First Community Bankshares Inc: Form 10-Q for the period ended Sep 30, 2016

Unless the context suggests otherwise, the terms “First Community,” “Company,” “we,” “our,” and “us” refer to First Community Bancshares, Inc. and its subsidiaries as a consolidated entity. Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand our financial condition, changes in our financial condition, and our results of operations. MD&A contains forward-looking statements and should be read in conjunction with our consolidated financial statements, accompanying notes, and other financial information included in this Quarterly Report on Form 10-Q and our 2015 Annual Report on Form 10-K (the “2015 Form 10-K”).

Cautionary Statement Regarding Forward-Looking Statements

We may make forward-looking statements in filings with the Securities and Exchange Commission, including this Quarterly Report on Form 10-Q and the accompanying exhibits, filings incorporated by reference, reports to our shareholders, and other communications that we make in good faith pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements represent our beliefs, plans, objectives, goals, guidelines, expectations, anticipations, estimates, and intentions. These statements are not guarantees of future performance and involve certain risks, uncertainties, and assumptions that are based on various factors, many of which are beyond our control. The words “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan,” and other similar expressions identify forward-looking statements. The following factors, among others, could cause our financial performance to differ materially from that expressed in such forward-looking statements:

• the strength of the U.S. economy in general and the strength of the local economies in which we conduct operations;
• the effects of, and changes in, trade, monetary, and fiscal policies and laws, including interest rate policies of the Federal Reserve System;
• inflation, interest rate, market and monetary fluctuations;
• our timely development of competitive new products and services and the acceptance of these products and services by new and existing customers;
• the willingness of customers to substitute competitors’ products and services for our products and services and vice versa;
• the impact of changes in financial services laws and regulations, including laws about taxes, banking, securities, and insurance, and the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act;
• the impact of the U.S. Department of the Treasury and federal banking regulators’ continued implementation of programs to address capital and liquidity in the banking system;
• further, future and proposed rules, including those that are part of the process outlined in the International Basel Committee on Banking Supervision’s “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems,” which require banking institutions to increase levels of capital;
• technological changes;
• the effect of acquisitions, including, without limitation, the failure to achieve the expected revenue growth and/or expense savings from such acquisitions;
• the growth and profitability of our noninterest, or fee, income being less than expected;
• unanticipated regulatory or judicial proceedings;
• changes in consumer spending and saving habits; and
• our success at managing the risks involved in the foregoing.

We caution that the foregoing list of important factors is not exclusive. If one or more of the factors affecting these forward-looking statements proves incorrect, our actual results, performance, or achievements could differ materially from those expressed in, or implied by, forward-looking statements contained in this Quarterly Report on Form 10-Q and other reports we filed with the Securities and Exchange Commission. Therefore, we caution you not to place undue reliance on our forward-looking information and statements. We do not intend to update any forward-looking statements, whether written or oral, to reflect changes. These cautionary statements expressly qualify all forward-looking statements that apply to our Company. See Part II, Item 1A, “Risk Factors,” of this report and Part I, Item 1A, “Risk Factors,” of our 2015 Form 10-K.

Corporate Overview

First Community Bancshares, Inc. (the “Company”), a financial holding company, was founded in 1989 and incorporated under the laws of Nevada in 1997. The Company provides commercial banking products and services through its wholly owned subsidiary First Community Bank (the “Bank”), a Virginia-chartered banking institution founded in 1874. The Bank operates forty-five branch banking locations in Virginia, West Virginia, and North Carolina and under the trade name People’s Community Bank, a Division of First Community Bank, in Tennessee. The Bank offers wealth management and investment advice through its wholly-owned subsidiary First Community Wealth Management (“FCWM”)

and the Bank’s Trust Division, which reported combined assets under management of $767 million as of September 30, 2016. These assets are managed under various fee-based arrangements as fiduciary or agent. The Bank provides insurance services from certain branch locations through its full-service insurance agency subsidiary First Community Insurance Services (“FCIS”) in Virginia and West Virginia. We reported total assets of $2.45 billion as of September 30, 2016. Our common stock trades on the NASDAQ Global Select Market under the symbol, “FCBC”.

Net interest income, the difference between interest earned on assets and interest paid on liabilities, is our primary source of earnings. Fees for services, commissions on sales, and various deposit service charges supplement our net interest income. We fund our lending and investing activities primarily through the retail deposit operations of our branch banking network and, to a lesser extent, retail and wholesale repurchase agreements and Federal Home Loan Bank (“FHLB”) borrowings. We invest our funds primarily in loans to retail and commercial customers and various investment securities.

Critical Accounting Estimates

We prepare our consolidated financial statements in accordance with generally accepted accounting principles (“GAAP”) in the United States and conform to general practices within the banking industry. Our financial position and results of operations require management to make judgments and estimates to develop the amounts reflected and disclosed in the consolidated financial statements. Different assumptions in the application of estimates could result in material changes to our consolidated financial position and consolidated results of operations. Estimates, assumptions, and judgments, which are periodically evaluated, are based on historical experience and other factors, including expectations of future events believed reasonable under the circumstances. These estimates are generally necessary when assets and liabilities are required to be recorded at estimated fair value, a decline in the value of an asset carried on the financial statements at fair value warrants an impairment write-down or establishment of a valuation reserve, or an asset or liability needs recorded based on the probability of occurrence of a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. Fair values and information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or, when available, are provided by third-party sources. When third-party information is not available, management estimates valuation adjustments primarily through the use of financial modeling techniques and appraisal estimates.

Our accounting policies are fundamental in understanding MD&A and the disclosures presented in Item 1, “Financial Statements,” of this report. Our critical accounting estimates are described in detail in the “Critical Accounting Estimates” section in Part II, Item 7 of our 2015 Form 10-K.

Recent Business Combinations

On July 15, 2016, the Company completed the previously announced branch exchange with First Bank, North Carolina, pursuant to which the Bank exchanged a portion of its North Carolina branch network for First Bank’s Virginia branch network. Under the agreements, the Bank simultaneously sold six branches in the Winston-Salem and Mooresville areas of North Carolina and acquired seven branches in Southwestern Virginia. The Company acquired total assets of $160.69 million, including total loans of $149.12 million, and total liabilities of $134.39 million, including total deposits of $134.31 million and recorded goodwill of $2.45 million. The Company divested total deposits of $111.02 million and total loans of $155.34 million. The Company recorded a net gain of $3.07 million in connection with the divestiture.

On October 1, 2016, the Company sold two North Carolina offices operating as Greenpoint Insurance Group, Inc. and two Virginia offices operating under the trade name Carr & Hyde Insurance to Ascension Insurance Agency, Inc. The transaction does not impact the Company’s in-branch insurance offices operating as FCIS in West Virginia and Virginia.

Performance Overview

Highlights of our results of operations for the three and nine months ended September 30, 2016, and financial condition as of September 30, 2016, include the following:

• We completed the branch exchange with First Bank on July 15, 2016.
• Net income available to common shareholders increased $124 thousand, or 1.98%, to $6.38 million and diluted earnings per share increased $0.03 to $0.37 for the third quarter of 2016 compared to the same quarter of 2015.
• Net income available to common shareholders increased $435 thousand, or 2.38%, to $18.72 million and diluted earnings per share increased $0.10 to $1.07 for the first nine months of 2016 compared to the same period of 2015.
• The net interest margin decreased 10 basis points to 3.95% for the third quarter of 2016, while the normalized net interest margin increased 9 basis points to 3.77% compared to the same quarter of 2015.
• The net interest margin increased 9 basis points to 4.01% and normalized net interest margin increased 18 basis points to 3.77% for the first nine months of 2016 compared to the same period of 2015.
• The non-covered loan portfolio experienced significant growth, increasing $151.04 million, or 9.30%, compared to December 31, 2015, which resulted in a loan loss provision of $755 thousand for first nine months of 2016. The provision included a reversal of $1.35 million in loan loss provisions related to loans divested in the First Bank transaction.
• The Company’s book value per common share increased $0.92 to $19.87 compared to December 31, 2015.
• Asset quality improved as non-covered delinquent loans as a percentage of total non-covered loans decreased 21 basis points to 1.51% and non-covered nonperforming assets decreased $1.08 million compared to December 31, 2015.
• The Company repurchased 171,225 common shares during the quarter resulting in 1,152,776 shares repurchased year-to-date. Since September 30, 2013, the Company has repurchased 3,928,257 shares including the redemption of preferred stock.
• The Company significantly exceeds regulatory “well capitalized” targets as of September 30, 2016.

Results of Operations

Net Income

The following table presents our net income and related information for the periods indicated:

(Amounts in thousands, except per share data)

Three-Month Comparison. Net income increased for the third quarter of 2016 compared to the same quarter of 2015 due to a $1.54 million decrease in the provision for loan losses and a $462 thousand decrease in noninterest expense offset by a $1.18 million decrease in noninterest income, a $548 thousand decrease in net interest income, and a $146 thousand increase in income tax.

Nine-Month Comparison. Net income increased for the first nine months of 2016 compared to the same period of 2015 due to a $1.00 million decrease in the provision for loan losses, a $995 thousand decrease in noninterest expense, and a $345 thousand increase in net interest income offset by a $1.22 million decrease in noninterest income and a $793 thousand increase in income tax.

Net Interest Income

Net interest income is analyzed on a fully taxable equivalent (“FTE”) basis, a non-GAAP financial measure. The FTE basis adjusts for the tax benefits of income from certain tax exempt loans and investments using the federal statutory rate of 35%. We believe FTE basis is the preferred industry measurement of net interest income and provides better comparability between taxable and tax exempt amounts. We use this non-GAAP financial measure to monitor net interest income performance and to manage the composition of our balance sheet.

The following table presents our average consolidated balance sheets, as of the dates indicated, and the net interest analysis, on a FTE basis, for the periods indicated:

(Amounts in thousands)

(1) Fully taxable equivalent (“FTE”) basis based on the federal statutory rate of 35%

(2) Nonaccrual loans are included in average balances; however, no related interest income is recorded during the period of nonaccrual.

(Amounts in thousands)

(1) Fully taxable equivalent (“FTE”) basis based on the federal statutory rate of 35%

(2) Nonaccrual loans are included in average balances; however, no related interest income is recorded during the period of nonaccrual.

The following table presents the impact on FTE net interest income resulting from changes in volume (average volume times the prior year’s average rate), rate (average rate times the prior year’s average volume), and rate/volume (average volume times the change in average rate), for the periods indicated:

(Amounts in thousands)

(1) FTE basis based on the federal statutory rate of 35%

(2) Nonaccrual loans are included in average balances; however, no related interest income is recorded during the period of nonaccrual.

The following table reconciles net interest income, as presented in our consolidated statements of income, and net interest income on a FTE basis, for the periods indicated:

(Amounts in thousands)

(1) FTE basis based on the federal statutory rate of 35%

The interest earned and the average yield on loans include accretion income from acquired loan portfolios. The following table presents our average consolidated balance sheets, as of the dates indicated, and net interest analysis, on a FTE basis excluding the impact of non-cash purchase accounting accretion, for the periods indicated:

(Amounts in thousands)

(1) FTE basis based on the federal statutory rate of 35%

(2) Nonaccrual loans are included in average balances; however, no related interest income is recorded during the period of nonaccrual.

(3) Normalized totals are non-GAAP financial measures that exclude non-cash loan interest accretion related to PCI loans.

(Amounts in thousands)

(1) FTE basis based on the federal statutory rate of 35%

(2) Nonaccrual loans are included in average balances; however, no related interest income is recorded during the period of nonaccrual.

(3) Normalized totals are non-GAAP financial measures that exclude non-cash loan interest accretion related to PCI loans.

Three-Month Comparison. Net interest income comprised 78.18% of total net interest and noninterest income for the third quarter of 2016 compared to 75.39% for the same quarter of 2015. Net interest income on a FTE basis decreased $603 thousand, or 2.71%, and net interest income on a GAAP basis decreased $548 thousand, or 2.53%, for the third quarter of 2016 compared to the same quarter of 2015. Normalized net interest income on a FTE basis is a non-GAAP measure that excludes non-cash loan accretion income related to purchased credit impaired (“PCI”) loans. The normalized net interest margin increased 9 basis points compared to a decrease of 10 basis points on a GAAP basis for the third quarter of 2016 compared to the same quarter of 2015. The normalized net interest spread increased 8 basis points compared to a decrease of 11 basis points on a GAAP basis.

Average earning assets decreased $964 thousand, or 0.04%, during the third quarter of 2016 compared to the same quarter of 2015 primarily due to a decrease in securities available for sale offset by loan growth. The normalized yield on earning assets increased 6 basis points compared to a decrease of 13 basis points on a GAAP basis. Average loans increased $145.11 million, or 8.66%, during the third quarter of 2016 compared to the same quarter of 2015 and the average loan to deposit ratio increased to 98.25% from 87.51%. The normalized yield on loans decreased 21 basis points compared to a decrease of 48 basis points on a GAAP basis. Non-cash accretion income decreased $1.04 million, or 51.46%, during the third quarter of 2016 compared to the same quarter of 2015. We expect accretion income to decline in future periods due to continued acquired portfolio attrition.

Average interest-bearing liabilities, which consist of interest-bearing deposits and borrowings, decreased $42.95 million, or 2.55%, during the third quarter of 2016 compared to the same quarter of 2015 primarily due to the decline in average interest-bearing time deposit balances. The yield on interest-bearing liabilities decreased 2 basis points, which was largely due to a decrease in the average balance and rate of time deposits. Average interest-bearing deposits decreased $91.13 million, or 6.15%, which was driven by an $84.25 million, or 13.73%, decrease in average time deposits and an $8.94 million, or 1.68%, decrease in savings deposits, which include money market and savings accounts, offset by a $2.06 million, or 0.61%, increase in interest-bearing demand deposits. Average borrowings increased $48.19 million, or 23.65%, which was driven by a $52.85 million, or 65.26%, increase in average FHLB advances and other borrowings.

Nine-Month Comparison. Net interest income comprised 75.42% of total net interest and noninterest income for the first nine months of 2016 compared to 74.25% for the same period of 2015. Net interest income on a FTE basis increased $176 thousand, or 0.27%, and net interest income on a GAAP basis increased $345 thousand, or 0.54%, for the first nine months of 2016 compared to the same period of 2015. The normalized net interest margin increased 18 basis points compared to an increase of 9 basis points for the first nine months of 2016 compared to the same period of 2015. The normalized net interest spread increased 19 basis points compared to an increase of 10 basis points on a GAAP basis.

Average earning assets decreased $49.28 million, or 2.21%, during the first nine months of 2016 compared to the same period of 2015 primarily due to decreases in interest-bearing deposits with other banks and securities available for sale offset by loan growth. The normalized yield on earning assets increased 11 basis points compared to an increase of 2 basis points on a GAAP basis. Average loans increased $100.63 million, or 6.01%, during the first nine months of 2016 compared to the same period of 2015 and the average loan to deposit ratio increased to 95.57% from 85.45%. The normalized yield on loans decreased 18 basis points compared to a decrease of 33 basis points on a GAAP basis. Non-cash accretion income decreased $1.55 million, or 28.42%, during the first nine months of 2016 compared to the same period of 2015.

Average interest-bearing liabilities, which consist of interest-bearing deposits and borrowings, decreased $91.91 million, or 5.28%, during the first nine months of 2016 compared to the same period of 2015 primarily due to the decline in average interest-bearing time deposit balances. The yield on interest-bearing liabilities decreased 8 basis points, which was largely due to a decrease in the average balance and rate of time deposits. Average interest-bearing deposits decreased $129.82 million, or 8.48%, which was driven by a $128.26 million, or 19.57%, decrease in average time deposits and a $2.72 million, or 0.79%, decrease in interest-bearing demand deposits offset by a $1.16 million, or 0.22%, increase in savings deposits. Average borrowings increased $37.91 million, or 17.91%, which was driven by a $33.50 million, or 36.69%, increase in average FHLB advances and other borrowings.

Provision for Loan Losses

Three-Month Comparison. The provision for loan losses is added to the allowance for loan losses after net charge-offs have been deducted to bring the allowance to a level management determines necessary to absorb probable losses in the existing loan portfolio. The provision charged to operations decreased $1.54 million to reflect a recovery of $1.15 million during the third quarter of 2016 compared to the same quarter of 2015, which included a $1.55 million decrease in the non-PCI provision and a $20 thousand increase in the PCI provision resulting in no PCI provision as of September 30, 2016. The recovery of loan losses included the reversal of provisions totaling $1.35 million attributed to loans divested in the First Bank transaction.

Nine-Month Comparison. The provision charged to operations decreased $1.00 million during the first nine months of 2016 compared to the same period of 2015, which included a $970 thousand increase in the non-PCI provision and a $31 thousand decrease in the PCI provision resulting in a PCI recovery of $41 thousand. The provision charged to operations included a $1 thousand benefit attributed to the Federal Deposit Insurance Corporation (“FDIC”) indemnification asset to reflect the indemnified portion of the post-acquisition exposure during the first nine months of 2016 compared to a $29 thousand benefit during the same period of 2015. See “Allowance for Loan Losses” in the “Financial Condition” section below.

Noninterest Income

The following table presents the components of, and changes in, noninterest income for the periods indicated:

(Amounts in thousands)

Three-Month Comparison. Noninterest income comprised 21.82% of total net interest and noninterest income for the third quarter of 2016 compared to 24.61% for the same quarter of 2015. Noninterest income decreased $1.18 million, or 16.67%, for the third quarter of 2016 compared to the same quarter of 2015. The decrease in wealth management revenues, which include fees and commissions for trust and investment advisory services, was due to both FCWM and the Trust Division. Service charges on deposits and other service charges and fees decreased primarily from a decrease in service charges on checking accounts. Insurance commissions decreased largely due to a decrease in commissions from the sale of property and casualty policies. We realized net impairment losses of $4.64 million related to certain debt securities and a net gain of $25 thousand on the sale of securities during the third quarter of 2016. See Note 3, “Investment Securities,” to the Condensed Consolidated Financial Statements in Item 1 of this report. Net negative amortization related to the FDIC indemnification asset decreased as a result of improved loss estimates and payoffs in the covered loan portfolio associated with the acquisition of Waccamaw Bank (“Waccamaw”). We realized a net gain on the divestiture of six bank branches to First Bank. See Note 2, “Acquisitions and Divestitures,” to the Condensed Consolidated Financial Statements in Item 1 of this report. Other operating income increased primarily due to legal settlements received.

Excluding the impact from impairment losses, sales of securities and branches, net FDIC indemnification asset amortization, and net gain on divestiture, noninterest income decreased $149 thousand, or 1.98%, to $8.73 million for the third quarter of 2016, from $8.88 million for the same quarter of 2015.

Nine-Month Comparison. Noninterest income comprised 24.58% of total net interest and noninterest income for the first nine months of 2016 compared to 25.75% for the same period of 2015. Noninterest income decreased $1.22 million, or 5.53%, for the first nine months of 2016 compared to the same period of 2015. The decrease in wealth management revenues was due to both FCWM and the Trust Division. Service charges on deposits and other service charges and fees increased primarily from an increase in referral fees, credit card income, and interchange income. Insurance commissions increased largely due to an increase in commissions from the sale of life and health policies. We realized net impairment losses of $4.65 million related to certain debt and equity securities and a net loss of $53 thousand on the sale of securities during the first nine months of 2016. See Note 3, “Investment Securities,” to the Condensed Consolidated Financial Statements in Item 1 of this report. Net negative amortization related to the FDIC indemnification asset decreased as a result of improved loss estimates and payoffs in the covered loan portfolio associated with the acquisition of Waccamaw. We realized a net gain on the divestiture of six bank branches to First Bank. See Note 2, “Acquisitions and Divestitures,” to the Condensed Consolidated Financial Statements in Item 1 of this report. Other operating income decreased primarily due to a $1.14 million net death benefit from the maturity of a life insurance policy recognized during the second quarter of 2015 offset by a gain on the sale of closed branches and legal settlements received.

Excluding the impact from impairment losses, sales of securities and branches, net FDIC indemnification asset amortization, net gain on divestiture, and the net death benefit recognized during the second quarter of 2015, noninterest income decreased $55 thousand, or 0.21%, to $25.88 million for the first nine months of 2016, from $25.93 million for the same period of 2015.

Noninterest Expense

The following table presents the components of, and changes in, noninterest expense for the periods indicated:

(Amounts in thousands)

Three-Month Comparison. Noninterest expense decreased $462 thousand, or 2.43%, for the third quarter of 2016 compared to the same quarter of 2015. Full-time equivalent employees, calculated using the number of hours worked, decreased to 624 as of September 30, 2016, from 679 as of September 30, 2015, primarily due to personnel restructuring as a result of the First Bank transaction, the sale of an insurance agency in 2015, and discontinuing secondary mortgage operations. Occupancy, furniture, and equipment expense decreased $387 thousand, or 14.32%, for the third quarter of 2016 compared to the same quarter of 2015 due to branch closures and divestitures. We incurred expenses totaling $226 thousand related to the branch exchange with First Bank during the third quarter of 2016. The decrease in other operating expense was primarily due to a $943 thousand decrease in the net loss on sales and expenses related to other real estate owned (“OREO”) to $278 thousand compared to the same quarter of 2015. The decrease was offset by a $381 thousand increase in legal fees and a $236 thousand increase in consulting fees.

Nine-Month Comparison. Noninterest expense decreased $995 thousand, or 1.74%, for the first nine months of 2016 compared to the same period of 2015. The decrease was largely due to the prepayment of $25 million of a FHLB convertible advance during the second quarter of 2015, which resulted in a prepayment penalty of $1.70 million. Occupancy, furniture, and equipment expense decreased $848 thousand, or 10.27%, for the first nine months of 2016 compared to the same period of 2015 due to branch closures and divestitures. We incurred expenses totaling $675 thousand related to the First Bank branch exchange during the first nine months of 2016. The decrease in other operating expense was primarily due to a $727 thousand decrease in the net loss on sales and expenses related to OREO to $1.24 million compared to the same period of 2015. The decrease was offset by a $450 thousand increase in consulting fees and a $413 thousand increase in legal fees.

Income Tax Expense

Three-Month Comparison. The Company’s effective tax rate, income tax as a percent of pretax income, may vary significantly from statutory rates due to permanent differences, which are items of income and expense excluded by law from the calculation of taxable income. Our most significant permanent differences generally include interest income on municipal securities and increases in the cash surrender value of life insurance policies, which are both exempt from federal income tax. Income tax expense increased $146 thousand, or 4.73%, and the effective rate increased 59 basis points to 33.60% for the third quarter of 2016 compared to the same quarter of 2015. The increase in the effective rate was largely due to an increase in taxable revenues as a percent of operating earnings.

Nine-Month Comparison. Income tax expense increased $793 thousand, or 9.45%, and the effective rate increased 158 basis points to 32.90% for the first nine months of 2016 compared to the same period of 2015. The increase in the effective rate was largely due to an increase in taxable revenues as a percent of operating earnings.

Financial Condition

Total assets as of September 30, 2016, decreased $12.00 million, or 0.49%, to $2.45 billion from $2.46 billion as of December 31, 2015. Total liabilities as of September 30, 2016, decreased $6.52 million, or 0.31%, to $2.11 billion from $2.12 billion as of December 31, 2015.

Total stockholders’ equity as of September 30, 2016, decreased $5.48 million, or 1.60%, to $337.54 million from $343.02 million as of December 31, 2015. The change in stockholders’ equity was largely due to the repurchase of 1,152,776 shares

of our common stock totaling $23.09 million, net income of $18.72 million, dividends declared on our common stock of $7.68 million, and an increase in other comprehensive income of $5.62 million. Our book value per common share increased $0.92, or 4.85%, to $19.87 as of September 30, 2016, from $18.95 as of December 31, 2015.

Cash and Cash Equivalents

Cash and cash equivalents as of September 30, 2016, increased $14.14 million, or 27.31%, compared to December 31, 2015, primarily due to the sale of investment securities and the branch exchange transaction. Interest-bearing deposits in banks are primarily comprised of excess liquidity kept at correspondent banks bearing overnight market rates.

Investment Securities

Our investment securities are used 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.

Available-for-sale securities as of September 30, 2016, decreased $145.32 million, or 39.69%, compared to December 31, 2015, primarily due to the sale of certain corporate securities, mortgage-backed Agency securities, and U.S. Agency securities. The market value of securities available for sale as a percentage of amortized cost was 101.20% as of September 30, 2016, compared to 98.33% as of December 31, 2015.

Held-to-maturity securities as of September 30, 2016, decreased $359 thousand, or 0.49%, compared to December 31, 2015. The market value of securities held to maturity as a percentage of amortized cost was 100.59% as of September 30, 2016, compared to 99.93% as of December 31, 2015.

Investment securities are reviewed quarterly for possible other-than-temporary impairment (“OTTI”) charges. Due to our change in intent to hold to recovery, we recognized OTTI charges in earnings associated with debt securities of $4.64 million during the three and nine months ended September 30, 2016. We selected specific trust preferred securities in our portfolio to sell that would increase cash reserves, reduce exposure to the financial industry, and reduce credit concentrations with two issuers. We recognized no OTTI charges in earnings associated with debt securities during the three and nine months ended September 30, 2015.We recognized no OTTI charges in earnings associated with certain equity securities during the three months ended September 30, 2016, and $11 thousand during the nine months ended September 30, 2016. We recognized no OTTI charges in earnings associated with equity securities during the three and nine months ended September 30, 2015. See Note 3, “Investment Securities,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

Loans Held for Investment

Loans held for investment, our largest component of interest income, are grouped into commercial, consumer real estate, and consumer and other loan segments. Each segment is divided into various loan classes based on collateral or purpose. Certain loans acquired in FDIC-assisted transactions are covered under loss share agreements (“covered loans”). Total loans held for investment, net of unearned income, as of September 30, 2016, increased $129.84 million, or 7.61%, compared to December 31, 2015, due to a $151.04 million, or 9.30%, increase in non-covered loans, which was driven by demand in the non-farm, non-residential real estate segment of the loan portfolio. The increase was offset by a $21.20 million, or 25.53%, decrease in covered loans due to continued runoff in the covered Waccamaw portfolio. See Note 4, “Loans,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

The following table presents loans, net of unearned income, with non-covered loans disaggregated by class as of the periods indicated:

(Amounts in thousands)

52

The following table presents covered loans disaggregated by class as of the periods indicated:

(Amounts in thousands)

Risk Elements

We seek to mitigate credit risk by adhering to specific underwriting practices and by ongoing monitoring of our loan portfolio. We track certain credit quality indicators that include: trends related to the risk rating of commercial loans, the level of classified commercial loans, net charge-offs, nonperforming loans, and general economic conditions. The Company’s loan review function generally analyzes all commercial loan relationships greater than $4.0 million annually and at various times during the year. Smaller commercial and retail loans are sampled for review during the year.

Nonperforming assets consist of nonaccrual loans, accrual loans contractually past due 90 days or more, unseasoned troubled debt restructurings (“TDRs”), and OREO. Ongoing activity in the classification and categories of nonperforming loans include collections on delinquencies, foreclosures, loan restructurings, and movements into or out of the nonperforming classification due to changing economic conditions, borrower financial capacity, or resolution efforts. See Note 5, “Credit Quality,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

The following table summarizes the components of nonperforming assets and presents additional details for nonperforming and restructured loans as of the periods indicated:

(Amounts in thousands)

(1) TDRs restructured within the past six months and nonperforming TDRs exclude nonaccrual TDRs of $268 thousand, $923 thousand, and $485 thousand for the periods ended September 30, 2016, December 31, 2015, and September 30, 2015, respectively.

(2) TDRs with six months or more of satisfactory payment performance exclude nonaccrual TDRs of $1.04 million, $416 thousand, and $338 thousand for the periods ended September 30, 2016, December 31, 2015, and September 30, 2015, respectively.

(3) Total TDRs exclude nonaccrual TDRs of $1.31 million, $1.34 million, and $823 thousand for the periods ended September 30, 2016, December 31, 2015, and September 30, 2015, respectively.

Non-covered nonperforming loans as a percent of total non-covered loans totaled 1.00% as of September 30, 2016, 1.10% as of December 31, 2015, and 1.07% as of September 30, 2015. Non-covered nonperforming assets as a percent of total non-covered assets totaled 0.91% as of September 30, 2016, 0.96% as of December 31, 2015, and 0.93% as of September 30, 2015.

Non-covered nonaccrual loans as of September 30, 2016, decreased $360 thousand, or 2.02%, from December 31, 2015, and increased $387 thousand, or 2.26%, from September 30, 2015. Non-covered nonaccrual loans were largely attributed to single family owner occupied loans (42.33%) and non-farm, non-residential loans (40.46%) as of September 30, 2016. As of September 30, 2016, approximately $283 thousand, or 1.62%, of non-covered nonaccrual loans were attributed to performing loans acquired in business combinations. Certain loans included in the nonaccrual category have been written down to estimated realizable value or assigned specific reserves in the allowance for loan losses based on management’s estimate of loss at ultimate resolution.

Non-covered delinquent loans, comprised of loans 30 days or more past due and nonaccrual loans, as of September 30, 2016, decreased $1.07 million, or 3.83%, to $26.81 million from December 31, 2015, and increased $3.85 million, or 16.76%, from September 30, 2015. Non-covered delinquent loans as a percent of total non-covered loans totaled 1.51% as of September 30, 2016, which included loans past due (0.53%) and nonaccrual loans (0.98%).

When restructuring loans for borrowers experiencing financial difficulty, we generally make concessions in interest rates, loan terms, and/or amortization terms. Certain TDRs are classified as nonperforming when modified and are returned to performing status after six months of satisfactory payment performance; however, these loans remain identified as impaired until full payment or other satisfaction of the obligation occurs. Accruing TDRs as of September 30, 2016, decreased $511 thousand, or 3.66%, to $13.45 million from December 31, 2015, and $588 thousand, or 4.19%, from September 30, 2015. Nonperforming accruing TDRs as of September 30, 2016, increased $42 thousand from December 31, 2015, and $41 thousand from September 30, 2015. Accruing nonperforming TDRs as a percent of total accruing TDRs totaled 0.85% as of September 30, 2016, 0.52% as of December 31, 2015, and 0.53% as of September 30, 2015. Specific reserves on TDRs totaled $552 thousand as of September 30, 2016, $590 thousand as of December 31, 2015, and $641 thousand as of September 30, 2015.

Non-covered OREO, which is carried at the lesser of estimated net realizable value or cost, decreased $821 thousand, or 16.85%, as of September 30, 2016, from December 31, 2015, and $1.04 million, or 20.36%, from September 30, 2015. Non-covered OREO consisted of 26 properties with an average holding period of 10 months as of September 30, 2016. The net loss on the sale of OREO totaled $184 thousand for the third quarter of 2016 compared to $1.08 million for the same quarter of 2015 and $1.00 million for the first nine months of 2016 compared to $1.50 million for the same period of 2015.

The following table details activity within OREO for the periods indicated:

(Amounts in thousands)

Allowance for Loan Losses

The allowance for loan losses is maintained at a level management deems sufficient to absorb probable loan losses inherent in the loan portfolio. The allowance is increased by the provision for loan losses and recoveries of prior loan charge-offs and decreased by loans charged off. The provision for loan losses is calculated and charged to expense to bring the allowance to an appropriate level using a systematic process of measurement that requires significant judgments and estimates.

Management performs quarterly assessments to determine the appropriate level of the allowance for loan losses. The allowance for loan losses includes specific allocations related to significant individual loans and credit relationships and general reserves related to loans not individually evaluated. Loans not individually evaluated are grouped into pools based on similar risk characteristics. Management’s general reserve allocations are based on judgments of qualitative and quantitative factors about macro and micro economic conditions reflected in the loan portfolio and the economy. Our qualitative risk factors reflect a stable risk of loan losses as of September 30, 2016, due to consistent asset quality metrics and relatively stable business and economic conditions in our primary market areas. Loans acquired in business combinations that are deemed impaired at acquisition are grouped into pools and evaluated separately from the non-PCI portfolio. Our PCI loans were aggregated into the following loan pools as of September 30, 2016: Waccamaw commercial, Waccamaw serviced home equity lines, Waccamaw residential, Peoples Bank of Virginia (“Peoples”) commercial, and Peoples residential. There were five PCI loan pools as of September 30, 2016, compared to six PCI loan pools as of December 31, 2015, and six loan pools as of September 30, 2015. The cash flow analysis performed for the PCI loan pools identified one pool as impaired as of September 30, 2016, compared to two pools as of December 31, 2015, and two loan pools as of September 30, 2015. The PCI loan provision is offset by an adjustment to the FDIC indemnification asset to reflect the indemnified portion of the post-acquisition exposure. See “Critical Accounting Estimates” above, as well as “Significant Accounting Policies” in Note 1, “Basis of Presentation,” and Note 6, “Allowance for Loan Losses,” to the Condensed Consolidated Financial Statements in Item 1 of this report.

The allowance for loan losses as of September 30, 2016, decreased $600 thousand, or 2.97%, from December 31, 2015, and $494 thousand, or 2.45%, from September 30, 2015. The non-PCI allowance as a percent of non-covered loans totaled 1.11% as of September 30, 2016, 1.24% as of December 31, 2015, and 1.26% as of September 30, 2015. Net charge-offs decreased $125 thousand, or 28.60%, during the third quarter of 2016 and $474 thousand, or 25.93%, during the first nine months of 2016 compared to the same periods of 2015. The following table presents activity in our allowance for loan losses for the periods indicated:

(Amounts in thousands)

The loan portfolio is continually monitored for deterioration in credit, which may result in the need to increase the allowance for loan losses in future periods. Management considered the allowance adequate as of September 30, 2016; however, no assurance can be made that additions to the allowance will not be required in future periods.

Deposits

Total deposits as of September 30, 2016, decreased $11.36 million, or 0.61%, compared to December 31, 2015. Noninterest-bearing deposits increased $22.00 million while interest-bearing deposits decreased $8.14 million, savings deposits, which include money market accounts and savings accounts, decreased $8.86 million, and time deposits decreased $16.36 million.

Borrowings

Total borrowings as of September 30, 2016, increased $4.87 million, or 2.22%, compared to December 31, 2015. Short-term

borrowings generally consist of federal funds purchased and retail repurchase agreements. There were no federal funds purchased as of September 30, 2016, or December 31, 2015. The balance of retail repurchase agreements decreased $20.08 million, or 22.66%, and the weighted average rate decreased 6 basis points to 0.07%, as of September 30, 2016, compared to December 31, 2015.

Long-term borrowings generally consist of wholesale repurchase agreements; FHLB borrowings, including convertible and callable advances; subordinated debt; and other obligations. The balance and weighted average contractual rate of wholesale repurchase agreements remained constant at $50.00 million and 3.71%, respectively, as of September 30, 2016, compared to December 31, 2015. Wholesale repurchase agreements had contractual maturities between three months and three years as of September 30, 2016. The balance of FHLB borrowings as of September 30, 2016, increased $25.00 million and the weighted average contractual rate decreased 103 basis points to 3.01%, compared to December 31, 2015. FHLB borrowings had contractual maturities between one month and five years as of September 30, 2016. The balance of subordinated debt remained constant at $15.46 million as of September 30, 2016, compared to December 31, 2015. The junior subordinated debentures (“Debentures”), which are currently callable, carry an interest rate of three-month London InterBank Offered Rate (“LIBOR”) plus 2.95% and mature October 8, 2033.

In addition, the Company maintains a $15.00 million unsecured, committed line of credit with an unrelated financial institution that carries an interest rate of one-month LIBOR plus 2.00% and matures in April 2017. There was no outstanding balance on the line of credit as of September 30, 2016, or December 31, 2015.

Liquidity and Capital Resources

Liquidity

Liquidity is a measure of our ability to raise sufficient cash, or convert assets to cash, to meet our financial obligations. We maintain a liquidity risk management policy and contingency funding policy (“Liquidity Plan”) designed to detect potential liquidity issues to protect depositors, creditors, and shareholders. The Liquidity Plan includes various internal and external indicators that are reviewed on a recurring basis by our Asset/Liability Management Committee (“ALCO”) and the Board of Directors. ALCO reviews liquidity risk exposure and policies related to liquidity management, ensures that systems and internal controls are consistent with liquidity policies, and provides accurate reports about liquidity needs, sources, and compliance.

We maintained liquidity in the form of unencumbered cash on hand and deposits with other financial institutions of $65.93 million, availability on federal funds lines with correspondent banks of $105.00 million, availability from the Federal Reserve Bank discount window of $9.08 million, unused borrowing capacity with the FHLB of $495.15 million, and unpledged available-for-sale securities of $69.04 million as of September 30, 2016. Cash on hand and deposits with other financial institutions and lines of credit with correspondent banks and the Federal Reserve Bank are immediately available to satisfy deposit withdrawals, customer credit needs, and our operations. Our approved lines of credit with correspondent banks are available as backup liquidity sources. Unused borrowing capacity with the FHLB is reported net of letters of credit that collateralize public unit deposits of $74.32 million as of September 30, 2016. Available-for-sale securities represent a secondary source of liquidity upon conversion to a liquid asset.

As a holding company with no significant operations of its own, the Company’s primary sources of liquidity are dividends received from the Bank and borrowings. Dividends paid by the Bank are subject to certain regulatory limitations. The Company’s liquid assets consisted of cash and investment securities totaling $12.08 million as of September 30, 2016. The Company’s cash reserves and investments provide adequate working capital to meet obligations and projected dividends to shareholders for the next twelve months. The Company maintains a $15.00 million unsecured, committed line of credit with an unrelated financial institution. There was no outstanding balance on the line of credit as of September 30, 2016.

Capital Adequacy Requirements

Risk-based capital guidelines, issued by state and federal banking agencies, include balance sheet assets and off-balance sheet arrangements weighted by the risks inherent in the specific asset type. Basel III Capital Rules became effective on January 1, 2015, subject to a four-year phase-in period. The Company’s required initial minimum capital ratios under Basel III include:

• 4.5% Common equity Tier 1 capital to risk-weighted assets
• 6.0% Tier 1 capital to risk-weighted assets
• 8.0% Total capital to risk-weighted assets
• 4.0% Tier 1 leverage ratio

The following table presents our capital ratios as of the dates indicated:

Our regulatory capital ratios as of September 30, 2016, decreased from December 31, 2015, primarily due to the phase-in of certain Basel III Capital Rules related to common equity Tier 1 deductions and an increase in risk-weighted assets. Our capital ratios were well in excess of the minimum standards and classified as “well capitalized” under regulatory capital adequacy standards applicable to that period as of September 30, 2016. Additionally, our capital ratios were in excess of the minimum standards under the Basel III Capital Rules on a fully phased-in basis, if such requirements were in effect, as of September 30, 2016. A description of the Basel III Capital Rules is included in Part I, Item 1 of the Company’s 2015 Form 10-K.

Off-Balance Sheet Arrangements

We extend contractual commitments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. Our exposure to credit loss in the event of nonperformance by other parties to financial instruments is the same as the contractual amount of the instrument. The following table presents our off-balance sheet arrangements as of the dates indicated:

(Amounts in thousands)

Impact of Inflation and Changing Prices

Our consolidated financial statements and related notes are presented in accordance with GAAP, which requires the measurement of results of operations and financial position in historical dollars. Inflation may cause a rise in price levels and changes in the relative purchasing power of money. These inflationary effects are not reflected in historical dollar measurements. The primary effect of inflation on our operations is increased operating costs. In management’s opinion, interest rates have a greater impact on our financial performance than inflation. Interest rates do not necessarily fluctuate in the same direction, or to the same extent, as the price of goods and services; therefore, the effect of inflation on businesses with large investments in property, plant, and inventory is generally more significant than the effect on financial institutions. The U.S. inflation rate continues to be relatively stable, and management believes that any changes in inflation will not be material to our financial performance.

Our profitability is largely dependent on net interest income, which is the difference between interest income on interest-earning assets, such as loans and securities, and interest expense on interest-bearing liabilities, such as deposits and borrowings. Our Company, like other financial institutions, is subject to interest rate risk to the degree that interest-earning assets reprice differently than interest-bearing liabilities. We manage our mix of assets and liabilities with the goal of limiting exposure to interest rate risk, ensuring adequate liquidity, and coordinating sources and uses of funds while maintaining an acceptable level of net interest income given the current interest rate environment.

Net interest income, our primary component of operational revenue, is subject to variation due to changes in interest rate environments and unbalanced repricing opportunities on earning assets and interest-bearing liabilities. Interest rate risk has four primary components: repricing risk, basis risk, yield curve risk, and option risk. Repricing risk occurs when earning assets and paying liabilities reprice at differing times as interest rates change. Basis risk occurs when underlying rates on assets and liabilities change at different levels or in varying degrees. Yield curve risk is the risk of adverse consequences that occurs when the same instrument experiences unequal change in the spread between two or more rates for different maturities. Lastly, option risk occurs from embedded options, often put or call options, given or sold to holders of financial instruments.

To mitigate the effect of changes in the general level of interest rates, we manage repricing opportunities and thus, our interest rate sensitivity. We seek to control our interest rate risk exposure to insulate net interest income and net earnings from fluctuations in the general level of interest rates. To measure our exposure to interest rate risk, quarterly simulations of net interest income are performed using financial models that project net interest income through a range of possible interest rate environments, including rising, declining, most likely, and flat rate scenarios. We use a simulation model that captures all earning assets, interest-bearing liabilities, and off-balance sheet financial instruments and combines the various factors affecting rate sensitivity into an earnings outlook for a range of assumed interest rate scenarios. Simulation results show the existence and severity of interest rate risk in each rate environment based on the current balance sheet position, assumptions about changes in the volume and mix of interest-earning assets and interest-paying liabilities, and our estimate of yields earned on assets and rates paid on deposit instruments and borrowings. These assumptions are inherently uncertain and, as a result, the model cannot precisely predict the impact of fluctuations in interest rates on net interest income. Actual results will differ from simulated results due to the timing, magnitude, and frequency of interest rate changes and changes in market conditions and our strategies. The earnings simulation model provides the best tool for managing interest rate risk available to us and the industry.

We have established policy limits for tolerance of interest rate risk in various interest rate scenarios. In addition, the policy addresses exposure limits to changes in the economic value of equity per predefined policy guidelines. The most recent simulation indicates that current exposure to interest rate risk is within our defined policy limits.

The following table summarizes the impact of immediate and sustained rate shocks in the interest rate environment on net interest income. The model simulates rate changes of plus 300 to minus 100 basis points from the base simulation and illustrates the prospective effects of hypothetical interest rate changes over a twelve-month period. This modeling technique, although useful, does not take into account all strategies that management might undertake in response to a sudden and sustained rate shock as depicted. As market conditions vary from those assumed in the sensitivity analysis, actual results will differ due to prepayment and refinancing levels likely deviating from those assumed, the varying impact of interest rate change caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, and other internal and external variables. The Federal Open Market Committee maintained a target range for federal funds of 25 to 50 basis points as of September 30, 2016, rendering a complete downward shock of 200 basis points meaningless; thus, downward rate scenarios are limited to minus 100 basis points. In the downward rate shocks presented, benchmark interest rates are assumed to have floors near 0%.

(Amounts in thousands, except percents)

Evaluation of Disclosure Controls and Procedures

In connection with this report, we conducted an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of our disclosure controls and procedures under the Exchange Act Rule 13a-15(b). The CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2016.

Disclosure controls and procedures are our Company’s controls and other procedures that are designed to ensure that information we are required to disclose in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information we are required to disclose in the reports that we file or submit under the Exchange Act is accumulated and communicated to management, including the CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure.

Management, including the CEO and CFO, does not expect that our disclosure controls and internal controls will prevent all errors and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives are met. Inherent limitations exist in all control systems; therefore, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur from simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, collusion of two or more people, or management’s override of controls.

Changes in Internal Control over Financial Reporting

We assess the adequacy of our internal control over financial reporting quarterly and enhance our controls in response to internal control assessments and internal and external audit and regulatory recommendations. No changes in our internal control over financial reporting occurred during the quarter ended September 30, 2016, that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Our risk factors discuss potential events, trends, or other circumstances that could adversely affect our business, financial condition, results of operations, cash flows, liquidity, access to capital resources, and, consequently, cause the market value of our common stock to decline. These risks could cause our future results to differ materially from historical results and expectations of future financial performance. There may be risks and uncertainties that we have not identified or that we have deemed immaterial that could adversely affect our business; therefore, our risk factors are not intended as an exhaustive list of all risks we face. There have been no material changes from the risk factors previously disclosed in Part I, Item 1A, “Risk Factors,” of our 2015 Form 10-K.