United Community Banks, Inc.
UNITED COMMUNITY BANKS INC (Form: 10-Q, Received: 05/07/2008 16:42:12)


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 
Washington, D.C. 20549
 
FORM 10-Q
 
x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended March 31, 2008
 
OR
 
o      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Transition Period from ___________ to ___________
 
Commission file number 0-21656
 
UNITED COMMUNITY BANKS, INC.

(Exact name of registrant as specified in its charter)
 
                      Georgia                     
                      58-1807304                     
(State of Incorporation)
(I.R.S. Employer Identification No.)


63 Highway 515
 
               Blairsville, Georgia               
               30512               
Address of Principal Executive Offices
(Zip Code)

(706) 781-2265
(Telephone Number)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
YES  x   NO o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company.  See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer  x
Accelerated filer
  o
Non-accelerated filer  o (Do not check if a smaller reporting company)
Smaller Reporting Company
  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
 
YES  o   NO x
 
Common stock, par value $1 per share:  47,004,223 shares
outstanding as of March 31, 2008
 

 
INDEX


PART I - Financial Information
 
       
            
Item 1.     Financial Statements.  
       
           
 
Consolidated Statement of Income (unaudited) for the Three Months Ended  March 31, 2008 and 2007
2
       
            
 
Consolidated Balance Sheet at March 31, 2008 (unaudited), December 31, 2007  (audited) and March 31, 2007 (unaudited)
3
       
           
 
Consolidated Statement of Changes in Shareholders’ Equity (unaudited) for the  Three Months Ended March 31, 2008 and 2007
4
       
      
 
Consolidated Statement of Cash Flows (unaudited) for the Three Months Ended  March 31, 2008 and 2007
5
       
          
 
Notes to Consolidated Financial Statements
6
       
  Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations.
12
       
  Item 3.     Quantitative and Qualitative Disclosures About Market Risk.
28
       
  Item 4.     Controls and Procedures.
28
       
PART II - Other Information
 
       
  Item 1.     Legal Proceedings.
29
  Item 1A.  Risk Factors.
29
  Item 2.     Unregistered Sales of Equity Securities and Use of Proceeds.
29
  Item 3.     Defaults Upon Senior Securities.
29
  Item 4.     Submission of Matters to a Vote of Security Holders.
29
  Item 5.     Other Information.
29
  Item 6.     Exhibits.
29

1


Part I – Financial Information
 
Item 1 – Financial Statements
 
UNITED COMMUNITY BANKS, INC.
           
Consolidated Statement of Income (unaudited)
           
   
   
Three Months Ended
 
   
March 31,
 
 (in thousands, except per share data)
 
2008
   
2007
 
             
Interest revenue:
           
Loans, including fees
  $ 109,266     $ 114,073  
Investment securities:
               
Taxable
    18,628       13,968  
Tax exempt
    394       447  
Federal funds sold and deposits in banks
    222       58  
Total interest revenue
    128,510       128,546  
                 
Interest expense:
               
Deposits:
               
NOW
    8,587       10,627  
Money market
    2,913       2,540  
Savings
    227       309  
Time
    38,884       41,625  
Total deposit interest expense
    50,611       55,101  
Federal funds purchased, repurchase agreements, & other short-term borrowings
    4,318       1,817  
Federal Home Loan Bank advances
    5,745       4,801  
Long-term debt
    2,080       2,204  
Total interest expense
    62,754       63,923  
Net interest revenue
    65,756       64,623  
Provision for loan losses
    7,500       3,700  
Net interest revenue after provision for loan losses
    58,256       60,923  
                 
Fee revenue:
               
Service charges and fees
    7,813       7,253  
Mortgage loan and other related fees
    1,963       2,223  
Consulting fees
    1,807       1,747  
Brokerage fees
    1,093       944  
Securities gains, net
    -       207  
Other
    1,521       2,008  
Total fee revenue
    14,197       14,382  
Total revenue
    72,453       75,305  
                 
Operating expenses:
               
Salaries and employee benefits
    28,754       28,317  
Communications and equipment
    3,832       3,812  
Occupancy
    3,716       3,191  
Advertising and public relations
    1,351       2,016  
Postage, printing and supplies
    1,592       1,660  
Professional fees
    1,921       1,479  
Amortization of intangibles
    767       564  
Other
    5,596       3,802  
Total operating expenses
    47,529       44,841  
Income before income taxes
    24,924       30,464  
Income taxes
    8,846       11,119  
Net income
  $ 16,078     $ 19,345  
                 
Net income available to common shareholders
  $ 16,074     $ 19,340  
                 
Earnings per common share:
               
Basic
  $ .34     $ .45  
Diluted
    .34       .44  
Dividends per common share
    .09       .09  
Weighted average common shares outstanding:
               
Basic
    46,966       43,000  
Diluted
    47,272       43,912  
 
 
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2

 
 UNITED COMMUNITY BANKS, INC.
                 
 Consolidated Balance Sheet
                 
   
   
March 31,
   
December 31,
   
March 31,
 
(in thousands, except share and per share data)
 
2008
   
2007
   
2007
 
   
(unaudited)
   
(audited)
   
(unaudited)
 
ASSETS
                 
                   
Cash and due from banks
  $ 169,538     $ 157,549     $ 159,543  
Interest-bearing deposits in banks
    13,417       62,074       22,644  
Cash and cash equivalents
    182,955       219,623       182,187  
                         
Securities available for sale
    1,508,402       1,356,846       1,150,424  
Mortgage loans held for sale
    28,451       28,004       31,633  
Loans, net of unearned income
    5,967,839       5,929,263       5,402,198  
Less allowance for loan losses
    89,848       89,423       68,804  
Loans, net
    5,877,991       5,839,840       5,333,394  
                         
Premises and equipment, net
    180,746       180,088       150,332  
Accrued interest receivable
    59,585       62,828       60,677  
Goodwill and other intangible assets
    324,041       325,305       166,073  
Other assets
    224,084       194,768       111,882  
Total assets
  $ 8,386,255     $ 8,207,302     $ 7,186,602  
                         
LIABILITIES AND SHAREHOLDERS' EQUITY
                       
Liabilities:
                       
Deposits:
                       
Demand
  $ 690,028     $ 700,941     $ 675,969  
NOW
    1,523,942       1,474,818       1,406,287  
Money market
    431,623       452,917       277,184  
Savings
    187,911       186,392       176,891  
Time:
                       
Less than $100,000
    1,535,742       1,573,604       1,619,865  
Greater than $100,000
    1,375,000       1,364,763       1,366,360  
Brokered
    431,523       322,516       319,131  
Total deposits
    6,175,769       6,075,951       5,841,687  
                         
Federal funds purchased, repurchase agreements, and other short-term borrowings
    532,896       638,462       77,367  
Federal Home Loan Bank advances
    615,324       519,782       464,072  
Long-term debt
    107,996       107,996       113,151  
Accrued expenses and other liabilities
    82,818       33,209       51,869  
Total liabilities
    7,514,803       7,375,400       6,548,146  
                         
Shareholders' equity:
                       
Preferred stock, $1 par value; $10 stated value; 10,000,000 shares authorized;
                       
25,800, 25,800 and 32,200 shares issued and outstanding
    258       258       322  
Common stock, $1 par value; 100,000,000 shares authorized;
                       
48,809,301, 48,809,301 and 43,037,840 shares issued
    48,809       48,809       43,038  
Common stock issuable; 90,505, 73,250 and 35,154 shares
    2,410       2,100       1,043  
Capital surplus
    463,095       462,881       273,575  
Retained earnings
    359,248       347,391       321,721  
Treasury stock; 1,805,078 and 1,905,921 shares, at cost
    (41,351 )     (43,798 )     -  
Accumulated other comprehensive income (loss)
    38,983       14,261       (1,243 )
Total shareholders' equity
    871,452       831,902       638,456  
                         
Total liabilities and shareholders' equity
  $ 8,386,255     $ 8,207,302     $ 7,186,602  

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
3

 
UNITED COMMUNITY BANKS, INC.
Consolidated Statement of Changes in Shareholders' Equity (Unaudited)
For the Three Months Ended March 31,
 
                                       
Accumulated
       
               
Common
                     
Other
       
   
Preferred
   
Common
   
Stock
   
Capital
   
Retained
   
Treasury
   
Comprehensive
       
(in thousands, except share and per share data)
Stock
   
Stock
   
Issuable
   
Surplus
   
Earnings
   
Stock
   
Income (Loss)
   
Total
 
                                                 
Balance, December 31, 2006
  $ 322     $ 42,891     $ 862     $ 270,383     $ 306,261     $ -     $ (3,952 )   $ 616,767  
                                                                 
Comprehensive income:
                                                               
Net income
                                    19,345                       19,345  
Other comprehensive income:
                                                               
Unrealized holding gains on available for
                                                             
sale securities, net of deferred tax
                                                             
expense and reclassification adjustment
                                                    2,000       2,000  
Unrealized gains on derivative financial
                                                               
instruments qualifying as cash flow
                                                               
hedges, net of deferred tax expense
                                                    709       709  
                                                                 
Comprehensive income
                                    19,345               2,709       22,054  
Cash dividends declared on common stock
                                                               
($.09 per share)
                                    (3,880 )                     (3,880 )
Exercise of stock options (72,703 shares)
            73               629                               702  
Common stock issued to Dividend Reinvestment
                                                           
Plan and employee benefit plans (52,914 shares)
        53               1,693                               1,746  
Amortization of stock option and restricted
                                                               
stock awards
                            729                               729  
Vesting of restricted stock (21,360 shares)
            21               (21 )                             -  
Deferred compensation plan, net, including
                                                               
dividend equivalents
                    181                                       181  
Tax benefit from options exercised
                            162                               162  
Dividends declared on preferred stock
                                                               
($.15 per share)
                                    (5 )                     (5 )
                                                                 
Balance, March 31, 2007
  $ 322     $ 43,038     $ 1,043     $ 273,575     $ 321,721     $ -     $ (1,243 )   $ 638,456  
                                                                 
Balance, December 31, 2007
  $ 258     $ 48,809     $ 2,100     $ 462,881     $ 347,391     $ (43,798 )   $ 14,261     $ 831,902  
                                                                 
Comprehensive income:
                                                               
Net income
                                    16,078                       16,078  
Other comprehensive income:
                                                               
Unrealized holding gains on available for
                                                               
sale securities, net of deferred tax expense
                                                  12,341       12,341  
Unrealized gains on derivative financial
                                                               
instruments qualifying as cash flow
                                                               
hedges, net of deferred tax expense
                                                    12,381       12,381  
                                                                 
Comprehensive income
                                    16,078               24,722       40,800  
Cash dividends declared on common stock
                                                               
($.09 per share)
                                    (4,217 )                     (4,217 )
Exercise of stock options (60,271 shares)
                            (691 )             1,470               779  
Common stock issued to Dividend Reinvestment
                                                           
Plan and employee benefit plans (31,944 shares)
                        (266 )             769               503  
Amortization of stock options and restricted stock
                        975                               975  
Vesting of restricted stock (7,912 shares issued,
                                                           
3,125 shares deferred)
                    91       (282 )             191               -  
Deferred compensation plan, net, including
                                                               
dividend equivalents
                    238                                       238  
Shares issued from deferred compensation plan
                                                           
(716 shares)
                    (19 )     2               17               -  
Tax benefit from options exercised
                            476                               476  
Dividends declared on preferred stock
                                                               
($.15 per share)
                                    (4 )                     (4 )
                                                                 
Balance, March 31, 2008
  $ 258     $ 48,809     $ 2,410     $ 463,095     $ 359,248     $ (41,351 )   $ 38,983     $ 871,452  


SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
4

 
UNITED COMMUNITY BANKS, INC.
Consolidated Statement of Cash Flows (Unaudited)
   
   
Three Months Ended
 
   
March 31,
 
(in thousands)
2008
   
2007
 
Operating activities:
           
Net income
  $ 16,078     $ 19,345  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation, amortization and accretion
    3,568       3,372  
Provision for loan losses
    7,500       3,700  
Stock based compensation
    975       729  
Gain on sale of securities available for sale
    -       (207 )
Gain on sale of other assets
    (7 )     (207 )
Changes in assets and liabilities:
               
Other assets and accrued interest receivable
    8,867       (1,143 )
Accrued expenses and other liabilities
    (4,783 )     8,340  
Mortgage loans held for sale
    (447 )     3,692  
Net cash provided by operating activities
    31,751       37,621  
                 
Investing activities:
               
Proceeds from sales of securities available for sale
    25,000       915  
Proceeds from maturities and calls of securities available for sale
    174,956       78,934  
Purchases of securities available for sale
    (296,228 )     (120,125 )
Net increase in loans
    (63,119 )     (29,622 )
Proceeds from sales of premises and equipment
    288       635  
Purchases of premises and equipment
    (3,773 )     (13,549 )
Proceeds from sale of other real estate
    8,156       1,804  
Net cash used by investing activities
    (154,720 )     (81,008 )
                 
Financing activities:
               
Net change in deposits
    99,818       68,801  
Net change in federal funds purchased, repurchase agreements,
               
and other short-term borrowings
    (105,566 )     11,483  
Proceeds from FHLB advances
    300,000       425,000  
Repayments of FHLB advances
    (205,000 )     (450,000 )
Proceeds from exercise of stock options
    779       702  
Proceeds from issuance of common stock for dividend reinvestment
               
and employee benefit plans
    503       1,746  
Cash dividends on common stock
    (4,229 )     (3,437 )
Cash dividends on preferred stock
    (4 )     (5 )
Net cash provided by financing activities
    86,301       54,290  
                 
Net change in cash and cash equivalents
    (36,668 )     10,903  
                 
Cash and cash equivalents at beginning of period
    219,623       171,284  
                 
Cash and cash equivalents at end of period
  $ 182,955     $ 182,187  
                 
Supplemental disclosures of cash flow information:
               
Cash paid during the period for:
               
Interest
  $ 65,789     $ 65,675  
Income taxes
    152       1,506  

SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
5

 
United Community Banks, Inc.
 
Notes to Consolidated Financial Statements
 
Note 1 - Accounting Policies
 
The accounting and financial reporting policies of United Community Banks, Inc. (“United”) and its subsidiaries conform to accounting principles generally accepted in the United States of America and general banking industry practices.  The accompanying interim consolidated financial statements have not been audited.  All material intercompany balances and transactions have been eliminated.  A more detailed description of United’s accounting policies is included in the 2007 annual report filed on Form 10-K.
 
In management’s opinion, all accounting adjustments necessary to accurately reflect the financial position and results of operations on the accompanying financial statements have been made. These adjustments are normal and recurring accruals considered necessary for a fair and accurate presentation. The results for interim periods are not necessarily indicative of results for the full year or any other interim periods.
 
Note 2 - Stock-Based Compensation
 
United has an equity compensation plan that allows for grants of incentive stock options, nonqualified stock options, restricted stock awards (also referred to as “nonvested stock” awards), stock awards, performance share awards or stock appreciation rights.  Options granted under the plan can have an exercise price no less than the fair market value of the underlying stock at the date of grant.  The general terms of the plan include a vesting period (usually four years) with an exercisable period not to exceed ten years.  Certain option and restricted stock awards provide for accelerated vesting if there is a change in control (as defined in the plan).  As of March 31, 2008, approximately 1,953,000 additional awards could be granted under the plan.  Through March 31, 2008, only incentive stock options, nonqualified stock options and restricted stock awards had been granted under the plan.

 The following table shows stock option activity for the first quarter of 2008.
 
Options
 
Shares
   
Weighted-
Average Exercise Price
   
Weighted-
Average
Remaining Contractual
Term (Years)
   
Aggregate Intrinisic
Value ($000)
 
                         
Outstanding at December 31, 2007
    2,912,557     $ 21.57              
Granted
    15,000       15.32              
Exercised
    (65,450 )     13.54              
Forfeited
    (33,875 )     29.14              
Expired
    (15,800 )     24.65              
Outstanding at March 31, 2008
    2,812,432     $ 21.62       6.2     $ 3,936  
                                 
Exercisable at March 31, 2008
    1,658,316     $ 16.99       4.6     $ 3,911  
 
The weighted average fair value of stock options granted in the first quarter of 2008 and 2007 was $3.33 and $8.80, respectively.  The fair value of each option granted was estimated on the date of grant using the Black-Scholes model.  Because United’s option plan has not been in place long enough to gather sufficient information about exercise patterns to establish an expected life, United uses the formula provided by the Securities and Exchange Commission in Staff Accounting Bulletin No. 107 to determine the expected life of options.  The key assumptions used to determine the fair value of stock options are presented in the table below.
 
   
Three Months Ended
 
   
March 31,
 
   
2008
   
2007
 
             
Expected volatility
    23 %     20 %
Expected dividend yield
 
2.1% to 2.5%
      1.1 %
Expected life (in years)
    6.25       6.25  
Risk-free rate
 
2.9% to 3.5%
      4.7 %
 
6

 
United’s stock trading history began in March of 2002 when United listed on the Nasdaq National Market.  For 2008 and 2007, expected volatility was determined using United’s historical monthly volatility over the period beginning in March of 2002 through the end of the last completed year.  Compensation expense for stock options was $549,000 and $486,000 for the three months ended March 31, 2008 and 2007, respectively, which was net of deferred tax benefits of $222,000 and $114,000, respectively.  The amount of compensation expense for both periods was determined based on the fair value of the options at the time of grant, multiplied by the number of options granted that were expected to vest, which was then amortized, net of any applicable tax benefit, over the vesting period.  The forfeiture rate for options is estimated to be approximately 3% per year.  The total intrinsic value of options exercised during the quarter ended March 31, 2008 and 2007 was $275,000 and $1,693,000, respectively.
 
The table below presents the activity in restricted stock awards for the first quarter of 2008.
 
Restricted Stock
 
Shares
   
Weighted-
Average Grant-
Date Fair Value
 
             
Outstanding at December 31, 2007
    84,413     $ 29.26  
Granted
    7,000       14.83  
Vested
    (11,037 )     25.67  
Cancelled
    (3,000 )     30.10  
Outstanding at March 31, 2008
    77,376     $ 28.43  
 
Compensation expense for restricted stock is based on the fair value of restricted stock awards at the time of grant, which is equal to the value of United’s common stock on the date of grant.  The value of restricted stock grants that are expected to vest is amortized into expense over the vesting period.  For the three months ended March 31, 2008 and 2007, compensation expense of $204,000 and $129,000, respectively, was recognized related to restricted stock awards.  The total intrinsic value of the restricted stock was $1.3 million at March 31, 2008.
 
As of March 31, 2008, there was $7.9 million of unrecognized compensation cost related to nonvested stock options and restricted stock awards granted under the plan.  That cost is expected to be recognized over a weighted-average period of 1.4 years.  The aggregate grant date fair value of options and restricted stock awards that vested during the quarter ended March 31, 2008, was $322,000.
 
Note 3 – Common Stock Issued / Common Stock Issuable
 
United provides a Dividend Reinvestment and Share Purchase Plan (DRIP) to its shareholders. Under the DRIP, shareholders of record can voluntarily reinvest all or a portion of their cash dividends into shares of United’s common stock, as well as purchase additional stock through the plan for cash.  United’s 401(k) retirement plan regularly purchases shares of United’s common stock directly from United.  In addition, United has an Employee Stock Purchase Program (ESPP) that allows eligible employees to purchase shares of common stock at a 5% discount, with no commission charges.  For the three months ended March 31, 2008 and 2007, United issued 31,944 and 52,914 shares, respectively, and increased capital by $503,000 and $1.7 million, respectively, through these programs.
 
In the fourth quarter of 2005, United began offering its common stock as an investment option in its deferred compensation plan.  The common stock component of the deferred compensation plan is accounted for as an equity instrument and is reflected in the consolidated financial statements as common stock issuable.  At March 31, 2008 and 2007, 90,505 and 35,154 shares, respectively, are issuable under the deferred compensation plan.
 
7

 
Note 4 - Earnings Per Share
 
The following table sets forth the computation of basic and diluted earnings per share for the three months ended March 31 .
 
(in thousands, except per share data)
 
   
Three Months Ended
 
   
March 31,
 
   
2008
   
2007
 
             
Net income available to common shareholders
  $ 16,074     $ 19,340  
                 
Weighted average shares outstanding:
               
Basic
    46,966       43,000  
Effect of dilutive securities:
               
Stock options and restricted stock
    220       878  
Common stock issuable under deferred compensation plan
    86       34  
Diluted
    47,272       43,912  
                 
Earnings per common share:
               
Basic
  $ .34     $ .45  
Diluted
  $ .34     $ .44  

Note 5 - Mergers and Acquisitions
 
On June 1, 2007, United acquired 100 percent of the outstanding common shares of Gwinnett Commercial Group, Inc. (Gwinnett), a community bank holding company headquartered in Lawrenceville, Georgia.  Gwinnett’s results of operations are included in consolidated financial results from the acquisition date.  Gwinnett was the parent company of First Bank of the South, a community bank with five full service banking offices serving the north metro Atlanta counties of Gwinnett, DeKalb and north Fulton and a commercial loan office in Walton County.  United has continued to expand its presence in metropolitan Atlanta and the acquisition of Gwinnett accomplished a long-standing strategic goal of encircling metro Atlanta.  Additionally, Gwinnett brings strong commercial lending experience to better diversify United’s business mix.  The aggregate purchase price was approximately $222.9 million, including 5,691,948 shares of United’s common stock and $31.5 million in cash that was exchanged for all of the outstanding common shares and options to purchase common shares of Gwinnett.  The value of the common stock issued of $33.62 per share was determined based on the average of the closing market price of United’s common shares over the period beginning two days before and ending two days after the terms of the acquisition were agreed to and announced.
 
The financial information below presents the pro forma earnings of United assuming that the results of operations of Gwinnett were included in consolidated earnings for the three months ended March 31.
 
   
Three Months Ended
 
   
March 31,
 
   
2008
   
2007
 
             
Total revenue
  $ 72,453     $ 82,709  
Net income
    16,078       22,498  
                 
Diluted earnings per common share
    .34       .45  
 
At March 31, 2008, accrued merger costs of $608,000 remained unpaid relating to acquisitions closed in 2007, 2006 and 2004.  The severance and related costs include change of control payments for which payment had been deferred.
 
Activity with accrued merger cost
For the Three Months Ended March 31, 2008
   
Beginning
Balance
   
Amounts
Paid
   
Ending
Balance
 
                   
Severance and related costs
  $ 2,481     $ (1,877 )   $ 604  
Professional fees
    4       -       4  
                         
Totals
  $ 2,485     $ (1,877 )   $ 608  
 
8


Note 6 - Assets and Liabilities Measured at Fair Value
 
On January 1, 2008, United adopted Statement of Financial Accounting Standards No. 157, Fair Value Measurements (“SFAS No. 157”).  SFAS No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements.  SFAS No. 157 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.
 
SFAS No. 157 emphasizes that fair value is a market-based measurement, not an entity-specific measurement.  Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.  As a basis for considering market participant assumptions in fair value measurements, SFAS No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).
 
Fair Value Hierarchy
 
 
Level 1
Valuation is based upon quoted prices (unadjusted) in active markets for identical assets or liabilities that United has the ability to access.
 
 
Level 2
Valuation is based upon quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates, and yield curves that are observable at commonly quoted intervals.
 
 
Level 3
Valuation is generated from model-based techniques that use at least one significant assumption based on unobservable inputs for the asset or liability, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. United’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.
 
The following is a description of valuation methodologies used for assets and liabilities recorded at fair value
 
Securities Available for Sale
 
Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.
 
Deferred Compensation Plan Assets and Liabilities
 
Included in other assets in the consolidated balance sheet are assets related to employee deferred compensation plans. The assets associated with these plans are invested in mutual funds and classified as Level 1. Deferred compensation liabilities, also classified as Level 1, are carried at the fair value of the obligation to the employee, which mirrors the fair value of the invested assets and is included in other liabilities in the consolidated balance sheet.
 
Loans Held for Sale
 
Loans held for sale are carried at the lower of cost or market value. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, United classifies loans subjected to nonrecurring fair value adjustments as Level 2.
 
9


Loans
 
United does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with SFAS 114, “Accounting by Creditors for Impairment of a Loan,” (SFAS 114). The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At March 31, 2008, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS 157, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, United records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, United records the impaired loan as nonrecurring Level 3.
 
Foreclosed Assets
 
Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, United records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, United records the foreclosed asset as nonrecurring Level 3.
 
Goodwill and Other Intangible Assets
 
Goodwill and identified intangible assets are subject to impairment testing. United’s approach to testing goodwill for impairment is to compare the business unit’s carrying value to the implied fair value based on multiples of earnings and tangible book value for recently completed merger transactions.  In the event the fair value is determined to be less than the carrying value, the asset is recorded at fair value as determined by the valuation model. As such, United classifies goodwill and other intangible assets subjected to nonrecurring fair value adjustments as Level 3.
 
Derivative Financial Instruments
 
Currently, United uses interest rate swaps and interest rate floors to manage its interest rate risk.  The valuation of these instruments is determined using widely accepted valuation techniques including discounted cash flow analysis on the expected cash flows of each derivative. This analysis reflects the contractual terms of the derivatives, including the period to maturity, and uses observable market-based inputs, including interest rate curves and implied volatilities.  The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts and the discounted expected variable cash payments.  The variable cash payments are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves.
 
The fair values of interest rate options are determined using the market standard methodology of discounting the future expected cash receipts that would occur if variable interest rates fell below the strike rate of the floors.  The variable interest rates used in the calculation of projected receipts on the floor are based on an expectation of future interest rates derived from observable market interest rate curves and volatilities.  To comply with the provisions of SFAS No. 157, United incorporates credit valuation adjustments to appropriately reflect both its own nonperformance risk and the respective counterparty’s nonperformance risk in the fair value measurements.  In adjusting the fair value of its derivative contracts for the effect of nonperformance risk, United has considered the impact of netting and any applicable credit enhancements, such as collateral postings, thresholds, mutual puts, and guarantees.
 
Although United has determined that the majority of the inputs used to value its derivatives fall within Level 2 of the fair value hierarchy, the credit valuation adjustments associated with its derivatives utilize Level 3 inputs, such as estimates of current credit spreads to evaluate the likelihood of default by itself and its counterparties.  However, as of March 31, 2008, United has assessed the significance of the impact of the credit valuation adjustments on the overall valuation of its derivative positions and has determined that the credit valuation adjustments are not significant to the overall valuation of its derivatives.  As a result, United has determined that its derivative valuations in their entirety are classified in Level 2 of the fair value hierarchy.
 
10


Assets and Liabilities Measured at Fair Value on a Recurring Basis
 
The table below presents United’s assets and liabilities measured at fair value on a recurring basis as of March 31, 2008, aggregated by the level in the fair value hierarchy within which those measurements fall.
 
(in thousands)
                       
                     
Balance at
 
Description
 
Level 1
   
Level 2
   
Level 3
   
March 31, 2008
 
Assets
                       
Securities available for sale
  $ -     $ 1,508,402     $ -     $ 1,508,402  
Deferred compensation plan assets
    4,884       -       -       4,884  
Derivative financial instruments
    -       48,454       -       48,454  
Total
  $ 4,884     $ 1,556,856     $ -     $ 1,561,740  
                                 
Liabilities
                               
Deferred compensation plan liability
  $ 4,884     $ -     $ -     $ 4,884  
Total
  $ 4,884     $ -     $ -     $ 4,884  

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis
 
United may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. Generally Accepted Accounting Principles.  These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period.  The table below presents United’s assets and liabilities measured at fair value on a nonrecurring basis as of March 31, 2008, aggregated by the level in the fair value hierarchy within which those measurements fall.
 
(in thousands)
                       
                     
Balance at
 
Description
 
Level 1
   
Level 2
   
Level 3
   
March 31, 2008
 
Assets
 
                   
Loans
  $ -     $ -     $ 44,749     $ 44,749  
Foreclosed assets
    -       -       13,583       13,583  
Total
  $ -     $ -     $ 58,332     $ 58,332  
 
Note 7 – Recent Accounting Pronouncements
 
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 159 (SFAS No. 159), The Fair Value for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 115 .  This statement permits entities to choose to measure many financial instruments and certain other items at fair value.  The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.  This statement is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement objective for accounting for financial instruments.  This statement became effective for United beginning January 1, 2008.  United chose not to apply fair value measurements to any financial instruments in accordance with SFAS No. 159, and therefore, the adoption of this standard did not have a material effect on United’s financial position, results of operations or disclosures.

11


Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Forward-Looking Statements
 
This Form 10-Q contains forward-looking statements regarding United Community Banks, Inc. (“United”), including, without limitation, statements relating to United’s expectations with respect to revenue, credit losses, levels of nonperforming assets, expenses, earnings and other measures of financial performance.  Words such as “may”, “could”, “would”, “should”, “believes”, “expects”, “anticipates”, “estimates”, “intends”, “plans”, “targets” or similar expressions are intended to identify forward-looking statements.   These forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties that are subject to change based on various factors (many of which are beyond United’s control).  The following factors, among others, could cause United’s financial performance to differ materially from the expectations expressed in such forward-looking statements:
 
 
our recent operating results may not be indicative of future operating results;
 
our business is subject to the success of the local economies in which we operate;
 
our concentration of construction and land development loans is subject to unique risks that could adversely affect our earnings;
 
we may face risks with respect to future expansion and acquisitions or mergers;
 
changes in prevailing interest rates may negatively affect our net income and the value of our assets;
 
if our allowance for loan losses is not sufficient to cover actual loan losses, our earnings would decrease;
 
we may be subject to losses due to fraudulent and negligent conduct of our loan customers, third party service providers or employees;
 
competition from financial institutions and other financial service providers may adversely affect our profitability;
 
business increases, productivity gains and other investments are lower than expected or do not occur as quickly as anticipated;
 
competitive pressures among financial services companies increase significantly;
 
the success of our business strategy;
 
the strength of the United States economy in general changes;
 
trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System, change;
 
inflation or market conditions fluctuate;
 
conditions in the stock market, the public debt market and other capital markets deteriorate;
 
financial services laws and regulations change;
 
technology changes and United fails to adapt to those changes;
 
consumer spending and saving habits change;
 
unanticipated regulatory or judicial proceedings occur; and
 
United is unsuccessful at managing the risks involved in the foregoing.

Additional information with respect to factors that may cause actual results to differ materially from those contemplated by such forward-looking statements may also be included in other reports that United files with the Securities and Exchange Commission.  United cautions that the foregoing list of factors is not exclusive and not to place undue reliance on forward-looking statements.  United does not intend to update any forward-looking statement, whether written or oral, relating to the matters discussed in this Form 10-Q.
 
12

 
Overview
 
The following discussion is intended to provide insight into the results of operations and financial condition of United and its subsidiaries and should be read in conjunction with the consolidated financial statements and accompanying notes.
 
United is a bank holding company registered with the Federal Reserve under the Bank Holding Company Act of 1956 that was incorporated under the laws of the state of Georgia in 1987 and commenced operations in 1988.  At March 31, 2008, United had total consolidated assets of $8.4 billion, total loans of $6.0 billion, total deposits of $6.2 billion and stockholders’ equity of $871.5 million.
 
United activities are primarily conducted by its wholly-owned Georgia banking subsidiary (the “Bank”) and Brintech, Inc., a consulting firm providing professional services to the financial services industry.  The Bank operations are conducted under a community bank model that operates 27 “Community Banks” with local bank presidents and boards in north Georgia, the Atlanta and Gainesville metropolitan statistical area (the “Atlanta Region”), coastal Georgia, western North Carolina, and east Tennessee.
 
Net income was $16.1 million during the first quarter of 2008, a decrease of 17%   from the $19.3 million during the first quarter of 2007.  Diluted earnings per common share was $.34 for the first quarter of 2008, a decrease of 23%   from the $.44 for the first quarter of 2007.  Return on tangible equity for the first quarter of 2008 was 13.16%, compared to 17.18% for the first quarter of 2007.  Return on assets for the first quarter of 2008 was .78% as compared to 1.11% for the first quarter of 2007.
 
Earnings decreased primarily as a result of higher credit costs and margin compression due to competitive deposit pricing and higher levels of non-performing assets. Housing starts have slowed significantly, leading to a surplus of lot inventory in our footprint, most notably in the Atlanta Region.  This increase in lot inventory negatively affects both the cash flows of our residential construction and land development customers, and the demand for new land development loans.
 
Nonperforming assets increased to 1.07% of total assets as of March 31, 2008, a significant increase from .20% as of March 31, 2007.  This increase is a reflection of the downstream effects of the lot inventory buildup in the Atlanta Region, which itself is indicative of the regional economic slowdown that is occurring in much of the Southeast.  To date, the rise in nonperforming assets has been mostly confined to the residential construction portfolio and predominantly within the Atlanta Region.
 
Fee revenue was flat and operating expenses increased 6%   from the first quarter of 2007.  Operating expenses increased across most categories primarily due to the acquisition of First Bank of the South (“Gwinnett”) in June, 2007, the higher level of legal fees and write downs on foreclosed properties, and the increase in FDIC insurance premiums.
 
Critical Accounting Policies
 
The accounting and reporting policies of United are in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and conform to general practices within the banking industry.  The more critical accounting and reporting policies include United’s accounting for the allowance for loan losses and accounting for intangible assets.  In particular, United’s accounting policies related to allowance for loan losses and intangibles involve the use of estimates and require significant judgment to be made by management.  Different assumptions in the application of these policies could result in material changes in United’s consolidated financial position or consolidated results of operations.  See “Asset Quality and Risk Elements” herein for additional discussion of United’s accounting methodologies related to the allowance.
 
Non-GAAP Performance Measures
 
The presentation of United’s financial results herein include references to operating performance measures, which are measures of performance determined by methods other than GAAP. Management included non-GAAP performance measures because it believes they are useful for evaluating United’s operations and performance over periods of time, and uses operating performance measures in managing and evaluating United’s business and intends to use them in discussions about United’s operations and performance.
 
Operating performance measures exclude the effect of the special $15 million fraud-related provision for loan losses recorded in the second quarter of 2007 and an additional $3 million provision and $18 million in related charge-offs in the fourth quarter of 2007 involving lot loans near Spruce Pine, North Carolina.  Management believes that the circumstances leading to the special provision and subsequent charge-offs were isolated, non-recurring events and do not reflect overall trends in United’s performance.  Management also believes that these non-GAAP performance measures provide users of United’s financial information with a meaningful measure for assessing United’s financial results and credit trends and comparing financial results to prior periods.
 
13

 
A reconciliation of operating earnings measures to reported earnings measures using GAAP is presented below:
 
Table 1 - Operating Earnings to GAAP Earnings Reconciliation
 
(in thousands, except per share data)
 
   
   
First
   
Fourth
   
Third
   
Second
 
   
Quarter
   
Quarter
   
Quarter
   
Quarter
 
   
2008
   
2007
   
2007
   
2007
 
                         
Special provision for fraud related loan losses
  $ -     $ 3,000     $ -     $ 15,000  
                                 
Income tax effect of special provision
    -       1,167       -       5,835  
After-tax effect of special provision
  $ -     $ 1,833     $ -     $ 9,165  
                                 
Net Income Reconciliation
                               
Operating net income
  $ 16,078     $ 6,034     $ 22,536     $ 21,076  
After-tax effect of special provision and merger-related charges
    -       (1,833 )     -       (9,165 )
Net income (GAAP)
  $ 16,078     $ 4,201     $ 22,536     $ 11,911  
 
                               
Basic Earnings Per Share Reconciliation
                               
Basic operating earnings per share
  $ .34     $ .13     $ .47     $ .47  
Per share effect of special provision and merger-related charges
    -       (.04 )     -       (.21 )
Basic earnings per share (GAAP)
  $ .34     $ .09     $ .47     $ .26  
                                 
Diluted Earnings Per Share Reconciliation
                               
Diluted operating earnings per share
  $ .34     $ .13     $ .46     $ .46  
Per share effect of special provision and merger-related charges
    -       (.04 )     -       (.20 )
Diluted earnings per share (GAAP)
  $ .34     $ .09     $ .46     $ .26  
                                 
Provision for Loan Losses Reconciliation
                               
Operating provision for loan losses
  $ 7,500     $ 26,500     $ 3,700     $ 3,700  
Special provision for fraud related loan losses
    -       3,000       -       15,000  
Provision for loan losses (GAAP)
  $ 7,500     $ 29,500     $ 3,700     $ 18,700  
                                 
Nonperforming Assets Reconciliation
                               
Nonperforming assets excluding fraud-related assets
  $ 85,182     $ 40,956     $ 39,761     $ 19,968  
Fraud-related loans and OREO included in nonperforming assets
    4,682       5,302       23,576       23,633  
Nonperforming assets (GAAP)
  $ 89,864     $ 46,258     $ 63,337     $ 43,601  
                                 
Allowance for Loan Losses Reconciliation
                               
Allowance for loan losses excluding special fraud-related allowance
  $ 89,848     $ 89,423     $ 75,935     $ 77,471  
Fraud-related allowance for loan losses
    -       -       15,000       15,000  
Allowance for loan losses (GAAP)
  $ 89,848     $ 89,423     $ 90,935     $ 92,471  
                                 
Net Charge Offs Reconciliation
                               
Net charge offs excluding charge off of fraud-related loans
  $ 7,075     $ 13,012     $ 5,236     $ 2,124  
Fraud-related loans charged off
    -       18,000       -       -  
Net charge offs (GAAP)
  $ 7,075     $ 31,012     $ 5,236     $ 2,124  
                                 
Allowance for Loan Losses to Loans Ratio Reconciliation
                               
Allowance for loan losses to loans ratio excluding fraud-related allowance
    1.51 %     1.51 %     1.28 %     1.29 %
Portion of allowance assigned to fraud-related loans
    -       -       .25       .25  
Allowance for loan losses to loans ratio (GAAP)
    1.51 %     1.51 %     1.53 %     1.54 %
                                 
Nonperforming Assets to Total Assets Ratio Reconciliation
                               
Nonperforming assets to total assets ratio excluding fraud-related assets
    1.02 %     .50 %     .49 %     .25 %
Fraud-related nonperforming assets
    .05       .06       .28       .29  
Nonperforming assets to total assets ratio (GAAP)
    1.07 %     .56 %     .77 %     .54 %
                                 
Net Charge Offs to Average Loans Ratio Reconciliation
                               
Net charge offs to average loans ratio excluding fraud-related loans
    .48 %     .87 %     .35