UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended: September 30, 2002

Commission file number: 33-42286

HENDERSON CITIZENS BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Texas		6712		75-2371232
(State or other jurisdiction of incorporation or organization)		(Primary Standard Industrial Classification Code Number)		(IRS Employer Identification No.)

201 West Main Street, P.O. Box 1009

Henderson, Texas 75653-1009

(903) 657-8521

(Address, including ZIP code, and telephone number, including

area code, of registrant’s principal executive offices)

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.

Yes x No ¨

At October 31, 2002, 1,994,218 shares of Common Stock, $5.00 par value, were outstanding.

HENDERSON CITIZENS BANCSHARES, INC.

QUARTER ENDED SEPTEMBER 30, 2002

Table of Contents

		Page
PART I—FINANCIAL INFORMATION

ITEM 1—Financial Statements

Consolidated Balance Sheets		3

Consolidated Statements of Income		4

Consolidated Statements of Changes in Stockholders’ Equity		5

Condensed Consolidated Statements of Cash Flows		6

Notes to Consolidated Financial Statements		7

ITEM 2—Management’s Discussion and Analysis of Financial Condition and Results of Operations		13

ITEM 3—Quantitative and Qualitative Disclosure About Market Risk		18

ITEM 4—Controls and Procedures		19

PART II—OTHER INFORMATION		20

SIGNATURES		21

CERTIFICATIONS		22

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

HENDERSON CITIZENS BANCSHARES, INC.

Consolidated Balance Sheets—unaudited

(dollars in thousands, except share and per share amounts)

	September 30, 2002			December 31, 2001
Assets
Cash and due from banks	$	14,536		14,390
Interest-bearing deposits with financial institutions		1,317		4,659
Federal funds sold		12,170		16,860

Total cash and cash equivalents		28,023		35,909

Interest-bearing time deposits		695		7,287
Securities available for sale, at fair value		166,061		185,410
Securities held to maturity, estimated fair value of $98,171 in 2002 and $57,171 in 2001		94,940		57,170

Loans, net		224,589		212,665
Premises and equipment, net		11,199		11,302
Accrued interest receivable		3,496		4,157
Goodwill		5,876		5,876
Intangible assets		5,020		4,201
Other assets		5,324		2,208

	$	545,223		526,185

Liabilities and Stockholders’ Equity
Deposits:
Demand—non interest-bearing	$	73,887		70,527
Interest-bearing transaction accounts		82,758		87,781
Money market and savings		81,071		94,844
Certificates of deposit and other time deposits		250,867		220,578

Total deposits		488,583		473,730

Accrued interest payable		1,113		1,394
Other borrowings		3,029		4,098
Other liabilities		5,159		3,029

		497,884		482,251
Stockholders’ equity:
Preferred stock, $5 par value; 2,000,000 shares authorized, none issued or outstanding		—		—
Common stock, $5 par value; 10,000,000 shares authorized, 2,160,000 issued		10,800		10,800
Surplus		5,400		5,400
Retained earnings		32,771		29,243
Accumulated other comprehensive income		785		903
Treasury stock, 165,782 shares in 2002 and 165,582 shares in 2001, at cost		(2,417	)	(2,412	)

Total stockholders’ equity		47,339		43,934

	$	545,223		526,185

See accompanying notes to consolidated financial statements.

HENDERSON CITIZENS BANCSHARES, INC.

Consolidated Statements of Income—unaudited

(dollars in thousands, except share and per share amounts)

	Three months ended September 30,			Nine months ended September 30,
	2002		2001	2002	2001
Interest income:
Loans, including fees	$	4,016	4,277	11,956	11,478
Securities:
Taxable—available for sale		1,697	2,277	5,534	6,927
Taxable—held to maturity		604	125	1,762	376
Tax-exempt—held to maturity		490	496	1,459	1,476
Federal funds sold		70	155	253	640
Interest-bearing deposits with financial institutions		28	318	160	699

Total interest income		6,905	7,648	21,124	21,596

Interest expense:
Deposits:
Transaction accounts		222	318	730	1,034
Money market and savings		232	544	922	1,515
Certificates of deposit and other time deposits		2,251	3,021	6,806	9,088
Other borrowed funds		16	10	45	30

Total interest expense		2,721	3,893	8,503	11,667


Net interest income		4,184	3,755	12,621	9,929

Provision for loan losses		250	159	740	389

Net interest income after provision for loan losses		3,934	3,596	11,881	9,540


Noninterest income:
Service charges, commissions, and fees		1,657	1,287	4,649	3,439
Income from fiduciary activities		369	328	1,106	985
Net realized gains on securities transactions		31	52	1,065	65
Other		302	318	838	783

Total noninterest income		2,359	1,985	7,658	5,272

Noninterest expenses:
Salaries and employee benefits		2,885	2,444	8,246	6,566
Occupancy and equipment		674	607	1,855	1,574
Other		1,407	1,002	3,539	2,746

Total other expenses		4,966	4,053	13,640	10,886

Income before income tax expense		1,327	1,528	5,899	3,926
Income tax expense		250	228	1,354	598

Net income	$	1,077	1,300	4,545	3,328


Basic earnings per common share	$	0.54	0.65	2.28	1.67


Weighted average number of shares outstanding		1,994,218	1,995,016	1,994,243	1,995,149

See accompanying notes to consolidated financial statements.

HENDERSON CITIZENS BANCSHARES, INC.

Consolidated Statements of Changes in Stockholders’ Equity—unaudited

Nine months ended September 30, 2002 and 2001

(dollars in thousands, except share and per share amounts)

	Preferred Stock		Common Stock	Surplus	Retained Earnings		Accumulated Other Comprehensive Income (Loss)		Treasury Stock		Total
Balances at January 1, 2001	$	—	10,800	5,400	25,894		(575	)	(2,397	)	39,122
Comprehensive income:
Net Income		—	—	—	3,328		—		—		3,328
Other comprehensive income:
Unrealized gain (loss) on available-for-sale securities arising during the period		—	—	—	—		2,870		—		2,870
Reclassification adjustment for net realized (gains) losses on available-for- sale securities included in net income		—	—	—	—		(65	)	—		(65	)

Net unrealized gain		—	—	—	—		2,805		—		2,805
Tax effect of other comprehensive income		—	—	—	—		(954	)	—		(954	)

Total other comprehensive income		—	—	—	—		1,851		—		1,851

Total comprehensive income		—	—	—	—		—		—		5,179
Purchase of 400 shares of treasury stock		—	—	—	—		—		(8	)	(8	)
Cash dividends declared ($.34 per share)		—	—	—	(680	)	—		—		(680	)

Balances at September 30, 2001		—	10,800	5,400	28,542		1,276		(2,405	)	43,613

Balances at January 1, 2002	$	—	10,800	5,400	29,243		903		(2,412	)	43,934
Comprehensive income:
Net Income		—	—	—	4,545		—		—		4,545
Other comprehensive income:
Unrealized gain (loss) on available-for-sale securities arising during the period		—	—	—	—		886		—		886
Reclassification adjustment for net realized (gains) losses on available-for- sale securities included in net income		—	—	—	—		(1,065	)	—		(1,065	)

Net unrealized loss		—	—	—	—		(179	)	—		(179	)
Tax effect of other comprehensive income		—	—	—	—		61		—		61

Total other comprehensive income		—	—	—	—		(118	)	—		(118	)

Total comprehensive income		—	—	—	—		—		—		4,427
Purchase of 200 shares of treasury stock		—	—	—	—		—		(5	)	(5	)
Cash dividends declared ($.51 per share)		—	—	—	(1,017	)	—		—		(1,017	)

Balances at September 30, 2002	$	—	10,800	5,400	32,771		785		(2,417	)	47,339

See accompanying notes to consolidated financial statements.

HENDERSON CITIZENS BANCSHARES, INC.

Condensed Consolidated Statements of Cash Flows—unaudited

Nine months ended September 30, 2002 and 2001

(dollars in thousands)

	2002			2001
Net cash provided by operating activities	$	5,529		10,033

Investing activities:
Interest-bearing time deposits:
Purchases		(100	)	(5,806	)
Maturities		6,692		1,589
Securities available for sale:
Sales		59,162		12,680
Purchases		(82,555	)	(77,547	)
Maturities and repayments		43,044		54,371
Securities held to maturity:
Purchases		(49,105	)	(231	)
Maturities and repayments		11,141		2,754
Net change in loans		(12,613	)	(11,810	)
Proceeds from sale of premises and equipment and other real estate		135		59
Purchases of bank premises, equipment and software		(733	)	(1,537	)
Net cash received from business combinations and acquisitions of branch facilities		12,994		9,653

Net cash from investing activities		(11,938	)	(15,825	)


Financing activities:
Net change in deposits		614		35,603
Net change in short-term borrowings		(1,069	)	983
Cash dividends paid		(1,017	)	(680	)
Purchase of treasury stock		(5	)	(8	)

Net cash from financing activities		(1,477	)	35,898


Change in cash and cash equivalents		(7,886	)	30,106
Cash and cash equivalents at beginning of period		35,909		25,993


Cash and cash equivalents at end of period	$	28,023		56,099


SUPPLEMENTAL DISCLOSURES OF CASH FLOW ACTIVITIES
Income taxes paid, net of refunds	$	1,223		936


Interest paid	$	8,784		11,710

See accompanying notes to consolidated financial statements.

HENDERSON CITIZENS BANCSHARES, INC.

Notes to Consolidated Financial Statements—unaudited

September 30, 2002

(1) Basis of Presentation

The accompanying consolidated financial statements are unaudited, but include all adjustments, consisting of normal recurring accruals, which management considers necessary for a fair presentation of the financial position, results of operations, and cash flows.

The accompanying consolidated financial statements have been prepared in accordance with the instructions to Form 10-Q as prescribed by the Securities and Exchange Commission (SEC) and, therefore, do not purport to contain all the necessary financial disclosures required by accounting principles generally accepted in the United States of America that might otherwise be necessary in the circumstances, and should be read in conjunction with our consolidated financial statements, and notes thereto, for the year ended December 31, 2001, included in the Company’s annual report on Form 10-K filed with the SEC on March 29, 2002 (the “2001 Form 10-K”). Refer to the Company’s accounting policies described in the notes to the consolidated financial statements contained in the 2001 Form 10-K which were consistently followed in preparing this Form 10-Q. Operating results for the three and nine months ended September 30, 2002 are not necessarily indicative of the results for the year ending December 31, 2002 or any future period.

The preparation of these interim financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. The allowance for loan losses, fair values of financial instruments and repossessed assets and the status of contingencies are particularly subject to change.

The accompanying consolidated financial statements of the Company include the accounts of Henderson Citizens Delaware Bancshares, Inc., a Delaware corporation, and its wholly owned subsidiary, Citizens National Bank. The financial statements of Citizens National Bank are consolidated with its wholly owned subsidiaries, HCB Insurance Agency, Inc. and Community Development Corporation (“CDC”). All significant intercompany balances and transactions have been eliminated in consolidation.

The Company is principally engaged in traditional community banking activities provided through its fourteen full service branches and its trust office located in east Texas. Community banking activities include the Company’s commercial and retail lending, deposit gathering and investment and liquidity management activities. The Company also operates an insurance agency.

Certain amounts in the prior financial statements have been reclassified to conform to the current presentation.

(2) Recent Accounting Pronouncements

On January 1, 2002, the Company adopted new accounting policies related to goodwill, intangibles and other long-lived assets in accordance with several recently issued accounting pronouncements. Our new accounting policies are discussed below:

Goodwill: On January 1, 2002, the Company stopped amortizing goodwill and adopted a new policy for measuring goodwill for impairment. The Company has completed its initial impairment test and no impairment of goodwill was recognized in connection with the adoption of this new policy. Under the new policy goodwill is assigned to reporting units. We currently operate as a single reporting unit and all of our goodwill is associated with the entire company. Goodwill is tested for impairment at least annually or on an interim basis if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of the reporting unit below its carrying value. Goodwill is tested for impairment using a two-step approach. The first step is to compare the fair value of the reporting unit to its carrying amount, including goodwill. If the fair value of the reporting unit is greater than its carrying amount, the second step of the impairment test measures the amount of the impairment loss, if any. The second step of the impairment test is to compare the implied fair value of goodwill to its carrying amount. If the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recognized equal to that excess. The implied fair value of goodwill is calculated in the same manner that goodwill is calculated in a business combination, whereby the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price. The excess “purchase price” over the amounts assigned to assets and liabilities would be the implied fair value of goodwill.

HENDERSON CITIZENS BANCSHARES, INC.

Notes to Consolidated Financial Statements

September 30, 2002

The following information for the three and nine months ended September 30, 2001 presents net income and earnings per share adjusted to exclude goodwill amortization expense recognized during those periods.

	Three Months Ended September 30, 2001		Nine Months Ended September 30, 2001
Reported net income	$	1,300	$	3,328
Add back goodwill amortization		65		195

Adjusted net income	$	1,365	$	3,523

Reported earnings per share	$	.65	$	1.67
Add back goodwill amortization		.03		.10

Adjusted earnings per share	$	.68	$	1.77

Intangible Assets and Other Long-Lived Assets: Intangible assets with definite useful lives are amortized on a straight-line basis over their estimated useful life. Intangible assets, premises and equipment and other long-lived assets are tested for impairment whenever events or changes in circumstances indicate the carrying amount of the assets may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.

Intangible assets include mortgage servicing rights, which represent the allocated value of retained servicing on loans sold, and core deposit intangibles recorded in connection with business combinations and branch acquisitions. Mortgage servicing rights totaled $425,000 at September 30, 2002 and $352,000 at December 31, 2001. Core deposit intangibles, totaled $4,595,000 at September 30, 2002 and $3,849,000 at December 31, 2001(net of accumulated amortization of $321,000 and $46,000).

Amortization expense related to core deposit intangibles totaled $173,000 and $341,000 during the three and nine months ended September 30, 2002. The estimated aggregate future amortization expense for core deposit intangibles remaining as of September 30, 2002 is as follows:

Remainder of 2002	$	186,000
2003		743,000
2004		743,000
2005		721,000
2006		716,000
Thereafter		1,486,000

Total	$	4,595,000

HENDERSON CITIZENS BANCSHARES, INC.

Notes to Consolidated Financial Statements

September 30, 2002

The following accounting standards were issued during the nine months ended September 30, 2002:

Statement of Financial Accounting Standards (SFAS) No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.”—SFAS 145 clarifies and simplifies existing accounting pronouncements related to gains and losses from debt extinguishments and certain lease modifications and eliminates certain transitional accounting standards that are no longer necessary. This statement also makes minor technical corrections to various other existing pronouncements. Certain provisions of this statement will become effective for the Company on January 1, 2003, while other provisions became effective for transactions occurring and financial statements issued after May 15, 2002. Adoption of the provisions of this statement that were effective after May 15, 2002 did not have a significant impact on the Company’s financial statements. Furthermore, adoption of the remaining provisions of this statement on January 1, 2003 is not expected to have a significant impact on the Company’s financial statements.

SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”—SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Such costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit of disposal activity. SFAS 146 replaces Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS 146 is required to be applied prospectively to exit or disposal activities initiated after December 31, 2002. Adoption of this statement on January 1, 2003 is not expected to have a significant impact on the Company’s financial statements.

SFAS No. 147, “Acquisitions of Certain Financial Institutions, an Amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9.” SFAS 147 removes acquisitions of financial institutions from the scope of both SFAS 72, “Accounting for Certain Acquisitions of Banking or Thrift Institutions,” and FASB Interpretation (FIN) No. 9, “Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a Similar Institution Is Acquired in a Business Combination Accounted for by the Purchase Method,” and requires such transactions be accounted for in accordance with SFAS 141, “Business Combinations,” and SFAS 142, “Goodwill and Other Intangible Assets.” In addition, SFAS 147 amends SFAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” to include in its scope long-term customer-relationship intangible assets of financial institutions such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets. The provisions of SFAS 147 became effective on October 1, 2002. Adoption of this statement did not have a significant impact on our financial statements.

(3) Business Combinations and Branch Acquisitions

On July 2, 2001, the Company acquired all of the outstanding shares of Rusk County Bancshares, Inc. Henderson, Texas, (“RCBI”) and its wholly owned indirect banking subsidiary, Peoples State Bank for a purchase price of $12,550,000 in cash. The results of operations of Peoples State Bank have been included in the Company’s consolidated income statement since that date. This transaction was accounted for using the purchase method of accounting. Of the $4,737,000 of goodwill and other intangible assets acquired, approximately $2,659,000 has been assigned to core deposit intangibles and is being amortized using the straight-line method over seven years. The residual of approximately $2,078,000 has been recorded as goodwill and is not being amortized, but is subject to annual impairment tests. The following is condensed pro-forma information for the acquisition of RCBI. Had this transaction occurred previously on January 1, 2001, net interest income for the nine months ended September 30, 2001 would have been $11,181,000, while net income for the same period would have been $3,559,000. Basic earnings per share for the nine months ended September 30, 2001 would have been $1.78.

On April 26, 2002, the Company completed the acquisition of two branch facilities in Corsicana, Texas from Cedar Creek Bank of Seven Points, Texas. The Company purchased these branch facilities for $1,068,000. In connection with the acquisition, the Company received $12,994,000 in cash and $155,000 in loans and assumed $14,239,000 in deposits. The Company also recognized core deposit and other intangibles of $1,087,000 which are being amortized using the straight-line method over a period of seven years.

HENDERSON CITIZENS BANCSHARES, INC.

Notes to Consolidated Financial Statements

September 30, 2002

(4) Securities

The amortized cost and estimated fair values of securities available for sale at September 30, 2002 and December 31, 2001, are summarized as follows (in thousands of dollars):

	September 30, 2002
	Amortized Cost		Gross Unrealized Gains	Gross Unrealized Losses		Estimated Fair Value
U.S. Government agencies	$	23,057	209	—		23,266
Mortgage-backed securities and collateralized mortgage obligations		141,818	1,204	(227	)	142,795

	$	164,875	1,413	(227	)	166,061


	December 31, 2001
	Amortized Cost		Gross Unrealized Gains	Gross Unrealized Losses		Estimated Fair Value
U.S. Treasury	$	8,002	301	—		8,303
U.S. Government agencies		57,483	779	(139	)	58,123
Mortgage-backed securities and collateralized mortgage obligations		118,555	742	(313	)	118,984

	$	184,040	1,822	(452	)	185,410

HENDERSON CITIZENS BANCSHARES, INC.

Notes to Consolidated Financial Statements

September 30, 2002

The amortized cost and estimated fair values of securities held to maturity at September 30, 2002 and December 31, 2001, are summarized as follows (in thousands of dollars):

	September 30 2002
	Amortized Cost		Gross Unrealized Gains	Gross Unrealized Losses		Estimated Fair Value
U.S. Government agencies	$	27,437	455	—		27,892
State and municipal		43,304	2,242	—		45,546
Mortgage-backed securities and collateralized mortgage obligations		22,162	502	—		22,664
Corporate		2,009	32	—		2,041
Other securities		28	—	—		28

	$	94,940	3,231	—		98,171


	December 31, 2001
	Amortized Cost		Gross Unrealized Gains	Gross Unrealized Losses		Estimated Fair Value
U.S. Government agencies	$	4,975	—	—		4,975
State and municipal		42,137	501	(611	)	42,027
Mortgage-backed securities and collateralized mortgage obligations		7,852	48	—		7,900
Corporate		2,025	67	—		2,092
Other securities		181	—	(4	)	177

	$	57,170	616	(615	)	57,171

HENDERSON CITIZENS BANCSHARES, INC.

Notes to Consolidated Financial Statements

September 30, 2002

(5) Loans and Allowance for Loan Losses

The composition of the Company’s loan portfolio is as follows (in thousands of dollars)

	September 30, 2002			December 31, 2001
Real estate mortgage	$	126,756		114,175
Commercial and industrial		64,837		62,619
Installment and other		36,416		39,093

Total		228,009		215,887

Less:
Allowance for loan losses		(3,416	)	(3,205	)
Unearned discount		(4	)	(17	)

Loans, net	$	224,589		212,665

Changes in the allowance for loan losses for the three months and nine months ended September 30, 2002 and 2001 are summarized as follows (in thousands of dollars):

	Three months ended September 30,					Nine months ended September 30,
	2002			2001		2002		2001
Balance, beginning of period	$	3,386		2,376		3,205		2,355
Provision charged to operating expense		250		159		740		389
Addition from acquisition		—		536		—		536

Charge offs:
Commercial, financial, and agriculture		(43	)	—		(111	)	(77	)
Real estate mortgage		(27	)	—		(27	)	(31	)
Installment loans to individuals		(236	)	(221	)	(582	)	(433	)

Recoveries:
Commercial, financial, and agriculture		5		—		17		6
Real estate mortgage		—		—		—		—
Installment loans to individuals		81		82		174		187


Balance, September 30	$	3,416		2,932		3,416		2,932

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITION

AND RESULTS OF OPERATIONS OF HENDERSON CITIZENS BANCSHARES, INC.

FOR THE NINE MONTHS AND THREE MONTHS ENDED SEPTEMBER 30, 2002 AND 2001

The following discussion and analysis of the consolidated financial condition and results of operations of the Company should be read in conjunction with the consolidated financial statements and the notes thereto, and other financial and statistical information appearing elsewhere in this report.

Forward-Looking Information

Statements and financial discussion and analysis by management contained throughout this Form 10-Q that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve a number of risks and uncertainties. Various factors could cause actual results to differ materially from the forward-looking statements, including, without limitation, changes in interest rates and economic conditions, increased competition for deposits and loans adversely affecting rates and terms, changes in availability of funds increasing costs or reducing liquidity, changes in applicable statutes and governmental regulations, and the loss of any member of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels.

Results of Operations

Net income for the first nine months of 2002 increased to $4,545,000, or $2.28 per share, compared to $3,328,000, or $1.67 per share for the same period in 2001. Net income for the three months ended September 30, 2002 decreased to $1,077,000, or $0.54 per share compared to $1,300,000, or $0.65 per share, for the same period in 2001. Details of the components of net income are discussed below.

Net Interest Income. Net interest income for the nine months ended September 30, 2002 was $12,621,000, an increase of $2,692,000 for the nine months when compared to the same period in 2001. Average interest-earning assets increased $80,753,000, while the net interest margin increased from 3.37% at September 30, 2001 to 3.70% at September 30, 2002. Total interest income decreased $472,000 during the nine months ended September 30, 2002. The decrease was a result of a decrease in the average yield on interest-bearing assets from 6.99% at September 30, 2001 to 5.98% at September 30, 2002. Even though volumes increased on average interest-bearing liabilities by $44,759,000, interest expense decreased by $3,164,000 during the nine months ended September 30, 2002. This decrease was attributable to a decrease in the average yield on interest-bearing liabilities from 4.30% at September 30, 2001to 2.72% at September 30, 2002.

Net interest income for the three-month period ended September 30, 2002 was $4,184,000 compared to $3,755,000 in 2001. Interest income was down $743,000 for the three months ended September 30, 2002, due largely to a significant decrease of 92 basis points in the average rates earned in the third quarter of 2002 compared to the same period in 2001. Interest expense decreased $1,172,000 due to a decline in average interest rates paid from 3.98% in the three months ended September 30, 2001, compared to 2.63% for the same period in 2002.

Provision for Loan Losses. The provision for loan losses was $740,000 for the first nine months of 2002 compared to $389,000 for the first nine months of 2001, and $250,000 for the three months ended September 30, 2002, compared to $159,000 in the same period in 2001. See “Management’s Discussion and Analysis of the Financial Condition and Results of Operations of the Company—Allowance for Loan Losses” for a more detailed discussion relative to the provision for loan losses.

Noninterest Income. Noninterest income, excluding securities gains/losses, was $6,593,000 for the first nine months of 2002 as compared to $5,207,000 in the first nine months of 2001. This increase is largely attributable to increases in service charges primarily due to the growth in fees collected for insufficient funds, which is largely attributable to the Peoples State Bank acquisition in July 2001 and the acquisition of four new branch facilities. Increases in trust fee income and increases in mortgage-servicing income realized from the sale of FHLMC loans also contributed to the rise in noninterest income. The Company experienced a net gain on securities transactions of $1,065,000 for the first nine months of 2002 compared to a net gain on securities transactions of $65,000 for the first six months of 2001. Given the level of interest rates on securities maturing in an 18-month period, the Company elected to capture most of the gain during the first quarter in anticipation of rising interest rates.

For the three months ended September 30, 2002, noninterest income, excluding securities gains was $2,328,000 compared to $1,933,000 for the same period in 2001. The increase was due primarily to increases in services charges, most notably due to the growth in fees collected for insufficient funds, which increased largely as a result of the acquisition of Peoples State Bank and four branch facilities. The Company experienced a net gain on securities of $31,000 for the three months ended September 30, 2002, compared to a net gain on securities of $52,000 during the same period in 2001.

Noninterest Expenses. Noninterest expenses for the nine-month period ended September 30, 2002, were $13,640,000 compared to $10,886,000 during the same period in 2001. The increase in other expenses is primarily due to the increase in salary and related benefits expense resulting from normal year-end salary increases in the current year combined with the additional expense of employees added in the acquisition of two branch facilities in October of 2001, and the acquisition of two branch facilities in April of 2002. Occupancy expenses continue to increase with the addition of new facilities and the remodeling of existing properties. Telephone expenses for the nine months ended September 30, 2002 were $323,000 compared to $216,000 for the same period in 2001. The reserve for contingent liabilities related to potential claims for the nine months ended September 30, 2002 was $355,000. There was no reserve for contingent liabilities for the nine months ended September 30, 2001. Noninterest expenses also increased due to the acquisition of new branches, which increased the amortization expense for other intangible assets and resulted in higher expenses overall as a result of the Company’s growth.

Noninterest expenses for the three-month period ended September 30, 2002, were $4,966,000 compared to $4,053,000 during the same period in 2001. The increase is a result of the same activities noted in the previous paragraph regarding the first nine months of 2002. The reserve for contingent liabilities related to potential claims for the three months ended September 30, 2002 was $255,000 compared to no reserve during the same period in 2001.

Income Taxes. Income tax expense for the first nine months of 2002 was $1,354,000, compared to $598,000 in the same period in 2001. The effective tax rates for the first nine months of 2002 and 2001 were 22.9% and 15.2%. Income tax expense for the three-month periods ended September 30, 2002 and September 30, 2001 was $250,000 and 228,000 respectively. The effective tax rates for the three-month periods ended September 30, 2002 and September 30, 2001 were 18.8% and 14.9%. The effective rates are less than the statutory rate of 34% primarily because of tax-free income provided from state and municipal bonds, leases and obligations.

Financial Condition

The Company’s total assets at September 30, 2002 of $545,223,000 increased from the total assets at December 31, 2001 of $526,185,000. The Company’s loan portfolio grew to $224,589,000 at September 30, 2002, up slightly from $212,665,000 at December 31, 2001. Total deposits were $488,583,000 at September 30, 2002, compared to the December 31, 2001 total of $473,730,000.

Deposits and Other Borrowings

Total deposits at September 30, 2002 increased from the December 31, 2001 balances by $14,853,000. This increase was due mostly to an increase in public funds combined with an increase in deposits resulting from the acquisition of two branch facilities in Corsicana, Texas, in the second quarter of 2002.

During July 2000, the Company changed from the Treasury Tax and Loan Daily Remittance Option to the Treasury Tax and Loan Note Option, which allows the Company to keep on deposit customer tax payments for short periods of time until withdrawn by the Treasury. At September 30, 2002, amounts payable under this note totaled $3,029,000 compared to $4,098,000 at December 31, 2001. The decrease was due to remittances made during the nine months ended September 30, 2002.

Liquidity

Liquidity is the ability of the Company to fund customers’ needs for borrowing and deposit withdrawals. The purpose of liquidity management is to assure sufficient cash flow to meet all of the financial commitments and to capitalize on opportunities for business expansion. This ability depends on the institution’s financial strength, asset quality and types of deposit and investment instruments offered by the Company to its customers. The Company’s principal sources of funds are deposits, loan and securities repayments, maturities of securities, sales of securities available for sale and other funds provided by operations. The Company also has various federal funds sources from correspondent banks. While scheduled loan repayments and maturing investments are relatively predictable, deposit flows and early loan and mortgage-backed security prepayments are more influenced by interest rates, general economic conditions and competition. The Company maintains investments in liquid assets based upon management’s assessment of (1) need for funds, (2) expected deposit flows, (3) yields available on short-term liquid assets and (4) objectives of the asset/liability management program.

Cash and cash equivalents decreased $7,886,000 from $35,909,000 at December 31, 2001 to $28,023,000 at September 30, 2002. Cash and cash equivalents represented 5.1% of total assets at September 30, 2002 compared to 6.8% of total assets at December 31, 2001. The Company has the ability to borrow federal funds from various correspondent banks should the Company need to supplement its future liquidity needs in order to meet deposit flows, loan demand or to fund investment opportunities. Management believes the Company’s liquidity position is sufficient to meet the Company’s needs for at least the next twelve months based on its level of cash and cash equivalents, core deposits, the stability of its other funding sources and the support provided by its capital base.

As summarized in the Consolidated Statements of Cash Flows, the most significant transactions that affected the Company’s level of cash and cash equivalents, cash flows and liquidity during the first nine months of 2002 were the securities purchases of $131,660,000, securities sales of $59,654,000 and securities maturities and repayments of $53,693,000.

Capital Resources

At September 30, 2002, stockholders’ equity totaled $47,339,000, or 8.7% of total assets, compared to $43,934,000, or 8.3% of total assets, at December 31, 2001.

The Company and its Bank subsidiary, Citizens National Bank, are subject to regulatory capital requirements administered by federal banking agencies. Bank regulators monitor capital adequacy very closely and consider it an important factor in ensuring the safety of depositors’ accounts. As a result, bank regulators have established standard risk based capital ratios that measure the amount of an institution’s capital in relation to the degree of risk contained in the balance sheet, as well as off-balance sheet exposure. Federal law requires each federal banking regulatory agency to take prompt corrective action to resolve problems of insured depository institutions including, but not limited to, those that fall below one or more prescribed capital ratios. According to the regulations, institutions whose Tier 1 and total capital ratios meet or exceed 6.0% and 10.0% of risk-weighted assets, respectively, are considered “well capitalized.” Tier 1 capital is shareholders’ equity excluding the unrealized gain or loss on securities classified as available for sale and intangible assets. Tier 2 capital, or total capital, includes Tier 1 capital plus the allowance for loan losses not to exceed 1.25% of risk weighted assets. Risk weighted assets are the Company’s total assets after such assets are assessed for risk and assigned a weighting factor based on their inherent risk. In addition to the risk-weighted ratios, all institutions are required to maintain Tier 1 leverage ratios of at least 5.0% to be considered “well capitalized” and 4.0% to be considered “adequately capitalized.” The leverage ratio is defined as Tier 1 capital divided by adjusted average assets for the most recent quarter.

The tables below set forth the Consolidated and Citizens National Bank only capital ratios as of September 30, 2002 and December 31, 2001.

	Consolidated		Bank Only
September 30, 2002
Tier 1 capital to risk-weighted assets ratio	14.4	%	14.2	%
Total capital to risk-weighted assets ratio	15.6		15.5
Leverage ratio	6.9		6.8

December 31, 2001
Tier 1 capital to risk-weighted assets ratio	13.9	%	13.7	%
Total capital to risk-weighted assets ratio	15.1		15.0
Leverage ratio	6.7		6.7

As of September 30, 2002 and December 31, 2001, Citizens National Bank met the level of capital required to be categorized as well capitalized under prompt corrective action regulations. Management is not aware of any conditions subsequent to September 30, 2002 and December 31, 2001 that would change the Company’s or the Bank’s capital categories.

Loans

The Company’s loan portfolio consists primarily of real estate, commercial and industrial, and consumer loans. Gross loans were $228,009,000 at September 30, 2002 compared to $215,887,000 at December 31, 2001.

As can be seen in the table in Note 5 in the accompanying Notes to Consolidated Financial Statements, an increase of approximately 3.5% in commercial and industrial loans, an increase of approximately 11.0% in real estate loans, and a decrease of 6.8% in installment loans occurred during the first nine months of 2002. The increase in real estate loans was due to an increase in 1-4 family residential loans and interim construction due mainly to customer repricing of residential loans,combined with an increase in non-residential real estate loans of approximately $3,000,000. The decrease in installment loans is due to an economic slow-down combined with the availability of zero percent financing by automobile makers.

Allowance for Loan Losses

The allowance for loan losses at September 30, 2002 and December 31, 2001 was 1.50% and 1.48% of gross loans, respectively. By its nature, the process through which management determines the appropriate level of the allowance requires considerable judgment. The determination of the necessary allowance, and correspondingly the provision for loan losses, involves assumptions about projections of national and local economic conditions, the composition of the loan portfolio, and prior loss experience, in addition to other considerations. As a result, no assurance can be given that future losses will not vary from the current estimates. However, the allowance at September 30, 2002 represents management’s best estimate of probable losses that have been incurred within the existing portfolio of loans. A migration analysis and an internal classification system for loans also help identify potential problems, if any, which are not identified otherwise. From these analyses, management determines which loans are potential candidates for nonaccrual status, including impaired loan status, or charge-off. Management continually reviews loans and classifies them consistent with the guidelines established by the Office of the Comptroller of Currency to help ensure that an adequate allowance is maintained.

The provision for loan losses is determined by management as the amount to be added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level, which is considered adequate to absorb losses inherent in the loan portfolio. The amount of the provision is based on management’s review of the loan portfolio, and the consideration of such factors as historical loss experience, general prevailing economic conditions, changes in the size and composition of the loan portfolio and specific borrower considerations, including the ability of the borrower to repay the loan and the estimated value of the underlying collateral.

The provision for loan losses for the three and nine months ended September 30, 2002 totaled $250,000 and $740,000 compared to $159,000 and $389,000 for the three and nine months ended September 30, 2001. Management anticipates it will continue its provisions to the allowance for loan losses at current levels for the near future, providing the volume of nonperforming loans remains insignificant, to compensate for overall loan growth, increased charge-offs, and general economic concerns.

Non Accrual, Past Due and Restructured Loans

The Company’s policy is to discontinue the accrual of interest income on loans whenever it is determined that reasonable doubt exists with respect to timely collectibility of interest and principal. Loans are placed on nonaccrual status if either material deterioration occurs in the financial position of the borrower, payment in full of interest or principal is not anticipated, payment in full of interest or principal is past due 90 days or more unless well secured, payment in full of interest or principal on a loan is past due 180 days or more, regardless of collateral, or the loan in whole or in part is classified as doubtful. A loan may remain on accrual status if it is in the process of collection and is either guaranteed or well secured. When a loan is placed on nonaccrual status, interest is no longer accrued or included in interest income and previously accrued income is reversed.

The following is a summary of the Company’s problem loans as of September 30, 2002 and December 31, 2001.

	September 30, 2002		December 31, 2001
	(dollars in thousands)
Nonaccrual loans	$	74	74
Restructured loans		—	—
Other impaired loans		85	475
Loans past due 90+ days and still accruing		105	18

Total non-performing loans	$	264	567

Other potential problem loans	$	—	—

Other non-performing assets, other real estate owned	$	104	90

Concentration of Credit Risk

The Company grants real estate, commercial, and industrial loans to customers primarily in Henderson, Texas, and surrounding areas of east Texas. Although the Company has a diversified loan portfolio, a substantial portion (approximately 55.6% at September 30, 2002) of its loans are secured by real estate and its ability to fully collect its loans is dependent upon the real estate market in this region. The Company typically requires collateral sufficient in value to cover the principal amount of the loan. Such collateral is evidenced by mortgages on property held and readily accessible to the Company. See additional information related to the composition of the Company’s loan portfolio included in Note 5 in the accompanying Notes to Consolidated Financial Statements.

Securities

The Investment Committee, under the guidance of the Company’s Investment Policy, assesses the short and long-term needs of the Company after consideration of loan demand, interest rate factors, and prevailing market conditions. Recommendations for purchases and other transactions are then made considering safety, liquidity, and maximization of return to the Company. Management determines the proper classification of securities at the time of purchase. Securities that management does not intend to hold to maturity or that might be sold under certain circumstances are classified as available for sale. If management has the intent and the Company has the ability at the time of purchase to hold the securities until maturity, the securities will be classified as held to maturity.

The management strategy for securities is to maintain a very high quality portfolio with generally short duration. The quality of the portfolio is maintained with 82% of the total as of September 30, 2002 comprised of U.S. Treasury, federal agency securities, and agency issued mortgage securities. The collateralized mortgage obligations (CMOs) and mortgage backed securities (MBS) held by the company are backed by agency collateral which consists of loans issued by the Federal Home Loan Mortgage Corporation (FHLMC), Federal National Mortgage Corporation (FNMA), and the Government National Mortgage Association (GNMA) with a blend of fixed and floating rate coupons.

Credit risk is minimized through agency backing, however, there are other risks associated with MBS and CMOs. These other risks include prepayment, extension, and interest rate risk. MBS are securities that represent an undivided interest in a pool of mortgage loans. CMOs are structured obligations that are derived from a pool of mortgage loans or agency mortgage backed securities. CMOs in general have widely varying degrees of risk, which results from the prepayment risk on the underlying mortgage loans and its effect on the cash flows of the security.

Prepayment risk is the risk of borrowers paying off their loans sooner than expected in a falling rate environment by either refinancing or curtailment. Extension risk is the risk that the underlying pool of loans will not exhibit the expected prepayment speeds thus resulting in a longer average life and slower cash flows than anticipated at purchase. Interest rate risk is based on the sensitivity of yields on assets that change in a different time period or in a different proportion from that of current market interest rates. Changes in average life due to prepayments and changes in interest rates in general will cause the market value of MBS and CMOs to fluctuate.

The Company’s MBS portfolio consists of fixed rate balloon maturity pools with short stated final maturities and adjustable rate mortgage (ARM) pools with coupons that reset annually and have longer maturities. Investments in CMOs consist mainly of Planned Amortization Classes (PAC), Targeted Amortization Classes (TAC), and sequential classes. As of September 30, 2002, floating rate securities made up 16% of the CMO portfolio. Support and liquidity classes with longer average lives and floating rate coupons comprise a relatively small portion of the portfolio.

To maximize after-tax income, investments in tax-exempt municipal securities are utilized but with somewhat longer maturities.

Securities are the Company’s single largest interest-earning asset representing approximately 47.9% of total assets at September 30, 2002. The securities portfolio totaled $261,001,000 at September 30, 2002, up from $242,580,000 at December 31, 2001. This increase resulted due to an increase in deposits combined with excess cash and proceeds from the maturity of interest-bearing time deposits being invested in mortgage-backed securities and government agency securities for increased yields.

Item 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company’s primary market risk exposures are interest rate risk and, to a lesser extent, liquidity risk. The Company does not maintain a trading account for any class of financial instrument and the Company is not affected by foreign currency exchange rate risk or commodity price risk.

Interest rate risk is the risk that the Company’s financial condition will be adversely affected due to movements in interest rates. The Company, like other financial institutions, is subject to interest rate risk to the extent that its interest-earning assets reprice differently than its interest-bearing liabilities. The income of financial institutions is primarily derived from the excess of interest earned on interest-earning assets over the interest paid on interest-bearing liabilities. A high ratio of interest sensitive liabilities tends to benefit net interest income during periods of falling interest rates as the average rate paid on interest-bearing liabilities declines faster than the average rate earned on interest-earning assets. The opposite holds true during periods of rising interest rates. One of the Company’s principal financial objectives is to achieve long-term profitability while reducing its exposure to fluctuations in interest rates. Management recognizes certain risks are inherent and that the goal is to measure the effect on net interest income and to adjust the balance sheet to minimize the risk while at the same time maximize income. Accordingly, the Company places great importance on monitoring and controlling interest rate risk.

There are several methods employed by the Company to monitor and control interest rate risk. One such method is using a simulation model to analyze net interest income sensitivity to movements in interest rates. The simulation model projects net interest income based on either an immediate rise or fall in interest rates (rate shock) over a twelve-month period. The model is based on the actual maturity and repricing characteristics of interest rate sensitive assets and liabilities. The repricing can occur due to changes in rates on variable rate products as well as maturities of interest-earning assets and interest-bearing liabilities. The model incorporates assumptions regarding the impact of changing interest rates on the prepayment rate of certain assets and liabilities as well as projections for anticipated activity levels by product lines offered by the Company. The simulation model also takes into account the Company’s historical core deposits. Management considers the Company’s market risk to be acceptable at this time.

One strategy used by the Company to reduce the volatility of its net interest income is to originate variable rate loans tied to market indices. Such loans reprice on an annual, quarterly, monthly or daily basis as the underlying market index change. Currently, approximately 19% of the Company’s loan portfolio reprices on at least an annual basis.

The Company has also structured the securities portfolio so that most of the mortgage-backed securities reprice on at least an annual basis. The Company also maintains most of its securities in the available for sale portfolio to take advantage of changes in interest rates and to maintain liquidity for loan funding and deposit withdrawals. The mortgage-backed and related securities also provide the Company with a constant cash flow stream from principal repayments. The Company invests short-term excess funds in overnight federal funds that mature and reprice on a daily basis.

The Company’s 2001 annual report details a table that provides information about the Company’s financial instruments that are sensitive to changes in interest rates as of December 31, 2001. The table is based on information and assumptions set forth in the discussion. The Company believes the assumptions utilized are reasonable. Management believes that no events have occurred since December 31, 2001 which would significantly change the ratio of rate sensitive assets to rate sensitive liabilities for the given time horizons in the table.

Item 4.

CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

The Company’s chief executive officer and chief financial officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in the Securities Exchange Act of 1934 Rules 13a-14(c) and 15d-14(c)) as of a date (the “Evaluation Date”) within 90 days before the filing date of this quarterly report on Form 10-Q, have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and designed to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities.

Changes in Internal Controls

There were no significant changes in the Company’s internal controls or, to the knowledge of the Company’s chief executive officer and chief financial officer, in other factors that could significantly affect the Company’s disclosure controls and procedures subsequent to the Evaluation Date.

Part II—OTHER INFORMATION

Item 1. Legal Proceedings

None

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

None

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.

		HENDERSON CITIZENS BANCSHARES, INC.

Date:	November 7, 2002	By:	/s/ MILTON S. MCGEE, JR.
			Milton S. McGee, Jr., CPA President


Date:	November 7, 2002	By:	/s/ REBECCA G. TANNER
			Rebecca G. Tanner, CPA Vice President, Treasurer, Chief Financial Officer and Chief Accounting Officer

Certifications

I, Milton S. McGee, Jr. certify that:

I have reviewed this quarterly report on Form 10-Q of Henderson Citizens Bancshares, Inc.;

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



Dated:	November 7, 2002	By:	/s/ MILTON S. MCGEE, JR.
			Name: Milton S. McGee, Jr. Title: President and Chief Executive Officer

HENDERSON CITIZENS BANCSHARES INC 10-Q