10-Q 1 hcb10q204.txt FORM 10Q 12/30/03 EARNINGS FORM 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Mark One [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended December 31, 2003. OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-22423 ------- HCB BANCSHARES, INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) OKLAHOMA 62-1670792 ------------------------------- ----------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 237 Jackson Street, SW, Camden, Arkansas 71701 ---------------------------------------- ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (870) 836-6841 -------------- 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 ninety days: Yes [X] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate the number of shares outstanding of each of the issuer's classes of common stock as of the latest practicable date: 1,450,230 shares of common stock outstanding as of January 31, 2004. CONTENTS PART I. FINANCIAL INFORMATION --------------------- Item 1. Condensed Consolidated Financial Statements Condensed Consolidated Statements of Financial Condition at December 31, 2003 (unaudited) and June 30, 2003 Condensed Consolidated Statements of Income and Comprehensive Income (Loss) Three Months and Six Months Ended December 31, 2003 and 2002 (unaudited) Condensed Consolidated Statements of Cash Flows Six Months Ended December 31, 2003 and 2002 (unaudited) Notes to Condensed Consolidated Financial Statements (unaudited) Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures about Market Risk Item 4. Controls and Procedures PART II. OTHER INFORMATION ----------------- Item 1. Legal Proceedings Item 2. Changes in Securities and Use of Proceeds 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 Page 2 HCB BANCSHARES, INC. CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2003 (UNAUDITED) and JUNE 30, 2003 --------------------------------------------------------------------------------

See accompanying notes to condensed consolidated financial statements. Page 3 HCB BANCSHARES, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (LOSS) THREE MONTHS AND SIX MONTHS ENDED DECEMBER 31, 2003 AND 2002 (UNAUDITED) --------------------------------------------------------------------------------

(Continued) Page 4 HCB BANCSHARES, INC. CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (LOSS) THREE MONTHS AND SIX MONTHS ENDED DECEMBER 31, 2003 AND 2002 (UNAUDITED) --------------------------------------------------------------------------------

See accompanying notes to condensed consolidated financial statements. Page 5 HCB BANCSHARES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS SIX MONTHS ENDED DECEMBER 31, 2003 AND 2002 (UNAUDITED) --------------------------------------------------------------------------------

(Continued) Page 6 HCB BANCSHARES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS SIX MONTHS ENDED DECEMBER 31, 2003 AND 2002 (UNAUDITED) --------------------------------------------------------------------------------

See accompanying notes to condensed consolidated financial statements. (Concluded) Page 7 HCB BANCSHARES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 - BASIS OF PRESENTATION AND CONSOLIDATION HCB Bancshares, Inc. ("Bancshares"), incorporated under the laws of the State of Oklahoma, is a savings bank holding company that owns HCB Investments, Inc. ("HCBI") and HEARTLAND Community Bank and its subsidiary (the "Bank"). Bancshares' business is primarily that of owning the Bank and participating in the Bank's activities. HCBI holds a $500,000 initial investment in EastPoint Technologies LLC, which is the company whose core processing software the Bank utilizes. The accompanying condensed consolidated financial statements include the accounts of Bancshares, HCBI and the Bank and are collectively referred to as the Company. All significant intercompany balances and transactions have been eliminated in consolidation. The accompanying unaudited condensed consolidated financial statements were prepared in accordance with instructions for Form 10-Q. Accordingly, they do not include all of the information required by generally accepted accounting principles. The unaudited statements reflect all adjustments, which are, in the opinion of management, necessary for fair presentation of the financial condition and results of operations and cash flows of the Company. Those adjustments consist only of normal recurring adjustments. The condensed consolidated statements of income and comprehensive income (loss) for the three months and six months ended December 31, 2003, are not necessarily indicative of the results that may be expected for the Company's fiscal year ending June 30, 2004. The unaudited condensed consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes thereto for the year ended June 30, 2003, contained in the Company's Annual Report on Form 10-K for the year ended June 30, 2003. NOTE 2 - EARNINGS PER SHARE The weighted average number of common shares used to calculate earnings per share for the three and six month periods ended December 31, 2003 and 2002, were as follows:

The Company has issued stock options that have the potential to be dilutive to its weighted average shares calculation and were dilutive for the three and six month periods ending December 31, 2003 and 2002. In addition, the Company has issued MRP shares that have the potential to be dilutive to its weighted average shares calculation, but were anti-dilutive for these periods. NOTE 3 - COMMITMENTS AND CONTINGENCIES In the ordinary course of business, the Company has various outstanding commitments and contingent liabilities that are not reflected in the accompanying consolidated financial statements. In addition, the Company may be a defendant from time to time in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated financial statements of the Company. NOTE 4 - MONTICELLO BRANCH SALE On July 19, 2002, the Bank sold its Monticello branch to Simmons First Bank of South Arkansas. The sale included approximately $8.3 million in loans, $1.5 million in fixed assets, $0.2 million in other assets and $13.2 million in deposits. The Bank recognized a premium on the deposits of approximately $0.9 million and the difference was paid in cash to the buyer. The Bank recognized a net gain on this sale of approximately $743,000. Page 8 NOTE 5 - ACQUISITION AGREEMENT On January 14, 2004, the Company announced that it had entered into an Agreement of Acquisition (the "Agreement"), dated as of January 13, 2004 with Rock Bancshares, Inc. ("RBI"), pursuant to which all of the issued and outstanding stock of the Company will be acquired by RBI (the "Share Acquisition"). Pursuant to the Share Acquisition, RBI will acquire all of the issued and outstanding shares of common stock of HCB at a purchase price of $18.63 per share, subject to an adjustment to $18.62 per share if the acquisition is consummated on or prior to July 31, 2004 and $18.61 if consummated on or prior to June 30, 2004. In each case the per share stock price is also subject to a price adjustment by an amount based on the amount by which HCB's stockholder's equity on the last date of the calendar month preceding the closing is less than $26,500,000, excluding certain transaction costs and other related expenses. Holders of options to acquire shares of HCB common stock will receive a cash payment equal to the share acquisition price less the exercise price applicable to such option. In addition, RBI has made a cash deposit of $750,000 that will be applied to the purchase price and would be forfeited by RBI under certain circumstances, including the failure to obtain regulatory approval by August 31, 2004. Consummation of the Share Acquisition is subject to a number of customary conditions, including, but not limited to: (i) the adoption and approval of the Agreement by the shareholders of the Company; and (ii) the receipt of all requisite regulatory approvals. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS When used in this Form 10-Q, the words or phrases "will likely result," "are expected to," "will continue," "is anticipated," "estimate," "project" or similar expressions are intended to identify "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are subject to certain risks and uncertainties including changes in economic conditions in the Company's market area, changes in policies by regulatory agencies, fluctuations in interest rates, demand for loans in the Company's market area and competition that could cause actual results to differ materially from historical earnings and those presently anticipated or projected. The Company wishes to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. The Company wishes to advise readers that the factors listed above could affect the Company's financial performance and could cause the Company's actual results for future periods to differ materially from any opinions or statements expressed with respect to future periods in any current statements. The Company does not undertake, and specifically disclaims any obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. SIGNIFICANT ACCOUNTING POLICIES The Company's significant accounting policies are set forth in Note 1 of the consolidated financial statements as of June 30, 2003, which was filed on Form 10-K. Of these significant accounting policies, the Company considers its policy regarding the allowance for loan losses to be its most critical accounting policy, because it requires management's most subjective and complex judgments. In addition, changes in economic conditions can have a significant impact on the allowance for loan losses and therefore the provision for loan losses and results of operations. The Company has developed appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The Company's assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations and the discovery of information with respect to borrowers which is not known to management at the time of the issuance of the consolidated financial statements. GENERAL The Bank's principal business consists of attracting savings deposits from the general public and investing those funds in loans secured by first mortgages on existing owner-occupied single-family residences in the Bank's primary Page 9 market area, commercial and multi-family real estate loans and consumer and commercial business loans. The Bank also maintains a substantial investment portfolio of mortgage-related securities, nontaxable municipal securities and U.S. government and agency securities. The Bank's net income is dependent primarily on its net interest income, which is the difference between interest income earned on its loans, mortgage-backed securities and securities portfolio and interest paid on customers' deposits and other borrowings. The Bank's net income is also affected by the level of noninterest income, such as service charges on customers' deposit accounts, net gains or losses on the sale of loans and securities and other fees. In addition, net income is affected by the level of noninterest expense, which primarily consists of employee compensation expenses, occupancy expenses and other expenses. The financial condition and results of operations of the Bank and the thrift and banking industries as a whole are significantly affected by prevailing economic conditions, competition and the monetary and fiscal policies of governmental agencies. Lending activities are influenced by demand for and supply of credit, competition among lenders and the level of interest rates in the Bank's market area. The Bank's deposit flows and costs of funds are influenced by prevailing market rates of interest, primarily on competing investments, as well as account maturities and the levels of personal income and savings in the Bank's market area. ASSET QUALITY The following table sets forth information with respect to the Bank's nonperforming assets at the dates indicated.

------------------ (1) Designated nonaccrual loan payments received are applied first to contractual principal and interest income is recognized only when contractually current. (2) Other nonperforming assets includes foreclosed real estate. (3) Loans modified in troubled debt restructurings include $823,854 reported in Other mortgage loans accounted for on a nonaccrual basis and $1,049,521 in accruing Other mortgage loans which are contractually past due 90 days or more. Page 10 During the six months ended December 31, 2003, total nonperforming loans increased $1,589,550 primarily due to one borrower with four other mortgage loans totaling $1.9 million which were 91 days past due on that date, offset by decreases in one-to-four family residential nonperforming loans. Of the $1.9 million loans to one borrower which were 91 days past due at December 31, 2003, $1.05 million was still accruing due to an anticipated sale of the collateral and payoff of the loan in January 2004. This anticipated sale has been delayed and although the sale is still expected, subsequent to December 31, 2003, the $1.05 million has been placed in nonaccrual status and approximately $39,000 in interest income was reversed. During the three months ended December 31, 2003 and 2002, gross interest income of approximately $88,000 and $49,000, respectively, would have been recorded on loans accounted for on a nonaccrual basis if the loans had been current throughout the respective periods. Interest on such loans included in income during such respective periods was not material. Page 11 AVERAGE BALANCES, INTEREST AND AVERAGE YIELDS AND RATES The following table sets forth information regarding the Company's average interest-earning assets and interest-bearing liabilities and reflects the average yield of interest-earning assets and the average cost of interest-bearing liabilities for the periods indicated. Average balances are derived from daily balances. The table also presents information for the periods indicated with respect to the difference between the weighted average yield earned on interest-earning assets and the weighted average rate paid on interest-bearing liabilities, or "interest rate spread," which savings institutions have traditionally used as an indicator of profitability. Another indicator of an institution's net interest income is its "net yield on interest-earning assets," which is its net interest income divided by the average balance of interest-earning assets. Net interest income is affected by the interest rate spread and by the relative amounts of interest-earning assets and interest-bearing liabilities. The yield on nontaxable securities has not been adjusted to a tax equivalent basis. The yield on available for sale securities is based on amortized cost. Loans on a nonaccrual basis are included in the computation of the average balance of loans receivable. Loan fees deferred and accreted into income are included in interest earned. Whenever interest-earning assets equal or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income.

Page 12

RATE/VOLUME ANALYSIS The following table analyzes dollar amounts of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. The table distinguishes between (i) changes attributable to volume (changes in volume multiplied by the prior period's rate) and (ii) changes attributable to rate (changes in rate multiplied by the prior period's volume). Page 13

COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 2003 AND JUNE 30, 2003 The Company had consolidated total assets of $232.5 million and $251.0 million at December 31, 2003, and June 30, 2003, respectively. During the six month period ended December 31, 2003, the Company experienced an $8.1 million decrease in its consolidated loan portfolio from $100.8 million at June 30, 2003, to $92.7 million at December 31, 2003. The Bank expects its total loan portfolio to continue to shrink if interest rates remain low and competition for quality loans remains high. During this same period, interest-bearing deposits in banks, investments, and mortgage-backed securities decreased from $134.2 million at June 30, 2003, to $125.1 million at December 31, 2003. While interest-bearing deposits in banks, investments, and mortgage-backed securities decreased $9.1 million for the six month period ended December 31, 2003, there were $21.8 million in purchases, offset with a $1.6 million decrease in interest-bearing deposits with banks, paydowns and net amortizations of premiums and discounts of $24.5 million, sales of $3.4 million, and a $1.4 million decrease in the market value of the securities. The Bank continues to purchase securities to replace both loan prepayments and securities prepayments. The Bank's emphasis in purchasing securities has been mortgage-backed securities with short average lives and very little extension risk if interest rates rise significantly. To provide some liquidity if interest rates rise significantly, the Bank has purchased $4.6 million in noncallable agency securities in a six month ladder formation yielding 2.78% with a weighted average maturity of 3 years. Deposits decreased from $152.0 million at June 30, 2003, to $139.8 million at December 31, 2003. Although the Bank's level of deposits has generally been sufficient to provide for adequate liquidity, the deposit market remains competitive and the Bank has lost some larger certificates of deposit due to rate shopping. The outstanding balances of FHLB borrowings decreased from $69.1 million at June 30, 2003, to $63.0 million at December 31, 2003. The Bank continues to pay off FHLB borrowings as they mature, however, during the quarter, the Bank did borrow and pay back $1.0 million in short term borrowings for short term cash needs. Stockholders' equity amounted to $27.7 million at December 31, 2003, and $28.5 million at June 30, 2003. The changes in equity were primarily due to a decrease in accumulated other comprehensive income offset by net income for the period. At December 31, 2003, the Bank's regulatory capital exceeded all applicable regulatory capital requirements. Page 14 COMPARISON OF RESULTS OF OPERATIONS FOR THE THREE AND SIX MONTHS ENDED DECEMBER 31, 2003 AND 2002 Net Income. Net income for the three months ended December 31, 2003, was approximately $215,000 compared to net income of $186,000 for the three months ended December 31, 2002. The changes resulted primarily from a decrease in net interest income of $164,000, a decrease in the income tax benefit of $66,000, offset by an increase in noninterest income of $26,000, a decrease in the provision for loan loss of $83,000, and a decrease in noninterest expense of $150,000. The specific reasons for the above changes are discussed below. Net income for the six months ended December 31, 2003, was approximately $337,000 compared to net income of $911,000 for the six months ended December 31, 2002. The changes resulted primarily from a decrease in net interest income of $476,000, a decrease in noninterest income of $669,000, offset by a decrease in the provision for loan loss of $53,000, an increase in the income tax benefit of $262,000, and a decrease in noninterest expense of $256,000. The specific reasons for the above changes and are discussed below. Interest Income. Interest income for the three months ended December 31, 2003, was approximately $3,072,000, or $642,000 less than interest income for the three months ended December 31, 2002. The total average interest-earning assets decreased $17.9 million, while the yield decreased from 6.13% to 5.47%. The primary contributing factors to the decrease in interest income were a $329,000 and $136,000 decrease due to volume and rate decreases, respectively in loans, a $196,000 decrease due to rate decreases on taxable investments and mortgage-backed securities, offset slightly by a $55,000 increase due to the volume of taxable investments and mortgage-backed securities. For the three months ended December 31, 2003, compared to the three months ended December 31, 2002, the average balance of loans receivable decreased $17.5 million, total loan interest income decreased $465,000 and the average yield on loans decreased 58 basis points. For the same comparative periods, the average balance of taxable investments and mortgage-backed securities receivable increased $4.2 million, while interest income decreased $141,000 and the average yield decreased 80 basis points. The average balance of nontaxable investments decreased $0.3 million, while interest income decreased $6,000 and the average yield decreased 2 basis points. Further, the average balance of other interest-earning assets (primarily FHLB DDA's and FHLB stock) decreased $4.3 million, interest income decreased $30,000 and the average yield decreased 55 basis points. Interest income for the six months ended December 31, 2003, was approximately $6,257,000, or $1,428,000 less than interest income for the six months ended December 31, 2002. The total average interest-earning assets decreased $15.8 million, while the yield decreased from 6.29% to 5.47%. Of the $1,428,000 decrease in interest income, $643,000 and $282,000 was due to volume and rate decreases, respectively in loans, $592,000 was due to rate decreases on taxable investment and mortgage-backed securities, $10,000 was due to volume decreases on nontaxable investments, $11,000 and $17,000 was due to volume and rate decreases, respectively on FHLB stock, $37,000 and $13,000 was due to volume and rate decreases, respectively on FHLB DDA, offset by a $180,000 increase in the volume of taxable investments and mortgage-backed securities. For the six months ended December 31, 2003, compared to the six months ended December 31, 2002, the average balance of loans receivable decreased $16.7 million, total loan interest income decreased $925,000 and the average yield on loans decreased 58 basis points. For the same comparative periods, the average balance of taxable investments and mortgage-backed securities receivable increased $6.5 million, while interest income decreased $412,000 and the average yield decreased 120 basis points. The average balance of nontaxable investments decreased $0.4 million, while interest income decreased $13,000 and the average yield decreased 3 basis points. Further, the average balance of other interest-earning assets (primarily FHLB DDA's and FHLB stock) decreased $5.3 million, interest income decreased $78,000 and the average yield decreased 59 basis points. The above described declines in interest income and average yields can be expected to continue as long as interest rates remain low and loans continue to decline. When the Bank is able to grow its loan portfolio instead of increasing its investment in lower yielding investment and mortgage-backed securities the Bank should experience an increase in both its interest income and yield on earning assets. Page 15 Interest Expense. For the three months ended December 31, 2003, compared to the three months ended December 31, 2002, the average balance of interest-bearing liabilities decreased $20.9 million, total interest expense decreased $478,000 and the average cost decreased 55 basis points. The average balance of NOW, MMDA, and statement savings accounts increased $5.8 million, interest expense increased $7,000 and the average cost decreased 11 basis points. The average balance of time deposits decreased $14.2 million, interest expense decreased $300,000 and the average cost decreased 85 basis points. The average balance of FHLB advances decreased $12.5 million, FHLB interest expense decreased $185,000 and the average cost increased 1 basis point. Of the $478,000 decrease in interest expense, $13,000 was due to rate decreases in NOW, MMDA and statement savings accounts offset by a $20,000 increase due to higher volumes of same, $116,000 and $184,000 was due to volume and rate decreases in time deposits, respectively, and $186,000 was due to volume decreases on FHLB advances offset by a $1,000 increase due to average rate increases on FHLB advances. For the six months ended December 31, 2003, compared to the six months ended December 31, 2002, the average balance of interest-bearing liabilities decreased $19.1 million, total interest expense decreased $952,000 and the average cost decreased 56 basis points. The average balance of NOW, MMDA, and statement savings accounts increased $5.9 million, interest expense remained the same and the average cost decreased 18 basis points. The average balance of time deposits decreased $12.5 million, interest expense decreased $584,000 and the average cost decreased 83 basis points. The average balance of FHLB advances decreased $12.4 million, FHLB interest expense decreased $368,000 and the average cost increased 1 basis point. Of the $952,000 decrease in interest expense, $212,000 and $372,000 was due to volume and rate decreases in time deposits, respectively, and $371,000 was due to volume decreases on FHLB advances offset by a $3,000 increase due to average rate increases on FHLB advances. The increase in volume of NOW, MMDA, and statement savings accounts was offset by the decrease in rate. Net Interest Income. Net interest income for the three months ended December 31, 2003, was $1.4 million, or $164,000 less than net interest income for the three months ended December 31, 2002. Of the $164,000 decrease in net interest income for the three months ended December 31, 2003, compared to the three months ended December 31, 2002, $149,000 was due to decreases in net rates. Although historically the Company has been liability sensitive, due to the extended length of time that interest rates have remained low, in recent months more of the Company's earning assets are repricing than its costing liabilities resulting in a reduction in its net interest spread. Specifically, due to high prepayments on the Company's loan portfolio, taxable investments and mortgage-backed securities portfolio, these funds are reinvested at significantly lower rates. While the Company's deposits continue to cost less as renewing deposits are booked at lower current market offering rates, as of December 31, 2003, the Company had $63.0 million in FHLB advances which represented 32.6% of costing liabilities at that date. All of the Company's FHLB advances carry prepayment penalties. These advances generally are longer term and carry rates of interest that are higher than the interest rates on the Company's deposits. While the Company initially utilized FHLB advances to fund loans and purchase investment securities, thereby leveraging its equity and producing a positive interest rate spread, a significant portion of those assets have since repriced or paid off as interest rates have decreased. The Company anticipated replacing maturing investment securities with loan growth and maturing FHLB advances with deposit growth. The anticipated loan growth has not occurred. As of December 31, 2003, the Company's FHLB advances were costing a weighted average rate of 5.99% and had a weighted average maturity of approximately 6 years. As a result, the higher interest rates on FHLB advances paid by the Company contribute to a lower interest rate spread than the Company might otherwise have if it were able to fund all its assets with deposits or lower rate borrowings. Moreover, interest rates on FHLB advances are fixed for longer periods of time than are the interest rates on deposits. As a result, in the event of a decrease in interest rates, the Company will be unable to reprice its FHLB advances without incurring a substantial prepayment penalty, which would result in a significant charge to income or a further reduction in the Company's interest rate spread. Conversely, in the event of increases in interest rates, the FHLB advances will not reprice and the prepayment penalty decreases eventually to zero. Page 16 Provision for Loan Losses. During the three months ended December 31, 2003, the Bank's management continued its review of the appropriateness of the amount of the allowance for loan losses. Based on these reviews, management made a total of $120,000 in provision for loan losses for the three months ended December 31, 2003. The allowance for loan losses of $1.6 million at December 31, 2003, represented 1.61% of gross outstanding loans which compares to 1.46% as of June 30, 2003. The provision was made in consideration of reviews of individual loans and the fact that nonperforming loans as of December 31, 2003, as a percent of total loans increased to 5.14% from 3.18% as of June 30, 2003. In addition, total classified assets as a percent of the Bank's tangible capital plus allowance for loan loss was 34.8% as of December 31, 2003, which compares to 39.8% as of June 30, 2003. As of December 31, 2003, the Bank had $8.8 million in assets classified substandard or doubtful as compared to $9.8 million as of June 30, 2003. Although total nonperforming loans increased from $3.5 million as of June 30, 2003, to $5.1 million as of December 31, 2003, total classified assets decreased $1.0 million. This was primarily due to the loans which caused the increase in nonperforming loans being classified substandard in both periods. Management evaluates the carrying value of the loan portfolio periodically and provisions are made, if necessary. While management uses the best information available to make evaluations, future provisions to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize changes to the allowance based upon their judgments and the information available to them at the time of their examination. There were no significant changes in loan terms during the period, nor were there significant changes in the estimation methodologies employed or assumptions utilized. Nonperforming loan and loss trends did not indicate a need to change loss experience factors during the period. Noninterest Income. Noninterest income is typically comprised primarily of gains on the sales of loans and service charges on deposit accounts. Noninterest income for the three months ended December 31, 2003, was approximately $430,000 compared to approximately $403,000 for the three months ended December 31, 2002. This increase of approximately $27,000 is the result of an $8,000 increase in service charges on deposit accounts, a $9,000 net gain on the sale of investment securities, a $93,000 increase in other noninterest income (consisting of a $30,000 one time recovery of expensed software costs and a one time loan prepayment fee of $63,000), offset by a $84,000 decrease in net gains on the sale of loans available for sale. Noninterest income for the six months ended December 31, 2003, was approximately $862,000 compared to approximately $1,531,000 for the six months ended December 31, 2002. This decrease of approximately $669,000 is the result of a gain on the sale of its Monticello branch of approximately $743,000 for the six months ended December 31, 2002, offset by a $9,000 net gain on the sale of investment securities and $66,000 increase in other noninterest income for the six months ended December 31, 2003 (consisting primarily of a $30,000 one time recovery of expensed software costs, a one time loan prepayment fee of $63,000 offset by a $33,000 decrease in late charge and credit life commissions). Noninterest Expense. The major components of noninterest expense are typically salaries and employee benefits paid to or on behalf of the Company's employees and directors, professional fees paid to consultants, attorneys, and accountants, occupancy expense for ownership and maintenance of the Company's buildings, furniture and equipment and data processing expenses. Total noninterest expense for the three months ended December 31, 2003, decreased $150,000 compared to the three months ended December 31, 2002. Significant components of the decrease in noninterest expense were a $91,000 decrease in salaries and employee benefits, a $29,000 decrease in net occupancy expense, a $23,000 decrease in advertising, a $40,000 decrease in other expenses, offset by a $22,000 increase in professional fees and a $17,000 increase in data processing expense. Total noninterest expense for the six months ended December 31, 2003, decreased $256,000 compared to the six months ended December 31, 2002. Significant components of the decrease in noninterest expense were a $165,000 decrease in salaries and employee benefits, a $50,000 decrease in net occupancy expense, a $51,000 decrease in advertising, a $97,000 decrease in other expenses, offset by an $86,000 increase in professional fees and a $26,000 increase in data processing expense. Page 17 The $86,000 increase in professional fees relates primarily to consulting and legal fees associated with the Company's decision to review all available alternatives to maximize shareholder value with the help of a consulting firm. Income Taxes. The effective income tax rates for the Company for the three months ended December 31, 2003 and 2002 were (0.2)% and (56.0)%, respectively. The effective income tax rates for the Company for the six months ended December 31, 2003 and 2002 were (20.9)% and 18.3%, respectively. The variance in the effective rate from the expected statutory rate is due primarily to tax exempt interest. The negative rates for three months ended December 31, 2003 and December 31, 2002, and the six months ended December 31, 2003, is a net tax benefit and increases net income. The net tax benefit is primarily due to tax exempt income. The corresponding deferred tax asset totals approximately $2.0 million as of December 31, 2003, and June 30, 2003. The recoverability of this asset is entirely contingent upon the production of taxable income for income tax reporting purposes. Management anticipates that the Company will produce such income in the near future based on management's current forecasts of earnings. SOURCES OF CAPITAL AND LIQUIDITY The Company has no business other than that of the Bank and banking related activities. Bancshares' primary sources of liquidity are cash, dividends paid by the Bank and earnings on investments and loans. In addition, the Bank is subject to regulatory limitations with respect to the payment of dividends to Bancshares. The Bank has historically maintained substantial levels of capital. The assessment of capital adequacy is dependent on several factors including asset quality, earnings trends, liquidity and economic conditions. Maintenance of adequate capital levels is integral to provide stability to the Bank. The Bank needs to maintain substantial levels of regulatory capital to give it maximum flexibility in the changing regulatory environment and to respond to changes in the market and economic conditions. The Bank's primary sources of funds are savings deposits, borrowed funds, proceeds from principal and interest payments on loans and mortgage-backed securities, interest payments and maturities of investment securities and earnings. While scheduled principal repayments on loans and mortgage-backed securities and interest payments on investment securities are a relatively predictable source of funds, deposit flows and loan and mortgage-backed securities prepayments are greatly influenced by general interest rates, economic conditions, competition and other factors. At December 31, 2003 and June 30, 2003, the Company had designated all securities as available for sale. In addition to internal sources of funding, the Bank as a member of the FHLB has substantial borrowing authority with the FHLB. The Bank's use of a particular source of funds is based on need, comparative total costs and availability. At December 31, 2003, the Bank had $4.2 million in commitments to originate loans (including unfunded portions of construction loans) and approximately $1.2 million in unused lines of credit. At the same date, the total amount of certificates of deposit which were scheduled to mature in one year or less was $65.6 million. Management anticipates that the Bank will have adequate resources to meet its current commitments through internal funding sources described above. Management is not aware of any current recommendations by its regulatory authorities, legislation, competition, trends in interest rate sensitivity, new accounting guidance or other material events and uncertainties that would have a material effect on the Bank's ability to meet its liquidity demands. IMPACT OF INFLATION AND CHANGING PRICES The financial statements and related financial data presented herein have been prepared in accordance with instructions to Form 10-Q which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in relative purchasing power over time due to inflation. Unlike most industrial companies, virtually all of the Bank's assets and liabilities are monetary in nature. As a result, changes in interest rates generally have a more significant impact on a financial institution's performance than do changes in the rate of inflation. Page 18 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK For a discussion of the Company's asset and liability management policies as well as the potential impact of interest rate changes upon the market value of the Bank's portfolio equity, see "MARKET RISK" in the Company's Annual Report on Form 10-K for the year ended June 30, 2003. There has been no material change in the Company's asset and liability position since June 30, 2003. ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by this report, management of the Company carried out an evaluation, under the supervision and with the participation of the Company's principal executive officer and principal financial officer, of the effectiveness of the Company's disclosure controls and procedures. Based on this evaluation, the Company's principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission's rules and forms. In addition, there have been no changes in the Company's internal control over financial reporting (to the extent that elements of internal control over financial reporting are subsumed within disclosure controls and procedures) identified in connection with the evaluation described in the above paragraph that occurred during the Company's last fiscal quarter, that has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. PART II. OTHER INFORMATION ----------------- Item 1. Legal Proceedings In the ordinary course of business, the Company has various outstanding commitments and contingent liabilities that are not reflected in the accompanying consolidated financial statements. In addition, the Company may be a defendant in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated financial statements of the Company. Item 2. Changes in Securities and Use of Proceeds None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K Exhibits: 31.1 Rule 13a-14(a) Certification of Chief Executive Officer 31.2 Rule 13a-14(a) Certification of Chief Financial Officer 32 18 USC Section 1350 Certification Page 19 REPORTS ON FORM 8-K: On November 5, 2003, the Registrant filed a Current Report on Form 8-K under items 7 and 12 to report that the Company had issued a press release announcing its unaudited financial results for the quarter ended September 30, 2003. On December 15, 2003, the Registrant filed a Current Report on Form 8-K under items 5 and 7 to report that the Company had issued a press release announcing that it had received an indication of interest letter from an investor group to engage in a business combination with the Company whereby the Company's stockholders would receive $18.63 per share in cash. The proposed business combination would be subject to, among other things, the negotiation of a definitive merger agreement, regulatory approval and the approval of the Company's stockholders. Page 20 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. HCB BANCSHARES, INC. Registrant Date: February 10, 2003 By: /s/Charles T. Black ------------------------ Charles T. Black President and Chief Executive Officer (Duly Authorized Representative) Date: February 10, 2003 By: /s/Scott A. Swain ------------------------ Scott A. Swain Senior Vice President and Chief Financial Officer (Principal Financial Officer) Page 21

HCB BANCSHARES INC 10-Q