| ECB BANCORP INC Item 1A Risk Factors _________________________________________________________________ The following summary describes factors we believe are material risks that apply to our business |
| Our discussions of these risks include forward-looking statements, and our actual results may differ substantially from results described in the forward-looking statements |
| In addition to the risks described below and investment risks that apply in the case of any financial institution, our business, financial condition and operating results could be harmed by other risks, including risks we have not yet identified or that we may believe are immaterial or unlikely |
| Risks Related to Our Business · Our business strategy includes the continuation of our growth plans, and our financial condition and operating results could be negatively affected if we fail to grow or fail to manage our growth effectively |
| We intend to continue to grow in our existing banking markets (internally and through additional offices) and to expand into new markets as appropriate opportunities arise |
| We have opened three de novo branch offices since May 2003, and we have tentative plans to open two de novo branches during 2007 |
| Consistent with our business strategy, and to sustain our growth, in the future we may establish other de novo branches or acquire other financial institutions or their branch offices |
| Our business prospects must be considered in light of the risks, expenses and difficulties frequently encountered by companies that are experiencing growth |
| We cannot assure you we will be able to expand our market presence in our existing markets or successfully enter new markets, or that expansion will not adversely affect our operating results |
| Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or operating results, and could adversely affect our ability to successfully implement our business strategy |
| Also, if our growth occurs more slowly than anticipated, or declines, our operating results could be materially affected in an adverse way |
| Our ability to successfully grow will depend on a variety of factors, including continued availability of desirable business opportunities and the competitive response from other financial institutions |
| Due to personnel and fixed asset costs of de novo branching, any new branch offices we establish may operate at a loss until we can establish a sufficient base of business to operate profitably |
| Also, in establishing a new office in a new market, we likely would be faced with competitors with greater knowledge of that local market |
| Although we believe we have management resources and internal systems in place to successfully manage our future growth, we will need to hire and rely on well-trained local managers who have local affiliations and to whom we may need to give significant autonomy |
| We cannot assure you that any de novo or other branch office we establish or acquire will not, for some period of time, operate at a loss and have an adverse effect on our earnings, that we will be able to hire managers who can successfully operate any new branch offices, or that we will become an effective competitor in any new banking market |
| · Our business depends on the condition of the local and regional economies where we operate |
| We currently have offices only in eastern North Carolina |
| Consistent with our community banking philosophy, a majority of our customers are located in and do business in that region, and we lend a substantial portion of our capital and deposits to commercial and consumer borrowers in our local banking markets |
| Therefore, our local and regional economy has a direct impact on our ability to generate deposits to support loan growth, the demand for loans, the ability of borrowers to repay loans, the value of collateral securing our loans (particularly loans secured by real estate), and our ability to collect, liquidate and restructure problem loans |
| The local economies of the coastal communities in our banking markets are heavily dependent on the tourism industry |
| If the economies of our banking markets are adversely affected by a general economic downturn or by other specific events or trends, including a significant decline in the tourism industry in our coastal communities, the resulting economic impact could have a direct adverse effect on our operating results |
| Adverse economic conditions in our banking markets could reduce our growth rate, affect the ability of our customers to repay their loans to us, and generally affect our financial condition and operating results |
| We are less able than larger institutions to spread risks of unfavorable local economic conditions across a large number of diversified economies |
| And, we cannot assure you that we will benefit from any market growth or favorable economic conditions in our banking markets even if they do occur |
| 14 ______________________________________________________________________ Any adverse market or economic conditions in North Carolina, particularly in the real estate, agricultural, seafood or tourism industries, may disproportionately increase the risk our borrowers will be unable to make their loan payments |
| Also, the market value of real estate securing our loans could be adversely affected by unfavorable changes in market and economic conditions |
| On December 31, 2005, approximately 75dtta0prca of the total dollar amount of our loan portfolio was secured by liens on real estate, with approximately 5dtta3prca of our portfolio representing home equity lines of credit |
| Our management believes that, in the case of many of those loans, the real estate collateral is not being relied upon as the primary source of repayment, and those relatively high percentages reflect, at least in part, our policy to take real estate whenever possible as primary or additional collateral rather than other types of collateral |
| However, any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in North Carolina could adversely affect the value of our assets, revenues, operating results and financial condition |
| · Hurricanes or other adverse weather events could negatively affect our local economies or disrupt our operations, which could have an adverse effect on our business or operating results |
| The economy of North Carolina’s coastal region is affected by adverse weather events, particularly hurricanes |
| Our banking markets lie primarily in coastal communities, and we cannot predict whether or to what extent damage caused by future hurricanes will affect our operations, our customers or the economies in our banking markets |
| However, weather events could cause a decline in loan originations, destruction or decline in the value of properties securing our loans, or an increase in the risks of delinquencies, foreclosures and loan losses |
| · Future expansion involves risks |
| In the future we may acquire other financial institutions or parts of those institutions, and we may establish de novo branch offices |
| Although we currently have no agreements or understandings for any acquisition, we will evaluate opportunities to establish or acquire branches that complement or expand our business |
| Acquisitions and mergers involve a number of risks, including the risk that: · we may incur substantial costs in identifying and evaluating potential acquisitions and merger partners, or in evaluating new markets, hiring experienced local managers, and opening new offices; · our estimates and judgments used to evaluate credit, operations, management and market risks relating to target institutions may not be accurate; · there may be substantial lag-time between completing an acquisition or opening a new office and generating sufficient assets and deposits to support costs of the expansion; · we may not be able to finance an acquisition, or the financing we obtain may have an adverse effect on our operating results or dilution to our existing shareholders; · our management’s attention in negotiating a transaction and integrating the operations and personnel of the combining businesses may be diverted from our existing business; · we may enter new markets where we lack local experience; · we may introduce new products and services we are not equipped to manage; · we may incur goodwill in connection with an acquisition, or the goodwill we incur may become impaired, which results in adverse short-term effects on our operating results; or · we may lose key employees and customers |
| We cannot assure you that we will have opportunities to acquire or establish any new branches, or that we will be able to negotiate, finance or complete any acquisitions available to us |
| We may incur substantial costs in expanding, and we cannot assure you that any expansion will benefit us, or that we will be able to successfully integrate any banking offices that we acquire into our operations or retain the deposit and loan customers of those offices |
| Additionally, we may experience disruption and incur unexpected expenses in branch acquisitions we complete, which may have a material adverse effect on our business, operating results or financial condition |
| Also, we may issue equity securities, including common stock and securities convertible into shares of our common stock, in connection with acquisitions, which could cause ownership and economic dilution to you |
| 15 ______________________________________________________________________ · Our increasing volume of loans makes loan quality more difficult to control |
| Increased loan losses could affect the value of our common stock |
| While growth in earning assets is desirable in a community bank, it can have adverse consequences if it is not well managed |
| For example, rapid increases in our loans could cause future loan losses if we cannot properly underwrite increasing volumes of loans as they are made and adequately monitor a larger loan portfolio to detect and deal with loan problems as they occur |
| Our business strategy calls for us to continue to grow in our existing banking markets (internally and through additional offices) and expand into new markets as appropriate opportunities arise |
| Because collection problems with some loans often do not arise until those loans have been in existence for some period of time, we cannot assure you that we will not have future problems collecting loans that now are performing according to their terms |
| · An inadequate loan loss allowance would reduce our earnings and could adversely affect the value of our common stock |
| We use underwriting procedures and criteria we believe minimize the risk of loan delinquencies and losses, but banks routinely incur losses in their loan portfolios, and we cannot assure you that all our borrowers will repay their loans |
| Regardless of the underwriting criteria we use, we will experience loan losses from time to time in the ordinary course of our business, and some of those losses will result from factors beyond our control |
| These factors include, among other things, changes in market, economic, business or personal conditions, or other events (including changes in market interest rates), that affect our borrowers’ abilities to repay their loans and the value of properties that collateralize loans |
| We maintain an allowance for loan losses based on our current judgments about the credit quality of our loan portfolio |
| On December 31, 2005, our allowance totaled 1dtta20prca of our total loans and approximately 7cmam154prca of our nonperforming loans |
| In determining the amount of the allowance, our management and Board of Directors consider relevant internal and external factors that affect loan collectibility |
| However, if delinquency levels increase or we incur higher than expected loan losses in the future, we cannot assure you that our allowance will be adequate to cover resulting losses |
| Charging future loan losses against the allowance may require us to increase our provision to the allowance, which would reduce our net income |
| So, without regard to the adequacy of our allowance, loan losses could have an adverse effect on our operating results and, depending on the magnitude of those losses, that effect could be material |
| · Building market share through our de novo branching strategy could cause our expenses to increase faster than revenues |
| We intend to continue to build market share in eastern North Carolina through our de novo branching strategy, and we have identified several sites for possible future de novo branches |
| There are considerable costs involved in opening branches, and new branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year |
| Therefore, any new branches we open can be expected to negatively affect our operating results until those branches reach a size at which they become profitable |
| Our expenses also could be increased if there are delays in opening any new branches |
| Finally, we cannot assure you that any new branches we open will be successful, even after they have become established |
| · Our recent results may not be indicative of our future results |
| We may not be able to sustain our historical rate of growth or even grow our business at all |
| Also, our recent and rapid growth may distort some of our historical financial ratios and statistics |
| In the future, we may not have the benefit of several recently favorable factors, such as a generally stable interest rate environment, a strong residential mortgage market, or the ability to find suitable expansion opportunities |
| Various factors, such as economic conditions, regulatory and legislative considerations, and competition also may impede or restrict our ability to expand our market presence |
| If we experience a significant decrease in our historical rate of growth, our operating results and financial condition may be adversely affected because a high percentage of our operating costs are fixed expenses |
| · We may need to raise additional capital in the future in order to continue to grow, but that capital may not be available when it is needed |
| Federal and state banking regulators require us to maintain adequate levels of capital to support our operations |
| On December 31, 2005, our three capital ratios were well above “well capitalized” levels under bank regulatory guidelines |
| 16 ______________________________________________________________________ However, our business strategy calls for us to continue to grow in our existing banking markets (internally and through additional offices) and to expand into new markets as appropriate opportunities arise |
| Growth in our earning assets resulting from internal expansion and new branch offices, at rates in excess of the rate at which our capital is increased through retained earnings, will reduce our capital ratios unless we continue to increase our capital |
| If our capital ratios fell below “well capitalized” levels, our FDIC deposit insurance assessment rate would increase until we restored and maintained our capital at a “well capitalized” level |
| A higher assessment rate would cause an increase in the assessments we pay the FDIC for deposit insurance, which would adversely affect our operating results |
| If, in the future, we need to increase our capital to fund additional growth or satisfy regulatory requirements, our ability to raise that additional capital will depend on conditions at that time in the capital markets that are outside our control, and on our financial performance |
| We cannot assure you that we will be able to raise additional capital on terms favorable to us or at all |
| If we cannot raise additional capital when needed, our ability to expand our operations through internal growth and acquisitions could be materially impaired |
| · Our profitability is subject to interest rate risk |
| Changes in interest rates can have different effects on various aspects of our business, particularly our net interest income |
| Our profitability depends, to a large extent, on our net interest income, which is the difference between our income on interest-earning assets and our expense on interest-bearing deposits and other liabilities |
| Like most financial institutions, we are affected by changes in general interest rate levels and by other economic factors beyond our control |
| Interest rate risk arises in part from the mismatch (ie, the interest sensitivity “gap”) between the dollar amounts of repricing or maturing interest-earning assets and interest-bearing liabilities, and is measured in terms of the ratio of the interest rate sensitivity gap to total assets |
| When more interest-earning assets than interest-bearing liabilities will reprice or mature over a given time period, a bank is considered asset-sensitive and has a positive gap |
| When more liabilities than assets will reprice or mature over a given time period, a bank is considered liability-sensitive and has a negative gap |
| A liability-sensitive position (ie, a negative gap) may generally enhance net interest income in a falling interest rate environment and reduce net interest income in a rising interest rate environment |
| An asset-sensitive position (ie, a positive gap) may generally enhance net interest income in a rising interest rate environment and reduce net interest income in a falling interest rate environment |
| Our ability to manage our gap position determines to a great extent our ability to operate profitably |
| However, fluctuations in interest rates are not predictable or controllable, and we cannot assure you we will be able to manage our gap position in a manner that will allow us to remain profitable |
| On December 31, 2005, we had a negative one-year cumulative interest sensitivity gap ratio of 17dtta4prca |
| That means that, during a one-year period, our interest-bearing liabilities generally would be expected to reprice at a faster rate than our interest-earning assets |
| A rising rate environment within that one-year period generally would have a negative effect on our earnings, while a falling rate environment generally would have a positive effect on our earnings |
| In our one-year cumulative interest sensitivity gap analysis, our savings, NOW and Money Market accounts, which totalled approximately dlra117dtta2 million at December 31, 2005, were treated as repricing immediately since those accounts do not have fixed terms and their rates could be changed weekly |
| However, our historical experience has shown that changes in market interest rates have little, if any, effect on those deposits within a given time period and, for that reason, those liabilities could be considered non-rate sensitive |
| If those deposits were treated as non-rate sensitive in our gap analysis, our rate sensitive liabilities would be more closely matched to our rate sensitive assets during the one-year period |
| If our historical experience with the relative insensitivity of these deposits to changes in market interest rates does not continue in the future and we experience more rapid repricing of interest-bearing liabilities than interest-earning assets in the near term rising interest rate environment, our net interest margin and net income may decline |
| · Our reliance on time deposits, including out-of-market certificates of deposit, as a source of funds for loans and our other liquidity needs could have an adverse effect on our operating results |
| However, our loan demand has exceeded the rate at which we have been able to build core deposits (particularly with respect to our new Wilmington branch), so we have relied heavily on time deposits, including out-of-market certificates of deposit, as a source of funds |
| Those deposits may not be as stable as other types of deposits and, in the 17 ______________________________________________________________________ future, depositors may not renew those time deposits when they mature, or we may have to pay a higher rate of interest to attract or keep them or to replace them with other deposits or with funds from other sources |
| Not being able to attract those deposits or to keep or replace them as they mature would adversely affect our liquidity |
| Paying higher deposit rates to attract, keep or replace those deposits could have a negative effect on our interest margin and operating results |
| · Competition from financial institutions and other financial service providers may adversely affect our profitability |
| Commercial banking in our banking markets and in North Carolina as a whole is extremely competitive |
| We compete against commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as other local and community, super-regional, national and international financial institutions that operate offices in our market areas and elsewhere |
| We compete with these institutions in attracting deposits and in making loans, and we have to attract our customer base from other existing financial institutions and from new residents |
| Our larger competitors have greater resources, broader geographic markets, and higher lending limits than we do, and they can offer more products and services and better afford and more effectively use media advertising, support services and electronic technology than we can |
| While we believe we compete effectively with other financial institutions, we may face a competitive disadvantage as a result of our size, lack of geographic diversification and inability to spread marketing costs across a broader market |
| Although we compete by concentrating our marketing efforts in our primary markets with local advertisements, personal contacts and greater flexibility and responsiveness in working with local customers, we cannot assure you that we will continue to be an effective competitor in our banking markets |
| · We are subject to extensive regulation that could limit or restrict our activities and adversely affect our earnings |
| We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies |
| Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits, and locations of offices |
| We also are subject to capital guidelines established by our regulators which require us to maintain adequate capital to support our growth |
| Many of these regulations are intended to protect depositors, the public and the FDIC’s Bank Insurance Fund rather than shareholders |
| The Sarbanes-Oxley Act of 2002, and the related rules and regulations issued by the Securities and Exchange Commission and The Nasdaq Stock Market, have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices, including the costs of completing our audit and maintaining our internal controls |
| The laws and regulations that apply to us could change at any time, and we cannot predict the effects of those changes on our business and profitability |
| Government regulation greatly affects the business and financial results of all commercial banks and bank holding companies, and our cost of compliance could adversely affect our earnings |
| · Our management beneficially owns a substantial percentage of our common stock, so our directors and executive officers can significantly affect voting results on matters voted on by our shareholders |
| On February 28, 2006, our current directors and executive officers, as a group, had the sole or shared right to vote, or to direct the voting of, an aggregate of 622cmam194 shares (or 30dtta50prca) of our outstanding common stock, including 377cmam378 shares held by an estate of which one of our directors serves as a co-executor |
| Because of their voting rights, in matters put to a vote of our shareholders it could be difficult for any group of our other shareholders to defeat a proposal favored by our management (including the election of one or more of our directors) or to approve a proposal opposed by management |
| · We depend on the services of our current management team |
| Our operating results and our ability to adequately manage our growth and minimize loan losses are highly dependent on the services, managerial abilities and performance of our current executive officers |
| Smaller banks, like us, sometimes find it more difficult to attract and retain experienced management personnel than larger banks |
| We have an 18 ______________________________________________________________________ experienced management team that our Board of Directors believes is capable of managing and growing the Bank |
| However, changes in key personnel and their responsibilities may disrupt our business and could have a material adverse effect on our business, operating results and financial condition |
| · We may need to invest in new technology to compete effectively, and that could have a negative effect on our operating results and the value of our common stock |
| The market for financial services, including banking services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation and Internet-based banking |
| We depend on third-party vendors for portions of our data processing services |
| In addition to our ability to finance the purchase of those services and integrate them into our operations, our ability to offer new technology-based services depends on our vendors’ abilities to provide and support those services |
| Future advances in technology may require us to incur substantial expenses that adversely affect our operating results, and our small size and limited resources may make it impractical or impossible for us to keep pace with our larger competitors |
| Our ability to compete successfully in our banking markets may depend on the extent to which we and our vendors are able to offer new technology-based services and on our ability to integrate technological advances into our operations |
| Risks Related to Our Common Stock · The trading volume in our common stock has been low, and the sale of a substantial number of shares in the public market could depress the price of our stock and make it difficult for you to sell your shares |
| Our common stock has been listed on The Nasdaq Capital Market since November 1998, and it has been approved for listing on The Nasdaq National Market |
| However, our common stock is thinly traded |
| Thinly traded stock can be more volatile than stock trading in an active public market |
| We cannot predict the extent to which an active public market for our common stock will develop or be sustained |
| In recent years, the stock market has experienced a high level of price and volume volatility, and market prices for the stock of many companies have experienced wide price fluctuations that have not necessarily been related to operating performance |
| We cannot predict what effect future sales of our common stock in the market, or the availability of shares of our common stock for sale in the market, will have on the market price of our common stock |
| So, we cannot assure you that sales of substantial amounts of our common stock in the market, or the potential for large amounts of market sales, would not cause the price of our common stock to decline or impair our ability to raise capital |
| Of the shares of our common stock beneficially owned by our directors and executive officers, 377cmam378 shares (18dtta50prca of our currently outstanding shares) are held by the Estate of Anna Mae H Gibbs |
| We cannot predict the timing or amount of sales, if any, of those shares in the public markets or the effects any such sales may have on the trading price of our common stock |
| · Our ability to pay dividends is limited and we may be unable to pay future dividends |
| Our ability to pay dividends is limited by regulatory restrictions and the need to maintain sufficient consolidated capital |
| Also, our only source of funds with which to pay dividends to our shareholders is dividends we receive from the Bank, and the Bank’s ability to pay dividends to us is limited by its own obligations to maintain sufficient capital and regulatory restrictions |
| If these regulatory requirements are not satisfied, we will be unable to pay dividends on our common stock |
| · Holders of our junior subordinated debentures have rights that are senior to those of our common stockholders |
| We have supported our continued growth by issuing trust preferred securities from a special purpose trust and accompanying junior subordinated debentures |
| At December 31, 2005, we had outstanding trust preferred securities totaling dlra10dtta0 million |
| We unconditionally guaranteed payment of principal and interest on the trust preferred securities |
| Also, the junior subordinated debentures we issued to the special purpose trust that relate to those trust preferred 19 ______________________________________________________________________ securities are senior to our common stock |
| So, we must make payments on the junior subordinated debentures before we can pay any dividends on our common stock |
| In the event of our bankruptcy, dissolution or liquidation, holders of our junior subordinated debentures must be satisfied before any distributions can be made on our common stock |
| We do have the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, but during that time we would not be able to pay dividends on our common stock |