News Column

PARK STERLING CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

The purpose of this discussion and analysis is to focus on significant changes in our financial condition as of and results of operations during the three- and six-month period ended June 30, 2014. This discussion and analysis highlights and supplements information contained elsewhere in this Quarterly Report on Form 10-Q, particularly the preceding unaudited condensed consolidated financial statements and accompanying notes (the "Unaudited Financial Statements"). Executive Overview The Company reported net income available to common shareholders of $7.0 million, or $0.16 per share, for the six months ended June 30, 2014 compared to $6.7 million, or $0.15 per share, for the six months ended June 30, 2013. The Company reported adjusted net income available to common shareholders, which excludes merger-related expenses and gain or loss on sale of securities, of $7.3 million, or $0.17 per share, for the six months ended June 30, 2014 compared to $7.7 million, or $0.18 per share, for the six months ended June 30, 2013. The first six months of 2014 reflect a lower adjustment for merger-related expenses and a higher adjustment for gain on sale of securities, compared to the first six months of 2013. Net interest margin was 3.96% for the six month period ended June 30, 2014, representing a 27 basis point decrease from 4.23% for the six month period ended June 30, 2013. The reduction in net interest margin from June 30, 2013, resulted primarily from a 23 basis point decrease in average yield on loans reflecting both a lower mix of higher yielding PCI loans and lower accelerated accretion, and an 11 basis point increase in the cost of interest-bearing liabilities, driven primarily by the expiration of accounting-related fair market value adjustments on acquired deposits in the fourth quarter of 2013. On May 1, 2014, we completed our acquisition of Provident Community which was merged with and into the Company with the Company as the surviving entity. Total assets increased $285.1 million, or 14.5%, to $2.25 billion at June 30, 2014, compared to total assets of $1.96 billion at December 31, 2013 driven both by organic growth and the Provident Community acquisition. Cash and equivalents increased $14.0 million, or 25%, to $104.8 million, and total securities, including non-marketable securities, increased $67.4 million, or 17%, to $474.7 million, compared to December 31, 2013. These increases were primarily the result of the merger with Provident Community. Total loans, excluding loans held for sale, increased $177.9 million, or 14%, to $1.47 billion at June 30, 2014, compared to total loans, excluding loans held for sale, of $1.30 billion at December 31, 2013. The increase included $70.8 million resulting from organic growth and $100.0 million resulting from the Provident Community acquisition, net of acquisition accounting fair market value adjustments. Asset quality continued to improve during the first half of 2014 and remains a point of strength for the Company. Nonperforming loans decreased $2.8 million, or 23%, to $9.5 million at June 30, 2014, or 0.65% of total loans, compared to $12.3 million at December 31, 2013, or 0.95% of total loans. Nonperforming assets decreased $1.1 million, or 4%, to $25.7 million at June 30, 2014, or 1.14% of total assets, compared to $26.8 million at December 31, 2013, or 1.37% of total assets. Nonperforming assets at June 30, 2014 include $5.2 million of covered other real estate owned ("OREO") representing 20% of total nonperforming assets at June 30, 2014, compared to $5.1 million of covered OREO representing 19% of total nonperforming assets at December 31, 2013. The Company currently expects 80% of losses and associated expenses on covered OREO to be reimbursed under its FDIC loss share agreements. Total deposits increased $262.8 million, or 16.4%, to $1.86 billion at June 30, 2014, compared to $1.60 billion at December 31, 2013, reflecting both the Provident Community acquisition and strong results in retail and commercial banking. Total borrowings increased $8.8 million, or 11%, to $86.8 million at June 30, 2014 compared to $78.0 million at December 31, 2013. The Company exercised an optional prepayment, which had no impact on net income, to fully redeem $6.9 million in 11% Tier 2 eligible subordinated debt at the Bank on June 30, 2014. This decrease in borrowings was more than offset by $5.7 million in repurchase agreements and $7.8 million in trust preferred subordinated debt, net of acquisition accounting fair market value adjustments, assumed in the Provident Community acquisition. Total shareholders' equity increased $7.4 million, or 3%, to $269.5 million at June 30, 2014 compared to $262.1 million at December 31, 2013, driven by retained earnings and lower unrealized losses in the marketable securities portfolio. The Company's ratio of tangible common equity to tangible assets decreased to 10.35% at June 30, 2014 from 11.79% at December 31, 2013. The Company's Tier 1 leverage ratio decreased to 10.59% in June 30, 2014 from 11.63% at December 31, 2013. 51 -------------------------------------------------------------------------------- Adjusted net income and related per share measures, as well as tangible common equity and tangible assets, and related ratios, are non-GAAP financial measures. For reconciliations to the most comparable GAAP measure, see "Non-GAAP Financial Measures" below. Business Overview The Company, a North Carolina corporation, was formed in October 2010 to serve as the holding company for the Bank and is a bank holding company registered with the Federal Reserve Board. The Bank was incorporated in September 2006 as a North Carolina-chartered commercial nonmember bank. On January 1, 2011, the Company acquired all of the outstanding common stock of the Bank in exchange for shares of the Company's Common Stock, on a one-for-one basis, in a statutory share exchange transaction effected under North Carolina law pursuant to which the Company became the bank holding company for the Bank. Consistent with our growth strategy, in January 2014, the Bank opened a loan production office in Richmond, Virginia. In addition, on May 1, 2014, the Company completed its acquisition of Provident Community pursuant to the Agreement and Plan of Merger, dated as of March 4, 2014 (the "Agreement"), under which Provident Community, a bank holding company headquartered in Rock Hill, South Carolina, was merged with and into the Company with the Company as the surviving entity. Pursuant to the Agreement, each share of Provident Community common stock was cancelled and converted into the right to receive a cash payment from the Company equal to $0.78 per share, or approximately $1.4 million in the aggregate. In addition, immediately prior to completion of the merger, the Company purchased from the United States Department of the Treasury ("Treasury") the issued and outstanding shares of Provident Community's Fixed Rate Cumulative Perpetual Preferred Stock, Series A (the "Provident Community Series A Preferred Stock"), and all of the related warrants to purchase shares of Provident Community's common stock, for an aggregate purchase price of approximately $5.1 million (representing a 45% discount from face value). Thereafter, pursuant to the Agreement, the Provident Community Series A Preferred Stock and related warrants were cancelled in connection with the completion of the merger. Simultaneously with completion of the merger, Provident Community Bank, N.A. merged into the Bank. The merger strengthens our position in the Charlotte metro market, improves our branch density in South Carolina's Upstate and Midlands regions, provides an attractive source of core deposits to help fund organic loan growth, and creates efficiencies which are expected to enhance financial returns to shareholders. The Company provides a full array of retail and commercial banking services, including wealth management, through its offices located in North Carolina, South Carolina, Virginia and Georgia. Our objective since inception has been to provide the strength and product diversity of a larger bank and the service and relationship attention that characterizes a community bank. Non-GAAP Financial Measures In addition to traditional measures, management uses tangible assets, tangible common equity, tangible book value, adjusted allowance for loan losses, adjusted net income, adjusted net interest margin and adjusted noninterest expenses, and related ratios and per-share measures, each of which is a non-GAAP financial measure. Management uses (i) tangible assets, tangible common equity and tangible book value (which exclude goodwill and other intangibles from equity and assets) and related ratios to evaluate the adequacy of shareholders' equity and to facilitate comparisons with peers; (ii) adjusted allowance for loan losses (which includes net fair market value adjustments related to acquired loans) as supplemental information for comparing the combined allowance and fair market value adjustments to the combined acquired and non-acquired loan portfolios (fair market value adjustments are available only for losses on acquired loans); and (iii) adjusted net income and adjusted noninterest expense (which exclude merger-related expenses and gain or loss on sale of securities, as applicable) and adjusted net interest margin (which excludes accelerated accretion of net acquisition accounting fair market value adjustments) to evaluate its core earnings and to facilitate comparisons with peers. 52 -------------------------------------------------------------------------------- The following table presents these non-GAAP financial measures and provides a reconciliation of these non-GAAP measures to the most directly comparable GAAP measure reported in the Company's consolidated financial statements: Reconciliation of Non-GAAP Financial Measures June 30, December 31, 2014 2013 (Unaudited) (Unaudited) (dollars in thousands, except per share amounts) Tangible common equity to tangible assets Total assets $ 2,245,456$ 1,960,790 Less: intangible assets (41,478 ) (35,049 ) Tangible assets $ 2,203,978$ 1,925,741 Total common equity $ 269,510$ 262,083 Less: intangible assets (41,478 ) (35,049 ) Tangible common equity $ 228,032$ 227,034 Tangible common equity 228,032 227,034 Divided by: tangible assets 2,203,978 1,925,741 Tangible common equity to tangible assets 10.35 % 11.79 % Common equity to assets 12.00 %



13.37 %

Adjusted allowance for loan losses Allowance for loan losses $ 9,178 $



8,831

Plus: acquisition accounting net FMV adjustments to acquired loans 40,987



37,783

Adjusted allowance for loan losses $ 50,165 $ 46,614 Divided by: total loans (excluding LHFS)

1,473,661



1,295,808

Adjusted allowance for loan losses to total loans 3.40 % 3.60 % Allowance for loan losses to total loans 0.62 % 0.68 % Three months ended Six months ended June 30, June 30, June 30, June 30, 2014 2013 2014 2013 (Unaudited) (Unaudited) (Unaudited) (Unaudited) (dollars in thousands, except per share amounts) Adjusted net income Pretax income (as reported) $ 5,186$ 5,780$ 10,221$ 10,744 Plus: merger-related expenses 594 822 675 1,568 (gain) loss on sale of securities 33 (104 ) (243 ) (104 ) Adjusted pretax income 5,813 6,498 10,653 12,208 Tax expense 1,972 2,235 3,386 4,231 Adjusted net income $ 3,841$ 4,263$ 7,267$ 7,977 Preferred dividends - 302 - 353 Adjusted net income available to common shareholders $ 3,841$ 3,961$ 7,267$ 7,624 Divided by: weighted average diluted shares 44,213,802 44,204,581 44,240,105 44,137,495 Adjusted net income available to common shareholders per share $ 0.09$ 0.09$ 0.16$ 0.17 Estimated tax rate 33.93 % 34.40 % 31.78 % 34.66 % Adjusted net interest margin Net interest income (as reported) $ 19,079$ 18,671$ 36,354$ 36,407 Less: accelerated mark accretion (86 ) (560 ) (104 ) (560 ) Adjusted net interest income 18,993 18,111 36,250 35,847 Divided by: average earning assets 1,938,459 1,742,312 1,851,794 1,737,276 Mutliplied by: annualization factor 4.01 4.01 2.02 2.02 Adjusted net interest margin 3.93 % 4.17 % 3.95 % 4.16 % Net interest margin 3.95 % 4.30 % 3.96 % 4.23 % Adjusted noninterest expense Noninterest expense $ 18,274$ 16,784$ 34,017$ 32,705 Less: merger-related expenses (594 ) (822 ) (675 ) (1,568 ) Adjusted noninterest expense $ 17,680$ 15,962$ 33,342$ 31,137 53

--------------------------------------------------------------------------------



Recent Accounting Pronouncements

See Note 2 to the Unaudited Financial Statements for a description of recent accounting pronouncements including the respective expected dates of adoption and effects on results of operations and financial condition.



Critical Accounting Policies and Estimates

In the preparation of our financial statements, we have adopted various accounting policies that govern the application of accounting principles generally accepted in the United States ("GAAP") and in accordance with general practices within the banking industry. Our significant accounting policies are described in Note 2 - Summary of Significant Accounting Policies to the Company's audited consolidated financial statements and accompanying notes (the "2013 Audited Financial Statements") included in the 2013 Form 10-K. While all of these policies are important to understanding the Unaudited Financial Statements, certain accounting policies described below involve significant judgment and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgment and assumptions we make, actual results could differ from these judgments and assumptions that could have a material impact on the carrying values of our assets and liabilities and our results of operations. PCI Loans. Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered credit impaired. Evidence of credit quality deterioration as of the purchase date may include statistics such as internal risk grade, past due and nonaccrual status, recent borrower credit scores and recent loan-to-value ("LTV") percentages. Purchased credit-impaired ("PCI") loans are initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loan. Accordingly, the associated allowance for credit losses related to these loans is not carried over at the acquisition date. We estimate the cash flows expected to be collected at acquisition using specific credit review of certain loans, quantitative credit risk, interest rate risk and prepayment risk models, and qualitative economic and environmental assessments, each of which incorporates our best estimate of current key relevant factors, such as property values, default rates, loss severity and prepayment speeds. Under the accounting guidance for PCI loans, the excess of cash flows expected to be collected over the estimated fair value is referred to as the accretable yield and is recognized in interest income over the remaining life of the loan, or pool of loans, in situations where there is a reasonable expectation about the timing and amount of cash flows to be collected. The difference between the contractually required payments and the cash flows expected to be collected at acquisition, considering the impact of prepayments, is referred to as the nonaccretable difference and is available to absorb future charge-offs. In addition, subsequent to acquisition, we periodically evaluate our estimate of cash flows expected to be collected. These evaluations, performed quarterly, require the continued usage of key assumptions and estimates, similar to the initial estimate of fair value. In the current economic environment, estimates of cash flows for PCI loans require significant judgment given the impact of home price and property value changes, changing loss severities, prepayment speeds and other relevant factors. Decreases in the expected cash flows will generally result in a charge to the provision for credit losses resulting in an increase to the allowance for loan losses. Significant increases in the expected cash flows will generally result in an increase in interest income over the remaining life of the loan, or pool of loans. Disposals of loans, which may include sales of loans to third parties, receipt of payments in full or part from the borrower or foreclosure of the collateral, result in removal of the loan from the PCI loan portfolio at its carrying amount. Trends are reviewed in terms of traditional credit metrics such as accrual status, past due status, and weighted-average grade of the loans within each of the accounting pools. In addition, the relationship between the change in the unpaid principal balance and change in the fair value mark is assessed to correlate the directional consistency of the expected loss for each pool. At June 30, 2014, PCI loans represent loans acquired from Community Capital, Citizens South and Provident Community that were deemed credit impaired at the time of acquisition. PCI loans that were classified as nonperforming loans by the acquired institutions are no longer classified as nonperforming so long as, at acquisition and quarterly re-estimation periods, we believe we will fully collect the new carrying value of these loans. It is important to note that judgment regarding the timing and amount of cash flows to be collected is required to classify PCI loans as performing, even if the loan is contractually past due. 54

-------------------------------------------------------------------------------- Allowance for Loan Losses. The allowance for loan losses is based upon management's ongoing evaluation of the loan portfolio and reflects an amount considered by management to be its best estimate of known and inherent losses in the portfolio as of the balance sheet date. The determination of the allowance for loan losses involves a high degree of judgment and complexity. In making the evaluation of the adequacy of the allowance for loan losses, management considers current economic and market conditions, independent loan reviews performed periodically by third parties, portfolio trends and concentrations, delinquency information, management's internal review of the loan portfolio, internal historical loss rates and other relevant factors. While management uses the best information available to make evaluations, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, regulatory examiners may require us to recognize changes to the allowance for loan losses based on their judgments about information available to them at the time of their examination. Although provisions have been established by loan segments based upon management's assessment of their differing inherent loss characteristics, the entire allowance for losses on loans, other than the portion related to PCI loans and specific reserves on impaired loans, is available to absorb further loan losses in any segment. Further information regarding our policies and methodology used to estimate the allowance for possible loan losses is presented in Note 5 - Loans and Allowance for Loan Losses to the 2013 Audited Financial Statements, and Note 5 - Loans and Allowance for Loan Losses to the Unaudited Financial Statements included in this Form 10-Q. OREO. OREO, consisting of real estate acquired through, or in lieu of, loan foreclosures, is recorded at the lower of cost or fair value less estimated selling costs when acquired. Fair value is determined based on independent market prices, appraised values of the collateral or management's estimation of the value of the collateral. Management also considers other factors, including changes in absorption rates, length of time the property has been on the market and anticipated sales values, which have resulted in adjustments to the collateral value estimates indicated in certain appraisals. At the time of foreclosure or initial possession of collateral, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses. Subsequent declines in the fair value of OREO below the new cost basis are recorded through valuation adjustments. Significant judgments and complex estimates are required in estimating the fair value of other real estate, and the period of time within which such estimates can be considered current is significantly shortened during periods of market volatility. In response to market conditions and other economic factors, management may utilize liquidation sales as part of its problem asset disposition strategy. As a result of the significant judgments required in estimating fair value and the variables involved in different methods of disposition, the net proceeds realized from sales transactions could differ significantly from appraisals, comparable sales, and other estimates used to determine the fair value of other real estate. Management reviews the value of other real estate periodically and adjusts the values as appropriate. Revenue and expenses from OREO operations as well as gains or losses on sales and any subsequent adjustments to the value are recorded as net cost (earnings) of operation of other real estate owned, a component of non-interest expense. FDIC Indemnification Asset. In accordance with Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") Topic 805, the FDIC indemnification asset was initially recorded at its fair value, and is measured separately from the related covered assets because the indemnification asset is not contractually embedded in the covered assets or transferrable with them in the event of disposal. The FDIC indemnification asset is measured at carrying value subsequent to initial measurement. Improved cash flows of the underlying covered assets will result in impairment of the FDIC indemnification asset and thus amortization through non-interest income. Impairment of the underlying covered assets will increase the cash flows of the FDIC indemnification asset and result in a credit to the provision for loan losses for acquired loans. Impairment and, when applicable, its subsequent reversal are included in the provision for loan losses in the condensed consolidated statements of income. 55

-------------------------------------------------------------------------------- The purchase and assumption agreements between the Bank and the FDIC, as discussed in Note 6 - FDIC Loss Share Agreements to the 2013 Audited Financial Statements, and Note 6 - FDIC Loss Share Agreements to the Unaudited Financial Statements included in this Form 10-Q, each contain a provision that obligates the Bank to make a true-up payment to the FDIC if the realized losses of each of the applicable acquired banks are less than expected. Any such true-up payment that is materially higher than current estimates could have a negative effect on our business, financial condition and results of operations. These amounts are recorded in other liabilities on the balance sheet. The actual payment will be determined at the end of the term of the loss sharing agreements and is based on the negative bid, expected losses, intrinsic loss estimate, and assets covered under the loss share agreements. Income Taxes. Income taxes are provided based on the asset-liability method of accounting, which includes the recognition of deferred tax assets ("DTAs") and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, we record a DTA when the event giving rise to the tax benefit has been recognized in the consolidated financial statements. As of June 30, 2014 and December 31, 2013, we had a net DTA in the amount of approximately $38.0 million and $37.4 million, respectively. We evaluate the carrying amount of our DTA quarterly in accordance with the guidance provided in FASB ASC Topic 740, in particular, applying the criteria set forth therein to determine whether it is more likely than not (i.e., a likelihood of more than 50%) that some portion, or all, of the DTA will not be realized within its life cycle, based on the weight of available evidence. In most cases, the realization of the DTA is dependent upon the Company generating a sufficient level of taxable income in future periods, which can be difficult to predict. If our forecast of taxable income within the carry forward periods available under applicable law is not sufficient to cover the amount of net deferred assets, such assets may be impaired. Based on the weight of available evidence, we have determined that it is more likely than not that we will be able to fully realize the existing DTA. Accordingly, we considered it appropriate not to establish a DTA valuation allowance at either June 30, 2014 or December 31, 2013.



Additional information regarding our income taxes is presented in Note 9 -Income Taxes to the 2013 Audited Financial Statements.

56 --------------------------------------------------------------------------------



Financial Condition at June 30, 2014 and December 31, 2013

Total assets increased $285.1 million to $2.25 billion at June 30, 2014 compared to total assets of $1.96 billion at December 31, 2013. During the six months, cash and equivalents increased $14.0 million, or 25%. Total loans, excluding loans held for sale, increased $177.5 million, or 14%, to $1.47 billion at June 30, 2014. Total securities, including non-marketable securities, increased $67.4 million, or 17%, to $468.8 million at June 30, 2014 from $401.4 million at December 31, 2013. These increases were all driven by the merger with Provident Community as well as approximately $70.8 million in organic loan growth. Total liabilities of $1.98 billion at June 30, 2014 increased $277.2 million, or 16.3%, compared to total liabilities of $1.70 billion at December 31, 2013. Total deposits increased $262.8 million, or 16.43%, to $1.86 billion at June 30, 2014, reflecting both the Provident Community acquisition as well as strong results in retail and commercial banking. Total short-term borrowings increased $7.6 million, to $8.6 million at June 30, 2014 from $1.0 million at December 31, 2013primarily driven by the merger with Provident Community. Total borrowings increased $8.8 million, or 11%, to $86.8 million at June 30, 2014 compared to $78.0 million at December 31, 2013. The Company exercised an optional prepayment, which had no impact on net income, to fully redeem $6.9 million in 11% Tier 2 eligible subordinated debt at the Bank on June 30, 2014. This decrease in borrowings was more than offset by $5.7 million in repurchase agreements and $7.8 million in trust preferred subordinated debt, net of acquisition accounting fair market value adjustments, assumed in the Provident Community acquisition. Total shareholders' equity increased $7.9 million, or 3.0%, during the first six months to $269.9 million at June 30, 2014. The $7.9 million increase was the result of (i) net income of $7.0 million during the first six months of 2014; (ii) a $3.0 million increase in accumulated other comprehensive income from unrealized securities gains; (iii) $531thousand of net share based compensation expense; and (iv) $177 thousand in proceeds from the exercise of 39,451 stock options. The increases were offset by $1.8 million in dividends on common stock and the repurchase of 136,743 shares of common stock, at an average cost of $6.52 per share, for a total of $892 thousand during the first six months of 2014, as part of our previously announced stock repurchase program.



The following table presents selected ratios for the Company for the six months ended June 30, 2014 and 2013 and for the year ended December 31, 2013:

Selected Ratios Six months ended Twelve months June 30, ended (annualized) December 31, 2014 2013 2013* Return on Average Assets 0.68% 0.68% 0.76% Return on Average Equity 5.29% 4.82% 5.42% Period End Equity to Total Assets 12.02% 14.04%



13.37%

* Derived from audited financial statements.

Investments and Other Interest-earning Assets

We use investment securities to generate interest income through the employment of excess funds, to provide liquidity, to fund loan demand or deposit liquidation, and to pledge as collateral, where required. The composition of our investment portfolio changes from time to time as we consider our liquidity needs, interest rate expectations, asset/liability management strategies, and capital requirements. Securities available-for-sale are carried at fair market value, with unrealized holding gains and losses reported in accumulated other comprehensive income, net of tax. Securities held-to-maturity are carried at amortized cost. At June 30, 2014, investment securities totaled $468.8 million compared to $401.4 million at December 31, 2013. The increase in investment securities is due to the reinvestment of the proceeds received from the liquidation of securities acquired in the Provident Community acquisition. 57 -------------------------------------------------------------------------------- During the second quarter of 2014, we re-designated $58.5 million of residential mortgage pass-through and collateralized mortgage obligation securities from available-for-sale to held-to-maturity to mitigate the risk of unrealized mark-to-market losses from rising interest rates. These securities had an aggregate unrealized loss of $2.2 million ($1.5 million, net of tax) on the date of transfer. The "Volcker Rule" under the Dodd-Frank Act generally prohibits banks and their affiliates from engaging in proprietary trading and investing in and sponsoring a covered fund (such as a hedge fund or private equity fund). Included in our investment securities portfolio are two investments in senior tranches of collateralized loan obligations ("CLOs") totaling $14.8 million at June 30, 2014 with respect to which the collateral eligibility provisions have not yet been amended to comply with the new bank investment criteria under the Volcker Rule. The two securities had a net unrealized loss of $178 thousand at June 30, 2014 that may result in the Company recognizing other than temporary impairment should they be determined not to comply with the Volcker Rule. We recognized a loss of $33,000 on the sale of an additional CLO during the second quarter given expectations that it would not be amended to comply with the Volcker Rule. Further information about our investment securities portfolio is presented in Note 4 - Investment Securities to the Unaudited Financial Statements included in this Form 10-Q.



At June 30, 2014, we had $47.6 million in interest-bearing deposits at correspondent banks, of which $44.7 million was on deposit with the Federal Reserve Bank, compared to $41.7 million in interest-bearing deposits at correspondent banks at December 31, 2013. Our balances have increased slightly with cash being redeployed in our loan and investment portfolios.

Loans We consider asset quality to be of primary importance, and employ seasoned credit professionals and documented processes to ensure effective oversight of credit approvals and asset quality monitoring. Our internal loan policy is reviewed by our board of directors' Loan and Risk Committee on an annual basis and our underwriting guidelines are reviewed and updated on a periodic basis. A formal loan review process is maintained both to ensure adherence to lending policies and to ensure accurate loan grading and is reviewed by our board of directors at least annually. Since inception, we have promoted the separation of loan underwriting from the loan production staff through our credit department. Currently, credit administration analysts are responsible for underwriting and assigning proper risk grades for all loans with an individual, or relationship, exposure in excess of $500 thousand. Underwriting is completed on standardized forms including a loan approval form and separate credit memorandum. The credit memorandum includes a summary of the loan's structure and a detailed analysis of loan purpose, borrower strength (including individual and global cash flow worksheets), repayment sources and, when applicable, collateral positions and guarantor strength. The credit memorandum further identifies exceptions to policy and/or regulatory limits, total exposure, internal risk grades and other relevant credit information. Loans are approved or denied by varying levels of signature authority based on total customer relationship exposure, with a minimum requirement of at least two authorized signatures. A management-level loan committee is responsible for approving all credits in excess of the chief credit officer's lending authority, which was increased in March 2013 from $1 million to $3 million. Our loan underwriting policy contains loan-to-value ("LTV") limits that are at or below levels required under regulatory guidance, when such guidance is available, including limitations for non-real estate collateral, such as accounts receivable, inventory and marketable securities. When applicable, we compare LTV with loan-to-cost guidelines and ultimately limit loan amounts to the lower of the two ratios. We also consider FICO scores and strive to uphold a high standard when extending loans to individuals. We have not underwritten any subprime, hybrid, no-documentation or low-documentation products. All acquisition, construction and development ("AC&D") loans, whether related to commercial or consumer borrowers, are subject to policies, guidelines and procedures specifically designed to properly identify, monitor and mitigate the risk associated with these loans. Loan officers receive and review a cost budget from the borrower at the time an AC&D loan is originated. Loan draws are monitored against the budgeted line items during the development period in order to identify potential cost overruns. Individual draw requests are verified through review of supporting invoices as well as site inspections performed by an external inspector. Additional periodic site inspections are performed by loan officers at times that do not coincide with draw requests in order to keep abreast of ongoing project conditions. Our exposure to AC&D loans has declined significantly since inception of the Bank and current loan origination is focused on 1 - 4 family residential construction for retail customers and 1-4 family residential home construction to selected well-qualified builders, as well as owner-occupied commercial and pre-leased commercial build-to-suit properties. Concentrations as a percent of capital are reported to the board of directors on a quarterly basis. Market conditions for AC&D loans continued to improve in 2014 due to increasing new home sales in our primary markets. As of June 30, 2014, approximately 2% of our AC&D loan portfolio, commercial and consumer, is included on the watch list. 58 -------------------------------------------------------------------------------- Our second mortgage exposure is primarily attributable to our home equity lines of credit ("HELOC") portfolio, which totaled approximately $154 million as of June 30, 2014, of which approximately 57% is secured by second mortgages and approximately 43% is secured by first mortgages. All loans are assigned an internal risk grade and are reviewed continuously for payment performance and updated through annual portfolio reviews. Loans on the Bank's watch list are monitored through quarterly watch meetings and monthly impairment meetings. Classified loans are generally managed by a dedicated special asset team who is experienced in various loan rehabilitation and work out practices. Special asset loans are generally managed with a least-loss strategy. At June 30, 2014, total loans, net of deferred fees, increased $177.9 million compared to December 31, 2013 due to the merger with Provident Community and organic loan growth. The composition of the portfolio remained unchanged from December 31, 2013 with commercial loans representing 71% of the total loan portfolio and consumer loans representing 29% of the total loan portfolio at June 30, 2014.



Asset Quality and Allowance for Loan Losses

Our Allowance for Loan Losses Committee is responsible for overseeing our allowance and works with our chief executive officer, senior financial officers, senior risk management officers and the Audit Committee of the board of directors in developing and achieving our allowance methodology and practices. Our allowance for loan loss methodology includes four components - specific reserves, quantitative reserves, qualitative reserves and reserves on PCI loans. 59

-------------------------------------------------------------------------------- The following table presents a breakdown of our allowance for loan losses, by component and by loan product type, as of June 30, 2014 and December 31, 2013. Details of the seven environmental factors for consideration in the qualitative component of the allowance methodology as well as additional information about the four components and our policies and methodology used to estimate the allowance for loan losses are presented in Note 5 - Loans and Allowance for Loan Losses to the Unaudited Financial Statements included in this Form 10-Q. Allowance Allocation by Component June 30, 2014 Specific Reserve Quantitative Reserve Qualitative Reserve PCI Reserve % of Total % of Total % of Total % of Total $ Allowance $ Allowance $ Allowance $ Allowance (dollars in thousands) Commercial: Commercial and industrial $ 20 0.22 % $ 1,413 15.40 % $ 340 3.70 % $ - 0.00 % CRE - owner-occupied 30 0.33 % 204 2.22 % 239 2.60 % - 0.00 % CRE - investor income producing 68 0.74 % 1,084 11.81 % 273 2.97 % - 0.00 % AC&D - 1-4 family construction - 0.00 % 971 10.58 % 244 2.66 % - 0.00 % AC&D - lots, land & development 8 0.09 % 1,149 12.52 % 289 3.15 % - 0.00 % AC&D - CRE - 0.00 % 22 0.24 % 201 2.19 % - 0.00 % Other commercial 43 0.47 % 3 0.03 % 5 0.05 % - 0.00 % Consumer: Residential mortgage 171 1.86 % 161 1.75 % 40 0.44 % - 0.00 % HELOC 415 4.52 % 829 9.03 % 208 2.27 % - 0.00 % Residential construction 193 2.10 % 366 3.99 % 92 1.00 % - 0.00 % Other loans to individuals 11 0.12 % 2 0.02 % 84 0.92 % - 0.00 % $ 959 10.45 % $ 6,204 67.60 % $ 2,015 21.95 % $ - 0.00 % December 31, 2013 Specific Reserve Quantitative Reserve Qualitative Reserve Reserve on PCI Loans % of Total % of Total % of Total % of Total $ Allowance $ Allowance $ Allowance $ Allowance (dollars in thousands) Commercial: Commercial and industrial $ 14 0.16 % $ 1,304 14.77 % $ 173 1.96 % $ - 0.00 % CRE - owner-occupied 14 0.16 % 319 3.61 % 66 0.75 % - 0.00 % CRE - investor income producing 527 5.97 % 1,111 12.58 % 159 1.80 % 360 4.08 % AC&D - 1-4 family construction - 0.00 % 755 8.55 % 84 0.95 % - 0.00 % AC&D - lots, land, & development - 0.00 % 1,496 16.94 % 255 2.89 % - 0.00 % AC&D - CRE - 0.00 % 267 3.02 % 32 0.36 % - 0.00 % Other commercial 18 0.20 % 5 0.06 % 1 0.01 % - 0.00 % Consumer: Residential mortgage 167 1.89 % 135 1.53 % 56 0.63 % - 0.00 % HELOC 137 1.55 % 699 7.92 % 214 2.42 % - 0.00 % Residential construction 7 0.08 % 336 3.80 % 48 0.54 % - 0.00 % Other loans to individuals - 0.00 % 64 0.72 % 8 0.09 % - 0.00 % Total $ 884 10.01 % $ 6,491

73.50 % $ 1,096 12.41 % $ 360 4.08 %



The allowance for loan losses is increased by provisions charged to operations and reduced by loans charged off, net of recoveries. The increase in the allowance for loan losses was a function of the following:

(i) A decrease of $287 thousand in the quantitative component of the allowance

due to changes in look back periods in the residential construction loan

type which better reflect the inherent loss in the portfolio and the

reclassification of the minimum reserve amounts to the qualitative

component. In the past, we have recorded a minimum reserve as part of the

quantitative component. A minimum reserve is utilized when we have

insufficient internal loss history or when internal loss history falls below

the minimum reserve percentage. Minimums are determined by analyzing Federal

Reserve Bank charge-off data for all insured federal- and state-chartered

commercial banks. For the second quarter of 2014, we calculated the average

historical loss rates and adjusted incrementally to the minimum reserve

amounts in the qualitative component. This change represented a

reclassification between components of the allowance and had no impact on

the calculation in total. 60

--------------------------------------------------------------------------------



(ii) An increase of $919 thousand in the qualitative component of the allowance

primarily due to the reclassification of minimum reserve amounts noted in

item (i) above as well as management's decision to apply a factor of 0.075%

to its portfolio trends factor. Our loan portfolio experienced rapid loan

growth in the second quarter of 2014. As these loans are not yet seasoned,

and because rapid loan growth can cause loss rates to be understated,

management used prudence in applying this factor. (iii) A decrease of $360 thousand in the reserve on PCI loans due to the reversal of $360 thousand of previously recognized impairments.



(iv) An increase of $75 thousand in specific reserves which change periodically

as loans move through or out of the impairment process. In accordance with GAAP, loans acquired from Community Capital, Citizens South and Provident Community were adjusted at the time of acquisition to reflect estimated fair market value at acquisition and the associated allowance for loan losses was eliminated. At June 30, 2014, acquired loans comprised 39% of our total loans, compared to 44% at December 31, 2013. The ratio of the allowance for loan losses to total loans was 0.62% at June 30, 2014 and 0.68% at December 31, 2013. The ratio of the adjusted allowance for loan losses to total loans, which includes the remaining acquisition accounting fair market value adjustments for acquired loans, was 3.40% at June 30, 2014 and 3.60% at December 31, 2013. Adjusted allowance for loan losses to loans is a non-GAAP financial measure which is provided as supplemental information for comparing the combined allowance and fair market value adjustments to the combined acquired and non-acquired loan portfolios. Fair market value adjustments are available only for losses on acquired loans. For a reconciliation to the most comparable GAAP measure, see "Non-GAAP Financial Measures" above. While management believes that it uses the best information available to determine the allowance for loan losses, and that its allowance for loan losses is maintained at a level appropriate in light of the risk inherent in our loan portfolio based on an assessment of various factors affecting the loan portfolio, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the final determination. The allowance for loan losses to total loans may increase if our loan portfolio deteriorates due to economic conditions or other factors. We evaluate and estimate off-balance sheet credit exposure at the same time we estimate credit losses for loans by a similar process, including an estimate of commitment usage levels. These estimated credit losses are not recorded as part of the allowance for loan losses, but are recorded to a separate liability account by a charge to income, if material. Loan commitments, unused lines of credit and standby letters of credit make up the off-balance sheet items reviewed for potential credit losses. At both June 30, 2014 and December 31, 2013, $125 thousand was recorded as an other liability for off-balance sheet credit exposure. Nonperforming Assets Nonperforming assets, which consist of nonaccrual loans, accruing troubled debt restructurings ("TDRs"), accruing loans for which payments are 90 days or more past due, and OREO, totaled $25.7 million at June 30, 2014 compared to $26.8 million at December 31, 2013. Nonperforming loans, which consist of nonaccrual loans, accruing TDRs and accruing loans for which payments are 90 days or more past due, decreased $2.8 million, or 23%, to $9.5 million, or 0.65% of total loans at June 30, 2014, compared to $12.3 million, or 0.95% of total loans at December 31, 2013. It is our general policy to place a loan on nonaccrual status when it is over 90 days past due and there is reasonable doubt that all principal and interest will be collected. Nonaccrual loans decreased $3.2 million, or 38%, in the first half of 2014 from $8.5 million at December 31, 2013. Nonaccrual TDRs are included in the nonaccrual loan amounts noted. At June 30, 2014, nonaccrual TDR loans were $1.6 million and had an allowance of $411 thousand recorded. At December 31, 2013, nonaccrual TDR loans were $4.4 million and had no recorded allowance. Accruing TDRs totaled $3.6 million at June 30, 2014 and $3.9 million at December 31, 2013. 61

-------------------------------------------------------------------------------- We grade loans with an internal risk grade scale of 10 through 90, with grades 10 through 50 representing "pass" loans, grade 60 representing "special mention" and grades 70 and higher representing "classified" credit grades, respectively. Loans are reviewed on a regular basis internally, and at least annually by an external loan review group, to ensure loans are graded appropriately. Credits are reviewed for past due trends, declining cash flows, significant decline in collateral value, weakened guarantor financial strength, management concerns, market conditions and other factors that could jeopardize the repayment performance of the loan. Documentation deficiencies including collateral perfection and outdated or inadequate financial information are also considered in grading loans. All loans graded 60 or worse are included on our list of "watch loans," which represent potential problem loans, and are updated and reported to both management and the Loan and Risk Committee of the board of directors quarterly. Additionally, the watch list committee may review other loans with more favorable ratings if there are concerns that the loan may become a problem. Impairment analyses are performed on all loans graded "substandard" (risk grade of 70 or worse) and generally greater than $150 thousand as well as selected other loans as deemed appropriate. At June 30, 2014, we maintained "watch loans" totaling $27.6 million compared to $35.2 million at December 31, 2013. Approximately $6 million and $7 million of the watch loans at June 30, 2014 and December 31, 2013, respectively, were acquired loans. The future level of watch loans cannot be predicted, but rather will be determined by several factors, including overall economic conditions in the markets served.



We employ one of three potential methods to determine the fair value of impaired loans:

1) Fair value of collateral method. This is the most common method and is used when the loan is collateral dependent. In most cases, we will obtain an "as is" appraisal from a third-party appraisal group. The fair value from that appraisal may be adjusted downward for liquidation discounts for foreclosure or quick sale scenarios, as well as any applicable selling costs.



2) Cash flow method. This method is used when we believe that we will collect the loan primarily from cash flows generated by the borrower.

3) Observable market value method. This is the method used least often by us. Fair value is based on the offering price from a note buyer, in either the local community or a national loan sale advisor. With respect to nonaccrual commercial and nonaccrual consumer AC&D loans, we typically utilize an "as-is," or "discounted," value to determine an appropriate fair value. When appraising projects with an expected cash flow to be received over a period of time, such as acquisition and development/land development loans, fair value is determined using a discounted cash flow methodology. We also account for expected selling and holding costs when determining an appropriate property value. At June 30, 2014, OREO totaled $16.2 million, all of which is recorded at values based on our most recent appraisals. Included in that total is $5.2 million of OREO covered under the FDIC loss share agreements. At December 31, 2013, OREO totaled $14.5 million, all of which was recorded at values based on the most recent appraisals then available. Included in that total is $5.1 million of OREO covered under the FDIC loss share agreements. Deposits and Other Borrowings We offer a broad range of deposit instruments, including personal and business checking accounts, individual retirement accounts, business and personal money market accounts and certificates of deposit at competitive interest rates. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. We regularly evaluate the internal cost of funds, survey rates offered by competing institutions, review cash flow requirements for lending and liquidity and execute rate changes when deemed appropriate. 62 -------------------------------------------------------------------------------- Total deposits at June 30, 2014 were $1.86 billion, an increase of $262.8 million, or 16.4%, from December 31, 2013. Noninterest bearing demand deposits increased $76.0 million, or 29.7%, and represented 18% of total deposits at June 30, 2014. Money market, NOW and savings deposits increased $142.6 million, or 19.4%. Non-brokered time deposits increased $67.3 million, or 15.2%. Increases in these deposit types were the result of both the Provident Community acquisition and strong retail sales efforts. Finally, brokered deposits decreased $23.1 million, or 13.9%. Brokered deposits remain attractive given their relatively lower interest costs and flexible term structures, and will continue to be selectively utilized in our normal funding and interest rate risk management practices. Brokered deposits consist of brokered interest-bearing deposits, brokered money market accounts, and brokered certificates of deposits. Brokered money market and interest-bearing deposits are the result of the brokered money market deposit program initiated in December 2013 in connection with our $50 million investment strategy. The following is a summary of deposits at June 30, 2014 and December 31, 2013: June 30, December 31, 2014 2013 (dollars in thousands) Noninterest bearing demand deposits $ 331,866 $



255,861

Interest-bearing demand deposits 353,997 296,995 Money market deposits 436,613 390,059 Savings 87,779 48,701 Brokered deposits 143,156 166,280 Certificates of deposit and other time deposits 509,296 441,989 Total deposits $ 1,862,707$ 1,599,885 Total borrowings increased $8.8 million, or 11%, to $86.8 million at June 30, 2014 compared to $78.0 million at December 31, 2013. Borrowings at June 30, 2014 include $23.2 million (after acquisition accounting fair market value adjustments) of Tier 1-eligible subordinated debt. Our Tier-2-eligible subordinated debt, which consisted of $6.9 million aggregate principal amount of the Bank's 11% Subordinated Notes due June 30, 2019, was redeemed in full at the option of the Bank on June 30, 2014. The redemption price was 100% of the principal amount plus accrued but unpaid interest. 63 --------------------------------------------------------------------------------

Results of Operations



The following table summarizes components of net income and the changes in those components for the three and six months ended June 30, 2014 and 2013:

Three Months Ended Six Months Ended June 30, June 30, 2014 2013 Change 2014 2013 Change (Unaudited) $ % (Unaudited) $ % (Dollars in thousands) (Dollars in thousands)

Gross interest income $ 21,157$ 20,144$ 1,013 5.0 % $ 40,363$ 39,467$ 896 2.3 % Gross interest expense 2,078 1,473 605 41.1 % 4,009 3,060 949 31.0 % Net interest income 19,079 18,671 408 2.2 % 36,354 36,407 (53 ) -0.1 % Provision for loan losses (365 ) 75 (440 ) -586.7 % (382 ) 384 (766 ) -199.5 % Noninterest income 4,016 3,968 48 1.2 % 7,502 7,426 76 1.0 % Noninterest expense 18,274 16,784 1,490 8.9 % 34,017 32,705 1,312 4.0 % Net income before taxes 5,186 5,780 (594 ) -10.3 % 10,221 10,744 (523 ) -4.9 % Income tax expense 1,760 1,968 (208 ) -10.6 % 3,240 3,692 (452 ) -12.2 % Net income 3,426 3,812 (386 ) -10.1 % 6,981 7,052 (71 ) -1.0 % Preferred dividends - 302 (302 ) -100.0 % - 353 (353 ) -100.0 % Net income available to common shareholders $ 3,426$ 3,510$ (84 ) -2.4 % $ 6,981$ 6,699$ 282 4.2 % Net Income available to common shareholders. Net income available to common shareholders for the three months ended June 30, 2014 was $3.4 million compared to $3.5 million for the same period in 2013. This decrease in net income for the three-month period primarily was the result of noninterest expenses which increased $1.5 million, or 8.9%, due to hiring initiatives and the merger with Provident Community, which were partially offset by increased revenues and a reversal of provision expense. Net income available to common shareholders for the six months ended June 30, 2014, was $7.0 million compared to $6.7 million for the same period in 2013. This increase in net income is due to a reduced provision for loan losses, reduced rate on income taxes and the elimination of the preferred stock dividend on the SBLF shares redeemed in September 2013. Annualized return on average assets remained flat during the six-month period ended June 30, 2014 at 0.68%. Annualized return on average equity improved to 5.29% during the six-month period ended June 30, 2014 from 4.82% for the six-month period ended June 30, 2013. Net Interest Income. Our largest source of earnings is net interest income, which is the difference between interest income on interest-earning assets and interest expense paid on deposits and other interest-bearing liabilities. The primary factors that affect net interest income are changes in volume and yields of earning assets and interest-bearing liabilities, which are affected in part by management's responses to changes in interest rates through asset/liability management. Net interest income increased to $19.1 million for the three-month period ended June 30, 2014 from $18.7 million for the three months ended June 30, 2013. The increase is primarily due to the increase in average earning assets. Net interest income remained flat at $36.4 million for the six-month period ended June 30, 2014 when compared to the six months ended June 30, 2013. Total average interest-earning assets increased to $1.9 billion for the three months ended June 30, 2014, from $1.7 billion for the same period in the previous year. Average balances of total interest-bearing liabilities increased to $1.6 billion in the three-month period ended June 30, 2014, compared to $1.4 billion for the same period in 2013. Our net interest margin decreased from 4.30% in the three-month period ended June 30, 2013 to 3.95% in the corresponding period in 2014. The increases in average balances are the result of the Provident Community merger and organic growth for the three-month period. The decrease in net interest margin reflects the lower interest rates on new loans as well as the increase in cost of interest bearing liabilities. 64 -------------------------------------------------------------------------------- Total average interest-earning assets increased to $1.9 billion for the six months ended June 30, 2014, from $1.7 billion for the same period in the previous year. Average balances of total interest-bearing liabilities increased to $1.5 billion in the six-month period ended June 30, 2014, compared to $1.4 billion for the same period in 2013. Our net interest margin decreased from 4.23% in the six-month period ended June 30, 2013 to 3.96% in the corresponding period in 2014. The increases in average balances are the result of the Provident Community merger and organic growth for the six-month period. The decrease in net interest margin reflects the lower interest rates on new loans, the expiration of accounting-related fair market value adjustments on acquired deposits in the third quarter of 2013, as well as the increase in cost of interest bearing liabilities.



The following tables summarize net interest income and average yields and rates paid for the periods indicated:

Average Balance Sheets and Net Interest Analysis For the Three Months Ended June 30, 2014 2013 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate (dollars in thousands) Assets Interest-earning assets: Loans, including fees (1)(2) $ 1,397,158$ 18,734 5.38 % $ 1,337,318$ 18,805 5.64 % Federal funds sold 427 - 0.00 % 12,330 7 0.23 % Taxable investment securities 416,187 2,152 2.07 % 284,775 1,068 1.48 % Tax-exempt investment securities 12,809 133 4.15 % 17,583 195 4.39 % Nonmarketable equity securities 5,697 85 5.98 % 5,909 25 1.70 % Other interest-earning assets 106,181 53 0.20 % 84,397 44 0.21 % Total interest-earning assets 1,938,459 21,157 4.38 % 1,742,312 20,144 4.64 % Allowance for loan losses (9,588 ) (11,736 ) Cash and due from banks 17,856 14,315 Premises and equipment 58,347 57,292 Other assets 163,840 165,553 Total assets $ 2,168,914$ 1,967,736 Liabilities and shareholders' equity Interest-bearing liabilities: Interest-bearing demand $ 333,130$ 87 0.10 % $ 285,697$ 62 0.09 % Savings and money market 515,943 473 0.37 % 445,158 317 0.29 % Time deposits - core 488,936 693 0.57 % 493,995 313 0.25 % Brokered deposits 154,520 190 0.49 % 102,716 215 0.84 % Total interest-bearing deposits 1,492,529 1,443 0.39 % 1,327,566 907 0.27 % Federal Home Loan Bank advances 55,000 128 0.93 % 55,000 137 1.00 % Other borrowings 32,556 507 6.25 % 24,187 429 7.11 % Total borrowed funds 87,556 635 2.91 % 79,187 566 2.87 % Total interest-bearing liabilities 1,580,085 2,078 0.53 % 1,406,753 1,473 0.42 % Net interest rate spread 19,079 3.85 % 18,671 4.22 % Noninterest-bearing demand deposits 298,313 256,383 Other liabilities 24,212 22,589 Shareholders' equity 266,304 282,011 Total liabilities and shareholders' equity $ 2,168,914$ 1,967,736 Net interest margin 3.95 % 4.30 %



(1) Average loan balances include nonaccrual loans.

(2) Interest income and yields include accretion from acquisition accounting adjustments associated with acquired loans.

65 --------------------------------------------------------------------------------

Average Balance Sheets and Net Interest Analysis For the Six Months Ended June 30, 2014 2013 Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate (dollars in thousands) Assets Interest-earning assets: Loans, including fees (1)(2) $ 1,351,412$ 35,660 5.32 % $ 1,341,937$ 36,945 5.55 % Federal funds sold 437 - 0.00 % 29,112 24 0.17 % Taxable investment securities 399,990 4,123 2.06 % 264,947 1,934 1.45 % Tax-exempt investment securities 14,194 355 5.00 % 17,739 385 4.32 % Nonmarketable equity securities 5,746 151 5.30 % 6,274 73 2.35 % Other interest-earning assets 80,015 74 0.19 % 77,267 106 0.28 % Total interest-earning assets 1,851,794 40,363 4.40 % 1,737,276 39,467 4.58 % Allowance for loan losses (9,477 ) (11,726 ) Cash and due from banks 16,127 22,172 Premises and equipment 57,147 57,340 Other assets 157,718 167,804 Total assets $ 2,073,309$ 1,972,866 Liabilities and shareholders' equity Interest-bearing liabilities: Interest-bearing demand $ 312,865$ 150 0.10 % $ 294,887$ 153 0.10 % Savings and money market 489,349 941 0.39 % 440,576 633 0.29 % Time deposits - core 462,806 1,377 0.60 % 500,214 658 0.27 % Brokered deposits 160,421 354 0.44 % 105,034 477 0.92 % Total interest-bearing deposits 1,425,441 2,822 0.40 % 1,340,711 1,921 0.29 % Federal Home Loan Bank advances 55,265 255 0.93 % 55,083 274 1.00 % Other borrowings 27,823 932 6.76 % 27,462 865 6.35 % Total borrowed funds 83,088 1,187 2.88 % 82,545 1,139 2.78 % Total interest-bearing liabilities 1,508,529 4,009 0.54 % 1,423,256 3,060 0.43 % Net interest rate spread 36,354 3.86 % 36,407 4.15 % Noninterest-bearing demand deposits 275,715 248,370 Other liabilities 23,145 20,858 Shareholders' equity 265,920 280,382 Total liabilities and shareholders' equity $ 2,073,309$ 1,972,866 Net interest margin 3.96 % 4.23 %



(1) Average loan balances include nonaccrual loans.

(2) Interest income and yields include accretion from acquisition accounting adjustments associated with acquired loans.

Provision for Loan Losses. Our provision for loan losses decreased $0.4 million, or 587%, to a release of $365 thousand during the three months ended June 30, 2014, from a $75 thousand charge during the corresponding period in 2013. Included in the loan loss provision for the second quarter of 2014 was (i) a net impairment reversal of $521 thousand associated with PCI pools, (ii) a $9 thousand charge attributable to FDIC loss share agreements caused by a decrease in expected loss in those acquired loans and (iii) a net $165 thousand provision on our originated portfolio which saw significant organic growth in the second quarter. Our provision for loan losses decreased $0.7 million, or 200%, to a release of $382 thousand during the six months ended June 30, 2014, from a $384 thousand charge during the corresponding period in 2013. Included in the loan loss provision for the first six months of 2014 was (i) a net impairment reversal of $209 thousand associated with PCI pools, (ii) a $278 thousand reversal of a previous charge attributable to FDIC loss share agreements caused by an increase in expected loss in those acquired loans and (iii) a net $451 thousand release of provision on our originated portfolio. 66 -------------------------------------------------------------------------------- We had $0.4 million in net recoveries, excluding charge-offs on PCI loans, during the three months ended June 30, 2014 compared to net charge-offs of $0.3 million during the corresponding period in 2013. We had $1.2 million in net recoveries, excluding charge-offs on PCI loans, during the six months ended June 30, 2014 compared to net recoveries of $34 thousand during the corresponding period in 2013. The net recoveries during 2014 reflected the favorable resolution of problem assets from the legacy Park Sterling portfolio, including both disposition of a single troubled debt restructuring that was designated a nonaccrual loan in the fourth quarter of 2013 as well as recoveries from a large residential development nonaccrual loan.



Noninterest Income. The following table presents components of noninterest income for the three and six months ended June 30, 2014 and 2013:

Noninterest Income Three months ended Six months ended June 30, June 30, 2014 2013 Change 2014 2013 Change (Unaudited) $ % (Unaudited) $ % (dollars in thousands) Service charges on deposit accounts $ 1,001$ 616$ 385 62.5 %



$ 1,634$ 1,380$ 254 18.4 % Income from fiduciary activities

642 648 (6 ) -0.9 % 1,320 1,246 74 5.9 % Commissions and fees from investment brokerage 131 83 48 57.8 % 228 193 35 18.1 % Gain (loss) on sale of securities available for sale (33 ) 104 (137 ) -131.7 %



243 104 139 133.7 % ATM and card income

764 692 72 10.4 %



1,312 1,180 132 11.2 % Mortgage banking income

653 977 (324 ) -33.2 % 897 1,945 (1,048 ) -53.9 % Income from bank-owned life insurance 525 528 (3 ) -0.6 % 1,645 909 736 81.0 % Amortization of indemnification asset (859 ) (38 ) (821 ) 2160.5 %

(1,112 ) (65 ) (1,047 ) 1610.8 % Other noninterest income 1,192 358 834 233.0 % 1,335 534 801 150.0 % Total noninterest income $ 4,016$ 3,968$ 48 1.2 %

$ 7,502$ 7,426$ 76 1.0 % Noninterest income remained flat for the three months ended June 30, 2014 when compared to the three months ended June 30, 2013. Noteworthy changes among categories include (i) a $385 thousand increase in service charges on deposit accounts, a direct contribution of the Provident Community merger; (ii) a $137 thousand change in sale of securities available-for-sale resulting from a gain of $104 thousand in the three months ended June 30, 2013 compared to a loss of $33 thousand in the three months ended June 30, 2014; (iii) a $324 thousand decrease in mortgage banking income due to lower activity in loan closings and the period end pipeline; (iv) an $821 thousand increase in amortization of the indemnification asset related to the loss share agreements with the FDIC; and (v) an $834 thousand increase in other noninterest income primarily as a result of the conversion of MasterCard Class B shares held by the Company into MasterCard Class A shares and the subsequent sale of such shares for $936 thousand. Noninterest income also remained flat for the six months ended June 30, 2014 compared to the six months ended June 30, 2013. Noteworthy changes among categories include (i) a $254 thousand increase in service charges on deposit accounts, as a direct contribution of the Provident Community merger; (ii) a $1.0 million decrease in mortgage banking income due to lower activity in loan closings and the period end pipeline; (iii) a $736 thousand increase in income from bank-owned life insurance due primarily to death benefit proceeds of $651 thousand received in the first quarter of 2014; (iv) a $1.0 million increase in amortization of indemnification assets related to the loss share agreements with the FDIC; and (v) an $801 thousand increase in other noninterest income primarily as a result of the sale of MasterCard shares for $936 thousand. 67 --------------------------------------------------------------------------------



Noninterest Expense. The following table presents components of noninterest expense for the three and six months ended June 30, 2014 and 2013:

Noninterest Expense Three months ended Six months ended June 30, June 30, 2014 2013 Change 2014 2013 Change (Unaudited) $ % (Unaudited) $ % (dollars in



thousands)

Salaries and employee benefits $ 9,684$ 8,800$ 884 10.0 % $ 18,912$ 17,578$ 1,334 7.6 % Occupancy and equipment 2,249 1,980 269 13.6 % 4,254 3,888 366 9.4 % Advertising and promotion 223 150 73 48.7 % 456 370 86 23.2 % Legal and professional fees 1,122 861 261 30.3 % 1,783 1,754 29 1.7 % Deposit charges and FDIC insurance 368 409 (41 ) -10.0 % 608 896 (288 ) -32.1 % Data processing and outside service fees 1,544 1,640 (96 ) -5.9 % 2,890 3,293 (403 ) -12.2 % Communication fees 576 448 128 28.6 % 1,012 880 132 15.0 % Core deposit intangible amortization 317 257 60 23.3 % 574 514 60 11.7 % Net cost (earnings) of % operation of OREO 206 (36 ) 242 -672.2 259 (464 ) 723 -155.8 % Loan and collection expense 304 679 (375 ) -55.2 % 592 1,005 (413 ) -41.1 % Postage and supplies 170 298 (128 ) -43.0 % 345 627 (282 ) -45.0 % Other tax expense 494 127 367 289.0 % 563 303 260 85.8 % Other noninterest expense 1,017 1,171 (154 ) -13.2 %



1,769 2,061 (292 ) -14.2 %

Total noninterest expense $ 18,274$ 16,784$ 1,490 8.9 % $ 34,017$ 32,705$ 1,312 4.0 % Total noninterest expense increased to $18.3 million for the three months ended June 30, 2014, an increase of 8.9% from $16.8 million for the corresponding period in 2013. Excluding merger-related expenses of $594 thousand and $822 thousand for the three-month periods ended June 30, 2014 and 2013, respectively, noninterest expense increased $1.7 million, or 10.8%, for the three months ended June 30, 2014, compared to the corresponding period in the prior year. Total noninterest expense increased to $34.0 million for the six months ended June 30, 2014, an increase of 4.0% from $32.7 million for the corresponding period in 2013. Excluding merger-related expenses of $675 thousand and $1.6 million for the six-month periods ended June 30, 2014 and 2013, respectively, noninterest expense increased $2.3 million, or 7.1%, for the six months ended June 30, 2014, compared to the corresponding period in the prior year. Total full-time equivalents increased to 541 at June 30, 2014 from 452 at June 30, 2013. Adjusted noninterest expenses, which exclude merger-related expenses, is a non-GAAP financial measure. For a reconciliation to the most comparable GAAP measure, see "Non-GAAP Financial Measures" above.



Three-month comparison and analysis

Salaries and employee benefits expenses increased $884 thousand, or 10.0%, to $9.7 million in the three months ended June 30, 2014 compared to $8.8 million in the comparable period of 2013. These increases are primarily due to hiring initiatives designed to drive future organic growth opportunities and the increase in number of employees resulting from the Provident Community acquisition. Other notable changes between categories during the three months ended June 30, 2014 when compared to the three months ended June 30, 2013 include (i) an increase in occupancy and equipment expense of $269 thousand, or 13.6%, to $2.2 million primarily due to the addition of the Richmond Market and Provident Community; (ii) an increase in legal and professional fees of $261 thousand, or 30.3%, to $1.1 million primarily due to the Provident Community acquisition; (iii) a decrease in loan and collection expenses of $375 thousand, or 55.2%, to $304 thousand due to improved asset quality issues; and (iv) an increase in other tax expense of $367 thousand, or 289.0%, to $494 thousand is due to a true-up of franchise taxes in the second quarter 2014. Additionally, we realized a net loss on operation of other real estate during the second quarter of 2014 of $206 thousand. This represents an increase of $242 thousand, or 672.2%, when compared to the earnings from operation of OREO of $0.04 million during the comparable period of 2013. We sold 45 properties in the second quarter of 2014 at a net loss of approximately $19 thousand compared to 72 properties in the second quarter of 2013 at a net gain of approximately $743 thousand. 68

--------------------------------------------------------------------------------



Six-month comparison and analysis

Salaries and employee benefits expenses increased $1.3 million, or 7.6%, to $18.9 million in the six months ended June 30, 2014 compared to $17.6 million in the comparable period of 2013. These increases are primarily due to hiring initiatives designed to drive future organic growth opportunities and the increase in number of employees resulting from the Provident Community acquisition.

Other notable changes between categories during the six months ended June 30, 2014 when compared to the six months ended June 30, 2013 include (i) an increase in occupancy and equipment expense of $366 thousand, or 9.4%, to $4.2 million primarily due to the addition of the Richmond Market and Provident Community; (ii) a decrease in FDIC insurance of $288 thousand, or 32.1%, to $0.6 million resulting from a true-up of the estimated assessment; (iii) a decrease in data processing and outside service fees of $403 thousand, or 12.2%, to $2.9 million related to merger costs, in 2013, from the Citizens South acquisition; (iv) a decrease in loan and collection expense of $413 thousand, or 41.1%, to $0.6 million primarily due to improved asset quality; (v) a decrease in postage and supplies of $282 thousand, or 45.0% to $0.3 million related to merger costs, in 2013, from the Citizens South acquisition; and (vi) an increase in other tax expense of $260 thousand, or 85.8%, to $563 thousand primarily due to a true-up of franchise taxes. Additionally, we realized a net loss on operation of OREO during the first half of 2014 of $259 thousand. This represents an increase of $723 thousand, or 155.8%, when compared to the earnings from operation of OREO of $0.5 million during the comparable period of 2013. We sold 79 properties in the first half of 2014 at a net gain of approximately $109 thousand compared to 152 properties in the first half of 2013 at a net gain of approximately $1.4 million. Income Taxes. We generate non-taxable income from tax-exempt investment securities and loans as well as from bank-owned life insurance. Accordingly, the level of such income in relation to income before taxes affects our effective tax rate. For the three months ended June 30, 2014, we recognized income tax expense of $1.8 million compared to income tax expense of $2.0 million for the same period in 2013. The effective tax rate for the three months ended June 30, 2014 is 33.94% compared to 34.05% for the same period in 2013. The change in the effective tax rate for the three-month periods was due to the amount of tax-exempt income on tax-exempt loans and municipal securities and nondeductible merger-related expenses relative to the size of pre-tax income. For the six months ended June 30, 2014, we recognized income tax expense of $3.2 million compared to income tax expense of $3.7 million for the same period in 2013. The effective tax rate for the six months ended June 30, 2014 is 31.70% compared to 34.36% for the same period in 2013. The change in the effective tax rate for the six-month periods was due to the amount of tax-exempt income on tax-exempt loans and municipal securities, nondeductible merger-related expenses and the death benefits received on bank-owned life insurance relative to the size of pre-tax income.



Liquidity and Capital Resources

Liquidity refers to the ability to manage future cash flows to meet the needs of depositors and borrowers and to fund operations. We strive to maintain sufficient liquidity to fund future loan demand and to satisfy fluctuations in deposit levels. This is achieved primarily in the form of available lines of credit from various correspondent banks, the FHLB, the Federal Reserve Discount Window and through our investment portfolio. In addition, we may have short-term investments at our primary correspondent bank in the form of Federal funds sold. Liquidity is governed by an asset/liability policy approved by the board of directors and administered by an internal Asset-Liability Management Committee (the "ALCO"). The ALCO reports monthly asset/liability-related matters to the Loan and Risk Committee of the board of directors. 69 -------------------------------------------------------------------------------- Our internal liquidity ratio (total liquid assets, or cash and cash equivalents, divided by deposits and short-term liabilities) at June 30, 2014 was 18.75% compared to 20.92% at December 31, 2013. The slight decline in liquidity is due to the deployment of cash into loans and the reclassification of available-for-sale investments to the held-to-maturity classification. Both ratios exceeded our minimum internal target of 10%. In addition, at June 30, 2014, we had $289.9 million of credit available from the FHLB, $151.6 million of credit available from the Federal Reserve Discount Window, and available lines totaling $70.0 million from correspondent banks. At June 30, 2014, we had $365.1 million of pre-approved but unused lines of credit, $3.2 million of standby letters of credit and $4.9 million of commercial letters of credit. In management's opinion, these commitments represent no more than normal lending risk to us and will be funded from normal sources of liquidity. Our capital position is reflected in our shareholders' equity, subject to certain adjustments for regulatory purposes. Shareholders' equity, or capital, is a measure of our net worth, soundness and viability. We continue to remain in a well-capitalized position. Shareholders' equity on June 30, 2014 was $269.5 million compared to $262.1 million at December 31, 2013. The details of this increase are discussed under "- Financial Condition at June 30, 2014 and December 31, 2013." Risk-based capital regulations adopted by the Federal Reserve Board and the FDIC require bank holding companies and banks to achieve and maintain specified ratios of capital to risk-weighted assets. The risk-based capital rules currently in effect are designed to measure "Tier 1" capital (consisting generally of common shareholders' equity, a limited amount of qualifying perpetual preferred stock and trust preferred securities, and minority interests in consolidated subsidiaries, net of goodwill and other intangible assets, deferred tax assets in excess of certain thresholds and certain other items) and total capital (consisting of Tier 1 capital and Tier 2 capital, which generally includes certain preferred stock, mandatorily convertible debt securities and term subordinated debt) in relation to the credit risk of both on- and off-balance sheet items. Under the guidelines, one of four risk weights is applied to the different on-balance sheet items. Off-balance sheet items, such as loan commitments, are also subject to risk weighting after conversion to balance sheet equivalent amounts. Under current regulations, all banks must maintain a minimum total capital to total risk weighted assets ratio of 8.00%, at least half of which must be in the form of core, or Tier 1, capital. These guidelines also specify that banks that are experiencing internal growth or making acquisitions will be expected to maintain capital positions substantially above the minimum supervisory levels. At June 30, 2014, the Company and the Bank both satisfied their minimum regulatory capital requirements and each was "well capitalized" within the meaning of federal regulatory requirements. 70 -------------------------------------------------------------------------------- Actual and required capital levels at June 30, 2014 and December 31, 2013 are presented below: Regulatory Minimums To Be Well For Capital Capitalized Under Adequacy Prompt Corrective Purposes Actions Provisions June 30, December 31, 2014 2013 Ratio Ratio (dollars in thousands) Park Sterling Corporation Tier 1 capital $ 222,490$ 218,552 Tier 2 capital 9,430 15,956 Total capital $ 231,920$ 234,508 Risk-weighted assets $ 1,602,743$ 1,424,574 Average assets for Tier 1 $ 2,100,048$ 1,879,283 Risk-based capital ratios Tier 1 capital 13.88 % 15.34 % 4.00 % 6.00 % Total capital 14.47 % 16.46 % 8.00 % 10.00 % Tier 1 leverage ratio 10.59 % 11.63 % 4.00 % 5.00 % Park Sterling Bank Tier 1 capital $ 206,718$ 193,830 Tier 2 capital 9,430 15,956 Total capital $ 216,148$ 209,786 Risk-weighted assets $ 1,599,321$ 1,420,331 Average assets for Tier 1 $ 2,089,293$ 1,861,925 Risk-based capital ratios Tier 1 capital 12.93 % 13.65 % 4.00 % 6.00 % Total capital 13.51 % 14.77 % 8.00 % 10.00 % Tier 1 leverage ratio 9.89 % 10.41 % 4.00 % 5.00 % In July 2013, the federal banking regulatory agencies approved Final Rules that will replace the existing general risk-based capital and related rules, broadly revising the basic definitions and elements of regulatory capital and making substantial changes to the credit risk weightings for banking and trading book assets. The new regulatory capital rules establish the benchmark capital rules and capital floors that are generally applicable to United States banks under the Dodd-Frank Act and make the capital rules consistent with heightened international capital standards known as Basel III. These new capital standards will apply to all banks, regardless of size, and to all bank holding companies with consolidated assets greater than $500 million. Under the Final Rules, Tier 1 capital will consist of two components: common equity Tier 1 capital and additional Tier 1 capital. Total Tier 1 capital, plus Tier 2 capital, will constitute total risk-based capital. The required minimum ratios will be (i) common equity Tier 1 risk-based capital ratio of 4.5%; (ii) Tier 1 risk-based capital ratio of 6%; (iii) total risk-based capital ratio of 8%; and (iv) Tier 1 leverage ratio of average consolidated assets of 4%. Advanced approaches banking organizations (those organizations with either total assets of $250 billion or more, or with foreign exposure of $10 billion or more) also will be subject to a supplementary leverage ratio that incorporates a broader set of exposures in the denominator. The Final Rules also incorporate these changes in regulatory capital into the prompt corrective action framework, under which the thresholds for "adequately capitalized" banking organizations will be equal to the new minimum capital requirements. Under this framework, in order to be considered "well capitalized", insured depository institutions will be required to maintain a Tier 1 leverage ratio of 5%, a common equity Tier 1 risk-based capital measure of 6.5%, a Tier 1 risked-based capital ratio of 8% and a total risk-based capital ratio of 10%. 71 -------------------------------------------------------------------------------- The Final Rules also provide that all covered banking organizations must maintain a new capital conservation buffer of common equity Tier 1 capital in an amount greater than 2.5% of total risk-weighted assets to avoid being subject to limitations on capital distributions and discretionary bonus payments to executive officers. Advanced approaches organizations also will be subject to a countercyclical capital buffer. Failure to satisfy the capital buffer requirements would result in increasingly stringent limitations on various types of capital distributions, including dividends, share buybacks and discretionary payments on Tier 1 instruments, and discretionary bonus payments. The Final Rules reflect changes from the June 2012 proposals that minimize the impact of the revised capital regulations on community banks. In particular, banking organizations with less than $15 billion in total assets (including the Company and the Bank) will not be subject to the phase-out of non-qualifying Tier 1 capital instruments, such as trust preferred securities ("TruPS"), that were issued and outstanding prior to May 19, 2010. In addition, non-advanced approaches banking organizations will have a one-time option to exclude certain components of accumulated other comprehensive income from inclusion in regulatory capital, comparable to treatment under the current capital rules. The Final Rules also retain the existing treatment for residential mortgage exposures in the current risk-based capital rules, rather than adopt the proposed changes that would have required banking organizations to determine the risk weights based on a complex categorization and loan-to-value assessment. Although the Final Rules alleviate some of the concerns of community banks with the capital standards as originally proposed, the new capital standards will impose significant changes on the definition of capital, including the inability to include instruments such as TruPS in Tier 1 capital going forward and new constraints on the inclusion of minority interests, mortgage servicing assets, deferred tax assets and certain investments in the capital of unconsolidated financial institutions. In addition, the Final Rules increase the risk-weights of various assets, including certain high volatility commercial real estate and past due asset exposures. Non-advanced approaches banking organizations, including the Company and the Bank, must begin compliance with the new minimum capital ratios and the standardized approach for risk-weighted assets as of January 1, 2015, and the revised definitions of regulatory capital and the revised regulatory capital deductions and adjustments will be phased in over time for such organizations beginning as of that date. The capital conservation buffer will be phased in for all banking organizations beginning January 1, 2016.



Management is currently assessing the impact of the Final Rules to its regulatory capital ratios but does not expect these changes to result in a material difference.

Contractual Obligations, Commitments and Off-Balance Sheet Arrangements

In the ordinary course of operations, we enter into certain contractual obligations. Such obligations include the funding of operations through debt issuances as well as leases for premises and equipment.

Information about our off-balance sheet risk exposure is presented in Note 16 - Off-Balance Sheet Risk of the 2013 Audited Financial Statements. As part of ongoing business, we have not participated in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as special purpose entities ("SPE"s), which generally are established for facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of June 30, 2014, we were not involved in any unconsolidated SPE transactions, other than the investments in the four statutory trusts associated with our TruPS. 72 --------------------------------------------------------------------------------



Impact of Inflation and Changing Prices

As a financial institution, we have an asset and liability make-up that is distinctly different from that of an entity with substantial investments in plant and inventory because the major portions of a commercial bank's assets are monetary in nature. As a result, our performance may be significantly influenced by changes in interest rates. Although we, and the banking industry, are more affected by changes in interest rates than by inflation in the prices of goods and services, inflation is a factor that may influence interest rates. However, the frequency and magnitude of interest rate fluctuations do not necessarily coincide with changes in the general inflation rate. Inflation does affect operating expenses in that personnel expenses and the cost of supplies and outside services tend to increase more during periods of high inflation. 73



--------------------------------------------------------------------------------


For more stories on investments and markets, please see HispanicBusiness' Finance Channel



Source: Edgar Glimpses


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters