Coastal Carolina Bancshares, Inc.: Form 10-Q for the period ended Mar 31, 2012

The following discussion reviews our results of operations and assesses our financial condition. You should read the following discussion and analysis in conjunction with the accompanying consolidated financial statements. The commentary should be read in conjunction with the discussion of forward-looking statements, the consolidated financial statements, and the related notes and the other statistical information included in this report.

DISCUSSION OF FORWARD-LOOKING STATEMENTS

This report contains statements which constitute forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may relate to our financial condition, results of operation, plans, objectives, or future performance. These statements are based on many assumptions and estimates and are not guarantees of future performance. Our actual results may differ materially from those anticipated in any forward-looking statements, as they will depend on many factors about which we are unsure, including many factors which are beyond our control. The words “may,” “would,” “could,” “should,” “will,” “expect,” “anticipate,” “predict,” “project,” “potential,” “believe,” “continue,” “assume,” “intend,” “plan,” and “estimate,” as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ from those anticipated in our forward-looking statements include, but are not limited to, those described in our Annual Report on Form 10-K for the year ended December 31, 2011 under Item 1A—Risk Factors and the following:

• significant increases in competitive pressure in the banking and financial services industries;
• changes in the interest rate environment which could reduce anticipated or actual margins;
• changes in political conditions or the legislative or regulatory environment;
• general economic conditions, either nationally or regionally and especially in our primary service area, becoming less favorable than expected, resulting in, among other things, a deterioration in credit quality;
• changes occurring in business conditions and inflation;
• changes in technology;
• the level of allowance for loan loss and the lack of seasoning of our loan portfolio;
• the rate of delinquencies and amounts of charge-offs;
• the rates of loan growth;
• adverse changes in asset quality and resulting credit risk-related losses and expenses;
• changes in monetary and tax policies;
• loss of consumer confidence and economic disruptions resulting from terrorist activities;
• changes in the securities markets; and
• other risks and uncertainties detailed from time to time in our filings with the Securities and Exchange Commission.

These risks are exacerbated by the volatility and disruption experienced in national and international financial, capital, and credit markets during the last three years. Beginning in 2008 and continuing through 2011, the capital and credit markets experienced unprecedented levels of extended volatility and disruption. During the first quarter of 2012, economic conditions, while slow by historical standards, have shown signs of stabilization. However, as a result of U.S. government fiscal challenges, continued volatility in European sovereign and bank debt, slow improvement in domestic employment conditions, and the economic and monetary policy statements by the Board of Governors of the Federal Reserve System (the “Federal Reserve”), it is difficult to predict if this stabilization is indicative of a lasting trend. Current economic reports are mixed and the outlook for the remainder of 2012 is unclear and does not yet indicate expectations of a sustained recovery. There can be no assurance that the current level of economic activity will not continue to materially and adversely impact the U.S. economy in general, the banking industry, and our business, financial condition and results of operations, as well as our ability to maintain sufficient capital or other funding for liquidity and business purposes.

Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee you that these expectations will be achieved. We undertake no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

Overview

Coastal Carolina Bancshares, Inc. is a bank holding company headquartered in Myrtle Beach, South Carolina. We were incorporated in February 2008 and our national bank subsidiary, Coastal Carolina National Bank, opened for business on June 8, 2009. The principal business activity of our bank is to provide retail and commercial banking services in Myrtle Beach and our surrounding market areas. Our deposits are insured by the Federal Deposit Insurance Corporation.

We completed our stock offering in June 2009, upon the issuance of 2,180,000 shares for gross proceeds of $21.8 million, pursuant to a closing in June 2009. We capitalized the bank with $19.9 million of the proceeds from the stock offering.

Like most community banks, we derive most of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on the majority of which we pay interest. Consequently, one of the key measures of our success is our amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits and borrowings. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb probable losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our earnings. In the following section we have included a detailed discussion of this process.

The following discussion describes our results of operations for the three months ended March 31, 2012 and 2011 and also analyzes our financial condition as of March 31, 2012 and December 31, 2011.

Critical Accounting Policies

We have adopted various accounting policies, which govern the application of accounting principles generally accepted in the United States of America in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to our audited consolidated financial statements as of December 31, 2011, as filed in our Annual Report on Form 10-K.

Certain accounting policies involve significant judgments and assumptions by us that may have a material impact on the carrying value of certain assets and liabilities. We consider such accounting policies to be critical accounting policies. The judgments and assumptions we use are based on historical experience and other factors, which we believe are reasonable under the circumstances. Because of the nature of the judgments and assumptions we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.

Allowance for Loan Losses

We believe the allowance for loan losses is the critical accounting policy that requires the most significant judgment and estimates used in preparation of our consolidated financial statements. Some of the more critical judgments supporting the amount of our allowance for loan losses include judgments about the credit worthiness of borrowers, the estimated value of the underlying collateral, assumptions about cash flow, determination of loss factors for estimating credit losses, and the impact of current events, conditions, and other factors impacting the level of probable inherent losses. Under different conditions, the actual amount of credit losses incurred by us may be different from management’s estimates provided in our consolidated financial statements. Refer to the portion of this discussion that addresses our allowance for loan losses for a more complete discussion of our processes and methodology for determining our allowance for loan losses.

Income Taxes

We use assumptions and estimates in determining income taxes payable or refundable for the current year, deferred income tax liabilities and assets for events recognized differently in our consolidated financial statements and income tax returns, and income tax benefit or expense. Determining these amounts requires analysis of certain transactions and interpretation of tax laws and regulations. Management exercises judgment in evaluating the amount and timing of recognition of resulting tax liabilities and assets. These judgments and estimates are reevaluated on a continual basis as regulatory and business factors change. Valuation allowances are established to reduce deferred tax assets if it is determined to be possible that all or some portion of the potential deferred tax asset will not be realized. We believe our loss position may adversely impact our ability to recognize the full benefit of our deferred tax asset. Therefore, we currently have placed a valuation allowance for our full deferred tax asset. No assurance can be given that either the tax returns submitted by us or the income tax reported on the financial statements will not be adjusted by either adverse rulings by the United States Tax Court, changes in the tax code, or assessments made by the Internal Revenue Service. We are subject to potential adverse adjustments, including, but not limited to, an increase in the statutory federal or state income tax rates, the permanent non-deductibility of amounts currently considered deductible either now or in future periods, and the dependency on the generation of future taxable income, including capital gains, in order to ultimately realize deferred income tax assets.

Results of Operations

Our primary source of revenue is net interest income. Net interest income is the difference between income earned on interest-bearing assets and interest paid on deposits and borrowings used to support such assets. The level of net interest income is determined by the balances of interest-earning assets and interest-bearing liabilities and corresponding interest rates earned and paid on those assets and liabilities, respectively. In addition to the volume of and corresponding interest rates associated with these interest-earning assets and interest-bearing liabilities, net interest income is affected by the timing of the repricing of these interest-earning assets and interest-bearing liabilities.

Three months ended March 31, 2012 and 2011

We incurred a net loss of $142,101, or .06 cents per share, for the three months ended March 31, 2012, compared to a net loss of $791,370, or .36 cents per share, for the three months ended March 31, 2011. Interest income was $921,629 and $646,941 for the three months ended March 31, 2012 and 2011, respectively. The increase in interest income is attributed to the larger loan portfolio maintained by the bank in 2012, offset by less interest income received on investments and interest bearing bank deposits. Interest income for the three months ended March 31, 2012 was comprised of $770,452 earned on loans, $139,333 earned on investment securities, and $11,844 earned on fed funds sold and interest bearing bank deposits.

Interest expense was $190,612 for the three months ended March 31, 2012, compared to $212,751 for the three months ended March 31, 2011. The decrease in interest expense is attributed to a reduction in deposit rates. Our net interest spread and net interest margin were 2.90% and 3.08%, respectively, for the three months ended March 31, 2012, compared to 2.23% and 2.53%, respectively, for the three months ended March 31, 2011. We are achieving higher yields on earning assets due to loan growth, as lower yielding liquidity has been redeployed into higher yielding loans. We are also achieving lower costs associated with deposit liabilities.

The loan loss provision, which is driven primarily by loan growth, non-performing loans, and a historical loss and environmental analysis, was $14,094 for the three months ended March 31, 2012, compared to $318,431 for the three months ended March 31, 2011. The decrease in loan loss provision is attributed primarily to higher specific reserves needed in 2011 for non-performing loans.

Non-interest income was $68,844 for the three months ended March 31, 2012, of which $19,272 came from service charges on deposits, $19,850 came from gains on the sale of mortgage loans, and $7,930 came from gains on sale of investments. For the three months ended March 31, 2011, non-interest income was $17,107, of which $5,120 came from service charges on deposits and $6,605 came from gains on the sale of mortgage loans. There were no gains on sale of investment securities during the first quarter 2011. Service charge fee income has increased due to consumer NSF activity. Additionally, the Bank received $15,891 on a fully depreciated bank vehicle that was disposed during the three months ended March 31, 2012. Non-interest expense was $927,868 and $924,236 for the three months ended March 31, 2012 and 2011, respectively. Employee benefit expenses, occupancy and equipment expense, and marketing expenses all decreased while data processing and consulting services, including an executive search firm, increased during the three months ended March 31, 2012 compared to the same time period in 2011.

Assets and Liabilities

General

Total assets as of March 31, 2012 were $99.0 million, representing an increase of $4.6 million, or 4.9%, compared to $94.4 million as of December 31, 2011. The increase in assets is due primarily to net loan growth of $3.0 million, which was funded primarily by deposit growth of $4.6 million. At March 31, 2012, total assets consisted principally of $16.1 million in cash and cash equivalents, $26.8 million in available-for-sale investment securities and $54.4 million in net loans. Net loans at December 31, 2011 were $51.4 million. The primary source of funding is deposits that are acquired locally. Liabilities at March 31, 2012 totaled $85.0 million, represented almost entirely by retail customer deposits totaling $84.4 million. Liabilities as of December 31, 2011 totaled $80.3 million, including $79.8 million in deposits. At March 31, 2012, shareholders’ equity was $14.0 million, compared to $14.1 million as of December 31, 2011. The reason for the decrease in shareholders’ equity is net losses. Book value per share was $6.41 at March 31, 2012, compared to $6.43 as of December 31, 2011.

Loans

Loans typically provide higher interest yields than other types of interest-earning assets. Net loans have increased $3.0 million, or 5.8%, to $54.4 million, during the three months ended March 31, 2012, primarily in the category of Real Estate – Other, compared to $51.4 million as of December 31, 2011. The following table summarizes the composition of our loan portfolio as of March 31, 2012 and December 31, 2011.

Classified Loans

Classified loans are performing loans with elevated levels of credit risk. These loans are assigned credit risk grades of substandard or worse. The Bank’s classified loans decreased during the first three months of 2012 from $3,337,162 as of December 31, 2011 to $3,200,781 as of March 31, 2012, primarily due to the payoff of one loan relationship.

Nonperforming Loans

At March 31, 2012, nonaccrual loans totaled $531,822, related to four lending relationships, compared to $698,570 in nonaccrual loans as of December 31, 2011. There were no accruing loans which were contractually past due 90 days or more as to principal or interest payments at March 31, 2012 and December 31, 2011. Generally, a loan will be placed on nonaccrual status when it becomes 90 days past due as to principal or interest, or when management believes, after considering economic and business conditions and collection efforts, that the borrower's financial condition is such that collection of the loan is doubtful. The nonaccrual loan relationship is considered impaired.

As of March 31, 2012, we were not aware of any other loans that were not already considered for impairment or categorized as impaired or on nonaccrual.

Provision and Allowance for Loan Losses

The allowance for loan losses represents an amount which we believe will be adequate to absorb probable losses on existing loans that may become uncollectible. Additions to the allowance are often the result of growth in the loan portfolio. Additionally, our judgment as to the adequacy of the allowance for loan losses is based on an ongoing review of the quality, mix, and size of our overall loan portfolio. We make a number of assumptions regarding current portfolio and economic conditions. We consider our historical loan loss experience, the loan loss experience of our peers, and any specific problem loans and commitments that may affect the borrower’s ability to pay. We believe the assumptions we have made to be reasonable, but which may or may not prove to be accurate.

Periodically, we will adjust the amount of the allowance based on changing circumstances. We will charge recognized losses to the allowance and add subsequent recoveries back to the allowance for loan losses. There can be no assurance that charge-offs of loans in future periods will not exceed the allowance for loan losses as estimated at any point in time or that provisions for loan losses will not be significant to a particular accounting period.

We have established an allowance for loan losses through a provision for loan losses charged to expense on our consolidated statement of operations. The allowance for loan losses was $1,105,971 as of March 31, 2012, or 1.99% of gross loans outstanding, compared to $1,091,877 as of December 31, 2011, or 2.07% of gross loans outstanding. Total provision expense for the three months ended March 31, 2012 was $14,094, compared to $318,431 for the three months ended March 31, 2011. The decrease in provision expense in 2012 compared to 2011 was primarily due to less growth in the loan portfolio and additional provision in 2011 needed for classified and nonperforming loan relationships.

There were no charge offs or recoveries during the first three months of 2012 and 2011. As of March 31, 2012, management considered the allowance for loan losses to be adequate and sufficient to meet presently known and inherent losses in the loan portfolio.

Deposits

Our primary source of funds for loans and investments is the funds obtained through our customer deposits. At March 31, 2012, we had $84.4 million in deposits, representing an increase of $4.6 million from December 31, 2011. Our deposits as of March 31, 2012 consisted primarily of $8.9 million in demand deposit accounts, $36.4 million in certificates of deposit, and $39.1 million of savings and money market accounts. The primary source of funding for our loan portfolio is deposits that are acquired locally. As of March 31, 2012, we have no brokered or wholesale deposits and no borrowings.

Liquidity

Liquidity represents the ability of a company to convert assets into cash or cash equivalents without significant loss, and the ability to raise additional funds by increasing liabilities. For an operating bank, liquidity represents the ability to provide steady sources of funds for loan commitments and investment activities, as well as to maintain sufficient funds to cover deposit withdrawals and payment of debt and operating obligations. Liquidity management involves monitoring our sources and uses of funds in order to meet our day-to-day cash flow requirements while maximizing profits. Liquidity management is made more complicated because different balance sheet components are subject to varying degrees of management control. For example, the timing of maturities of our investment portfolio is fairly predictable and subject to a high degree of control at the time investment decisions are made. However, net deposit inflows and outflows are far less predictable and are not subject to the same degree of control.

Our primary sources of liquidity are deposits, scheduled repayments on our loans, and interest/principal payments received on and maturities of our investments. We plan to meet our future cash needs through the generation of deposits. Occasionally, we might sell investment securities in connection with the management of our interest sensitivity gap or to manage cash availability. We may also utilize our cash and due from banks and federal funds sold to meet liquidity requirements as needed. In addition, we have the ability, on a short-term basis, to purchase federal funds from other financial institutions or borrow advances from the Federal Home Loan Bank Atlanta. As of March 31, 2012, our primary sources of liquidity included cash, non-interest and interest-bearing deposits and federal funds sold with financial institutions totaling $16.1 million. In addition, the fair value of our available for sale investment portfolio was $26.8 million as of March 31, 2012. Our lines of credit available with correspondent banks total $8.0 million with no outstanding principal or interest on these lines at March 31, 2012 and are unsecured. These lines may be withdrawn at the discretion of the correspondent financial institutions. Our credit availability at the Federal Home Loan Bank is $9.35 million as of March 31, 2012 and requires collateralization by eligible investment securities or loans. We believe our liquidity levels are adequate to meet our operating needs.

Off-Balance Sheet Risk

Through the operations of our bank, we have made contractual commitments to extend credit in the ordinary course of our business activities. These commitments are legally binding agreements to lend money to our customers at predetermined interest rates for a specified period of time. At March 31, 2012, we had issued commitments to extend credit of $9.8 million through various types of lending arrangements, compared to $10.1 million as of December 31, 2011. We evaluate each customer’s credit worthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by us upon extension of credit, is based on our credit evaluation of the borrower. Collateral varies but may include accounts receivable, inventory, property, plant and equipment, and commercial and residential real estate. We manage the credit risk on these commitments by subjecting them to normal underwriting and risk management processes.

Capital Resources

Total shareholders’ equity was $14.0 million at March 31, 2012 compared to $14.1 million at December 31, 2011. The decrease is primarily a result of net losses of $142,101 for the three months ended March 31, 2012.

Our bank and the Company are subject to various regulatory capital requirements administered by the federal banking agencies. However, the Federal Reserve guidelines contain an exemption from the capital requirements for “small bank holding companies”

which in 2006 were amended to cover most bank holding companies with less than $500 million in total assets that do not have a material amount of debt or equity securities outstanding registered with the SEC. Since our assets are less than $500 million and our stock is not registered under Section 12 of the Securities Exchange Act of 1934, we believe our Company qualifies as a small bank holding company and is exempt from the capital requirements. Nevertheless, our bank remains subject to these capital requirements. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the bank must meet specific capital guidelines that involve quantitative measures of the bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Regardless, our bank is “well capitalized” under these minimum capital requirements as set per bank regulatory agencies.

Under the capital adequacy guidelines, regulatory capital is classified into two tiers. These guidelines require an institution to maintain a certain level of Tier 1 and Tier 2 capital to risk-weighted assets. Tier 1 capital consists of common shareholders’ equity, excluding the unrealized gain or loss on securities available for sale, minus certain intangible assets. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100% based on the risks believed to be inherent in the type of asset. Tier 2 capital consists of Tier 1 capital plus the general reserve for loan losses, subject to certain limitations. A third capital ratio that is closely monitored, known as the Tier 1 Leverage Ratio, measures Tier 1 capital as a percentage of average assets during the quarter.

At the bank level, we are subject to various regulatory capital requirements administered by the federal banking agencies. To be considered “adequately capitalized” under these capital guidelines, we must maintain a minimum total risk-based capital of 8%, with at least 4% being Tier 1 capital. In addition, we must maintain a minimum Tier 1 leverage ratio of at least 4%. To be considered “well-capitalized,” we must maintain total risk-based capital of at least 10%, Tier 1 capital of at least 6%, and a leverage ratio of at least 5%.

In approving the bank’s application for deposit insurance, the FDIC required that the bank maintain a leverage ratio of at least 8% during the bank’s “de novo” period. In addition, the business plan submitted as part of our application with the OCC to obtain a national bank charter calls for the Bank to maintain a Tier 1 risked-based capital ratio of at least 8% and a total risk-based capital ratio of 12% during the Bank’s “de novo” period.”

The bank exceeded its minimum regulatory capital ratios as of March 31, 2012 and December 31, 2011, as well as the ratios to be considered “well capitalized.”

The following table sets forth the bank’s various capital ratios at March 31, 2012 and December 31, 2011:

(Unaudited)

We believe our capital is sufficient to fund the activities of the bank as we grow. As of March 31, 2012, there were no significant firm commitments outstanding for capital expenditures.

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Principal Executive Officer and Principal Financial Officer, of the effectiveness of our disclosure controls and procedures as defined in Exchange Act Rule 15d-15(e). Based upon that evaluation, our Principal Executive Officer and Principal Financial Officer have concluded that our current disclosure controls and procedures are effective as of March 31, 2012. There have been no significant changes in our internal controls over financial reporting during the fiscal quarter ended March 31, 2012 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

The design of any system of controls and procedures is based in part upon certain assumptions about the likelihood of future events. There can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions, regardless of how remote.