CORNERSTONE BANCSHARES, INC.

(Exact name of small business issuer as specified in its charter)

 

Tennessee (State of Jurisdiction of Incorporation or Organization)		62-1173944 (I.R.S. Employer Identification Number)
	5319 Highway 153 Hixson, TN 37343 (423) 385-3000 (Address, and Telephone Number of Principal Executive Offices and Principal Place of Business)

 

PART I — FINANCIAL INFORMATION

 

Item 1.        Financial Statements

 

CONSOLIDATED BALANCE SHEETS

		Unaudited September 30,			December 31,			Unaudited September 30,
ASSETS		2005			2004			2004
Cash and due from banks		$	21,316,511		$	6,900,054		$	5,677,330
Federal funds sold			-			-			11,290,000
Cash and cash equivalents			21,316,511			6,900,054			16,967,330
Securities available for sale			29,786,444			26,470,691			23,021,742
Securities held to maturity			334,553			390,599			506,392
Federal Home Loan Bank stock, at cost			1,021,400			854,200			854,200
Loans, net of allowance for loan losses of			250,206,577			202,555,862			187,245,833
$ 3,275,486 at September 30, 2005, $2,665,464 at
December 31, 2004 and $2,460,541 at September 30, 2004
Bank premises and equipment, net			6,226,589			5,967,735			4,850,941
Accrued interest receivable			1,520,314			1,184,478			1,003,513
Goodwill			2,541,476			2,541,476			2,541,476
Other assets			2,391,573			1,749,539			2,551,955
Total Assets		$	315,345,437		$	248,614,634		$	239,543,382
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits		$	37,640,383		$	34,024,241		$	32,514,366
Interest-bearing demand deposits			34,839,459			32,855,396			29,567,891
Savings deposits and money market accounts			50,401,011			31,211,457			36,434,436
Time deposits of $100,000 or more			38,123,652			30,089,057			30,893,490
Time deposits of less than $100,000			74,411,258			59,652,751			58,655,159
Total deposits			235,415,763			187,832,902			188,065,342
Federal funds purchased and securites sold under
agreements to repurchase			16,113,028			7,409,162			2,335,094
Federal Home Loan Bank advances and note payable			32,000,000			27,000,000			29,150,000
Accrued interest payable			193,844			91,595			97,176
Other liabilities			1,580,400			1,473,655			1,169,523
Total Liabilities			285,303,035			223,807,314			220,817,135
Stockholders' Equity
Preferred stock - no par value; 2,000,000 shares
authorized; no shares issued
Common stock - $l.00 par value; 10,000,000 authorized
at September 30, 2005, December 31, 2004
and September 30, 2004; shares issued and
outstanding - 3,072,334 at September 30, 2005, 2,868,823 at
December 31, 2004, and 2,487,234 at September 30, 2004			3,072,334			2,868,823			2,487,234
Commom stock subscribed; 119,961 shares at			-			119,961			-
December 31, 2004
Additional paid-in capital			19,892,354			19,160,936			12,193,318
Retained earnings			7,079,676			4,340,981			3,905,777
Accumulated other comprehensive income			(1,962	)		116,034			139,918
			30,042,402			26,606,735			18,726,247
Stock subscription receivable			-			(1,799,415	)		-
Total Stockholders' Equity			30,042,402			24,807,320			18,726,247
Total liabilities and stockholders' equity		$	315,345,437		$	248,614,634		$	239,543,382

 

 

1

---

 

CONSOLIDATED STATEMENTS OF INCOME  

		Unaudited Three months ended September 30,						Unaudited Nine months ended September 30,
INTEREST INCOME			2005			2004			2005			2004
Loans, including fees		$	5,102,644		$	3,422,954		$	13,631,816		$	9,421,457
Investment Securities			303,200			275,140			883,224			755,084
Federal funds sold			30,663			5,773			83,570			8,512
Other earning assets			1,374			729			5,765			1,745
Total interest income			5,437,881			3,704,596			14,604,375			10,186,798
INTEREST EXPENSE
Interest bearing demand accounts			91,369			39,252			238,216			90,486
Money market accounts			282,958			103,615			712,245			280,526
Savings accounts			19,899			9,920			52,172			28,228
Time deposits of less than $100,000			580,386			362,566			1,531,219			1,079,828
Time deposits of more than $100,000			343,196			176,518			781,314			442,810
Federal funds purchased			35,643			9,336			56,153			26,090
Securities sold under agreements to repurchase			16,400			4,569			44,243			15,371
Other borrowings			271,740			240,984			788,678			608,856
Total interest expense			1,641,591			946,760			4,204,240			2,572,195
Net interest income before provision for loan losses			3,796,290			2,757,836			10,400,135			7,614,603
Provision for loan losses			349,600			175,000			899,600			585,000
Net interest income after the provision for loan losses			3,446,690			2,582,836			9,500,535			7,029,603
NONINTEREST INCOME
Service charges			171,365			184,546			488,655			527,835
Other income			320,383			129,894			575,186			395,133
Total noninterest income			491,748			314,440			1,063,841			922,968
NONINTEREST EXPENSE
Salaries and employee benefits			1,139,569			970,194			3,306,804			2,877,762
Occupancy and equipment expense			230,874			314,127			657,259			680,457
Other operating expense			599,204			457,658			1,767,010			1,366,343
Total noninterest expense			1,969,647			1,741,979			5,731,073			4,924,562
Income before provision for income taxes			1,968,791			1,155,297			4,833,303			3,028,009
Provision for income taxes			738,000			447,700			1,850,500			1,174,500
NET INCOME		$	1,230,791		$	707,597		$	2,982,803		$	1,853,509
EARNINGS PER COMMON SHARE
Basic net income per common share		$	0.40		$	0.28		$	0.99		$	0.75
Diluted net income per common share		$	0.37		$	0.25		$	0.90		$	0.67
DIVIDENDS DECLARED PER COMMON SHARE		$	-		$	-		$	0.08		$	-

 

2

---

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

 For the Nine Months ended September 30,

		Unaudited 2005			Unaudited 2004
Cash flows from operating activities:
Net income		$	2,982,803		$	1,853,509
Adjustments to reconcile net income
to net cash provided by operating actvities:
Provision for loan losses			899,600			585,000
Depreciation and amortization			258,878			385,140
Changes in other operating assets and liabilities:
Accrued interest receivable			(335,836	)		(64,750	)
Accrued interest payable			102,249			(4,987	)
Other assets and liabilities			(107,589	)		(726,611	)
Net cash provided by operating activities			3,800,105			2,027,301
Cash flows from investing activities:
Purchase of investment securities: AFS			(13,900,263	)		(16,944,627	)
Proceeds from security transactions: AFS			10,348,160			19,212,356
Proceeds from security transactions: HTM			55,619			133,335
Purchase of FHLB Stock			(167,200	)		-
Loan originations and principal collections, net			(48,577,271	)		(32,597,429	)
Purchase of bank premises and equipment			(125,546	)		(1,708,764	)
Net cash used in investing activities			(52,366,501	)		(31,905,129	)
Cash flows from financing activities:
Net increase in deposits			47,582,861			28,713,067
Net increase (decrease) in securities sold under agreements to repurchase			8,703,866			(3,748,985	)
Proceeds from Federal Home Loan Bank advances and other borrowings			5,000,000			11,750,000
Dividends paid on common stock			(526,476	)		-
Issuance of common stock			2,222,603			-
Net cash provided by financing activities			62,982,854			36,714,082
Net increase in cash and cash equivalents			14,416,457			6,836,255
Cash and cash equivalents beginning of period			6,900,054			10,131,075
Cash and cash equivalents end of period		$	21,316,511		$	16,967,330
SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION
Cash paid during the period for interest		$	4,101,989		$	1,657,404
Cash paid during the period for taxes			1,106,200			1,127,822
NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure		$	427,700		$	44,916

 

 

3

---

 

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statement of Changes in Stockholders' Equity - Unaudited

September 30, 2005  

		Comprehensive Income			Common Stock			Common Stock Subscribed			Additional Paid-in Capital			Retained Earnings			Other Comprehensive Income			Stock Subscriptions Receivable			Total Stockholders' Equity
BALANCE, December 31, 2004					$	2,868,823		$	119,961		$	19,160,936		$	4,340,981		$	116,034		$	(1,799,415	)	$	24,807,320
Issuance of common stock						3,550			-			19,638			-			-			-			23,188
Issuance of common stock						80,000			-			711,780			-			-			-			791,780
under Director's stock option plan
Dividend Common Stock - $0.08 per share						-			-			-			(244,108	)		-			-			(244,108	)
Stock subscriptions redeemed						119,961			(119,961	)		-			-			-			1,799,415			1,799,415
Comprehensive income:
Net income		$	2,982,803			-			-			-			2,982,803			-			-			2,982,803
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment			(117,996	)		-			-			-			-			(117,996	)		-			(117,996	)
Total comprehensive income		$	2,864,807
BALANCE, September 30, 2005					$	3,072,334		$	-		$	19,892,354		$	7,079,676		$	(1,962	)	$	-		$	30,042,402

 

4

---

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

CORNERSTONE BANCSHARES, INC.

 

PRESENTATION OF FINANCIAL INFORMATION

The financial information in this report for September 30, 2005 and September 30, 2004 has not been audited. The information included herein should be read in conjunction with the notes to the consolidated financial statements included in the 2004 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone Bancshares, Inc. (“Cornerstone”) in March of 2005. The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices.

Consolidation

The accompanying consolidated financial statements include the accounts of Cornerstone and its subsidiary Cornerstone Community Bank (the “Bank”).

Substantially all intercompany transactions, profits and balances have been eliminated.

Accounting Policies

During interim periods, Cornerstone follows the accounting policies set forth in its 10-KSB for the year ended December 31, 2004, as filed with the Securities and Exchange Commission. Since December 31, 2004, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices.

Interim Financial Data (Unaudited)

In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

Earnings Per Common Share

Basic earnings per share (“EPS”) is computed by dividing income available to common shareholders (numerator) by the weighted average number of common shares outstanding during the period (denominator). Diluted EPS is computed by dividing income available to common shareholders (numerator) by the adjusted weighted average number of shares outstanding (denominator). The adjusted weighted average number of shares outstanding reflects the potential dilution occurring if securities or other contracts to issue common stock were exercised or converted into common stock resulting in the issuance of common stock that share in the earnings of the entity.

5

---

Stock Based Compensation

The company has two stock-based compensation plans. The company applies the recognition and measurement principles of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for those plans. No stock-based employee compensation is reflected in net income as all options granted under these plans have an exercise price equal to or above the market value of the underlying common stock on the date of the grant. The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of FASB Statement No. 123, "Accounting for Stock-Based Compensation," to stock-based compensation.

 

		Nine months ended						Years ended
		September-05			September-04			Dec-04			Dec-03
Net Income, as reported		$	2,982,803		$	1,853,509		$	2,571,083		$	1,881,859
Deduct: Total Stock-based employee compensation expense determined under fair value method for all awards, net of  the related tax effects			($54,048	)		($49,469	)		($49,469	)		($36,962	)
Pro Forma Net Income (2)		$	2,928,755		$	1,804,040		$	2,521,614		$	1,844,897
Basic-as reported		$	0.99		$	0.75		$	1.03		$	0.76
Basic-pro forma		$	0.97		$	0.73		$	1.01		$	0.74
Diluted-as reported		$	0.90		$	0.67		$	0.92		$	0.71
Diluted-pro forma		$	0.89		$	0.65		$	0.90		$	0.69
Stock Amounts
Average Common Stock issued and outstanding (1)			3,012,760			2,487,132			2,490,340			2,479,156
Effect of dilutive stock options:			292,433			297,263			308,873			184,762

 

1.	The number of average common shares issued as of December 2003 reflect the retroactive adjustment caused by a two-for-one- stock split in the form of a 100% stock dividend which occurred September 15, 2004.

2.	Three month periods ended September 30, 2005 and September 30, 2004 data is not presented within the table in that it does not differ significantly from the nine month periods data.

6

---

Off-Balance Sheet Arrangements

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include standby letters of credit and various commitments to extend credit. At September 30, 2005, commitments under standby letters of credit and undisbursed loan commitments aggregated $57,002,289. The Bank’s credit exposure for these financial instruments is represented by their contractual amounts. The Bank does not anticipate any material losses as a result of the commitments under standby letters of credit and undisbursed loan commitments.

Forward-Looking Statements

Certain written and oral statements made by or with the approval of an authorized executive officer of Cornerstone may constitute “forward-looking statements” as defined under the Private Securities Litigation Reform Act of 1995. Words or phrases such as “should result,” “are expected to,” “we anticipate,” “we estimate,” “we project” or similar expressions are intended to identify forward-looking statements. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from Cornerstone’s historical experience and its present expectations or projections. These risks and uncertainties include, but are not limited to, unanticipated economic changes, interest rate fluctuations and the impact of competition. Caution should be taken not to place undue reliance on any such forward-looking statements since such statements speak only as of the date they are made.

Item 2. Management's Discussion and Analysis or Plan of Operation.

Introduction

Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company and the parent of Cornerstone Community Bank, a Tennessee banking corporation (the “Bank”) that operates in and around Hamilton County, Tennessee. The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments.  The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses. 

The following discussion and analysis sets forth the major factors that affect Cornerstone’s results of operations and financial condition reflected in the unaudited financial statements for the three-month and nine-month periods ended September 30, 2005 and 2004. This discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements contained herein and notes attached thereto.

7

---

 

Overview

As of September 30, 2005 Cornerstone had total consolidated assets of $315.3 million, total loans of $250.2 million, total deposits of $235.4 million and stockholders equity of $30 million. The net income was $1,230,791 and $2,982,803 for the three and nine months ended September 30, 2005, respectively.

Results of Operations

Cornerstone ended the first nine months of 2005 with total assets of $315.3 million, a 26.8% increase from December 31, 2004 and a 31.6% increase from September 30, 2004. Cornerstone reported net income for the nine months ended September 30, 2005 of $2,982,803, or $0.99 basic earnings per share, compared to $1,853,509, or $0.75 basic earnings per share, for the same period in 2004. The increase in earnings during the first nine months of 2005 represents a 60.9% increase compared to the first nine months of 2004. The total number of outstanding shares as of the end of the third quarter ended September 30, 2005 was 3,072,334 compared to 2,487,234 in the third quarter ended September 30, 2004.

The increase in net income for the first nine months of 2005 was due primarily to the 23.5% growth of loans. The 25.3% growth of deposits supported the loan growth and also provided additional monies to invest in earning assets increasing the Bank’s net interest margin to 5.35%. The balance sheet growth and enlarged net interest margin enabled the Bank to increase its net interest income by $2.8 million or 36.6% compared to the same period in 2004. The Bank’s relationship managers continued their successful efforts to originate new loans and sell participations to banks outside of the Bank’s market area. These efforts provided an avenue for increased interest and fee income and allowed the opportunity to increase deposit accounts relative to these loans. In addition, the Bank’s asset sensitivity contributed 20-30 basis points of the net interest margin increase and should be considered temporary since the interest expense will catch up once the Federal Reserve stops increasing interest rates. The Bank’s success is considered to be directly related to the quality of its employees and the Bank intends to continue to add talented people to increase the Bank’s market share of business banking in the Chattanooga MSA.

The Bank was also able to increase deposits by 47.6 million over the first nine months of 2005. The Bank’s non-interest bearing checking accounts increased $3.6 million and interest bearing checking accounts increased $1.9 million or 6.0% while savings accounts and money market accounts increased 61.5% or $19.2 million when compared to the same time period in 2004. The Bank continues to focus on attracting transaction accounts that should allow the Bank to maintain its above peer average net interest margin. The Bank selects longer-term maturities to reduce its general interest rate risk, and utilizes its federal funds lines of credit as an inexpensive source of funds. The Bank anticipates slower deposit growth in transaction deposits during the last quarter of 2005.

8

---

Non-interest Income. Non-interest income increased 15.3% for the first nine months of 2005 compared to the same period in 2004. This increase was primarily due to gains from the sale of loans to the secondary market. The majority of the growth was centered on the Bank’s SBA program. The Bank participates in both SBA 7(a) and 504 programs. Adding to the Bank’s success in this area is the relationship managers’ depth of knowledge with respect to specialty loans and the Bank’s willingness to consider these loans while adhering to strict credit underwriting guidelines. The Bank has seen a decrease in overdraft charges year to date from $375 thousand for the first nine months of 2004 to $333 thousand for the first nine months of 2005. Offsetting this customer discretionary fee, the Bank saw a large increase in electronic payments revenue as fees from ACH payment increased $79 thousand during the first nine months of 2005.

 

On the qualitative side, the Bank maintained its asset quality, which is quantified by the Bank’s average of past due loans to net loans ratio of 0.13% and a bank average non-performing asset ratio of 0.42%. For the first nine months of 2005, the Bank’s net interest margin was 5.35%, compared to 5.01% for the same time period in 2004. The Bank’s management expects the Bank’s net interest margin to decrease slightly to a more historic level over the remainder of 2005.

Through the end of September 2005, the Federal Reserve continued its steady interest rate increase to a neutral stance with monetary policy. With increased energy prices in recent months and the devastation caused by hurricanes, the economy is beginning to show signs of rising inflation. Some economic indicators predict that the Federal Reserve will continue the interest rate increase at least through the remainder of 2005. As a result, management is maintaining an asset sensitive balance sheet which means the Bank’s assets will reprice more quickly than its liabilities as interest rates increase. Management will conservatively move the balance sheet to a more neutral position as the Federal Reserve becomes less likely to increase rates.

During the third quarter of 2005 the Bank continued to work on expanding its manpower and capital capacity to provide exceptional customer service in the rapidly growing environment. The Bank is determined to continue to add highly qualified commercial relationship managers as they become available in its market and build the appropriate support staff to enable them.

The Bank, pursuant to its strategic plan, intends to continue to focus on providing a competitive footprint (convenient branches) to the Chattanooga Metropolitan Statistical Area allowing it to compete with the three major regional banks located in the area. The Bank also intends to focus its efforts in the suburb branch network and not on a central hub bank located in downtown Chattanooga. It is also intended that special emphasis will be placed on providing services specifically targeted to small businesses and individual customers.

Financial Condition

Earning Assets. Average earning assets for the nine months ended September 30, 2005, increased by $56.5 million, or 27.7% compared to the nine months ended September 30, 2004, while actual earning assets increased $58.4 million or 26.2% during the same period. The average and actual balance increases were due to strong loan demand in the first nine months of 2005 and a strong growth in transaction account deposits during the current reporting period. Management expects average earning assets to grow at a similar pace during the remainder of 2005.

9

---

Loan Portfolio. The Bank's average loans for the first nine months of 2005 were $228.1 million, an increase of $51.9 million, or 29.5% compared to the first nine months of 2004, while actual balances increased to $250.2 million, an increase of 33.7% above the $187.2 million in loans as of September 30, 2004. Management anticipates similar loan growth for the remainder of the year in both average and actual balances.

Investment Portfolio. The Bank's average investment securities portfolio and Federal Funds Sold increased by 16.2% or $4.5 million for the nine months ended September 30, 2005 compared to the nine months ended September 30, 2004, while actual balances decreased $4.7 million or 13.5%. With current market conditions, bank management believes the current level of $30 million in investment securities is appropriate and intends to increase the portfolio cautiously. The Bank expects to maintain an investment strategy of making prudent investment decisions with active management of the portfolio to optimize, within the constraints of established policies, an adequate return and value. Investment objectives include, in order of priority, gap management, liquidity, pledging, return, and local community support. The Bank maintains two classifications of investment securities: "Held to Maturity" (HTM) and "Available for Sale" (AFS). The "Available for Sale" securities are carried at fair market value, whereas "Held to Maturity" securities are carried at book value. As of September 30, 2005, net unrealized losses in the "Available for Sale" portfolio amounted to ($2,972), a 0.01% decrease in value.

Deposits.   The Bank's average deposits increased by $41.5 million or 24.6% for the nine month period ended September 30, 2005 compared to the same period ended September 30, 2004, while actual deposit balances increased by $47.4 million or 25.2% during the same period. During the quarter, the Bank launched a successful campaign to raise funds by offering a certificate of deposit special. The majority of the actual deposit growth was represented by money market and time accounts with a $37.0 million increase or 29.3% over the same period in 2004. Management intends to continue focusing its efforts on attracting core deposits and expects certificates of deposits to increase over the remainder of 2005 as loan growth continues. The Bank intends to maintain as one of its highest priorities the continued solicitation of transaction accounts from new and existing customers, which should provide the Bank with an increased net interest margin.

Liquidity and Capital Resources.

As of the end of the third quarter of 2005 the Bank had $32 million of Federal Home Loan Bank of Cincinnati (“FHLB”) borrowings. The borrowings are designed with a maturity of 10 years with call and put options after a stated conversion date. Management believes that FHLB borrowings provide an inexpensive method to reduce interest rate risks by obtaining longer term liabilities to match the typically longer term assets the Bank has on its balance sheet that are usually below the cost of certificates of deposit.

Federal funds purchased increased $13.8 million during the nine months ended September 30, 2005 compared to the same period ended September 30, 2004. This increase accommodated the 27.7% growth in earning assets during the same period.

 

  Average stockholders' equity increased by $9.7 million or 54.4% to $27.5 million for the nine months ended September 30, 2005 compared with $17.8 million during the nine months ended September 30, 2004. Actual equity increased by $11.3 million or 60.4% from September 30, 2004 to September 30, 2005. This increase was primarily due to a stock offering during the last quarter of 2004 wherein 500,000 additional shares of stock were sold at $15 per share, raising stockholder’s equity by $7.5 million.

During 2005, 80 thousand shares of common stock were issued due to the exercise of stock options from the 1996 Non-qualified Directors Stock Option Plan. The Bank applies the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees”. No compensation expense was recognized in past periods as a result of the options price and estimated fair value of the stock being the same at the grant date. Since no cumulative compensation expense has been recognized in the financial statements, the tax deduction the company will receive for 2005, results in a corresponding decrease in taxes payable and increase in additional paid in capital of approximately $390 thousand.

10

---

CONSOLIDATED AVERAGE BALANCE SHEET

INTEREST INCOME / EXPENSE AND YIELD / RATES

Taxable equivalent basis

(in thousands)

		Unaudited Nine months ended September 30,
		2005									2004
Assets		Average Balance			Income / Expense			Yield / Rate			Average Balance			Income / Expense			Yield / Rate
Loans, net of unearned income		$	228,142		$	13,632			7.99	%	$	176,210		$	9,421			7.15	%
Investment securities			28,634			883			4.27	%		26,920			755			3.87	%
Other earning assets			3,759			90			3.20	%		949			10			1.41	%
Total earning assets			260,535			14,605			7.50	%		204,079			10,186			6.68	%
Allowance for loan losses			(2,913	)								(2,229	)
Cash and other assets			19,330									16,031
TOTAL ASSETS			276,952									217,881
Liabilities and Stockholders' Equity
Interest bearing liabilities:
Interest bearing demand deposits		$	34,033		$	238			0.93	%	$	28,023		$	90			0.43	%
Savings deposits			7,797			52			0.89	%		7,386			28			0.51	%
MMDA's			36,263			712			2.63	%		24,693			281			1.52	%
Time deposits			67,802			1,531			3.02	%		58,305			1,080			2.48	%
Time deposits of $100,000 or more			30,625			781			3.41	%		23,988			443			2.47	%
Federal funds and securities sold under
agreements to repurchase			6,409			104			2.17	%		4,904			65			1.77	%
Other borrowings			30,919			785			3.39	%		25,105			585			3.12	%
Total interest bearing liabilities			213,848			4,203			2.63	%		172,404			2,572			1.99	%
Net interest spread					$	10,402								$	7,614
Noninterest bearing demand deposits			33,853									26,431
Accrued expenses and other liabilities			1,765									1,238
Stockholders' equity			27,486									17,808
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY			276,952									217,881
Net interest margin on earning assets									5.35	%								5.00	%
Net interest spread on earning assets									4.87	%								4.68	%

 

 

11

---

Results of Operations - Nine months ended September 30, 2005 compared to nine months ended September 30, 2004

Net Interest Income.   Net interest income is the principal component of a financial institution's income stream and represents the spread between interest and fee income generated from earning assets and the interest expense paid on deposits. The following discussion is on a fully taxable equivalent basis.

Net interest income before loan loss provision for the first nine months of 2005 increased $2.8 million or 36.8% above net interest income before loan loss provision for the first nine months of 2004. As in previous quarters, the rapid growth in earning assets and the slower paced deposit costs were the driving factors to the increase in net interest income during the third quarter of 2005. Average earning assets grew to $260.5 million compared to $204.1 million in September 2004. Interest income from earning assets increased from 6.68% to 7.50% during the third quarter while the cost of deposits grew from 1.99% to 2.63% over the same period. The net interest margin outpaced the Bank’s projections again in the third quarter primarily from the rapid growth created by the successful accomplishments of the lending staff.

Interest income increased $4.4 million or 43.4% for the nine month period ended September 30, 2005 compared to the same period ended September 30, 2004. Interest income produced by the loan portfolio increased $4.2 million or 44.7% for the nine month period ended September 30, 2005 compared to nine month period ended September 30, 2004, due to the increase in average loans outstanding and origination fees associated with loan growth for the period. Management anticipates the average and actual balances will continue to increase throughout the remainder of 2005. Interest income on investment securities and other earning assets increased $207 thousand or 27.1% for the nine month period ended September 30, 2005 compared to the nine month period ended September 30, 2004. This was largely due to money market deposit growth providing opportunity for Federal Funds investments.

 

Due to the $41.4 million increase in average interest bearing liabilities from September 30, 2004 to September 30, 2005, the total interest expense increased $1.6 million or 63.5% during the same period.  

12

---

 

  The net interest margin for the nine months ended September 30, 2005 was 5.35% compared to 5.0% for the same period of 2004. The interest spread on earning assets increased 19 basis points to 4.87% for the period ended September 30, 2005, compared to 4.68% for the period ended September 30, 2004.

    The measure the Bank and many other financial institutions use to measure this interest rate sensitivity is a GAP report. The report determines the amount of difference between repricing assets and liabilities over a period of time. The period most commonly used by financial institutions is the one year cumulative GAP. Currently the Bank’s balance sheet structure is considered asset sensitive, which means the assets will reprice faster than liabilities. The Bank’s one year cumulative GAP is 23.98% and considered beneficial if rates are rising. Management anticipates that the Federal Reserve will continue to increase short term interest rates for the rest of 2005 which should benefit the Bank’s earning until liabilities have time to reprice and the Bank’s net interest margin returns to a more normal level. Management plans to actively manage the balance sheet and during the fourth quarter reduce the asset sensitivity of the Bank to a more neutral position that would not negatively impact earnings if short term interest rates started a downward turn.

Allowance for Loan Losses. The allowance for loan losses represents management's assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. Management believes that the $3.3 million allowance for loan losses as of September 30, 2005 reflects the full known extent of credit exposure. During the first nine months ended September 30, 2005, the loan portfolio grew 23.5%. To accommodate this growth, the Bank made $900 thousand in loan loss provision compared to $585 thousand during the same period of 2004, and anticipates similar provisions in the future as the loan portfolio continues to grow. The increase in the provision during 2005, represents management’s assessment of the loan portfolio and the inherent risks associated with the loan growth, classified loans and non-performing loans. Even with prudent credit underwriting, no assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

Non-performing Assets. Non-performing assets include non-performing loans and foreclosed real estate held for sale. Non-performing loans include loans classified as non-accrual or renegotiated. The Bank's policy is to place a loan on non-accrual status when payment of principal or interest is contractually 90 or more days past due. At the time a loan is placed on non-accrual status, interest previously accrued but not collected may be reversed and charged against current earnings. As of September 30, 2005, the Bank had $597 thousand in non-accruing loans and $458 thousand in repossessed and foreclosed properties of which the majority is one relationship with three, one to four family residences as collateral, compared to $23 thousand in non-accruing loans and $46 thousand in repossessed and foreclosed properties as of September 30, 2004.

 

Non-interest Income. Non-interest income consists of revenues generated from a broad range of financial services and activities, including fee-based services and profits, commissions earned through credit life insurance sales and other activities. In addition, gains or losses realized from the sale of residential mortgage loans are included in non-interest income. During the first nine months of 2005, total non-interest income increased $141 thousand or 15.3% compared with the first nine months of 2004.

Non-interest Expense. Non-interest expense for the first nine months of 2005 increased by $807 thousand or 16.4% compared to the first nine months in 2004. Expenses for salaries and employee benefits for the first nine months ended September 30, 2005 increased by $429 thousand or 14.9% over the same period ended from September 30, 2004. Occupancy and equipment expense as of September 30, 2005 decreased by $23 thousand or 3.4% over the same period in 2004. All other non-interest expenses for the nine-month period ended September 30, 2005 increased $401 thousand or 29.3% over the non-interest expenses for the same period ended September 30, 2004. The increase in non-interest expenses is broad based and used to support the rapid growth of the Bank’s assets and liabilities in a safe and sound manner.

 

13

---

CONSOLIDATED AVERAGE BALANCE SHEET

INTEREST INCOME / EXPENSE AND YIELD / RATES

Taxable equivalent basis

(in thousands)

		Unaudited Three months ended September 30,
		2005									2004
Assets		Average			Income /			Yield /			Average			Income /			Yield /
		Balance			Expense			Rate			Balance			Expense			Rate
Loans, net of unearned income		$	245,014		$	5,103			8.26	%	$	190,151		$	3,423			7.14	%
Investment securities			29,000			303			4.29	%		28,645			275			3.93	%
Other earning assets			3,092			32			4.11	%		1,675			7			1.66	%
Total earning assets			277,106			5,438			7.80	%		220,471			3,705			6.68	%
Allowance for loan losses			(3,103	)								(2,398	)
Cash and other assets			20,364									17,324
TOTAL ASSETS			294,367									235,397
Liabilities and Stockholders' Equity
Interest bearing liabilities:
Interest bearing demand deposits		$	35,871		$	91			1.01	%	$	31,313		$	39			0.49	%
Savings deposits			7,824			20			1.01	%		7,729			10			0.51	%
MMDA's			39,550			283			2.84	%		26,976			104			1.53	%
Time deposits under $100,000			72,295			580			3.19	%		59,808			363			2.41	%
Time deposits of $100,000 or more			33,367			343			4.08	%		26,958			177			2.60	%
Federal funds and securities sold under
agreements to repurchase			7,125			52			2.90	%		4,256			32			2.98	%
Other borrowings			32,000			272			3.37	%		29,150			222			3.02	%
Total interest bearing liabilities			228,033			1,642			2.86	%		186,190			947			2.02	%
					$	3,796								$	2,758
Noninterest bearing demand deposits			35,371									29,491
Accrued expenses and other liabilities			2,061									1,305
Stockholders' equity			28,901									18,411
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY			294,367									235,397
Net interest margin on earning assets									5.45	%								4.96	%
Net interest spread on earning assets									4.94	%								4.67	%

 

14

---

Results of Operations - Three months ended September 30, 2005 compared to three months ended September 30, 2004

Net Interest Income.     Net interest income before loan loss provision for the third quarter of 2005 increased $1.0 million or 37.7% above net interest income before loan loss provision for the third quarter of 2004. The increase in net interest income was primarily due to a strong earning asset growth during the three month period; actual loan growth, net unearned income representing $13.9 million of growth or 5.8% from June, 2005. The interest yield from earning assets increased 112 basis points from 6.68% to 7.80%, while interest cost from the Bank’s liabilities increased 84 basis points from 2.02% to 2.86% over the same time period in 2004. The Bank’s deposit mix shifted slightly with the percentage of average money market accounts increasing from $27.0 million during the three months ended September 30, 2004 to $39.6 million for the three months ended September 30, 2005. Time accounts also showed an increase of 21.8% or $18.9 million for the same periods.

The Bank’s percentage of average loans to average assets remained relatively constant for the three months ended September 30, 2005 compared to the same period ended September 30, 2004. The increase in net interest margin was above the Bank’s projections and can be directly attributed to the above-mentioned change in the Bank’s deposit mix. Management foresees the margin decreasing to more historic levels for the remainder of 2005.

Total interest income increased $1.7 million or 46.8% during the third quarter of 2005 compared to the third quarter 2004. Interest income produced by the loan portfolio increased $1.7 million or 49.07% for the three month period ended September 30, 2005 compared to the three month period ended September 30, 2004, due to the increase in average loans outstanding and origination fees associated with loan growth for the period. Management estimates the average balances will continue to increase.

 

Interest income on investment securities, federal funds sold and other investments increased $54 thousand or 19.0% for the quarter ended September 30, 2005 compared to the quarter ended September 30, 2004, largely due to an increase in investment in federal funds sold. The Bank strategically utilized the growth in money market deposits to invest in variable rate products and improve income thereby taking advantage of the rising rate environment.

 

15

---

 

Total interest expense increased $695 thousand or 73.4% during the three months ended September 30, 2005 from the same period ended September 30, 2004.   The interest expense increase from the third quarter of 2004 to the third quarter of 2005 was primarily due to an increase of $41.8 million or 22.5% in average interest bearing liabilities combined with the 84 basis point increase in rates.

The net interest margin for the three months ended September 30, 2005 was 5.45% compared to 4.96% for the three months ended September 30, 2004. The interest spread on earning assets increased 27 basis points to 4.94% for the period ended September 30, 2005, compared to 4.67% for the period ended September 30, 2004.

Allowance for Loan Losses. The allowance for loan losses represents management's assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. Management believes that the $3.3 million allowance for loan losses as of September 30, 2005 reflects the full known extent of credit exposure. During the three months ended September 30, 2005, the loan portfolio averaged $245 million, an increase of $55 million or 28.9% compared to the same period in 2004. The $350 thousand provision during the third quarter of 2005 compared to $175 during the same period in 2004 represents management’s analysis of the inherent risks associated with the loan growth, and currently classified and non-performing loans. The Bank anticipates similar provisions in the future as the loan portfolio grows and unanticipated loan losses occur. No assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

 

Non-interest Income.   Non-interest income consists of revenues generated from a broad range of financial services and activities, including fee-based services and profits, commissions earned through service charges of deposit accounts and other activities. In addition, gains or losses realized from   the sale of loans are included in non-interest income. Total non-interest income increased by $177 or 56.4% for the third quarter of 2005 compared with the third quarter of 2004. The increase of non-interest income during this period of 2005 was largely due to the heightened electronic transaction activity and the gains recognized on the sale of loans.

 

Non-interest Expense. Non-interest expense for the third quarter of 2005 increased by $228 thousand or 13.1% compared to the same three months in 2004. Salaries expense and employee benefits increased by $169 thousand or 17.5% for the three months ended September 30, 2005 over the same period ended September 30, 2004. Occupancy and equipment expense as of September 30, 2005 decreased by $83 thousand or 26.5% over the same period in 2004. All other non-interest expenses for the three-month period increased $142 thousand or 30.9% above the non-interest expenses for the same period ended September 30, 2004. The increase in non-interest expense is due primarily to the cost to hire highly knowledgeable and competent employees to support the Bank’s growth of assets and liabilities while protecting existing employees from competitors.

16

---

Item 3.     Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Cornerstone’s Chief Executive Officer and Treasurer have evaluated the effectiveness of Cornerstone’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Cornerstone’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Cornerstone (including its consolidated subsidiaries) required to be included in Cornerstone’s periodic filings under the Exchange Act.

Changes in Internal Controls

Since the Evaluation Date, there have not been any significant changes in Cornerstone’s internal controls or in other factors that could significantly affect such controls.

PART II

OTHER INFORMATION

Item 1.     Legal Proceedings

There are various claims and lawsuits in which the Bank is periodically involved incidental to the Bank’s business. In the opinion of Management, no material loss is expected from any of such pending claims or lawsuits.

 

Item 6.     Exhibits and Reports on Form 8-K

(a)

Exhibits

Exhibit Number	Description
3	First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. (1)
10.1	Employee Stock Ownership Plan between Cornerstone Community Bank and Nathaniel F. Hughes dated July 1, 2005. (2)
31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

_____________________

(1)   Incorporated by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on May 14, 2004.

(2)   Incorporated by reference from Exhibit 10.1 of the registrant’s Form 8-K dated July 18, 2005.

17

---

 

(b)	Reports on Form 8-K

(1)	Form 8-K dated July 18, 2005 (i) disclosing a press release related to the fiscal quarter ended June 30, 2005 and (ii) an announcement of Employee Stock Ownership Plan by and between Cornerstone Community Bank, a wholly owned subsidiary of Cornerstone Bancshares, Inc. and Nathaniel F. Hughes.

(2)	Form 8-K dated September 26, 2005 announcing the appointment of two new directors, W. Miller Welborn and Frank McDonald.

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

	Cornerstone Bancshares, Inc.
Date: November 10, 2005	By:	/s/ Gregory B. Jones
		Gregory B. Jones, Chairman and Chief Executive Officer

 

Date: November 10, 2005	By:	/s/ Nathaniel F. Hughes
		Nathaniel F. Hughes President and Treasurer

 

18

---

EXHIBIT INDEX

 

Exhibit Number	Description
3	First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. (1)
10.1	Employee Stock Ownership Plan between Cornerstone Community Bank and Nathaniel F. Hughes dated July 1, 2005. (2)
31	Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.
32	Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

_____________________

(1)   Incorporated by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on May 14, 2004.

(2)   Incorporated by reference from Exhibit 10.1 of the registrant’s Form 8-K dated July 18, 2005.

19

---