |   |   |
| Non-interest earning assets                         |       | 55,884                     |       |   |   |   |   | 43,038 |   |   |   |   |   |
| **Total assets**                                    |       | $                          | 686,906    |   |   |   |   |   | $ | 677,578 |   |   |   |   |   |
|                                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                    |       | $                          | 88,223     |   | $ | 240 |   | 1.09 | % | $ | 78,642 |   | $ | 205 |   | 1.04 | % |
| NOW and money market Accounts                       |       | 127,624                    |       | 160 |   | 0.50 |   | 113,071 |   | 253 |   | 0.90 |   |
| Certificates of deposit and other time  deposits    |       | 287,292                    |       | 2,128 |   | 2.96 |   | 305,151 |   | 2,655 |   | 3.48 |   |
| FHLB Advances                                       |       | 80,158                     |       | 923 |   | 4.64 |   | 77,710 |   | 933 |   | 4.80 |   |
| Trust Preferred Securities                          |       | 10,000                     |       | 124 |   | 4.96 |   | 10,000 |   | 128 |   | 5.12 |   |
| **Total interest bearing liabilities**              |       | 593,297                    |       | 3,575 |   | 2.41 |   | 584,574 |   | 4,174 |   | 2.86 |   |
| Non-interest bearing liabilities:                   |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing deposits                       |       | 33,783                     |       |   |   |   |   | 35,985 |   |   |   |   |   |
| Other liabilities                                   |       | 2,931                      |       |   |   |   |   | 3,768 |   |   |   |   |   |
| **Total liabilities**                               |       | 630,011                    |       |   |   |   |   | 624,327 |   |   |   |   |   |
|                                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                           |       | 56,895                     |       |   |   |   |   | 53,251 |   |   |   |   |   |
| **Total liabilities and stockholders’ equity** |       | $                          | 686,906    |   |   |   |   |   | $ | 677,578 |   |   |   |   |   |
|                                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| **Net interest income**                             |       |                       |       | $ | 5,870 |   |   |   |   |   | $ | 5,803 |   |   |   |
| **Net interest spread**                             |       |                       |       |   |   | 3.52 | % |   |   |   |   | 3.38 | % |
| **Net interest margin**                             |       |                       |       |   |   | 3.69 | % |   |   |   |   | 3.63 | % |

 

----

(1) Taxable equivalent yields are calculatedassuming a 34% federal income tax rate.

(2) Includes loan fees, immaterial in amount,in both interest income and the calculation of yield on loans.

(3) Calculations include non-accruing loansin the average loan amounts outstanding.

(4) Includes loans held for sale.

(5) Annualized

 

14

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**AVERAGEBALANCE SHEET**

 

The following table sets forth information relating to the Bank’saverage balance sheet and reflects the average yield on assets and average costof liabilities for the periods indicated. Dividing income or expense by the average monthly balance of assets orliabilities, respectively, derives such yields and costs for the periodspresented.

 
| ** **                                          | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------|------------|
| ** **                                          | ** ** | **2004**                      | ** ** | **2003** | ** ** |
| **(Dollars in thousands)**                          | ** ** | **Average  Balance**          | ** ** | **Interest** | ** ** | **Average  Yield/Cost (5)** | ** ** | **Average  Balance** | ** ** | **Interest** | ** ** | **Average  Yield/Cost (5)** | ** ** |
|                                                |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                          |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets:                            |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Equity securities                                   |       | $                             | 2,958      |   | $ | 64 |   | 4.33 | % | $ | 1,567 |   | $ | 26 |   | 3.32 | % |
| State and political subdivision securities **(1)**  |       | 1,071                         |       | 33 |   | 6.16 |   | 1,086 |   | 33 |   | 6.08 |   |
| U.S. Treasury and agencies                          |       | 22,045                        |       | 337 |   | 3.06 |   | 11,995 |   | 182 |   | 3.03 |   |
| Corporate bond                                      |       | 2,000                         |       | 30 |   | 3.00 |   | 2,000 |   | 34 |   | 3.40 |   |
| Mortgage-backed securities                          |       | 9,419                         |       | 170 |   | 3.61 |   | 4,893 |   | 86 |   | 3.52 |   |
| Loans receivable **(2) (3) (4)**                    |       | 569,017                       |       | 18,129 |   | 6.37 |   | 525,768 |   | 19,090 |   | 7.26 |   |
| FHLB stock                                          |       | 6,604                         |       | 131 |   | 3.97 |   | 6,359 |   | 126 |   | 3.96 |   |
| Interest bearing deposits                           |       | 24,611                        |       | 108 |   | 0.88 |   | 86,406 |   | 530 |   | 1.23 |   |
| **Total interest earning assets**                   |       | 637,725                       |       | 19,002 |   | 5.96 |   | 640,074 |   | 20,107 |   | 6.28 |   |
| Less:   Allowance for loan losses              |       | (5,653                        | )          |   |   |   |   | (4,740 | ) |   |   |   |   |
| Non-interest earning assets                         |       | 54,972                        |       |   |   |   |   | 41,710 |   |   |   |   |   |
| **Total assets**                                    |       | $                             | 687,044    |   |   |   |   |   | $ | 677,044 |   |   |   |   |   |
|                                                |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                       |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                    |       | $                             | 89,680     |   | $ | 428 |   | 0.95 | % | $ | 77,808 |   | $ | 423 |   | 1.09 | % |
| NOW and money market Accounts                       |       | 124,622                       |       | 381 |   | 0.61 |   | 112,607 |   | 512 |   | 0.91 |   |
| Certificates of deposit and other time  deposits    |       | 290,881                       |       | 4,444 |   | 3.06 |   | 305,270 |   | 5,423 |   | 3.55 |   |
| FHLB Advances                                       |       | 79,200                        |       | 1,851 |   | 4.67 |   | 77,709 |   | 1,855 |   | 4.77 |   |
| Trust Preferred Securities                          |       | 10,000                        |       | 248 |   | 4.96 |   | 10,000 |   | 257 |   | 5.14 |   |
| **Total interest bearing liabilities**              |       | 594,383                       |       | 7,352 |   | 2.47 |   | 583,394 |   | 8,470 |   | 2.90 |   |
| Non-interest bearing liabilities:                   |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing deposits                       |       | 32,851                        |       |   |   |   |   | 33,764 |   |   |   |   |   |
| Other liabilities                                   |       | 3,065                         |       |   |   |   |   | 3,657 |   |   |   |   |   |
| **Total liabilities**                               |       | 630,299                       |       |   |   |   |   | 620,815 |   |   |   |   |   |
|                                                |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                           |       | 56,745                        |       |   |   |   |   | 56,229 |   |   |   |   |   |
| **Total liabilities and stockholders’ equity** |       | $                             | 687,044    |   |   |   |   |   | $ | 677,044 |   |   |   |   |   |
|                                                |       |                          |       |   |   |   |   |   |   |   |   |   |   |
| **Net interest income**                             |       |                          |       | $ | 11,650 |   |   |   |   |   | $ | 11,637 |   |   |   |
| **Net interest spread**                             |       |                          |       |   |   | 3.49 | % |   |   |   |   | 3.38 | % |
| **Net interest margin**                             |       |                          |       |   |   | 3.65 | % |   |   |   |   | 3.64 | % |

 

----

(1) Taxable equivalent yieldsare calculated assuming a 34% federal income tax rate.

(2) Includes loan fees,immaterial in amount, in both interest income and the calculation of yield onloans.

(3) Calculations includenon-accruing loans in the average loan amounts outstanding.

(4) Includes loans held forsale.

(5) Annualized

 

15

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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,information is provided on changes attributable to (1) changes in rate (changesin rate multiplied by old volume); (2) changes in volume (change in volumemultiplied by old rate); and (3) changes in rate-volume (change in ratemultiplied by change in volume).  Changesin rate-volume are proportionately allocated between rate and volume variance.

 
| ** **                                       | ** ** | **Three Months Ended  June 30,  2004 vs. 2003** | ** ** | **Six Months Ended  June 30,  2004 vs. 2003** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                       | ** ** | **Increase (decrease)  Due to change in**       | ** ** | **Increase (decrease)  Due to change in**     | ** ** |
| **(Dollars  in thousands)**                      | ** ** | **Rate**                                        | ** ** | **Volume**                                    | ** ** | **Net  Change** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Net  Change** | ** ** |
| **Interest income:**                             |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Equity securities                                |       | $                                               | 4          |                                          | $          | 9 |   | $ | 13 |   | $ | 10 |   | $ | 28 |   | $ | 38 |   |
| State and political subdivision securities       |       | (1                                              | )          | —                                        |       | (1 | ) | 1 |   | (1 | ) | — |   |
| U.S. Treasury and agencies                       |       | 11                                              |       | 96                                            |       | 107 |   | 1 |   | 154 |   | 155 |   |
| Corporate bond                                   |       | (1                                              | )          | —                                        |       | (1 | ) | (4 | ) | — |   | (4 | ) |
| Mortgage-backed securities                       |       | (12                                             | )          | 18                                            |       | 6 |   | 2 |   | 82 |   | 84 |   |
| Loans                                            |       | (1,304                                          | )          | 873                                           |       | (431 | ) | (2,454 | ) | 1,493 |   | (961 | ) |
| FHLB stock                                       |       | (1                                              | )          | 3                                             |       | 2 |   | — |   | 5 |   | 5 |   |
| Interest bearing deposits                        |       | (61                                             | )          | (166                                          | )          | (227 | ) | (120 | ) | (302 | ) | (422 | ) |
|                                             |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| **Total interest earning assets**                |       | (1,365                                          | )          | 833                                           |       | (532 | ) | (2,564 | ) | 1,459 |   | (1,105 | ) |
|                                             |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| **Interest expense:**                            |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| Savings accounts                                 |       | 9                                               |       | 26                                            |       | 35 |   | (55 | ) | 60 |   | 5 |   |
| NOW and money market accounts                    |       | (122                                            | )          | 29                                            |       | (93 | ) | (181 | ) | 50 |   | (131 | ) |
| Certificates of deposit and other time  deposits |       | (378                                            | )          | (149                                          | )          | (527 | ) | (732 | ) | (247 | ) | (979 | ) |
| FHLB advances                                    |       | (39                                             | )          | 29                                            |       | (10 | ) | (39 | ) | 35 |   | (4 | ) |
| Trust Preferred Securities                       |       | (4                                              | )          | —                                        |       | (4 | ) | (9 | ) | — |   | (9 | ) |
|                                             |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| **Total interest bearing liabilities**           |       | (534                                            | )          | (65                                           | )          | (599 | ) | (1,016 | ) | (102 | ) | (1,118 | ) |
|                                             |       |                                            |       |                                          |       |   |   |   |   |   |   |   |   |
| **Net change in net interest income**            |       | $                                               | (831       | )                                             | $          | 898 |   | $ | 67 |   | $ | (1,548 | ) | $ | 1,561 |   | $ | 13 |   |

 

***Non-Interest Income***-Non-interest income increased $379,000, or 20% for the quarter endedJune 30, 2004 to $2.3 million compared to $1.9 million for the same quarter in2003.  Non-interest income increased$432,000 or 12% for the six months ended June 30, 2004 compared to the sameperiod in 2003.  The increased level ofnon-interest income during 2004 was primarily due to an increase in customerservice fees on deposit accounts, brokerage and insurance commissions, andgains on sale of real estate held for development.  Offsetting these increases was a decrease ingain on sale of mortgage loans.

 

Customer service fees on deposit accountsaccounted for $135,000 and $270,000 of the increase for the respective threeand six-month periods due to an increase in overdraft fee income on retailchecking accounts. Income from brokerage commissions and insurance sales increased$15,000 for the quarter and $31,000 year to date as a result of an increase indemand for these products.  During theJune 2004 quarter, the Bank sold a lot in Tanyard Springs for a gain of$135,000 and the Office Park recorded $236,000 in gains from the sale of twoproperties held for development.  Othernon-interest income increased $45,000 and $131,000 for the quarter and sixmonths ended June 30, 2004 primarily due to income received from the Bank’sinvestment in bank owned life insurance. Offsetting these increases was a decrease in gain on sale of mortgageloans of $187,000 for the quarter and $376,000 for the six months ended June30, 2004 resulting from a decline in refinancing activity.  Recent positive economic data has increasedlong-term interest rates and corresponding long-term mortgage rates.  This is likely to decrease the volume ofloans refinanced and decrease secondary market closing fee income in the comingmonths.

 

16

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***Non-Interest Expense -*** Non-interest expense increased $683,000 or 16% during the quarterended June 30, 2004 and $1.1 million, or 13% for the six months ended June 30,2004 compared to the same periods in 2003. The primary factors impacting non-interest expense included additionaloperating and employee compensation expenses relating to the recent retailexpansion efforts.  Employee compensationand benefits, the largest component of non-interest expense, increased $224,000and $386,000 for the respective three and six-month periods.  Seventeen retail staff positions have beenadded since the first quarter of 2003 for the expansion in Metro Louisville,coupled with an expanded facility in Hardin County, Kentucky.  Additional increases in staff have takenplace throughout the year as we strengthen our retail sales culture and provideexpanded products and services to our retail and commercial customers.  The increase in compensation was alsoattributable to an increase in the Bank’s self-funded health insurance programdue to an increase in the amount of health insurance claims.

 

Office occupancy and equipment expense, alsoincreased $103,000 and $144,000 for the respective three and six months endedJune 30, 2004 due to the addition of the new facilities. Marketing expense increasedfor the same periods due topostage expense for additional direct mailings forthe new branch locations. Outside services and data processing fees increased$87,000 and $134,000 for the respective three and six months ended June 30,2004 resulting from professional fees paid for consulting services andincreases in data processing fees due to additional transaction activity.  Bank franchise tax expense increased $66,000and $137,000 for the respective three and six months ended June 30, 2004 due toa higher tax expense resulting from the conversion froma federally chartered thrift to a Kentuckystate-chartered commercial bank.  Thestate tax expense for a Bank charter is calculated based upon different rulesresulting in an increase for 2004.  FDIC examfees decreased by $24,000 and $75,000 for the respective three and six monthsended June 30, 2004 due to lower exam fees for bank charters.

 

**ANALYSIS OF FINANCIAL CONDITION**

 

Total assets at June 30, 2004 were $691.7 million compared to $676.3million at December 31, 2003, an increase of $15.4 million.  The increase was primarily related to anincrease in loans receivable of $25.5 million and an increase in investmentsecurities of $11.0 million.  The growthin loans receivable and investment securities was principally funded with cashand cash equivalents, which decreased by $22.8 million and FHLB advances whichincreased by $17.6 million.

 

**Investment Securities**

 

Total investment securities were $45.9 million at June 30, 2004compared to $34.9 million at December 31, 2003, an increase of  $11.0 million or 32%.  The increase in investment securities wasattributable to the purchase of a mortgage-backed security and U.S. Governmentagency securities.

 

Thesecurities portfolio serves as a source of liquidity and earnings andcontributes to the management of interest rate risk.  The debt securities portfolio is comprisedprimarily of obligations collateralized by U.S. Government agencies (mainly inthe form of U.S. Government agency securities), mortgage-backed securities andmunicipal obligations.  With theexception of municipal obligations, the maturity structure of the debtsecurities portfolio is generally short-term in nature or indexed to variablerates.

 

**LoansReceivable**

 

Netloans receivable increased $25.5 million or 5% to $575.6 million at June 30,2004 compared to $550.2 million at December 31, 2003 reflecting our continuedemphasis on small to mid-size business lending. The Bank’s commitment to internal loan growth in the commercial andcommercial real estate portfolios produced loan growth of $39.4 million, a 15%increase in these loans to $309.8 million at June 30, 2004.  For the June 30, 2004 period, these loanscomprise 53% of the total loan portfolio compared to 49% of the loan portfolioat December 31, 2003, and 34% of the loan portfolio at December 31, 2002.

 

Offsettingthis growth was a $20.5 million, or 10% decrease in the real estateconstruction and residential mortgage loan portfolio to $183.4 million at June30, 2004, compared to $203.9 million at December 31, 2003.  The decrease

 

17

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wasdue to an increase in customer refinancing activity into fixed-rate, secondarymarket loan products.  For 2004, thedecline in mortgage loans is expected to slow.

 

**Allowance and Provision for Loan Losses**

 

The Bank’s financialperformance depends on the quality of the loans it originates and management’sability to assess the degree of risk in existing loans when it determines theallowance for loan losses.  An increasein loan charge-offs or non-performing loans or an inadequate allowance for loanlosses could reduce net interest income, net income and capital and limit therange of products and services the Bank can offer.

 

The Bank’s Executive Loan Committeeevaluates the allowance for loan losses quarterly to maintain a levelsufficient to absorb probable incurred credit losses existing in the loanportfolio.  Periodic provisions to theallowance are made as needed.  Theallowance is determined based on the application of loss estimates to gradedloans by categories.  The amount of theprovision for loan losses necessary to maintain an adequate allowance is alsobased upon an analysis of such factors as changes in lending policies andprocedures; underwriting standards; collection; charge-off and recoveryhistory; changes in national and local economic business conditions anddevelopments; changes in the characteristics of the portfolio; ability anddepth of lending management and staff; changes in the trend of the volume andseverity of past due, non-accrual and classified loans; troubled debtrestructuring and other loan modifications; and results of regulatoryexaminations.

 

The methodology for allocating the allowance for loan and lease lossestakes into account the Bank’s strategic plan to increase its emphasis oncommercial and consumer lending.  TheBank increases the amount of the allowance allocated to commercial loans andconsumer loans in response to the growth of the commercial and consumer loanportfolios and management’s recognition of the higher risks and loan losses inthese lending areas.

 

The following table sets forth an analysis ofthe Bank’s loan loss experience for the periods indicated.

 
| ** **                                               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **(Dollars  in thousands)**                              | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                     |       |                             |       |                           |       |   |   |   |   |
| **Balance at beginning of period**                       |       | $                                | 5,733      |                           | $          | 4,679 |   | $ | 5,568 |   | $ | 4,576 |   |
| Loans charged-off:                                       |       |                             |       |                           |       |   |   |   |   |
| Real estate mortgage                                     |       | —                           |       | 44                             |       | 41 |   | 45 |   |
| Consumer                                                 |       | 177                              |       | 180                            |       | 407 |   | 370 |   |
| Commercial                                               |       | 42                               |       | —                         |       | 42 |   | 68 |   |
| Total charge-offs                                        |       | 219                              |       | 224                            |       | 490 |   | 483 |   |
| Recoveries:                                              |       |                             |       |                           |       |   |   |   |   |
| Real estate mortgage                                     |       | —                           |       | —                         |       | — |   | — |   |
| Consumer                                                 |       | 49                               |       | 60                             |       | 96 |   | 93 |   |
| Commercial                                               |       | —                           |       | —                         |       | — |   | — |   |
| Total recoveries                                         |       | 49                               |       | 60                             |       | 96 |   | 93 |   |
|                                                     |       |                             |       |                           |       |   |   |   |   |
| **Net loans charged-off**                                |       | 170                              |       | 164                            |       | 395 |   | 390 |   |
|                                                     |       |                             |       |                           |       |   |   |   |   |
| Provision for loan losses                                |       | 259                              |       | 420                            |       | 648 |   | 749 |   |
|                                                     |       |                             |       |                           |       |   |   |   |   |
| **Balance at end of period**                             |       | $                                | 5,822      |                           | $          | 4,935 |   | $ | 5,822 |   | $ | 4,935 |   |
|                                                     |       |                             |       |                           |       |   |   |   |   |
| Allowance for loan losses to total loans                 |       |                             |       |                           |       | 1.00 | % | 0.94 | % |
| Net charge-offs to average loans  outstanding            |       |                             |       |                           |       | 0.07 | % | 0.07 | % |
| Allowance for loan losses to total  non-performing loans |       |                             |       |                           |       | 134 | % | 106 | % |

 

18

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The provision for loan losses decreased $161,000,or 38% to $259,000 for the quarter ended June 30, 2004, and $100,000, or 13% to$648,000 for the six months ended June 30, 2004 compared to the same periods in2003.  The decrease in provision expenseis due to a lower volume of commercial loan growth during the respectiveperiods in 2004.  The total allowance forloan losses increased $887,000 to $5.8 million from June 30, 2003 to June 30,2004.     Net loan charge-offs remainedrelatively constant for the comparative periods.

 

Federal regulations require insuredinstitutions to classify their own assets on a regular basis.  The regulations provide for three categoriesof classified loans — substandard, doubtful and loss.  The regulations also contain a specialmention and a specific allowance category. Special mention is defined as loans that do not currently expose aninsured institution to a sufficient degree of risk to warrant classificationbut do possess credit deficiencies or potential weaknesses deservingmanagement’s close attention. 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 June 30, 2004, based on management’sreview of the Bank’s loan portfolio, the Bank had $5.2 million of assetsclassified substandard, $1.1 million classified as doubtful, $2.4 millionclassified as special mention and $66,000 of assets classified as loss.

 

Loans are classified according to estimated loss as follows:  Substandard-2.5% to 35%; Doubtful-5% to 50%;Loss-100%; and Special Mention-2% to 10%. The Bank additionally provides areserve estimate for probable incurred losses in non-classified loans rangingfrom .20% to 3.50%.  Although the Bankmay allocate a portion of the allowance to specific loans or loan categories,the entire allowance is available for active charge-offs.  Allowance estimates are developed by the Bankin consultation with regulatory authorities, actual loss experience and areadjusted for current economic conditions. Allowance estimates are considered a prudent measurement of the risk ofthe Bank’s loan portfolio and are applied to individual loans based on loantype.

 

**Non-PerformingAssets**

 

Non-performing assets consist of certainrestructured loans where interest rate or other terms have been renegotiated,loans on which interest is no longer accrued, real estate acquired throughforeclosure and repossessed assets.   TheBank does not have any loans greater than 90 days past due still onaccrual.  Loans, including impaired loansunder SFAS 114, are placed on non-accrual status when they become past due 90days or more as to principal or interest, unless they are adequately securedand in the process of collection.  Loansare considered impaired if full principal or interest payments are notanticipated in accordance with the contractual loan terms.  Impaired loans are carried at the presentvalue of expected future cash flows discounted at the loan’s effective interestrate or at the fair value of the collateral if the loan is collateraldependent.

 

Loans are reviewed on a regularbasis and normal collection procedures are implemented when a borrower fails tomake a required payment on a loan.  Ifthe delinquency on a mortgage loan exceeds 90 days and is not cured throughnormal collection procedures or an acceptable arrangement is not worked outwith the borrower, the Bank institutes measures to remedy the default,including commencing 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 the Bank’s legal counsel.  The Bankanticipates that the increase in the volume of non-performing real estate loanswill continue due to the growth of the Bank’s loan portfolio.

 

Interest income on loans isrecognized on the accrual basis except for those loans in a non-accrual ofincome status. The accrual of interest on impaired loans is discontinued whenmanagement believes, after consideration of economic and business conditionsand collection efforts that the borrowers’ financial condition is such thatcollection of interest is doubtful, typically after the loan becomes 90 daysdelinquent.  When interest accrual isdiscontinued, interest income is subsequently recognized only to the extentcash payments are received.

 

Real estate acquired by theBank as a result of foreclosure or by deed in lieu of foreclosure is classifiedas real estate owned until such time as it is sold. New and used automobile,motorcycle and all terrain vehicles acquired by the Bank as a result offoreclosure are classified as repossessed assets until they are sold. When suchproperty is acquired it is recorded at the lower of the unpaid principalbalance of the related loan or its fair market value.  Any write-down of the property at the time ofacquisition is charged to the allowance for loan losses.  Subsequent gains and losses are included innon-interest income and non-interest expense.

 

19

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| **(Dollar  in thousands)**                                           | ** **                           | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------|--------------------------------------|--------------------|------------|------------------------|------------|
|                                                                 |                                 |               |       |                   |       |
| Restructured                                                         |                                 | $                  | 3,063      |                   | $          | 3,037 |   |
| Past due 90 days still on accrual                                    |                                 | —             |       | —                 |       |
| Loans on non-accrual status                                          |                                 | 1,275              |       | 2,281                  |       |
|                                                                 |                                 |               |       |                   |       |
| Total non-performing loans                                           |                                 | 4,338              |       | 5,318                  |       |
| Real estate acquired through foreclosure                             |                                 | 568                |       | 387                    |       |
| Other repossessed assets                                             |                                 | 60                 |       | 62                     |       |
| Total non-performing assets                                          |                                 | $                  | 4,966      |                   | $          | 5,767 |   |
|                                                                 |                                 |               |       |                   |       |
| Interest income that would have been earned  on non-performing loans |                                 | $                  | 138        |                   | $          | 374 |   |
| Interest income recognized on  non-performing loans                  |                                 | 104                |       | 227                    |       |
| Ratios:                                                              | Non-performing loans to total loans  |               | 0.75       | %                      | 0.96       | % |
|                                                                 | Non-performing assets to total loans |               | 0.85       | %                      | 1.04       | % |

 

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

 

Non-performing assetstotaled $5.0 million at June 30, 2004, a decrease of $801,000 from December 31,2003 as a result of a decrease in non-performing loans.  Included in non-performing assets is $3.1 millionin restructured commercial and residential mortgage loans.  The restructured loans primarily consist oftwo credit relationships aggregating $2.8 million, including a $2.3 millioncommercial relationship and a $465,000 residential mortgage relationship.   The terms of these loans have beenrenegotiated to reduce the rate of interest and extend the term thus reducingthe amount of cash flow required from the borrower to service the loans.  The terms of the restructured loans arecurrently being met.

 

**Deposits**

 

Total deposits decreased$2.8 million to $526.3 million at June 30, 2004, from $529.2 million atDecember 31, 2003.  The decrease indeposits for the period was primarily the result of a decrease in public funddeposits from the City of Bardstown, the Meade County School District, and theBullitt County School District.  Publicfund money fluctuates with the inflow of tax revenue and the timing ofdisbursements.  The Bank plans tocontinue its deposit gathering initiatives by utilizing pricing strategies andoffering competitive products in its existing markets.

 

The following table summarizes the Bank’sdeposits.

 
| ** **                           | ** ** | **June 30, 2004**  | ** ** | **December 31, 2003** | ** ** |
|--------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **(In Thousands)** | ** ** |
|                                 |       |               |       |                  |       |
| Non-interest bearing demand accounts |       | $                  | 34,694     |                  | $          | 28,632 |   |
| NOW demand accounts                  |       | 70,356             |       | 67,504                |       |
| Savings accounts                     |       | 82,556             |       | 86,419                |       |
| Money market deposit accounts        |       | 52,923             |       | 51,773                |       |
| Certificates of deposit              |       | 285,798            |       | 294,834               |       |
|                                 |       | $                  | 526,327    |                  | $          | 529,162 |   |

 

**FederalHome Loan Bank Advances**

 

Advances****increased$17.6 million or 22% to $95.9 million at June 30, 2004 compared to $78.3million at December 31, 2004 due to overnight borrowings.

 

20

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**LIQUIDITY**

 

##### **The Bankmust maintain sufficient liquidity to fund loan demand and routine depositwithdrawal activity.  Liquidity ismanaged by retaining sufficient liquid assets in the form of cash and cashequivalents.  Additional sources offunding and cash flows include, but are not limited to, the sale of securitiesin the available-for-sale portion of the investment portfolio, principalpaydowns on loans and mortgage-backed securities and proceeds realized fromloans held for sale.  The Corporation’sbanking centers also provide access to retail deposit markets.  If large certificate depositors shift to theBank’s competitors or the stock market in response to interest rate changes,the Bank has the ability to replenish those deposits through alternativefunding sources.  Traditionally, the Bankhas also utilized borrowings from the FHLB to supplement its fundingrequirements.  At June 30, 2004, the Bankhad an unused approved line of credit in the amount of $81.9 million andsufficient collateral available to borrow, approximately, an additional $27.8million in advances from the FHLB.** Managementbelieves its sources of liquidity are adequate to meet expected cash needs forthe foreseeable future.

 

**CAPITAL**

 

Stockholders’ equity increased $891,000 forthe six-month period ended June 30, 2004 compared to the 2003 period. Duringthe 2004 six-month period, the Corporation purchased 60,000 shares of its owncommon stock.  As a result, thetransaction decreased total capital by $1.6 million, which in turn reducedconsolidated regulatory capital. Offsetting the decrease was an increase in net income.  The Corporation and the Bank continued to bewell capitalized after the transaction. The Corporation’s stock repurchase programs have generally authorizedthe repurchase of up to 10% of the Corporation’s outstanding stock from time totime in the open market or private transactions during an 18-month period.Management considers repurchasing shares when the financial and other terms ofthe purchase and its impact on earnings per share and other financial measuresoffer an attractive return to stockholders. The Corporation adopted its most recent plan on March 18, 2003.

 

In March 2002, a trust formed by of the Corporation completed theprivate placement of 10,000 shares of cumulative trust preferred securitieswith a liquidation preference of $1,000 per security.  The proceeds of the offering were loaned tothe Corporation 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%.  The Corporationundertook the issuance of these securities to enhance its regulatory capitalposition as they are considered as Tier I capital under current regulatoryguidelines.

 

Kentucky banking laws limit theamount of dividends that may be paid to the Corporation by the Bank withoutprior approval of the KDFI.  Under theselaws, the amount of dividends that may be paid in any calendar year is limitedto current year’s net income, as defined in the laws, combined with the netincome of the preceding two years, less any dividends declared during thoseperiods.  At June 30, 2004, the Bank hadapproximately $14.5 million of retained earnings that could be utilized forpayment of dividends if authorized by its board of directors without prior regulatoryapproval.

 

Regulatory agencies measure capital adequacy within a framework thatmakes capital requirements, in part, dependent on the individual risk profilesof financial institutions.  TheCorporation on a consolidated basis and the Bank continue to exceed theregulatory requirements for Tier I, Tier I leverage and total risk-basedcapital.  Management intends to maintaina capital position that meets or exceeds the “well capitalized” requirements asdefined by the FDIC.  The Bank’s averagestockholders’ equity to average assets ratio declined to 8.26% year to dateJune 30, 2004 compared to 8.31% for the same period in 2003 due principally tostock repurchases.

 

21

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The actual and required capitalamounts and ratios are presented below.

 
| ** **                                           | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **To Be Considered  Well Capitalized  Under Prompt  Correction** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|------------------------------------------------------------------|------------|
| **(Dollars  in thousands)**                          | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **As of  June 30, 2004:**                            | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**                                                        | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total risk-based capital (to risk- weighted  assets) |       |       |       |                  |       |                  |       |                                                             |       |   |   |   |   |
| Consolidated                                         |       | $          | 64,478     |                  | 11.7       | %                     | $          | 43,956                                                           |       | 8.0 | % | $ | 54,944 |   | 10.0 | % |
| Bank                                                 |       | 61,748     |       | 11.3                  |       | 43,717                |       | 8.0                                                              |       | 54,647 |   | 10.0 |   |
| Tier I capital (to risk-weighted assets)             |       |       |       |                  |       |                  |       |                                                             |       |   |   |   |   |
| Consolidated                                         |       | 58,443     |       | 10.6                  |       | 21,978                |       | 4.0                                                              |       | 32,967 |   | 6.0 |   |
| Bank                                                 |       | 55,686     |       | 10.2                  |       | 21,859                |       | 4.0                                                              |       | 32,788 |   | 6.0 |   |
| Tier I capital (to average assets)                   |       |       |       |                  |       |                  |       |                                                             |       |   |   |   |   |
| Consolidated                                         |       | 58,443     |       | 8.6                   |       | 27,044                |       | 4.0                                                              |       | 33,806 |   | 5.0 |   |
| Bank                                                 |       | 55,686     |       | 8.3                   |       | 26,951                |       | 4.0                                                              |       | 33,689 |   | 5.0 |   |
|                                                      |            |            |            |                       |            |                       |            |                                                                  |            |  |  |  |  |  |  |  |

 
| ** **                                           | ** ** | ** ** | ** ** | ** **            | ** ** | **For Capital**       | ** ** | **To Be Considered  Well Capitalized  Under Prompt  Correction** | ** ** |
|------------------------------------------------------|------------|------------|------------|-----------------------|------------|-----------------------|------------|------------------------------------------------------------------|------------|
| **(Dollars  in thousands)**                          | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **As of  December 31, 2003:**                        | ** ** | **Amount** | ** ** | **Ratio**             | ** ** | **Amount**            | ** ** | **Ratio**                                                        | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| Total risk-based capital (to risk- weighted  assets) |       |       |       |                  |       |                  |       |                                                             |       |   |   |   |   |
| Consolidated                                         |       | $          | 63,094     |                  | 12.0       | %                     | $          | 42,073                                                           |       | 8.0 | % | $ | 52,591 |   | 10.0 | % |
| Bank                                                 |       | 60,602     |       | 11.6                  |       | 41,853                |       | 8.0                                                              |       | 52,316 |   | 10.0 |   |
| Tier I capital (to risk-weighted assets)             |       |       |       |                  |       |                  |       |                                                             |       |   |   |   |   |
| Consolidated                                         |       | 57,305     |       | 10.9                  |       | 21,037                |       | 4.0                                                              |       | 31,555 |   | 6.0 |   |
| Bank                                                 |       | 54,813     |       | 10.5                  |       | 20,926                |       | 4.0                                                              |       | 31,389 |   | 6.0 |   |
| Tier I capital (to average assets)                   |       |       |       |                  |       |                  |       |                                                             |       |   |   |   |   |
| Consolidated                                         |       | 57,305     |       | 8.6                   |       | 26,718                |       | 4.0                                                              |       | 33,398 |   | 5.0 |   |
| Bank                                                 |       | 54,813     |       | 8.2                   |       | 26,718                |       | 4.0                                                              |       | 33,398 |   | 5.0 |   |
|                                                      |            |            |            |                       |            |                       |            |                                                                  |            |  |  |  |  |  |  |  |

 

**PRELIMINARYNOTE REGARDING 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 “believes,” “anticipates,” “expects,” “intends,” “plans,”“targeted,” and similar expressions are intended to identify forward-lookingstatements, but are not the exclusive means of identifying such statements.

 

Forward-looking statements involve risks and uncertainties that maycause actual results to differ materially from those indicated by theforward-looking statements.  Some of theevents or circumstances that could cause such differences include thefollowing: changes in general economic conditions and economic conditions inKentucky and the markets served by the Corporation any of which may affect,among other things, the level of non-performing assets, charge-offs, andprovision expense; changes in the interest rate environment which may reduceinterest margins and impact funding sources; changes in market rates and priceswhich may adversely impact the value of financial products includingsecurities, loans and deposit; changes in tax laws, rules and regulations;various monetary and fiscal policies and regulations, including thosedetermined by the Federal Reserve Board, the Federal Deposit InsuranceCorporation and the Kentucky Department of Financial Institutions; competitionwith other local and regional commercial banks, savings banks, credit unionsand other non-bank financial institutions; ability to grow core businesses; abilityto develop and introduce new banking-related products, services andenhancements and gain market acceptance of such products; and management’sability to manage these and other risks.

 

22

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**Item 3****.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**Assetand Liability Management**

 

To minimize the volatilityof net interest income and exposure to economic loss that may result fromfluctuating interest rates, the Bank manages its exposure to adverse changes ininterest rates through asset and liability management activities withinguidelines established by its Asset Liability Committee (“ALCO”).  The ALCO, which includes senior managementrepresentatives, has the responsibility for approving and ensuring compliancewith asset/liability management polices of the Corporation.  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 bethe Bank’s most significant market risk.

 

The Bank utilizes an earnings simulationmodel to analyze net interest income sensitivity.  Potential changes in market interest ratesand their subsequent effects on net interest income are then evaluated.  The model projects the effect of instantaneousmovements in interest rates of both 100 and 200 basis points.  Assumptions based on the historical behaviorof the Bank’s deposit rates and balances in relation to changes in interestrates are also incorporated into the model. These assumptions are inherently uncertain and, as a result, the modelcannot precisely measure future net interest income or precisely predict theimpact of fluctuations in market interest rates on net interest income.  Actual results will differ from the model’ssimulated results due to timing, magnitude and frequency of interest ratechanges as well as changes in market conditions and the application and timingof various management strategies.

 

The Bank’s interestsensitivity profile was asset sensitive at both June 30, 2004 and December 31,2003.  Given a sustained 100 basis pointdecrease in rates, the Bank’s base net interest income would decrease by anestimated 3.44% at June 30, 2004 compared to a decrease of 4.34% at December31, 2003.  Given a 100 basis pointincrease in interest rates the Bank’s base net interest income would increaseby an estimated 2.64% at June 30, 2004 compared to an increase of 1.63% atDecember 31, 2003.

 

The interest sensitivity of the Corporation at any point in time willbe affected by a number of factors. These factors include the mix of interest sensitive assets andliabilities as well as their relative pricing schedules.  It is also influenced by market interestrates, decay rates and prepayment speed assumptions.

 

As demonstrated by the June 30, 2004 and December 31, 2003 sensitivitytables presented below, the Bank is continuing to transition away from aliability sensitive to an asset sensitive position as compared to prior periodsin anticipation of rising interest rates for the next several months. Thechange in the Bank’s asset sensitivity is a result of changes in the loanportfolio to a greater extent than changes in the investment portfolio.** **Whilelending practices have shifted to shorter term, variable rate commercial andconsumer loans, that impact will be evidenced in smaller degrees over time.

 

23

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The Corporation’s sensitivity to interest rate changes is presentedbased on data as of June 30, 2004 and December 31, 2003 annualized to a oneyear period.

 
| ** **                     | ** ** | **June 30, 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                          |       | $                     | 33,291     |   | $ | 35,649 |   | $ | 37,835 |   | $ | 39,887 |   | $ | 41,854 |   |
| Investments                    |       | 1,571                 |       | 1,932 |   | 2,257 |   | 2,519 |   | 2,785 |   |
| **Total interest income**      |       | 34,862                |       | 37,581 |   | 40,092 |   | 42,406 |   | 44,639 |   |
|                           |       |                  |       |   |   |   |   |   |   |   |   |
| **Projected interest expense** |       |                  |       |   |   |   |   |   |   |   |   |
| Deposits                       |       | 7,023                 |       | 8,180 |   | 9,535 |   | 10,902 |   | 12,270 |   |
| Borrowed funds                 |       | 4,100                 |       | 4,352 |   | 4,615 |   | 4,877 |   | 5,140 |   |
| **Total interest expense**     |       | 11,123                |       | 12,532 |   | 14,150 |   | 15,779 |   | 17,410 |   |
|                           |       |                  |       |   |   |   |   |   |   |   |   |
| **Net interest income**        |       | $                     | 23,739     |   | $ | 25,049 |   | $ | 25,942 |   | $ | 26,627 |   | $ | 27,229 |   |
| Change from base               |       | $                     | (2,203     | ) | $ | (893 | ) |   |   | $ | 685 |   | $ | 1,287 |   |
| % Change from base             |       | (8.49%                | )          | (3.44% | ) |   |   | 2.64 | % | 4.96 | % |

 
| ** **                      | ** ** | **December 31, 2003** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **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                           |       | $                     | 32,629     |   | $ | 34,706 |   | $ | 36,625 |   | $ | 38,380 |   | $ | 40,033 |   |
| Investments                     |       | 1,179                 |       | 1,286 |   | 2,250 |   | 2,764 |   | 3,283 |   |
| **Total interest income**       |       | 33,808                |       | 35,992 |   | 38,875 |   | 41,144 |   | 43,316 |   |
|                            |       |                  |       |   |   |   |   |   |   |   |   |
| **Projected interest ezxpense** |       |                  |       |   |   |   |   |   |   |   |   |
| Deposits                        |       | 6,925                 |       | 8,283 |   | 10,018 |   | 11,806 |   | 13,594 |   |
| Borrowed funds                  |       | 4,051                 |       | 4,130 |   | 4,208 |   | 4,287 |   | 4,366 |   |
| **Total interest expense**      |       | 10,976                |       | 12,413 |   | 14,226 |   | 16,093 |   | 17,960 |   |
|                            |       |                  |       |   |   |   |   |   |   |   |   |
| **Net interest income**         |       | $                     | 22,832     |   | $ | 23,579 |   | $ | 24,649 |   | $ | 25,051 |   | $ | 25,356 |   |
| Change from base                |       | $                     | (1,817     | ) | $ | (1,070 | ) |   |   | $ | 402 |   | $ | 707 |   |
| % Change from base              |       | (7.37%                | )          | (4.34% | ) |   |   | 1.63 | % | 2.87 | % |

 

**Item 4****.  CONTROLS ANDPROCEDURES**

 

As of the end of the period covered by this report, the Corporationcarried out an evaluation, under the supervision and with the participation ofthe Corporation’s management, including the Corporation’s Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of the Corporation’s disclosure controls and procedures. Based on theforegoing, the Corporation’s Chief Executive Officer and Chief FinancialOfficer concluded that the Corporation’s disclosure controls and procedureswere effective, in all material respects, to ensure that information requiredto be disclosed in the reports the Corporation files and submits under theExchange Act is recorded, processed, summarized and reported as and whenrequired.

 

The Corporation also conducted an evaluationof internal control over financial reporting to determine whether any changesoccurred during the quarter covered by this report that have materiallyaffected, or are reasonably likely to materially affect, the Corporation’sinternal control over financial reporting. Based on this evaluation, there hasbeen no such change during the quarter covered by this report.

 

24

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**Part II - OTHER INFORMATION**

 

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

 

Although theBank is, from time to time, involved in various legal proceedings in the normalcourse of business, there are no material pending legal proceedings to whichthe Corporation, the Bank, or its subsidiaries is a party, that managementbelieves will have an adverse effect on liquidity, financial condition, or resultsof operations.

 

**Item 2.****                                                          ****Changes in Securities, Useof Proceeds and Issuer Purchases of Equity Securities**

 

(e)  Issuer Purchases of Equity Securities

 

TheCorporation repurchasedno shares of its common stock during the quarter ended June   30, 2004.

 

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

 

Not Applicable

 

**Item 4.****                                                          ****Submission of Matters to aVote of Security Holders**

 

The Corporation’s 2004Annual Meeting of Shareholders was held on May 12, 2004.  At the meeting, the directors listed belowwere elected as directors of the Corporation for terms expiring at the annualmeeting in the year set forth to each of their names.  The voting results for the matters broughtbefore the 2004 Annual Meeting are as follows:

 

1.  Election of Directors.

 
| **Name**        | ** ** | **Term Expires** | ** ** | **Votes For** | ** ** | **Abstentions** | ** ** | **Broker  Non-Votes** | ** ** |
|-----------------|------------|------------------|------------|---------------|------------|-----------------|------------|-----------------------|------------|
| Robert M. Brown |       | 2007             |       | 2,623,573     |       | 14,429          |       | —                |       |
| J. Alton Rider  |       | 2007             |       | 2,622,985     |       | 14,429          |       | —                |       |
| Gail L. Schomp  |       | 2007             |       | 2,935,293     |       | 14,429          |       | —                |       |
| Donald Scheer   |       | 2006             |       | 2,613,914     |       | 14,429          |       | —                |       |

 

In addition, the followingdirectors will continue in office until the annual meeting of the year                                 set forthbeside each of their names.

 
| **Name**             | ** ** | **Term Expires** | ** ** |
|----------------------|------------|------------------|------------|
| Wreno M. Hall        |       | 2005             |       |
| Walter D. Huddleston |       | 2005             |       |
| J. Stephen Mouser    |       | 2005             |       |
| Michael L. Thomas    |       | 2005             |       |

 

2. Proposal tochange the Corporation’s name to “First Financial Service Corporation.”

 
| **Votes For** | ** ** | **Against** | ** ** | **Abstentions** | ** ** |
|---------------|------------|-------------|------------|-----------------|------------|
| 2,643,378     |       | 49,466      |       | 20,525          |       |

 

The Corporation hassubsequently amended its articles of incorporation to change its name to FirstFinancial Service Corporation.  TheNasdaq symbol FFKY will remain unchanged.

 

**Item 5.****                                                           OtherInformation**

 

None

 

25

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

 

3                  Amended and Restated Articles ofIncorporation.

 

31.1   Certification of Chief Executive Officer Pursuant to Section 302 ofSarbanes-Oxley Act

 

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

 

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

 

**Reports on Form 8-K:**

 

TheCorporation filed a Form 8-K on April 27, 2004 announcing its first quarterended March 31, 2004, earnings.  TheCorporation filed another 8-K on May 24, 2004 announcing a change in itscorporate name to First Financial Service Corporation.

 

26

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**FIRST FINANCIAL SERVICE CORPORATION**

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 

 
| DATE:  August 9, 2004 | BY:  (S)                               | B.  Keith Johnson     |   |
|----------------------------|----------------------------------------|-----------------------|--------|
|                       | B.  Keith Johnson                      |
|                       | President  and Chief Executive Officer |
|                       |                                   |
|                       |                                   |
| DATE:  August 9, 2004 | BY:  (S)                               | Gregory  S. Schreacke |   |
|                       | Gregory  S. Schreacke                  |
|                       | Chief  Financial Officer               |

 

27

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## **INDEX TO EXHIBITS**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                  |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                             |
| 3               |       | Amended and Restated  Articles of Incorporation                                                                                                                                  |
|            |       |                                                                                                                                                                             |
| 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) |

 

28

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