PEOPLES BANCORP OF NORTH CAROLINA INC (PEBK) FY 2022 MD&A

Management’s discussion and analysis of earnings and related data are presented to assist in understanding the consolidated financial condition and results of operations of the Company, for the years ended December 31, 2022, 2021 and 2020.  The Company is a registered bank holding company operating under the supervision of the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the parent company of the “Bank. The Bank is a North Carolina-chartered bank, with offices in Catawba, Lincoln, Alexander, Mecklenburg, Iredell, Wake, Rowan and Forsyth counties, operating under the banking laws of North Carolina and the rules and regulations of the Federal Deposit Insurance Corporation (the “FDIC”).

Overview

Our business consists principally of attracting deposits from the general public and investing these funds in commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. Our profitability depends primarily on our net interest income, which is the difference between the income we receive on our loan and investment securities portfolios and our cost of funds, which consists of interest paid on deposits and borrowed funds. Net interest income also is affected by the relative amounts of our interest-earning assets and interest-bearing liabilities. When interest-earning assets approximate or exceed interest-bearing liabilities, a positive interest rate spread will generate net interest income. Our profitability is also affected by the level of other income and operating expenses. Other income consists primarily of miscellaneous fees related to our loans and deposits, mortgage banking income and commissions from sales of annuities and mutual funds. Operating expenses consist of compensation and benefits, occupancy related expenses, federal deposit and other insurance premiums, data processing, advertising and other expenses.

Our operations are influenced significantly by local economic conditions and by policies of financial institution regulatory authorities. The earnings on our assets are influenced by the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve, inflation, interest rates, market and monetary fluctuations.  Lending activities are affected by the demand for commercial and other types of loans, which in turn is affected by the interest rates at which such financing may be offered.  Our cost of funds is influenced by interest rates on competing investments and by rates offered on similar investments by competing financial institutions in our market area, as well as general market interest rates. These factors can cause fluctuations in our net interest income and other income. In addition, local economic conditions can impact the credit risk of our loan portfolio, in that (1) local employers may be required to eliminate employment positions of individual borrowers, and (2) small businesses and commercial borrowers may experience a downturn in their operating performance and become unable to make timely payments on their loans. Management evaluates these factors in estimating the allowance for loan and lease losses (“ALLL”, “allowance for loan losses”, or “allowance”) and changes in these economic factors could result in increases or decreases to the provision for loan losses.

COVID-19 has adversely affected, and may continue to adversely affect economic activity globally, nationally and locally. Following the COVID-19 outbreak in December 2019 and January 2020, market interest rates declined significantly, with the 10-year Treasury bond falling below 1.00% on March 3, 2020 for the first time. Such events generally had an adverse effect on business and consumer confidence and the Company and its customers.  On March 3, 2020, the Federal Reserve Federal Open Market Committee (“FOMC”) reduced the target federal funds rate by 50 basis points to a range of 1.00% to 1.25%. Subsequently on March 16, 2020, the FOMC further reduced the target federal funds rate by an additional 100 basis points to a range of 0.00% to 0.25%. These reductions in interest rates and other effects of the COVID-19 pandemic had an adverse effect on the Company’s financial condition and results of operations.  Prior to the occurrence of the COVID-19 pandemic, economic conditions, while not as robust as the economic conditions during the period from 2004 to 2007, had stabilized such that businesses in our market area were growing and investing again.  The uncertainty expressed in the local, national and international markets through the primary economic indicators of activity were previously sufficiently stable to allow for reasonable economic growth in our markets.  Subsequently, continuing supply-chain disruption and rising inflation has caused the FOMC to increase the target federal funds rate by 425 basis points in 2022 to a range of 4.25% to 4.50% at December 31, 2022.

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Although we are unable to control the external factors that influence our business, by maintaining high levels of balance sheet liquidity, managing our interest rate exposures and by actively monitoring asset quality, we seek to minimize the potentially adverse risks of unforeseen and unfavorable economic trends.  Because the assets and liabilities of a bank are primarily monetary in nature (payable in fixed, determinable amounts), the performance of a bank is affected more by changes in interest rates than by inflation. Interest rates generally increase as the rate of inflation increases, but the magnitude of the change in rates may not be the same.  The effect of inflation on banks is normally not as significant as its influence on those businesses that have large investments in plants and inventories.  During periods of high inflation there are normally corresponding increases in the money supply, and banks will normally experience above average growth in assets, loans, and deposits.  Also, general increases in the price of goods and services can be expected to result in increased operating expenses.

Our business emphasis has been and continues to be to operate as a well-capitalized, profitable and independent community-oriented financial institution dedicated to providing quality customer service. We are committed to meeting the financial needs of the communities in which we operate. We expect growth to be achieved in our local markets and through expansion opportunities in contiguous or nearby markets.  While we would be willing to consider growth by acquisition in certain circumstances, we do not consider the acquisition of another company to be necessary for our continued ability to provide a reasonable return to our shareholders.  We believe that we can be more effective in serving our customers than many of our non-local competitors because of our ability to quickly and effectively provide senior management responses to customer needs and inquiries. Our ability to provide these services is enhanced by the stability and experience of our Bank officers and managers.

The Company does not have specific plans for additional offices in 2023 but will continue to look for growth opportunities in nearby markets and may expand if considered a worthwhile opportunity.

Summary of Significant and Critical Accounting Policies

The consolidated financial statements include the financial statements of the Company and its wholly owned subsidiary, the Bank, along with the Bank’s wholly owned subsidiaries, Peoples Investment Services, Inc., Real Estate Advisory Services, Inc. (“REAS”), Community Bank Real Estate Solutions, LLC (“CBRES”) and PB Real Estate Holdings, LLC.  All significant intercompany balances and transactions have been eliminated in consolidation.

The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition.  Many of the Company’s accounting policies require significant judgment regarding valuation of assets and liabilities and/or significant interpretation of specific accounting guidance.  The following is a summary of some of the more subjective and complex accounting policies of the Company.  A more complete description of the Company’s significant accounting policies can be found in Note 1 of the Notes to Consolidated Financial Statements in the Company’s 2022 Annual Report to Shareholders which is Appendix A to the Proxy Statement for the May 4, 2023 Annual Meeting of Shareholders.

The allowance for loan losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance for loan losses that management believes will be adequate in light of anticipated risks and loan losses.

Many of the Company’s assets and liabilities are recorded using various techniques that require significant judgment as to recoverability.  The collectability of loans is reflected through the Company’s estimate of the allowance for loan losses.  The Company performs periodic and systematic detailed reviews of its lending portfolio to assess overall collectability.  In addition, certain assets and liabilities are reflected at their estimated fair value in the consolidated financial statements.  Such amounts are based on either quoted market prices or estimated values derived from dealer quotes used by the Company, market comparisons or internally generated modeling techniques.  The Company’s internal models generally involve present value of cash flow techniques.  The various techniques are discussed in greater detail elsewhere in this management’s discussion and analysis and the Notes to Consolidated Financial Statements.

There are other complex accounting standards that require the Company to employ significant judgment in interpreting and applying certain of the principles prescribed by those standards.  These judgments include, but are not limited to, the determination of whether a financial instrument or other contract meets the definition of a derivative in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”).

The Company has an overall interest rate risk management strategy that has, in prior years, incorporated the use of derivative instruments to minimize significant unplanned fluctuations in earnings that are caused by interest rate volatility.  When using derivative instruments, the Company is exposed to credit and market risk.  If the counterparty fails to perform, credit risk is equal to the extent of the fair-value gain in the derivative.  The Company minimized the credit risk in derivative instruments by entering into transactions with high-quality counterparties that were reviewed periodically by the Company. The Company did not have any interest rate derivatives outstanding as of December 31, 2022 or 2021.

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Management of the Company has made a number of estimates and assumptions relating to reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare the accompanying consolidated financial statements in conformity with GAAP.  Actual results could differ from those estimates.

Results of Operations

Summary.  The Company reported earnings of $16.1 million or $2.94 per share and $2.85 per diluted share for the year ended December 31, 2022, as compared to $15.1 million or $2.71 per share and $2.63 per diluted share for the prior year.  The increase in year-to-date net earnings is primarily attributable to an increase in net interest income and an increase in non-interest income, which were partially offset by an increase in the provision for loan losses and an increase in non-interest expense for the year ended December 31, 2022, compared to the year ended December 31, 2021, as discussed below.

The Company reported earnings of $15.1 million or $2.71 per share and $2.63 per diluted share for the year ended December 31, 2021, as compared to $11.4 million or $2.01 per share and $1.95 per diluted share for the prior year.  The increase in year-to-date net earnings is primarily attributable to a recovery in the provision for loan losses and an increase in non-interest income, which were partially offset by a decrease in net interest income and an increase in non-interest expense.

The return on average assets in 2022 was 0.97%, as compared to 0.96% in 2021 and 0.83% in 2020. The return on average shareholders’ equity was 13.01% in 2022, as compared to 10.24% in 2021 and 8.04% in 2020.

Net Interest Income.  Net interest income, the major component of the Company’s net income, is the amount by which interest and fees generated by interest-earning assets exceed the total cost of funds used to carry them.  Net interest income is affected by changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as changes in the yields earned and rates paid.  Net interest margin is calculated by dividing tax-equivalent net interest income by average interest-earning assets, and represents the Company’s net yield on its interest-earning assets.

Net interest income in 2022 was $51.1 million, compared to $44.0 million in 2021.  The increase in net interest income is due to a $7.3 million increase in interest income, partially offset by a $118,000 increase in interest expense.  The increase in interest income is primarily due to a $1.9 million increase in interest income and fees on loans, a $2.0 million increase in interest income on balances due from banks and a $3.4 million increase in interest income on investment securities.  The increase in interest income and fees on loans is primarily due to an increase in total loans and rate increases by the Federal Reserve, partially offset by a $2.4 million decrease in fee income on SBA PPP loans.  The increase in interest income on balances due from banks is primarily due to rate increases by the Federal Reserve.  The increase in interest income on investment securities is primarily due to additional securities purchased with additional cash resulting from an increase in deposits combined with higher yields on securities purchased in 2022.  The increase in interest expense is primarily due to an increase in rates paid on interest-bearing liabilities.  Net interest income decreased to $44.0 million in 2021 from $44.1 million in 2020.

Table 1 sets forth for each category of interest-earning assets and interest-bearing liabilities, the average amounts outstanding, the interest incurred on such amounts and the average rate earned or incurred for the years ended December 31, 2022, 2021 and 2020. The table also sets forth the average rate earned on total interest-earning assets, the average rate paid on total interest-bearing liabilities, and the net yield on total average interest-earning assets for the same periods.  Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.  Yields and interest income on tax-exempt investments have been adjusted to a tax equivalent basis using an effective tax rate of 22.98% for securities that are both federal and state tax exempt and an effective tax rate of 20.48% for federal tax-exempt securities.  Non-accrual loans and the interest income that was recorded on non-accrual loans, if any, are included in the yield calculations for loans in all periods reported. The Company believes the presentation of net interest income on a tax-equivalent basis provides comparability of net interest income from both taxable and tax-exempt sources and facilitates comparability within the industry.  Although the Company believes these non-GAAP financial measures enhance investors’ understanding of its business and performance, these non-GAAP financial measures should not be considered an alternative to GAAP.  The reconciliations of these non-GAAP financial measures to their most directly comparable GAAP financial measures are presented below.

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*Includes U.S. Government agency securities that are non-taxable for state income tax purposes of $13.3 million in 2022, $12.7 million in 2021 and $19.2 million in 2020.  A tax rate of 2.50% was used to calculate the tax equivalent yields on these securities in 2022, 2021 and 2020.

Changes in interest income and interest expense can result from variances in both volume and rates.  Table 2 describes the impact on the Company’s tax equivalent net interest income resulting from changes in average balances and average rates for the periods indicated.  The changes in net interest income due to both volume and rate changes have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amounts of the changes in each.

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Net interest income on a tax equivalent basis totaled $51.5 million in 2022, as compared to $44.4 million in 2021.  The net interest spread, which represents the rate earned on interest-earning assets less the rate paid on interest-bearing liabilities, was 3.08% in 2022, as compared to a net interest spread of 2.85% in 2021.  The net yield on interest-earning assets was 3.22% in 2022 and 2.99% in 2021.

Tax equivalent interest income increased $7.2 million in 2022 primarily due to a $1.9 million increase in interest income and fees on loans, a $3.3 million increase in tax equivalent interest income on investment securities and a $2.0 million increase in interest income on balances due from banks.  The increase in interest income and fees on loans is primarily due to an increase in total loans and rate increases by the Federal Reserve, partially offset by a $2.4 million decrease in fee income on SBA PPP loans.  The increase in interest income on investment securities is primarily due to additional securities purchased with additional cash resulting from an increase in deposits combined with higher yields on securities purchased in 2022.  The increase in interest income on balances due from banks is primarily due to rate increases by the Federal Reserve.  The yield on interest-earning assets was 3.42% in 2022, as compared to 3.21% in 2021.

Interest expense increased $118,000 in 2022, as compared to 2021.  The increase in interest expense is primarily due to an increase in rates paid on interest-bearing liabilities.  Average interest-bearing liabilities increased by $82.4 million to $979.3 million in 2022, as compared to $896.9 million in 2021.  The cost of funds decreased to 0.34% in 2022 from 0.36% in 2021.

In 2021, net interest income on a tax equivalent basis was $44.4 million, as compared to $44.7 million in 2020.  The net interest spread was 2.85% in 2021, as compared to 3.34% in 2020.  The net yield on interest-earning assets was 2.99% in 2021, as compared to 3.52% in 2020.

Provision for Loan Losses.  Provisions for loan losses are charged to income in order to bring the total allowance for loan losses to a level deemed appropriate by management of the Company based on factors such as management’s judgment as to losses within the Bank’s loan portfolio, including the valuation of impaired loans, loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies and management’s assessment of the quality of the loan portfolio and general economic climate.

The provision for loan losses for the year ended December 31, 2022 was $1.5 million, compared to a recovery of $1.2 million for the year ended December 31, 2021.  The increase in the provision for loan losses is primarily attributable to an increase in reserves due to an increase in the balance of loans in the general reserve pool.  The recovery of provision for loan losses for the year ended December 31, 2021 was primarily attributable to a decrease in reserves on loans with payment modifications made as a result of the COVID-19 pandemic and a decrease in reserves in the general reserve pool.  There were no loans with modifications as a result of the COVID-19 pandemic at December 31, 2022 and 2021.

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Net charge-offs for 2022 were $333,000.  Net recoveries for 2021 were $610,000.  Net charge-offs for 2020 were $1.0 million.  The ratio of net charge-offs/(recoveries) to average total loans was 0.03% in 2022, -0.07% in 2021 and 0.11% in 2020.  The allowance for loan losses was $10.5 million or 1.02% of total loans outstanding at December 31, 2022.  For December 31, 2021 and 2020, the allowance for loan losses amounted to $9.4 million or 1.06% of total loans outstanding and $9.9 million, or 1.04% of total loans outstanding, respectively.

Table 3 presents a summary of net charge off activity for the years ended December 31, 2022, 2021 and 2020.

(1) The loss ratio for consumer loans is elevated because overdraft charge-offs related to DDA and NOW accounts are reported in consumer loan charge-offs and recoveries.  The net overdraft charge-offs are not considered material and are therefore not shown separately.

Please see the section below entitled “Allowance for Loan Losses” for a more complete discussion of the Bank’s policy for addressing potential loan losses.

Non-Interest Income.  Non-interest income was $26.7 million for the year ended December 31, 2022, compared to $24.9 million for the year ended December 31, 2021.  The increase in non-interest income is primarily attributable to a $2.8 million increase in appraisal management fee income due to an increase in appraisal volume and a $1.3 million increase in service charge income, primarily due to service charge changes implemented in March 2022, which were partially offset by a $2.1 million decrease in mortgage banking income due to a decrease in mortgage loan volume and additional mortgage loans being retained in the Bank’s portfolio.

Non-interest income was $24.9 million for the year ended December 31, 2021, compared to $22.9 million for the year ended December 31, 2020.  The increase in non-interest income is primarily attributable to a $2.1 million increase in appraisal management fee income due to an increase in the volume of appraisals and a $1.7 million increase in miscellaneous non-interest income primarily due to an increase in debit card income resulting from increased debit card activity and an increase in income on Small Business Investment Company (“SBIC”) investments.  These increases in non-interest income were partially offset by a $2.6 million decrease in gains on sale of securities.

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The Company periodically evaluates its investments for any impairment which would be deemed other-than-temporary.   No investment impairments were deemed other-than-temporary in 2022, 2021 or 2020.

Table 4 presents a summary of non-interest income for the years ended December 31, 2022, 2021 and 2020.

Non-Interest Expense.  Non-interest expense was $56.0 million for the year ended December 31, 2022, compared to $51.1 million for the year ended December 31, 2021.  The increase in non-interest expense is primarily attributable to a $2.2 million increase in appraisal management fee expense due to an increase in appraisal volume and a $1.6 million increase in salaries and employee benefits expense primarily due to increases in insurance costs and salary expense and a $421,000 increase in other non-interest expenses primarily due to increases in consulting expense, online banking expense and office supplies expense.

Non-interest expense was $51.1 million for the year ended December 31, 2021, compared to $48.9 million for the year ended December 31, 2020.  The increase in non-interest expense was primarily attributable to a $968,000 increase in salaries and employee benefits expense primarily due to an increase in incentive compensation and a $1.8 million increase in appraisal management fee expense due to an increase in the volume of appraisals.

Table 5 presents a summary of non-interest expense for the years ended December 31, 2022, 2021 and 2020.

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Income Taxes.  The Company reported income tax expense of $4.2 million, $3.8 million and $2.5 million for the years ended December 31, 2022, 2021 and 2020, respectively.  The Company’s effective tax rates were 20.56%, 20.05% and 17.98% in 2022, 2021 and 2020, respectively. The increase in the effective tax rate in 2021 and 2022 was primarily due to a reduction in non-taxable investments combined with an increase in earnings before income taxes.

Liquidity. The objectives of the Company’s liquidity policy are to provide for the availability of adequate funds to meet the needs of loan demand, deposit withdrawals, maturing liabilities and to satisfy regulatory requirements.  Both deposit and loan customer cash needs can fluctuate significantly depending upon business cycles, economic conditions and yields and returns available from alternative investment opportunities.  In addition, the Company’s liquidity is affected by off-balance sheet commitments to lend in the form of unfunded commitments to extend credit and standby letters of credit.  As of December 31, 2022, such unfunded commitments to extend credit were $382.7 million, while commitments in the form of standby letters of credit totaled $4.4 million.

The Company uses several funding sources to meet its liquidity requirements.  The primary funding source is core deposits, a non-GAAP measure, which includes demand deposits, savings accounts and non-brokered certificates of deposits of denominations less than $250,000.  Management believes it is useful to calculate and present core deposits because of the positive impact this low cost funding source provides to the Bank’s funding base The Company considers these to be a stable portion of the Company’s liability mix and the result of on-going consumer and commercial banking relationships.  As of December 31, 2022, the Company’s core deposits totaled $1.4 billion, or 98% of total deposits.

The Bank’s five largest deposit relationships, including securities sold under agreements to repurchase, amounted to $117.0 million and $118.9 million at December 31, 2022 and 2021, respectively.  These balances represent 7.89% of total deposits and securities sold under agreements to repurchase combined at December 31, 2022, as compared to 8.20% of total deposits and securities sold under agreements to repurchase combined at December 31, 2021.  Total deposits for the five largest relationships referenced above amounted to $85.7 million, or 5.97% of total deposits at December 31, 2022, as compared to $100.5 million, or 7.12% of total deposits at December 31, 2021.  Total securities sold under agreements to repurchase for the five largest relationships referenced above amounted to $31.4 million, or 65.76% of total securities sold under agreements to repurchase at December 31, 2022, as compared to $18.3 million, or 49.44% of total securities sold under agreements to repurchase at December 31, 2021.

The other sources of funding for the Company are through large denomination certificates of deposit, including brokered deposits, federal funds purchased, securities under agreement to repurchase and FHLB borrowings.  The Bank is also able to borrow from the Federal Reserve Bank (“FRB”) on a short-term basis.  The Bank’s policies include the ability to access wholesale funding up to 40% of total assets.  The Bank’s wholesale funding includes FHLB borrowings, FRB borrowings, brokered deposits and internet certificates of deposit.  The Bank’s ratio of wholesale funding to total assets was 0.92% as of December 31, 2022.

The Bank has a line of credit with the FHLB equal to 20% of the Bank’s total assets, with no balances outstanding at December 31, 2022.  At December 31, 2022, the carrying value of loans pledged as collateral totaled approximately $149.4 million.  The remaining availability under the line of credit with the FHLB was $86.5 million at December 31, 2022.  The Bank had no borrowings from the FRB at December 31, 2022.  FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB.  At December 31, 2022, the carrying value of loans pledged as collateral to the FRB totaled approximately $585.0 million.  Availability under the line of credit with the FRB was $445.1 million at December 31, 2021.

The Bank also had the ability to borrow up to $110.5 million for the purchase of overnight federal funds from five correspondent financial institutions as of December 31, 2022.

The liquidity ratio for the Bank, which is defined as net cash, interest-bearing deposits with banks, federal funds sold and certain investment securities, as a percentage of net deposits and short-term liabilities was 30.32%, 43.28% and 28.12% at December 31, 2022, 2021 and 2020, respectively.  The minimum required liquidity ratio as defined in the Bank’s Asset/Liability and Interest Rate Risk Management Policy for on balance sheet liquidity was 10% at December 31, 2022, 2021 and 2020.

As disclosed in the Company’s Consolidated Statements of Cash Flows included elsewhere herein, net cash provided by operating activities was approximately $22.7 million during 2022.  Net cash used in investing activities was $256.0 million during 2021 and net cash provided by financing activities was $27.4 million during 2022.

Asset Liability and Interest Rate Risk Management.  The objective of the Company’s Asset Liability and Interest Rate Risk strategies is to identify and manage the sensitivity of net interest income to changing interest rates and to minimize the interest rate risk between interest-earning assets and interest-bearing liabilities at various maturities.  This is done in conjunction with the need to maintain adequate liquidity and the overall goal of maximizing net interest income. Table 6 presents an interest rate sensitivity analysis for the interest-earning assets and interest-bearing liabilities for the year ended December 31, 2022.

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The Company manages its exposure to fluctuations in interest rates through policies established by the Asset/Liability Committee (“ALCO”) of the Bank.  The ALCO meets quarterly and has the responsibility for approving asset/liability management policies, formulating and implementing strategies to improve balance sheet positioning and/or earnings and reviewing the interest rate sensitivity of the Company.  ALCO seeks to minimize interest rate risk between interest-earning assets and interest-bearing liabilities by attempting to minimize wide fluctuations in net interest income due to interest rate movements.  The ability to control these fluctuations has a direct impact on the profitability of the Company. Management monitors this activity on a regular basis through analysis of its portfolios to determine the difference between rate sensitive assets and rate sensitive liabilities.

The Company’s rate sensitive assets are those earning interest at variable rates and those with contractual maturities within one year.  Rate sensitive assets therefore include both loans and available for sale (“AFS”) securities.  Rate sensitive liabilities include interest-bearing checking accounts, money market deposit accounts, savings accounts, time deposits and borrowed funds.  At December 31, 2022, rate sensitive assets and rate sensitive liabilities totaled $1.6 billion and $979.0 million, respectively.

Included in the rate sensitive assets are $185.2 million in variable rate loans indexed to prime rate subject to immediate repricing upon changes by the Federal Open Market Committee (“FOMC”).  The Bank utilizes interest rate floors on certain variable rate loans to protect against further downward movements in the prime rate.  At December 31, 2022, the Bank had $111.6 million in loans with interest rate floors.  The floors were in effect on $8,000 of these loans.

An analysis of the Company’s financial condition and growth can be made by examining the changes and trends in interest-earning assets and interest-bearing liabilities.  A discussion of these changes and trends follows.

Analysis of Financial Condition

Investment Securities.  The composition of the investment securities portfolio reflects the Company’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income.  The investment portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for the investment of available funds, furnishing liquidity, and supplying securities to pledge as required collateral for certain deposits.

All of the Company’s investment securities are held in the available for sale (“AFS”) category. At December 31, 2022 the market value of AFS securities totaled $445.4 million, as compared to $406.5 million and $245.2 million at December 31, 2021 and 2020, respectively.

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The Company’s investment portfolio consists of U.S. Government sponsored enterprise securities, municipal securities, U.S. Treasury securities, U.S. Government sponsored enterprise mortgage-backed securities, trust preferred securities and equity securities.  AFS securities averaged $467.5 million in 2022, $349.6 million in 2021 and $200.8 million in 2020.  Yield information does not give effect to changes in fair value that are reflected as a component of shareholders’ equity.  Yields are calculated on a tax equivalent basis.  Yields and interest income on tax-exempt investments have been adjusted to a tax equivalent basis using an effective tax rate of 22.98% for securities that are both federal and state tax exempt and an effective tax rate of 20.48% for federal tax-exempt securities.

Loans.  The loan portfolio is the largest category of the Company’s earning assets and is comprised of commercial loans, real estate mortgage loans, real estate construction loans and consumer loans. The Bank makes loans and extensions of credit primarily within the Catawba Valley region of North Carolina, which encompasses Catawba, Alexander, Iredell and Lincoln counties and also in Mecklenburg, Wake, Rowan and Forsyth counties in North Carolina.

Although the Bank has a diversified loan portfolio, a substantial portion of the loan portfolio is collateralized by real estate, which is dependent upon the real estate market.  Real estate mortgage loans include both commercial and residential mortgage loans.  At December 31, 2022, the Bank had $101.5 million in residential mortgage loans, $101.1 million in home equity loans and $610.0 million in commercial mortgage loans, which include $472.3 million secured by commercial property and $137.7 million secured by residential property.   Residential mortgage loans include $20.0 million in non-traditional mortgage loans from the former Banco division of the Bank.  All residential mortgage loans are originated as fully amortizing loans, with no negative amortization.

The mortgage loans originated in the traditional banking offices are generally 15 –30-year fixed rate loans with attributes that prevent the loans from being sellable in the secondary market.  These factors may include higher loan-to-value ratio, limited documentation on income, non-conforming appraisal or non-conforming property type.  These loans are generally made to existing Bank customers and have been originated throughout the Bank’s seven county service area, with no geographic concentration.

As of December 31, 2022, gross loans outstanding were $1.0 billion, as compared to $884.9 million at December 31, 2021.  Average loans represented 59% and 61% of average total earning assets for the years ended December 31, 2022 and 2021, respectively.  The Bank had $211,000 and $3.6 million in mortgage loans held for sale as of December 31, 2022 and 2021, respectively.

Past due TDR loans and non-accrual TDR loans totaled $3.7 million and $2.2 million at December 31, 2022 and December 31, 2021, respectively.  The terms of these loans have been renegotiated to provide a concession to original terms, including a reduction in principal or interest as a result of the deteriorating financial position of the borrower.  There were no performing loans classified as TDR loans at December 31, 2022 and December 31, 2021.

On March 27, 2020, President Trump signed the CARES Act, which established a $2 trillion economic stimulus package, including cash payments to individuals, supplemental unemployment insurance benefits and a $349 billion loan program administered through the Small Business Administration (“SBA”) Paycheck Protection Program (“PPP”). Under the PPP, small businesses, sole proprietorships, independent contractors and self-employed individuals were able to apply for loans from existing SBA lenders and other approved regulated lenders, subject to certain limitations and eligibility criteria. A second round of PPP funding provided a total of $320 billion additional funding for the PPP.  The Bank participated as a lender in the PPP.  Total PPP loans originated during the years ended December 31, 2020 and 2021 amounted to $128.1 million.  The outstanding balance of PPP loans was $103,000 and $18.0 million at December 31, 2022 and 2021, respectively.  These loans are classified as commercial loans in the tables above.  The Bank recognized $948,000 and $3.4 million of PPP loan fee income for the year ended December 31, 2022 and year ended December, 2021, respectively.  PPP loan fee income is reported in interest and fees on loans in the Consolidated Statements of Earnings on page A-23.

There were no loans with existing modifications as a result of the COVID-19 pandemic at December 31, 2022 and 2021.  At December 31, 2022, the Bank continues to maintain a pool of loans that were previously modified as a result of the COVID-19 pandemic.  The loan balances associated with those loans that were previously modified as a result of the COVID-19 pandemic related modifications have been grouped into their own pool within the Bank’s ALLL model as management considers that they have a higher risk profile, and a higher reserve rate has been applied to this pool.  As such, a higher reserve rate has been applied to this pool.  Loans included in this pool totaled $70.5 million and $88.7 million at December 31, 2022 and December 31, 2021, respectively.  Loan payment modifications associated with the COVID-19 pandemic are not classified as TDR due to Section 4013 of the CARES Act, which provides that a qualified loan modification is exempt by law from classification as a TDR pursuant to GAAP.

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Table 7 identifies the maturities of all loans as of December 31, 2022 and addresses the sensitivity of these loans to changes in interest rates.

In the normal course of business, there are various commitments outstanding to extend credit that are not reflected in the financial statements. At December 31, 2022, outstanding loan commitments totaled $382.7 million.  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the commitment contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since many of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Additional information regarding commitments is provided below in the section entitled “Commitments and Contingencies” and in Note 11 to the Consolidated Financial Statements.

Allowance for Loan Losses (ALLL).  The allowance for loan losses reflects management’s assessment and estimate of the risks associated with extending credit and its evaluation of the quality of the loan portfolio.  The Bank periodically analyzes the loan portfolio in an effort to review asset quality and to establish an allowance that management believes will be adequate in light of anticipated risks and loan losses.  In assessing the adequacy of the allowance, size, quality and risk of loans in the portfolio are reviewed. Other factors considered are:

Management uses several measures to assess and monitor the credit risks in the loan portfolio, including a loan grading system that begins upon loan origination and continues until the loan is collected or collectability becomes doubtful. Upon loan origination, the Bank’s originating loan officer evaluates the quality of the loan and assigns one of eight risk grades. The loan officer monitors the loan’s performance and credit quality and makes changes to the credit grade as conditions warrant. When originated or renewed, all loans over a certain dollar amount receive in-depth reviews and risk assessments by the Bank’s Credit Administration. Before making any changes in these risk grades, management considers assessments as determined by the third-party credit review firm (as described below), regulatory examiners and the Bank’s Credit Administration. Any issues regarding the risk assessments are addressed by the Bank’s senior credit administrators and factored into management’s decision to originate or renew the loan. The Bank Board reviews, on a monthly basis, an analysis of the Bank’s reserves relative to the range of reserves estimated by the Bank’s Credit Administration.

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As an additional measure, the Bank engages an independent third party to review the underwriting, documentation and risk grading analyses. This independent third party reviews and evaluates loan relationships greater than or equal to $1.5 million as well as a periodic sample of commercial relationships with exposures below $1.5 million, excluding loans in default, and loans in process of litigation or liquidation.  The third party’s evaluation and report is shared with management and the Board of Directors of the Bank (“Bank Board”).

Management considers certain commercial loans with weak credit risk grades to be individually impaired and measures such impairment based upon available cash flows and the value of the collateral. Allowance or reserve levels are estimated for all other graded loans in the portfolio based on their assigned credit risk grade, type of loan and other matters related to credit risk.

Management uses the information developed from the procedures described above in evaluating and grading the loan portfolio. This continual grading process is used to monitor the credit quality of the loan portfolio and to assist management in estimating the allowance.  The provision for loan losses charged or credited to earnings is based upon management’s judgment of the amount necessary to maintain the allowance at a level appropriate to absorb probable incurred losses in the loan portfolio at the balance sheet date.  The amount each quarter is dependent upon many factors, including growth and changes in the composition of the loan portfolio, net charge-offs, delinquencies, management’s assessment of loan portfolio quality, the value of collateral, and other macro-economic factors and trends.  The evaluation of these factors is performed quarterly by management through an analysis of the appropriateness of the allowance.

The allowance is comprised of three components: specific reserves, general reserves and unallocated reserves.  After a loan has been identified as impaired, management measures impairment.  When the measure of the impaired loan is less than the recorded investment in the loan, the amount of the impairment is recorded as a specific reserve. These specific reserves are determined on an individual loan basis based on management’s current evaluation of the Bank’s loss exposure for each credit, given the appraised value of any underlying collateral. Loans for which specific reserves are provided are excluded from the general allowance calculations as described below.

The general allowance reflects reserves established under GAAP for collective loan impairment.  These reserves are based upon historical net charge-offs using the greater of the last two, three, four, or five years’ loss experience.  This charge-off experience may be adjusted to reflect the effects of current conditions.  The Bank considers information derived from its loan risk ratings and external data related to industry and general economic trends in establishing reserves.  Qualitative factors applied in the Bank’s ALLL model include the impact to the economy from the COVID-19 pandemic and reserves on loans with payment modifications as a result of the COVID-19 pandemic.  There were no loans with existing modifications as a result of the COVID-19 pandemic at December 31, 2022 and 2021.  At December 31, 2022, the Bank continues to maintain a pool of loans that were previously modified as a result of the COVID-19 pandemic.  The loan balances associated with those loans that were previously modified as a result of the COVID-19 pandemic related modifications have been grouped into their own pool within the Bank’s ALLL model as management considers that they have a higher risk profile, and a higher reserve rate has been applied to this pool.  As such, a higher reserve rate has been applied to this pool.  Loans included in this pool totaled $70.5 million and $88.7 million at December 31, 2022 and December 31, 2021, respectively.

The unallocated allowance is determined through management’s assessment of probable losses that are in the portfolio but are not adequately captured by the other two components of the allowance, including consideration of current economic and business conditions and regulatory requirements. The unallocated allowance also reflects management’s acknowledgement of the imprecision and subjectivity that underlie the modeling of credit risk.  Due to the subjectivity involved in determining the overall allowance, including the unallocated portion, the unallocated portion may fluctuate from period to period based on management’s evaluation of the factors affecting the assumptions used in calculating the allowance.

There were no significant changes in the estimation methods or fundamental assumptions used in the evaluation of the allowance for the year ended December 31, 2022 as compared to the year ended December 31, 2021.   Revisions, estimates and assumptions may be made in any period in which the supporting factors indicate that loss levels may vary from the previous estimates. The Company adopted CECL as of January 1, 2023.

Effective December 31, 2012, certain mortgage loans from the former Banco division of the Bank were analyzed separately from other single-family residential loans in the Bank’s loan portfolio.  These loans are first mortgage loans made to the Latino market, primarily in Mecklenburg, North Carolina and surrounding counties.  These loans are non-traditional mortgages in that the customer normally did not have a credit history, so all credit information was accumulated by the loan officers.

PPP loans are excluded from the allowance as PPP loans are 100 percent guaranteed by the SBA.

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Various regulatory agencies, as an integral part of their examination process, periodically review the Bank’s allowance. Such agencies may require adjustments to the allowance based on their judgments of information available to them at the time of their examinations.  Management believes it has established the allowance for credit losses pursuant to GAAP, and has taken into account the views of its regulators and the current economic environment.  Management considers the allowance adequate to cover the estimated losses inherent in the Bank’s loan portfolio as of the date of the financial statements.  Although management uses the best information available to make evaluations, significant future additions to the allowance may be necessary based on changes in economic and other conditions, thus adversely affecting the operating results of the Company.

Non-performing Assets.  Non-performing assets were $3.7 million or 0.23% of total assets at December 31, 2022, compared to $3.2 million or 0.20% of total assets at December 31, 2021.  Non-performing assets include $3.7 million in commercial and residential mortgage loans and $8,000 in other loans at December 31, 2022, compared to $3.2 million in commercial and residential mortgage loans and $51,000 in other loans at December 31, 2021.  The Bank had no other real estate owned as of December 31, 2022 and 2021.  The Bank had no repossessed assets as of December 31, 2022 and 2021.

At December 31, 2022, the Bank had non-performing loans, defined as non-accrual and accruing loans past due more than 90 days, of $3.7 million or 0.36% of total loans.  Non-performing loans at December 31, 2021 were $3.2 million or 0.38% of total loans.

Management continually monitors the loan portfolio to ensure that all loans potentially having a material adverse impact on future operating results, liquidity or capital resources have been classified as non-performing.  Should economic conditions deteriorate, the inability of distressed customers to service their existing debt could cause higher levels of non-performing loans.  Management expects the future level of non-accrual loans to continue to be in-line with the level of non-accrual loans at December 31, 2022 and 2021.

It is the general policy of the Bank to stop accruing interest income when a loan is placed on non-accrual status and any interest previously accrued but not collected is reversed against current income.  Generally, a loan is placed on non-accrual status when it is over 90 days past due and there is reasonable doubt that all principal will be collected.

Deposits.  The Bank primarily uses deposits to fund its loan and investment portfolios. The Bank offers a variety of deposit accounts to individuals and businesses. Deposit accounts include checking, savings, money market and time deposits.  Total deposits were $1.4 billion as of December 31, 2022 and 2021.  Core deposits, a non-GAAP measure, which include noninterest-bearing demand deposits, NOW, MMDA, savings and non-brokered certificates of deposit of denominations less than $250,000, were $1.4 billion at December 31, 2022 and 2021.  Management believes it is useful to calculate and present core deposits because of the positive impact this low cost funding source provides to the Bank’s funding base.

Time deposits in amounts of $250,000 or more totaled $31.0 million and $26.3 million at December 31, 2022 and 2021, respectively.  At December 31, 2022 and 2021, the Bank had approximately $15.2 million and $11.1 million, respectively, in time deposits purchased through third party brokers, including certificates of deposit participated through the Certificate of Deposit Account Registry Service (“CDARS”) on behalf of local customers.  CDARS balances totaled $7.1 million and $3.0 million as of December 31, 2022 and 2021, respectively.  The weighted average rate of brokered deposits as of December 31, 2022 and 2021 was 1.27% and 1.49%, respectively.

Table 8 is a summary of the maturity distribution of time deposits in amounts of $250,000 or more as of December 31, 2022.

Borrowed Funds. The Bank has access to various short-term borrowings, including the purchase of federal funds and borrowing arrangements from the FHLB and other financial institutions.  There were no FHLB borrowings outstanding at December 31, 2022 and 2021.  Average FHLB borrowings for 2022 and 2021 were zero.  Additional information regarding FHLB borrowings is provided in Note 7 to the Consolidated Financial Statements.

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The Bank had no borrowings from the FRB at December 31, 2021 and 2021.  FRB borrowings are collateralized by a blanket assignment on all qualifying loans that the Bank owns which are not pledged to the FHLB.  At December 31, 2022, the carrying value of loans pledged as collateral totaled approximately $585.0 million.

Securities sold under agreements to repurchase were $47.7 million at December 31, 2022, compared to $37.1 million at December 31, 2021.

Junior subordinated debentures were $15.5 million at December 31, 2022 and December 31, 2021.

Contractual Obligations and Off-Balance Sheet Arrangements.  The Company’s contractual obligations include junior subordinated debentures, as well as certain payments under current lease agreements.  Other commitments include commitments to extend credit.

The Company enters into derivative contracts to manage various financial risks.  A derivative is a financial instrument that derives its cash flows, and therefore its value, by reference to an underlying instrument, index or referenced interest rate.  Derivative contracts are carried at fair value on the consolidated balance sheet with the fair value representing the net present value of expected future cash receipts or payments based on market interest rates as of the balance sheet date.  Derivative contracts are written in amounts referred to as notional amounts, which only provide the basis for calculating payments between counterparties and are not a measure of financial risk.  Therefore, the derivative amounts recorded on the balance sheet do not represent the amounts that may ultimately be paid under these contracts.  Further discussions of derivative instruments are included above in the section entitled “Asset Liability and Interest Rate Risk Management” beginning on page A-11 and in Note 1 to the Consolidated Financial Statements.  There were no derivatives at December 31, 2022 or 2021.

Capital Resources.  Shareholders’ equity was $105.2 million, or 6.49% of total assets, at December 31, 2022, compared to $142.4 million, or 8.77% of total assets, at December 31, 2021.

Average shareholders’ equity as a percentage of total average assets is one measure used to determine capital strength.   Average shareholders’ equity as a percentage of total average assets was 7.45%, 9.42% and 10.35% for 2022, 2021 and 2020, respectively.   The return on average shareholders’ equity was 13.01% at December 31, 2022, as compared to 10.24% and 8.04% at December 31, 2021 and December 31, 2020, respectively.  Total cash dividends paid on common stock were $4.9 million, $3.8 million and $4.4 million during 2022, 2021 and 2020, respectively.

The Board of Directors, at its discretion, can issue up to 5,000,000 shares of preferred stock.  The Board is authorized to determine the number of shares, voting powers, designations, preferences, limitations and relative rights.

In 2021, the Board of Directors authorized a stock repurchase program, whereby up to $4.0 million was allocated to repurchase the Company’s common stock.  Any purchases under the Company’s stock repurchase program may be made periodically as permitted by securities laws and other legal requirements in the open market or in privately-negotiated transactions. The timing and amount of any repurchase of shares will be determined by the Company’s management, based on its evaluation of market conditions and other factors. The stock repurchase program may be suspended at any time or from time-to-time without prior notice.  The Company repurchased approximately $3.6 million, or 127,597 shares of its common stock, under this stock repurchase program through December 31, 2021.

In 2022, the Board of Directors authorized a stock repurchase program, whereby up to $2.0 million was allocated to repurchase the Company’s common stock.  Any purchases under the Company’s stock repurchase program may be made periodically as permitted by securities laws and other legal requirements in the open market or in privately-negotiated transactions. The timing and amount of any repurchase of shares will be determined by the Company’s management, based on its evaluation of market conditions and other factors. The stock repurchase program may be suspended at any time or from time-to-time without prior notice.  The Company repurchased approximately $711,000, or 26,200 shares of its common stock, under this stock repurchase program through December 31, 2022.

In 2013, the FRB approved its final rule on the Basel III capital standards, which implement changes to the regulatory capital framework for banking organizations.  The Basel III capital standards, which became effective January 1, 2015, include new risk-based capital and leverage ratios, which were phased in from 2015 to 2019. The new minimum capital level requirements applicable to the Company and the Bank under the final rules are as follows: (i) a new common equity Tier 1 capital ratio of 4.5%; (ii) a Tier 1 capital ratio of 6% (increased from 4%); (iii) a total risk based capital ratio of 8% (unchanged from previous rules); and (iv) a Tier 1 leverage ratio of 4% (unchanged from previous rules).  An additional capital conservation buffer was added to the minimum requirements for capital adequacy purposes beginning on January 1, 2016 and was phased in through 2019 (increasing by 0.625% on January 1, 2016 and each subsequent January 1, until it reached 2.5% on January 1, 2019).  This resulted in the following minimum ratios beginning in 2019: (i) a common equity Tier 1 capital ratio of 7.0%, (ii) a Tier 1 capital ratio of 8.5%, and (iii) a total capital ratio of 10.5%. Under the final rules, institutions would be subject to limitations on paying dividends, engaging in share repurchases, and paying discretionary bonuses if its capital level falls below the buffer amount.  These limitations establish a maximum percentage of eligible retained earnings that could be utilized for such actions.

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Under the regulatory capital guidelines, financial institutions are currently required to maintain a total risk-based capital ratio of 8.0% or greater, with a Tier 1 risk-based capital ratio of 6.0% or greater and a common equity Tier 1 capital ratio of 4.5% or greater, as required by the Basel III capital standards referenced above.  Tier 1 capital is generally defined as shareholders’ equity and trust preferred securities less all intangible assets and goodwill.  Tier 1 capital includes $15.0 million in trust preferred securities at December 31, 2022 and December 31, 2021.  The Company’s Tier 1 capital ratio was 13.21% and 15.43% at December 31, 2022 and December 31, 2021, respectively.  Total risk-based capital is defined as Tier 1 capital plus supplementary capital.  Supplementary capital, or Tier 2 capital, consists of the Company’s allowance for loan losses, not exceeding 1.25% of the Company’s risk-weighted assets. Total risk-based capital ratio is therefore defined as the ratio of total capital (Tier 1 capital and Tier 2 capital) to risk-weighted assets.  The Company’s total risk-based capital ratio was 14.04% and 16.35% at December 31, 2022 and December 31, 2021, respectively.  The Company’s common equity Tier 1 capital consists of common stock and retained earnings.   The Company’s common equity Tier 1 capital ratio was 12.03% and 13.96% at December 31, 2022 and December 31, 2021, respectively.  Financial institutions are also required to maintain a leverage ratio of Tier 1 capital to total average assets of 4.0% or greater.  The Company’s Tier 1 leverage capital ratio was 9.82% and 9.64% at December 31, 2022 and December 31, 2021, respectively.

The Bank’s Tier 1 risk-based capital ratio was 13.10% and 15.27% at December 31, 2022 and December 31, 2021, respectively.  The total risk-based capital ratio for the Bank was 13.93% and 16.19% at December 31, 2022 and December 31, 2021, respectively.   The Bank’s common equity Tier 1 capital ratio was 13.10% and 15.27% at December 31, 2022 and December 31, 2021, respectively.  The Bank’s Tier 1 leverage capital ratio was 9.68% and 9.50% at December 31, 2022 and December 31, 2021, respectively.

A bank is considered to be “well capitalized” if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 8.0% or greater, a common equity Tier 1 capital ratio of 6.5% or greater and a leverage ratio of 5.0% or greater.  Based upon these guidelines, the Bank was considered to be “well capitalized” at December 31, 2022.

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[table omitted - see filing]