**UNITED STATES**
 **SECURITIES AND EXCHANGE COMMISSION**
 **WASHINGTON, D.C. 20549**
 
 **FORM 10-Q**
 
 (Mark One **)**
 
 x
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Quarterly Period Ended September 30, 2004 oro
Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Transition period from___________ to ___________ 
 Commission File Number: 0-23605
 
 
 (Exact Name of Registrant as Specified in Its Charter) 
 Tennessee
62-1721072(State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer I.D. Number) 
 
 114 West College Street, Murfreesboro, Tennessee
37130(Address of Principal Executive Offices)
(Zip Code) 
 (615) 893-1234Registrants telephone number, including area code 
 Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
 Yesx
Noo Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
 
 Yesx
Noo 
 Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
 
 Common Stock Issued and Outstanding: 6,729,752 shares as of November 5, 2004.
    
 
 **CAVALRY BANCORP, INC.**
 
 Table of Contents
 
 Part I
Financial Information
PageItem 1.
Financial StatementsConsolidated Balance Sheets at September 30, 2004 (unaudited)
and December 31, 2003 (audited)
1Consolidated Statements of Income (unaudited) for the Three Months and Nine Months Ended
September 30, 2004 and 2003
2Consolidated Statements of Comprehensive Income (unaudited) for the
Three Months and Nine Months Ended September 30, 2004 and 2003
3Consolidated Statements of Cash Flows (unaudited) for the Nine MonthsEnded September 30, 2004 and 2003
4Notes to Consolidated Financial Statements (unaudited)
5-8Item 2.
Managements Discussion and Analysis of Financial
Condition and Results of Operations
8-13Item 3.
Quantitative and Qualitative Disclosures About Market Risk
13-14Item 4.
Controls and Procedures
14Part II
Other Information
15Item 1.
Legal Proceedings
15Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
15Item 3.
Defaults Upon Senior Securities
15Item 4.
Submission of Matters to a Vote of Security Holders
15Item 5.
Other Information
15Item 6.
Exhibits
15Signatures

16 
 
      Part I.  Financial Information
 
 Item 1.  FINANCIAL STATEMENTS
 
 **CAVALRY BANCORP, INC.**
 **CONSOLIDATED BALANCE SHEETS**
 **SEPTEMBER 30, 2004 (UNAUDITED) AND DECEMBER 31, 2003 (AUDITED)**
 **(DOLLARS IN THOUSANDS)**
 
 
 September 30,

December 31,**Assets**

2004

2003(Unaudited)Cash

$
20,674


32,946Interest-bearing deposits with other financial institutions


35,366


37,967Cash and cash equivalents


56,040


70,913Investment securities available-for-sale at fair value (amortized cost: $43,865and $55,136 at September 30, 2004 and December 31, 2003, respectively)


43,707


55,123Loans held for sale, at estimated fair value


2,438


2,648Loans receivable, net of allowances for loan losses of $4,728 at September 30, 2004 and $4,525 at December 31, 2003


413,788


350,412Accrued interest receivable


1,813


1,668Office properties and equipment, net


17,822


18,431Required investments in stock of Federal Home Loan Bank and Federal Reserve Bank, at cost


3,099


2,992Foreclosed assets


13


-Bank owned life insurance


8,499


8,308Goodwill


1,772


1,772Other assets


2,911


2,905Total assets

$
551,902


515,172**Liabilities and Shareholders Equity**Liabilities:Deposits:Non-interest-bearing

$
90,212


72,443Interest-bearing


396,134


381,814Total deposits


486,346


454,257Advances from Federal Home Loan Bank of Cincinnati


2,848


2,889Accrued expenses and other liabilities


6,072


3,599Total liabilities


495,266


460,745Shareholders equity:Preferred stock, no par valueAuthorized- 250,000 shares; none issued or outstanding at September 30, 2004 and December 31, 2003


-


-Common stock, no par valueAuthorized- 49,750,000 shares; issued and outstanding 6,741,752 and 6,834,873 at September 30, 2004 and December 31, 2003, respectively


9,439


10,175Retained earnings


49,142


46,633Unallocated ESOP shares


(1,839
)

(2,373
)Accumulated other comprehensive loss, net of tax


(106
)

(8
)Total shareholders equity


56,636


54,427Total liabilities and shareholders equity

$
551,902


515,172 
 Note: The balance sheet presented above at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements.
 
 See accompanying notes to consolidated financial statements.
  1   **CAVALRY BANCORP, INC.**
 **CONSOLIDATED STATEMENTS OF INCOME**
 **(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)**
 **(UNAUDITED)**
 
 Three Months Ended

Nine Months EndedSeptember 30,

September 30,2004

2003

2004

2003Interest income:Loans

$
5,994


5,055


16,839


15,124Investment securities:Taxable


332


307


979


896Non-taxable


36


-


74


-Other


120


82


261


309Total interest income


6,482


5,444


18,153


16,329Interest expense - deposits


1,367


1,303


3,880


4,221Interest expense - borrowings


24


25


73


74Total interest expense


1,391


1,328


3,953


4,295Net interest income


5,091


4,116


14,200


12,034Provision for loan losses


176


-


352


101Net interest income after provision for loan losses


4,915


4,116


13,848


11,933Non-interest income:Servicing income


47


45


140


176Gain on sale of loans, net


879


1,687


2,281


4,711Gain on sale of other assets


-


-


53


-Gain on sale of investment securities, net


-


-


-


11Deposit servicing fees and charges


1,457


1,208


3,992


3,455Trust service fees


266


246


832


740Commissions and other non-banking fees


649


676


1,899


1,995Other operating income


221


196


701


579Total non-interest income


3,519


4,058


9,898


11,667Non-interest expenses:Salaries and employee benefits


3,603


3,962


10,834


11,498Occupancy expense


329


346


984


979Supplies, communications and other office expenses


223


286


706


791Advertising expense


87


107


404


330Equipment and service bureau expense


890


780


2,557


2,211Professional fees


257


130


656


365Other taxes


114


116


344


324Loss on sale of investment securities, net


81


-


3


-Other operating expense


377


332


1,120


1,003Total non-interest expenses


5,961


6,059


17,608


17,501Income before income taxes


2,473


2,115


6,138


6,099Income tax expense


994


835


2,475


2,373Net income

$
1,479


1,280


3,663


3,726Basic earnings per share

$
0.23


0.20


0.57


0.58Diluted earnings per share

$
0.22


0.19


0.55


0.56Weighted average shares outstanding - Basic


6,441,148


6,418,261


6,463,810


6,392,235Weighted average shares outstanding - Diluted


6,675,920


6,713,772


6,700,546


6,666,276 
 Dividends declared $0.06 per share payable October 8, 2004 for shareholders of record date September 30, 2004.
 
 See accompanying notes to consolidated financial statements.
  2   **CAVALRY BANCORP, INC.**
 **CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME**
 **(DOLLARS IN THOUSANDS)**
 **(UNAUDITED)**
 
 Three Months Ended

Nine Months EndedSeptember 30,
September 30,2004


2003


2004


2003Net income

$
1,479


1,280


3,663


3,726Other comprehensive income, net of tax:Unrealized gains (losses) on investment securities available-for-sale


286


30


(100
)

5Reclassification adjustment for (gains) losses included in net income


50


-


2


(7
)Comprehensive income

$
1,815


1,310


3,565


3,724 
 See accompanying notes to consolidated financial statements.
  3   **CAVALRY BANCORP, INC.**
 **CONSOLIDATED STATEMENTS OF CASH FLOWS**
 **NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003**
 **(DOLLARS IN THOUSANDS)**
 **(UNAUDITED)**
 
 
 2004

2003Operating activities:Net cash provided by operating activities

$
9,144


19,658Investing activities:Increase in loans receivable, net


(63,770
)

(31,849
)Principal payments on investment securities


2,406


5,572Purchase of investment securities available-for-sale


(47,746
)

(76,080
)Proceeds from maturities of investment securities


14,030


43,789Proceeds from sales of investment securities available-for-sale


42,429


2,500Purchase of Federal Reserve Stock


(35
)

-Purchase of office properties and equipment


(681
)

(1,984
)Proceeds from sale of assets


30


743Net cash used in investing activities


(53,337
)

(57,309
)Financing activities:Net increase in deposits


32,089


6,361Retirement of common stock


(1,840
)

(137
)Proceeds from exercise of stock options


271


-Dividends paid


(1,159
)

(1,045
)Net decrease in borrowings


(41
)

(41
)Net cash provided by financing activities


29,320


5,138Decrease in cash and cash equivalents


(14,873
)

(32,513
)Cash and cash equivalents, beginning of period


70,913


73,162Cash and cash equivalents, end of period

$
56,040


40,649**Supplemental Disclosures of Cash Flow Information:**Payments during the period for:Interest

$
3,919


4,365Income taxes

$
2,195


2,700**Supplemental Disclosures of Noncash Investing and Financing Activities**:Increase in deferred tax asset related to unrealized losses on investments

$
145


1Net unrealized losses on investment securities available for sale

$
(47
)

(3
)Dividends declared and payable

$
405


409 
 See accompanying notes to consolidated financial statements.
  4   **Cavalry Bancorp, Inc.**
 **Notes to Consolidated Financial Statements**
 
 1. B asis of Presentation
 
 Cavalry Bancorp, Inc. (the "Company"), a Tennessee corporation, is the holding company for Cavalry Banking (the "Bank") a state chartered Federal Reserve member commercial bank. Miller & Loughry Insurance and Services, Inc. ("Miller & Loughry"), an independent insurance agency, is a wholly-owned subsidiary of the Bank.
 
 The unaudited consolidated financial statements include the accounts of Miller & Loughry, the Bank and the Company. All material intercompany accounts and transactions have been eliminated in consolidation.
 
 The accompanying consolidated financial statements of the Company have been prepared in accordance with Instructions to Form 10-Q. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. However, such information reflects all adjustments (consisting solely of normal recurring adjustments), which are, in the opinion of management, necessary for a fair statement of results for the interim periods.
 
 The results of operations for the three months and nine months ended September 30, 2004, are not necessarily indicative of the results to be expected for the year ending December 31, 2004. The consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended December 31, 2003.
 
 2. Stock Options
 
 The Company accounts for its stock option plan in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations, as permitted by Statement of Financial Accounting Standard (SFAS) No. 123, "Accounting for Stock-Based Compensation." As such, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. SFAS 123 requires entities which continue to apply the provisions of APB 25 to provide pro-forma earnings per share disclosure for stock option grants made in 1995 and subsequent years as if the fair value based method defined in SFAS 123 had been applied. SFAS 148, "Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB No. 123," provides that an entity that has transitioned to the accounting treatment prescribed by SFAS 123 may use the intrinsic value method in lieu of the fair value based method for determining the fair value of stock options at the date of grant. SFAS 148 requires disclosure in addition to SFAS 123 if APB 25 is currently being applied.
 
 The Company applies APB 25 and related interpretations in accounting for the stock option plan. No compensation cost has been recognized for the plan because the stock option price is equal to or greater than the fair value at the grant date. Following is a reconciliation of reported and pro forma net income and earnings per share had compensation cost for the plan been determined based on the fair value method of SFAS 123, as amended:
 
 Three Months Ended

Nine Months EndedSeptember 30,

September 30,2004

2003

2004

2003(Dollars in thousands, except per share data)Net income:As reported

$
1,479


1,280


3,663


3,726Deduct: Total stock-based employee compensation expense determined under fair value methods for all awards granted, net of related tax effects


(110
)

(32
)

(311
)

(95
)Pro forma net income

$
1,369


1,248


3,352


3,631Earnings per share:Basic - as reported

$
0.23


0.20


0.57


0.58Basic - pro forma

$
0.21


0.19


0.52


0.57Diluted - as reported

$
0.22


0.19


0.55


0.56Diluted - pro forma

$
0.21


0.19


0.50


0.54 
 5
 3. Earnings Per Share
 
 The following schedule reconciles the numerators and denominators of the basic and diluted earnings per share (EPS) computations for the three months and nine months ended September 30, 2004 and 2003. Diluted common shares arise from the potentially dilutive effect of the Companys stock options outstanding that have exercise prices less than the fair market value of the Companys common stock.
 
 Three Months Ended
September 30,

Nine Months Ended
September 30,2004

2003

2004

2003Basic EPS:Net income

$
1,479,000


1,280,000


3,663,000


3,726,000Average common shares outstanding


6,441,148


6,418,261


6,463,810


6,392,235Earnings per share - basic

$
0.23


0.20


0.57


0.58Diluted EPS:Net income

$
1,479,000


1,280,000


3,663,000


3,726,000Average common shares outstanding


6,441,148


6,418,261


6,463,810


6,392,235Dilutive effect of stock options


234,772


295,511


236,736


274,041Average dilutive shares outstanding


6,675,920


6,713,772


6,700,546


6,666,276Earnings per share - diluted

$
0.22


0.19


0.55


0.56 
 4. Business Segments
 
 The Company and its subsidiaries provide community oriented financial services to individuals and businesses primarily within Davidson, Rutherford and Bedford counties in Middle Tennessee.
 
 The Companys segments are identified by the products and services offered, principally distinguished as banking, trust, insurance, and mortgage banking operations. The majority of loans originated for sale are sold with the servicing rights attached.
 
 Segment information is derived from the internal reporting system utilized by management with accounting policies and procedures consistent with those described in Note 1 of the financial statements included in the Companys 2003 Annual Report to Shareholders. Segment performance is evaluated by the Company based on profit or loss before income taxes. Revenue, expense, and asset levels reflect those which can be specifically identified and those assigned based on internally developed allocation methods. These methods have been consistently applied.
  6   
 
 For the three months ended

Banking

Mortgage Banking

Trust

Insurance

Eliminations

ConsolidatedSeptember 30, 2004:Interest income

$
6,482


-


-


-


-


6,482Other income-external customers


1,789


47


266


538


-


2,640Interest expense


1,391


-


-


-


-


1,391Depreciation and amortization


361


36


17


2


-


416Other significant items:Provision for loan losses


176


-


-


-


-


176Gain on sales of assets


-


879


-


-


-


879Segment profit


2,344


27


33


86


(17
)

2,473Segment assets


547,928


2,576


324


2,991


(1,917
)

551,902 
 
 For the three months ended

Banking

Mortgage Banking

Trust

Insurance

Eliminations

ConsolidatedSeptember 30, 2003:Interest income

$
5,444


-


-


-


-


5,444Other income-external customers


1,539


45


246


541


-


2,371Interest expense


1,328


-


-


-


-


1,328Depreciation and amortization


329


92


16


15


-


452Other significant items:Provision for loan losses


-


-


-


-


-


-Gain on sales of assets


-


1,687


-


-


-


1,687Segment profit


1,836


264


37


75


(97
)

2,115Segment assets


469,050


5,733


335


2,855


(2,270
)

475,703 
 
 For the nine months ended

Banking

Mortgage Banking

Trust

Insurance

Eliminations

ConsolidatedSeptember 30, 2004:Interest income

$
18,153


-


-


-


-


18,153Other income-external customers


5,040


140


832


1,552


-


7,564Interest expense


3,953


-


-


-


-


3,953Depreciation and amortization


1,062


123


52


19


-


1,256Other significant items:Provision for loan losses


352


-


-


-


-


352Gain on sales of assets


53


2,281


-


-


-


2,334Segment profit (loss)


5,985


(127
)

147


180


(47
)

6,138Segment assets


547,928


2,576


324


2,991


(1,917
)

551,902 
 
 For the nine months ended

Banking

Mortgage Banking

Trust

Insurance

Eliminations

ConsolidatedSeptember 30, 2003:Interest income

$
16,329


-


-


-


-


16,329Other income-external customers


4,360


176


740


1,669


-


6,945Interest expense


4,295


-


-


-


-


4,295Depreciation and amortization


942


274


50


45


-


1,311Other significant items:Provision for loan losses


101


-


-


-


-


101Gain on sales of assets


11


4,711


-


-


-


4,722Segment profit


5,380


713


102


191


(287
)

6,099Segment assets


469,050


5,733


335


2,855


(2,270
)

475,703 
 
  7   5. New Accounting Standards
 
 On March 9, 2004, the SEC staff issued Staff Accounting Bulletin No. 105, "Application of Accounting Principles to Loan Commitments", which provides guidance regarding mortgage loan interest rate lock commitments related to loans held for sale as written options, effective for commitments entered into after March 31, 2004. The Company enters into such commitments with customers in connection with residential mortgage loan applications, however, the amount of these commitments is not material to the Companys consolidated financial statements. The impact of implementing this guidance did not have a significant impact on the consolidated financial statements.
 
 Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 
 This Quarterly Report contains forward-looking statements within the meaning of the federal securities laws. These statements are not historical facts, but rather are statements based on the Company's current expectations regarding its business strategies and their intended results and its future performance. Forward-looking statements are preceded by terms such as "expects," "feels," "believes," "anticipates," "intends," and similar expressions. Forward-looking statements are not guarantees of future performance. Numerous risks and uncertainties could cause the Company's actual results, performance, and achievements to be materially different from those expressed or implied by the forward-looking statements. Factors that may cause or contribute to these differences include, without limitation, general economic conditions, including changes in market interest rates and changes in monetary and fiscal policies of the federal government; changes in market conditions in the Companys principal market area; adverse changes in the financial condition of the loan loss reserves; competitive pressures on loan or deposit terms; legislative and regulatory changes; and other factors disclosed periodically in the Company's filings with the Securities and Exchange Commission. Because of the risks and uncertainties inherent in forward-looking statements, readers are cautioned not to place undue reliance on them, whether included in this report or made elsewhere from time to time by the Company or on its behalf. The Company assumes no obligation to update any forward-looking statements.
 
 Overview of Operating Results for the Three Months Ended September 30, 2004 and September 30, 2003
 
 Net income increased from $1.3 million or $0.19 per diluted share for the quarter ended September 30, 2003 to $1.5 million or $0.22 per diluted share for the quarter ended September 30, 2004. The increase in earnings for the quarter was a result of increased net interest income, increased deposit servicing fees and decreased non-interest expense. These factors were partially offset by increased provision for loan losses and decreased gain on sale of loans . These items are discussed in further detail below.
 
 Overview of Operating Results for the Nine Months Ended September 30, 2004 and September 30, 2003
 
 Net income was $3.7 million or $0.56 per diluted share for the nine months ended September 30, 2003 and $3.7 million or $0.55 per diluted share for the same period ended September 30, 2004. The decrease in diluted earnings per share was a result of decreased gain on sale of loans, increased provision for loan losses and increased non-interest expense. These factors were partially offset by increased interest income, increased deposit servicing fees, and a decline in interest expense. These items are discussed in further detail below.
 
 Critical Accounting Policies
 
 The Companys consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America and follow general practices within the industries in which it operates. The Companys accounting policies are fundamental to understanding these financial statements. Certain accounting policies involve significant judgments and complex assumptions by management which may have a material impact on the carrying value of certain assets and liabilities; management considers these accounting policies to be critical accounting policies. Based on this definition, management considers the allowance for loan losses to be its most critical accounting policy. The Companys allowance for loan loss methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance that management believes to be appropriate for each reporting date. Quantitative and qualitative factors include the Companys historical loss experience, delinquency and charge-off trends, collateral values, and changes in non-performing loans. Additionally, the Company considers the general economic environment in the Companys markets, including economic conditions throughout the Southeast and the state of industries predominant in the Middle Tennessee area. The Company also incorporates known information about individual loans, including borrowers sensitivity to interest rate movements and other relevant factors.
 
 Management also considers its policy on non-accrual loans to be a critical accounting policy. Loans are classified as non-accrual loans when principal or interest is delinquent for 90 days or more. Once a loan is categorized as non-accrual, all previously recorded earned income is reversed and income is no longer accrued on an on-going basis. When the deficiency is cured, the loan is taken out of non-accrual status, the related income is recorded on the books, and interest income will start accruing again as usual.
 
 The final critical accounting policy identified by management relates to the sale of loans. The Bank sells mortgage loans for cash proceeds equal to the principal amount of the loans sold but with yield rates which reflect the current market rate. Gain or loss is recorded at the time of sale in an amount reflecting the difference between the contractual interest rates of the loans sold and the current market rate. The gain (or loss) on sales includes any fees received for release of servicing.
 
 8
 Comparison of Financial Condition at September 30, 2004 and December 31, 2003
 
 *Total Assets* . Total assets increased 7.12%, from $515.2 million at December 31, 2003 to $551.9 million at September 30, 2004. This overall increase reflects a $63.4 million or 18.09% increase in net loans receivable. The increase in net loans receivable is primarily due to a 30.13% increase in commercial lending, a 37.33% increase in construction lending, and an 9.50% increase in consumer lending. This increase in loans was partially offset by a $14.9 million or 20.97% decrease in cash and cash equivalents and an $11.4 million or 20.71% decrease in available-for-sale investment securities. The decrease in investment securities available-for-sale is primarily due to investments being called, investments maturing, and sales of investments. These decreases were partially offset by the purchase of municipal securities, collateralized mortgage obligations ("CMOs"), and mortgage-backed securities.
 
 *Deposits* . Total deposits increased $32.0 million or 7.04%, from $454.3 million at December 31, 2003 to $486.3 million at September 30, 2004. Non-interest-bearing deposits increased $17.8 million or 24.53%, primarily due to a $16.0 million or 23.61% increase in demand deposit accounts. Interest-bearing deposits increased $14.3 million or 3.75%, primarily due to an $11.6 million or 53.24% increase in non-personal money market accounts and a $6.8 million or 12.41% increase in certificates of deposit greater than $100,000. These increases were partially offset by a $4.0 million or 4.18% decrease in NOW accounts. Transaction accounts, which include both interest-bearing and non-interest-bearing accounts, increased $23.3 million, from $280.5 million at December 31, 2003 to $303.8 million at September 30, 2004. Savings accounts increased $1.1 million, from $21.0 million at December 31, 2003 to $22.1 million at September 30, 2004. Certificates of deposit increased $7.6 million, from $152.8 million at December 31, 2003 to $160.4 million at September 30, 2004. The overall increase in deposits is due to increased marketing strategies focused on gaining and retaining deposit accounts.
 
 *Shareholders Equity* . Shareholders equity increased from $54.4 million at December 31, 2003 to $56.6 million at September 30, 2004. This increase was primarily the result of net income of $3.7 million and the allocation of shares under the Bank's Employee Stock Ownership Plan (ESOP) that totaled $1.4 million. Additionally, the Company issued common stock as a result of options exercised in the amount of $287,000, inclusive of the related tax benefit. These increases were partially offset by a $98,000 decrease in the valuation allowance for available-for-sale investment securities, dividends of $1.2 million and the repurchase of $1.9 million of Company common stock.
 
 *Non-Performing Assets* . Non-performing assets totaled $1.2 million and $859,000 at September 30, 2004 and December 31, 2003, respectively. The allowance for loan losses increased 4.44%, from $4.5 million at December 31, 2003 to $4.7 million at September 30, 2004. Although the non-performing asset balance reflects an increase of $341,000 or 39.70%, non-performing assets have continued to be a relatively small portion of the Banks portfolio, with the balance equal to 0.29% of total loans and 0.22% of total assets. Therefore, management feels that the increase in the allowance for loan losses is adequate as of September 30, 2004.
  Comparison of Operating Results for the Three Months Ended September 30, 2004 and September 30, 2003.
 
 *Net Income* . Net income was $1.5 million for the three months ended September 30, 2004 compared to $1.3 million for the three months ended September 30, 2003. Diluted earnings per share increased $0.03, from $0.19 for the three months ended September 30, 2003 to $0.22 for the same period in 2004. Annualized return on average assets increased from 1.07% for the three months ended September 30, 2003 to 1.10% for the same period in 2004. Annualized return on average equity also increased, from 9.60% for the three months ended September 30, 2003 to 10.51% for the same period in 2004. These increases are mainly attributable to an increase in consumer, commercial, and construction lending activity as well as an increase in deposit fees during the three months ended September 30, 2004 compared to the same period in 2003, net of a decline in sale of loans. These changes are discussed in more detail in the following sections.
 
 9
 *Net Interest Income* . Net interest income increased 24.39%, from $4.1 million for the three months ended September 30, 2003 to $5.1 million for the same period in 2004. When comparing the three months ended September 30, 2004 and 2003, the Company experienced increased volume in both average interest-earning assets and average interest-bearing liabilities, while yields and costs varied. Average interest-earning assets increased $65.3 million or 15.51%, while average interest-bearing liabilities increased $32.9 million or 9.27%. Interest rate spread increased 0.24%, from 3.65% for the three months ended September 30, 2003 to 3.89% for the same period in 2004. Net interest margin increased 29 basis points, from 3.88% for the three months ended September 30, 2003 to 4.17% for the same period in 2004. The ratio of average interest-earning assets to average interest-bearing liabilities increased from 118.57% for the three months ended September 30, 2003 to 125.35% for the same period in 2004.
  *Interest Income* . Interest income increased $1.0 million or 19.07%, primarily due to an increase of $939,000 or 18.58% in loan interest income. This increase is the result of an increase of $75.5 million or 22.68% in average loans receivable, net. The average yield on these loans decreased, from 6.03% for the three months ended September 30, 2003 to 5.84% for the same period in 2004. Interest income on all other investments, including Federal Home Loan Bank stock, Federal Reserve Bank stock, and interest-bearing deposits with other financial institutions, increased by $99,000 or 25.45%. The average yield for these investments increased 84 basis points, from 1.76% for the three months ended September 30, 2003 to 2.60% for the same period in 2004. This increase is the result of a restructuring of the Companys investment portfolio. The Company replaced shorter-term agency bonds with longer-term CMOs, mortgage-backed securities, and municipal securities, resulting in increased yields.
 
 *Interest Expense* . Total interest expense increased $63,000 or 4.74%. Although the average cost of deposits declined from 1.47% for the three months ended September 30, 2003 to 1.41% for the same period in 2004, the average deposit balance increased, resulting in increased expense. Average deposits increased $33.0 million or 9.38%, from $351.9 million for the three months ended September 30, 2003 to $384.9 million for the same period in 2004. The total cost of funds decreased 5 basis points, from 1.48% for the three months ended September 30, 2003 to 1.43% for the same period in 2004, primarily as a result of a lower cost of funds for certificates of deposit.
 
 *Provision for Loan Losses* . The provision for loan losses is a charge to earnings to bring the total allowance for loan losses to a level management considers adequate to provide for inherent losses in the loan portfolio. Management examines a variety of factors on a monthly basis to determine the estimated charge or credit necessary to bring the allowance to an acceptable level. These factors include the nature of the portfolio, collateral values, credit concentrations, historical loss experience along with delinquency and charge-off trends, and economic conditions. Management also identifies specific impaired loans by incorporating known information about individual loans, including borrowers sensitivity to interest rate movements and other relevant factors.
 
 The provision for loan losses totaled $176,000 for the three months ended September 30, 2004 compared to no provision for the same period ended September 30, 2003. This increase is primarily due to the increase in the amount of the loan portfolio. Net charge-offs increased $3,000, from $45,000 for the quarter ended September 30, 2003 to $48,000 for the same period ended September 30, 2004. Management feels that their evaluations and estimations were reasonable for determining the provision, and the allowance for loan losses is deemed to be adequate as of September 30, 2004. However, a decline in economic conditions or other factors beyond managements control could significantly affect the amount of losses the Company recognizes in the future.
 
 *Non-Interest Income* . Non-interest income decreased $600,000 or 14.63%, from $4.1 million for the three months ended September 30, 2003 to $3.5 million for the same period in 2004. This decrease is primarily due to an $808,000 or 47.90% decrease in net gain on sale of loans. The overall volume of mortgage loans originated by the Company has declined significantly as a result of decreased refinancing activity. There has therefore been a decline in loans sold during the three month period ended September 30, 2004, compared to the same period ended September 30, 2003. The decrease in net gain on sale of loans is offset by an increase of $249,000 or 20.61% in deposit-related service fees and charges. This is due to an increase in the Banks service fee schedule as well as an increase in the number of deposit accounts. In the trust segment, trust service fees increased by $20,000 or 8.13% due to an increase in the assets under management. In the insurance segment, commission revenue declined slightly while overall segment profit increased by 14.67%, primarily due to expense management.
 
 10
 *Non-Interest Expense* . Non-interest expense decreased $100,000 or 1.64%, from $6.1 million for the three months ended September 30, 2003 to $6.0 million for the same period in 2004. Many factors contributed to this change. Salaries and employee benefits expense decreased $359,000 or 9.06%, which primarily is a result of decreased commission expense due to the closing of a mortgage origination location during the third quarter of 2004 as well as an overall decline in mortgage originations for the three months ended September 30, 2004 compared to the same period ended 2003. This decrease was partially offset by an increase of $110,000 or 14.10% in equipment and service bureau expense, which primarily is a result of increased processing costs. In addition, professional fees increased $127,000 or 97.69%. This increase is due to an increase in internal audit fees as well as an increase in consulting fees as a result of the internal control requirement of the Sarbanes-Oxley Act of 2002. Management anticipates that its professional fees will continue to exceed historical levels as the Company continues to address the internal control requirements of the Sarbanes-Oxley Act of 2002.
 
 Comparison of Operating Results for the Nine Months Ended September 30, 2004 and September 30, 2003.
 
 *Net Income* . Net income was $3.7 million for the nine months ended September 30, 2004 compared to $3.7 million for the nine months ended September 30, 2003. Diluted earnings per share decreased $0.01, from $0.56 for the nine months ended September 30, 2003 to $0.55 for the same period in 2004. Annualized return on average assets decreased from 1.10% for the nine months ended September 30, 2003 to 0.95% for the same period in 2004. Annualized return on average equity also decreased, from 9.76% for the nine months ended September 30, 2003 to 8.82% for the same period in 2004. These declines are mainly attributable to lower fees collected for mortgage banking as well as decreased gain on sale of loans, as refinancing slowed considerably during the first nine months of 2004 compared to high levels experienced during the same period ended September 30, 2003. Additionally, the Company experienced an increase in professional fees due to the Companys implementation of its compliance program related to the internal control requirement of the Sarbanes-Oxley Act of 2002. These changes are discussed in more detail in the following sections.
 
 *Net Interest Income* . Net interest income increased 18.33%, from $12.0 million for the nine months ended September 30, 2003 to $14.2 million for the same period in 2004. When comparing the nine months ended September 30, 2004 and 2003, the Company experienced increased volume in both average interest-earning assets and average interest-bearing liabilities, while yields and costs varied. Average interest-earning assets increased $67.9 million or 17.08%, while average interest-bearing liabilities increased $36.7 million or 10.60%. Interest rate spread increased 0.01%, from 3.83% for the nine months ended September 30, 2003 to 3.84% for the same period in 2004. Net interest margin increased 2 basis points, from 4.05% for the nine months ended September 30, 2003 to 4.07% for the same period in 2004. The ratio of average interest-earning assets to average interest-bearing liabilities increased from 114.70% for the nine months ended September 30, 2003 to 121.43% for the same period in 2004.
 
 *Interest Income* . Interest income increased $1.8 million or 11.17%, primarily due to an increase of $1.7 million or 11.34% in loan interest income. This increase is the result of an increase of $69.5 million or 21.78% in average loans receivable, net. The average yield on these loans decreased, from 6.34% for the nine months ended September 30, 2003 to 5.79% for the same period in 2004. Interest income on all other investments, including Federal Home Loan Bank stock, Federal Reserve Bank stock, and interest-bearing deposits with other financial institutions, increased by $109,000 or 9.05%. The average yield for these investments increased 29 basis points, from 2.05% for the nine months ended September 30, 2003 to 2.34% for the same period in 2004.
 
 *Interest Expense* . Total interest expense decreased $342,000 or 7.96%. This decrease is primarily due to a decrease in the average cost of deposits, which declined from 1.64% for the nine months ended September 30, 2003 to 1.36% for the same period in 2004. Average deposits increased $36.8 million or 10.71%, from $343.7 million for the nine months ended September 30, 2003 to $380.5 million for the same period in 2004. The total cost of funds decreased 28 basis points, from 1.66% for the nine months ended September 30, 2003 to 1.38% for the same period in 2004.
 
 *Provision for Loan Losses* . Please see the above section entitled "Comparison of Operating Results for the Three Months Ended September 30, 2004 and September 30, 2003 - Provision for Loan Losses" for a discussion as to how the Company derives the provision for loan losses.
 
 11
 The provision for loan losses totaled $352,000 for the nine months ended September 30, 2004 compared to $101,000 for the same period ended September 30, 2003. This increase is primarily due to an increase in the amount of the loan portfolio. Net charge-offs declined $39,000, from $188,000 for the nine months ended September 30, 2003 to $149,000 for the same period ended September 30, 2004. Management feels that their evaluations and estimations were reasonable for determining the provision, and the allowance for loan losses is deemed to be adequate as of September 30, 2004. However, a decline in economic conditions or other factors beyond managements control could significantly alter the amount of losses the Company recognizes in the future.
 
 *Non-Interest Income* . Non-interest income decreased $1.8 million or 15.38%, from $11.7 million for the nine months ended September 30, 2003 to $9.9 million for the same period in 2004. This overall decrease is primarily due to a $2.4 million or 51.58% decrease in net gain on sale of loans. The overall volume of mortgage loans originated by the Company has declined significantly as a result of decreased refinancing activity. There has therefore been a decline in loans sold during the nine month period ended September 30, 2004, compared to the same period ended September 30, 2003. The decrease in net gain on sale of loans is offset by an increase of $537,000 or 15.54% in deposit-related service fees and charges. This is due to an increase in the Banks service fee schedule as well as an increase in the number of deposit accounts. In the trust segment, trust service fees increased by $92,000 or 12.43% due to an increase in the assets under management. In the insurance segment, commission revenue decreased 7.01% and overall segment profit decreased 5.76% for the nine months ended September 30, 2004 compared to the same period ended 2003. These decreases are primarily due to a decrease in contingency commission, which is a result of increased claims paid during 2003 due to significant storm damage suffered by the middle Tennessee area during the spring and summer seasons of 2003.
  *Non-Interest Expense* . Non-interest expense increased $107,000 or 0.61%, from $17.5 million for the nine months ended September 30, 2003 to $17.6 million for the same period in 2004. Many factors contributed to this change. Equipment and service bureau expense increased $346,000 or 15.65%, which primarily is a result of increased equipment maintenance expense and increased processing expense. In addition, professional fees increased $291,000 or 79.73%. This increase is due to an increase in internal audit fees as well as an increase in consulting fees as a result of the internal control requirement of the Sarbanes-Oxley Act of 2002. Management anticipates that its professional fees will continue to exceed historical levels as the Company continues to address the internal control requirements of the Sarbanes-Oxley Act of 2002. The Company also experienced an increase of $74,000 or 22.42% in advertising expenses, due to the Bank celebrating its 75 th anniversary during the second quarter of 2004. This celebration resulted in numerous promotional activities aimed at recognizing current customers and attracting new prospects. These increases were partially offset by a decrease of $664,000 or 5.77% in salaries and employee benefits, which was primarily attributable to decreased commission expense due to the closing of a mortgage origination location during the third quarter of 2004, as well as an overall decline in mortgage originations during 2004.
 
 Liquidity and Capital Resources
  The Companys primary sources of funds are customer deposits, proceeds from loan principal and interest payments, sale of loans, maturing securities and Federal Home Loan Bank (FHLB) of Cincinnati advances. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are influenced greatly by general interest rates, other economic conditions, and competition. The Company and the Bank generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2004, cash and cash equivalents totaled $56.0 million or 10.15% of total assets, and investment securities available-for-sale totaled $43.7 million. At September 30, 2004, the Bank also maintained, but did not draw upon, a line of credit with the FHLB of Cincinnati in the amount of $50.0 million.
 
 As of September 30, 2004, the Company and the Banks regulatory capital ratios were in excess of all applicable regulatory requirements. At September 30, 2004, under the regulations of the Federal Reserve Board, the Banks actual leverage, Tier 1 risk-based, and risked-based capital ratios were 9.40%, 11.60% and 12.74%, respectively, compared to requirements of 3.0%, 4.0% and 8.0%, respectively. At September 30, 2004, under the regulations of the Federal Reserve Board, the Companys actual leverage, Tier 1, risk-based, and risked-based capital ratios were  10.33%, 12.93%, and 14.07%, respectively. The Company is currently involved in a share repurchase program. The Company has repurchased 120,043 shares this year at an average price of $15.33. The maximum number of shares that may yet be repurchased under the plan is 287,261 shares.
  12   
 At September 30, 2004, the Bank had off-balance sheet loan commitments of approximately $57.1 million. In addition, at September 30, 2004, the unused portion of lines of credit extended by the Bank was approximately $8.7 million for consumer loans and $35.0 million for commercial loans. Standby letters of credit and financial guarantees are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Most guarantees extend from one to two years. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. At September 30, 2004, the Bank had $8.1 million of letters of credit outstanding.
 
 Impact of Inflation and Changing Prices
 
 The consolidated financial statements of the Company and notes thereto, presented elsewhere herein, have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial condition and operating results in terms of historical dollars without considering the change in relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Companys operations. Unlike most industrial companies, nearly all the assets and liabilities of the Company are financial. As a result, interest rates have a greater impact on the Companys performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
 
 As a financial institution, the Companys primary component of market risk is interest rate risk. Ultimately, fluctuations in interest rates will impact liquidity, the level of income and expense recorded on most of the Companys assets and liabilities, and the market value of interest-earning assets and interest-bearing liabilities. The Company is not subject to foreign exchange or commodity price risk. The Company does not own any trading assets.
 
 Interest rate risk is managed in accordance with policies approved by the Banks Board of Directors. Management formulates strategies based on appropriate levels of interest rate risk. In determining the appropriate level of interest rate risk, management considers the impact on earnings and capital of the current outlook on interest rates, potential changes in interest rates, regional economy, liquidity, business strategies and other factors. Management meets regularly to review, among other things, the sensitivity of assets and liabilities to interest rate changes, the book and market value of assets and liabilities, unrealized gains and losses, purchase and sales activities, commitments to originate loans and the maturities of investments. Management uses an analysis of relationships between interest-earning assets and interest-bearing liabilities to manage interest rate risk.
 
 The following table presents the Company's repricing gap at September 30, 2004. The table indicates that at September 30, 2004 the Company was asset sensitive up to six months. This would indicate an increase in earnings in a rising rate environment.
  13   
 Within
Six
Months

Six
Months
to One
Year

After
One to
Three
Years

After
Three
to Five
Years

Over
Ten
Years

Total(in thousands)Interest-earning assets:Loans receivable, net

$
139,730


45,203


59,709


153,141


18,443


416,226FHLB and FRB stock


3,099


-


-


-


-


3,099Investment securities available-for-sale


11,213


2,675


6,316


5,105


18,398


43,707Interest-bearing deposits with other financial institutions


35,366


-


-


-


-


35,366Total rate sensitive assets

$
189,408


47,878


66,025


158,246


36,841


498,398Interest-bearing liabilities:Deposits:Savings deposits

$
2,212


2,212


8,848


8,847


-


22,119Demand deposits


70,290


70,290


36,512


36,512


-


213,604Certificates of deposit


56,104


36,095


49,645


18,533


34


160,411Borrowings


27


27


2,109


109


576


2,848Total rate sensitive liabilities

$
128,633


108,624


97,114


64,001


610


398,982Excess (deficiency) of interest sensitive assets over interest sensitive liabilities

$
60,775


(60,746
)

(31,089
)

94,245


36,231


99,416Cumulative excess (deficiency) of interest sensitive assets

$
60,775


29


(31,060
)

63,185


99,416


99,416Cumulative ratio of interest-earning assets to interest-bearing liabilities


147.25
%

100.01
%

90.71
%

115.86
%

124.92
%

124.92
%Interest sensitivity gap to total rate sensitive assets


12.19
%

(12.19
)%

(6.24
)%

18.91
%

7.27
%

19.95
%Ratio of interest-earning assets to interest -bearing liabilities


147.25
%

44.08
%

67.99
%

247.26
%

6,039.51
%

124.92
%Ratio of cumulative gap to total rate sensitive assets


12.19
%

0.01
%

(6.23
)%

12.68
%

19.95
%

19.95
% 
 The gap analysis provides the basis for more detailed analysis in a simulation model. Also gap results are popular rate risk indicators. However, to truly evaluate the impact of rate change on income, simulation is the best technique because variables are changed for various rate conditions. Each categorys interest change is calculated as rates ramp up and down. In addition, the prepayment speeds and repricing speeds are changed.
 
 Rate shock is a method for stress testing the net interest margin (NIM) over the next four quarters under several rate change levels. These levels span four 100 basis point increments up and down, as applicable, from the current interest rates. In order to simulate activity, maturing balances are replaced with new balances at the new rate level and repricing balances are adjusted to the new rate shock level. The interest is recalculated for each level along with the new average yield. NIM is then calculated and a margin risk profile is developed. This simulation reveals that the Bank will experience a loss in net interest income if rates decline in the next year. The magnitude and severity of potential loss for a 100 basis point decline in rates under projected growth conditions would be a decline of 21 basis points. The magnitude of potential gain for a 100 basis point increase under projected growth conditions would be an increase of 18 basis points.
 
 Item 4. Controls and Procedures
 
 Evaluation of disclosure controls and procedures.
 
 In accordance with Rule 13a-15(b) of the Securities Exchange Act of 1934(the "Exchange Act"), an evaluation was carried out with the participation of the Companys management, including the Companys Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Companys disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based upon their evaluation of these disclosure controls and procedures, the Chief Executive Officer and the Chief Financial Officer concluded that the disclosure controls and procedures were effective as of the end of the period covered by this report to ensure that material information relating to the Company, including its consolidated subsidiaries, was made known to them by others within those entities, particularly during the period in which this quarterly report on Form 10-Q was being prepared.
 
 
  14   Part II. Other Information
 
 Item 1. Legal Proceedings
 
 None.
 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
 
 (a)  Not applicable.
  (b)  Not applicable.
 
 (c)  The following table provides information about purchases by the Company during the quarter ended September 30, 2004 of equity securities that are registered by the Company pursuant to Section 12 of the Exchange Act:
 
 
 ISSUER PURCHASES OF EQUITY SECURITIESPeriod
Total number of shares purchased
Average price paid per share
Total number of shares purchased as part of publicly announced plans or programs
Maximum number of shares that may yet be purchased under the plans or programsJuly 1, 2004 through July 31, 2004
-
$ -
-
298,404August 1, 2004 through August 31, 2004
-
-
-
298,404September 1, 2004 through September 30, 2004
11,143
16.97
11,143
287,261Total
11,143
16.97
11,143
 
 On September 26, 2001, the Company announced its plans to implement a program to repurchase 710,480 shares of its common stock outstanding ("stock repurchase program"). The stock repurchase program does not have an expiration date and unless terminated earlier by resolution of the Companys board of directors, will expire when the Company has repurchased all shares authorized for repurchase thereunder. The Company has no other programs to repurchase common stock at this time.
 
 Item 3. Defaults Upon Senior Securities
 
 Not applicable.
 
 Item 4. Submission of Matters to a Vote of Security Holders
 
 None.
 
 Item 5. Other Information
 
 None.
 
 Item 6. Exhibits
 
 (a)  Exhibits
 
 31.1  CEO Certification Pursuant Rule 13a-14(a)/15d-14(a)
 31.2  CFO Certification Pursuant Rule 13a-14(a)/15d-14(a)
 32.1  CEO Certification Pursuant 18 U.S.C. Section 1350, Sarbanes - Oxley Act 2002
 32.2  CFO Certification Pursuant 18 U.S.C. Section 1350, Sarbanes - Oxley Act 2002
  15   **SIGNATURES**
 
 
 Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
 
 
 
 CAVALRY BANCORP, INC.Date: November 4, 2004
byEd C. Loughry, Jr.Chairman of the Board and Chief Executive Officer 
 Date: November 4, 2004
byHillard C. GardnerSenior Vice President and Chief Financial Officer(Principal Financial and Accounting Officer) 
 
 
 16