UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

METROCORP BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Texas		76-0579161
(State or other jurisdiction of		(I.R.S. Employer Identification No.)
incorporation or organization)

9600 Bellaire Boulevard, Suite 252
Houston, Texas 77036
(Address of principal executive offices including zip code)

(713) 776-3876
(Registrant’s telephone number, including area code)

     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 þ No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large Accelerated Filer o       Accelerated Filer þ       Non-accelerated Filer o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ

     As of November 2, 2006, the number of outstanding shares of Common Stock, par value $1.00 per share, was 10,931,143.

 

 

PART I

FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements.

METROCORP BANCSHARES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share amounts)
(Unaudited)

		September 30,				December 31,
		2006				2005
ASSETS
Cash and due from banks		$	24,870			$	28,213
Federal funds sold and other short-term investments			122,507				53,599
Total cash and cash equivalents			147,377				81,812
Securities available-for-sale, at fair value			194,037				236,100
Loans, net of allowance for loan losses of $11,852 and $13,169, respectively			828,420				758,304
Accrued interest receivable			5,000				4,835
Premises and equipment, net			7,283				6,196
Goodwill			21,827				21,607
Core deposit intangibles			1,238				1,428
Customers’ liability on acceptances			5,894				3,148
Foreclosed assets, net			6,038				3,866
Other assets			8,987				10,908
Total assets		$	1,226,101			$	1,128,204
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Noninterest-bearing		$	190,228			$	195,422
Interest-bearing			854,003				766,328
Total deposits			1,044,231				961,750
Junior subordinated debentures			36,083				36,083
Other borrowings			26,032				26,054
Accrued interest payable			1,405				1,126
Acceptances outstanding			5,894				3,148
Other liabilities			10,370				7,815
Total liabilities			1,124,015				1,035,976
Commitments and contingencies			—				—
Shareholders’ equity:
Common stock, $1.00 par value, 50,000,000 shares authorized; 10,994,965 shares and 7,329,977 shares issued and 10,927,155 shares and 7,232,239 shares outstanding at September 30, 2006 and December 31, 2005, respectively			10,995				7,330
Additional paid-in capital			25,759				28,576
Retained earnings			68,885				60,023
Accumulated other comprehensive loss			(3,027	)			(2,783	)
Treasury stock, at cost			(526	)			(918	)
Total shareholders’ equity			102,086				92,228
Total liabilities and shareholders’ equity		$	1,226,101			$	1,128,204

See accompanying notes to condensed consolidated financial statements

METROCORP BANCSHARES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
(Unaudited)

		For the Three Months								For the Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Interest income:
Loans		$	19,103			$	11,552			$	53,357			$	32,279
Securities:
Taxable			2,113				2,382				6,573				7,163
Tax-exempt			179				211				572				641
Federal funds sold and other short-term investments			1,171				207				2,830				343
Total interest income			22,566				14,352				63,332				40,426
Interest expense:
Time deposits			6,665				3,214				17,493				8,274
Demand and savings deposits			1,442				636				3,750				1,449
Other borrowings			318				365				957				1,420
Junior subordinated debentures			532				—				1,577				—
Total interest expense			8,957				4,215				23,777				11,143
Net interest income			13,609				10,137				39,555				29,283
Provision for loan losses			114				468				560				1,396
Net interest income after provision for loan losses			13,495				9,669				38,995				27,887
Noninterest income:
Service fees			1,397				1,711				4,303				4,972
Loan-related fees			212				168				647				485
Letters of credit commissions and fees			219				145				597				420
Other noninterest income			75				63				237				274
Total noninterest income			1,903				2,087				5,784				6,151
Noninterest expenses:
Salaries and employee benefits			5,455				4,225				16,077				12,229
Occupancy and equipment			1,907				1,424				5,109				4,160
Foreclosed assets, net			52				(67	)			213				357
Other noninterest expense			2,406				2,066				7,586				5,851
Total noninterest expenses			9,820				7,648				28,985				22,597
Income before provision for income taxes			5,578				4,108				15,794				11,441
Provision for income taxes			2,032				1,272				5,625				3,575
Net income		$	3,546			$	2,836			$	10,169			$	7,866
Earnings per common share*:
Basic		$	0.32			$	0.26			$	0.93			$	0.73
Diluted		$	0.32			$	0.26			$	0.92			$	0.72
Weighted average shares outstanding*:
Basic			10,924				10,814				10,895				10,805
Diluted			11,153				10,968				11,097				10,938
Dividends per common share*		$	0.04			$	0.04			$	0.12			$	0.12

See accompanying notes to condensed consolidated financial statements

METROCORP BANCSHARES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands)
(Unaudited)

		For the Three Months								For the Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
Net income		$	3,546			$	2,836			$	10,169			$	7,866
Other comprehensive income (loss), net of tax:
Unrealized gain (loss) on investment securities, net:
Unrealized holding gain (loss) arising during the period			1,567				(891	)			(236	)			(2,188	)
Less: reclassification adjustment for gain included in net income			6				—				8				—
Other comprehensive income (loss)			1,561				(891	)			(244	)			(2,188	)
Total comprehensive income		$	5,107			$	1,945			$	9,925			$	5,678

METROCORP BANCSHARES, INC.
CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY
For the Nine Months Ended September 30, 2006
(In thousands)
(Unaudited)

																		Accumulated
										Additional								Other				Treasury
		Common Stock								Paid-In				Retained				Comprehensive				Stock
		Shares				At Par				Capital				Earnings				Loss				At Cost				Total
Balance at December 31, 2005			7,232			$	7,330			$	28,576			$	60,023			$	(2,783	)		$	(918	)		$	92,228
Re-issuance of treasury stock			53				—				579				—				—				392				971
Stock-based compensation expense recognized in earnings			—				—				257				—				—				—				257
Tax benefit related to stock- based compensation			—				—				12				—				—				—				12
3-for-2 stock split in the form of a 50% stock dividend			3,642				3,665				(3,665	)			—				—				—				—
Net income			—				—				—				10,169				—				—				10,169
Other comprehensive loss			—				—				—				—				(244	)			—				(244	)
Cash dividends ($0.12 per share)			—				—				—				(1,307	)			—				—				(1,307	)
Balance at September 30, 2006			10,927			$	10,995			$	25,759			$	68,885			$	(3,027	)		$	(526	)		$	102,086

See accompanying notes to condensed consolidated financial statements

METROCORP BANCSHARES, INC
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

		For the Nine Months Ended
		September 30,
		2006				2005
Cash flows from operating activities:
Net income		$	10,169			$	7,866
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation			1,044				1,031
Provision for loan losses			560				1,396
Gain on sale or call of securities, net			(11	)			—
Loss on foreclosed assets			98				316
Loss on sale and disposal of premises and equipment			—				100
Amortization of premiums and discounts on securities			64				189
Amortization of deferred loan fees and discounts			(1,880	)			(1,351	)
Amortization of core deposit intangibles			360				—
Stock-based compensation			257				—
Excess tax benefits from stock-based compensation			(12	)			—
Changes in:
Accrued interest receivable			(165	)			(194	)
Other assets			2,143				(633	)
Accrued interest payable			203				31
Other liabilities			2,566				3,036
Net cash provided by operating activities			15,396				11,787
Cash flows from investing activities:
Purchases of securities available-for-sale			(1,183	)			(26,953	)
Proceeds from sales, maturities and principal paydowns of securities available-for-sale			42,664				51,029
Net change in loans			(71,065	)			(19,308	)
Proceeds from sale of foreclosed assets			—				2,450
Proceeds from sale of premises and equipment			—				4
Purchases of premises and equipment			(1,911	)			(884	)
Cash obtained from acquisition, net of cash paid			17,065				—
Net cash (used in) provided by investing activities			(14,430	)			6,338
Cash flows from financing activities:
Net change in:
Deposits			64,945				33,494
Other borrowings			(22	)			(16,815	)
Proceeds from issuance of common stock			—				109
Re-issuance of treasury stock			971				273
Dividends paid			(1,307	)			(1,296	)
Excess tax benefits from stock-based compensation			12				—
Net cash provided by financing activities			64,599				15,765
Net increase in cash and cash equivalents			65,565				33,890
Cash and cash equivalents at beginning of period			81,812				32,073
Cash and cash equivalents at end of period		$	147,377			$	65,963

See accompanying notes to condensed consolidated financial statements

METROCORP BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION

     The unaudited condensed consolidated financial statements include the accounts of MetroCorp Bancshares, Inc. (the “Company”) and wholly-owned subsidiaries, MetroBank, National Association (“MetroBank”) in Texas, and Metro United Bank (“Metro United”) in California (collectively, the “Banks”). The Banks are engaged in commercial banking activities through MetroBank’s thirteen branches in the Houston and Dallas, Texas metropolitan areas, and Metro United’s three branches in the greater San Diego and Los Angeles, California metropolitan areas, and one loan production office in San Mateo, California. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain principles which significantly affect the determination of financial position, results of operations and cash flows are summarized below.

     The Company determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity or a variable interest entity under accounting principles generally accepted in the United States of America. Voting interest entities are entities in which the total equity investment at risk is sufficient to enable the entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. The Company consolidates voting interest entities in which it has all, or at least a majority of, the voting interest. As defined in applicable accounting standards, variable interest entities (“VIEs”) are entities that lack one or more of the characteristics of a voting interest entity. A controlling financial interest is present when an enterprise has a variable interest, or a combination of variable interests, that will absorb a majority of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. The Company’s wholly-owned subsidiary, MCBI Statutory Trust I, is a VIE for which the Company is not the primary beneficiary. Accordingly, the accounts of this entity are not consolidated in the Company’s financial statements.

     The accompanying unaudited condensed consolidated financial statements were prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions for Form 10-Q. In the opinion of management, the unaudited condensed consolidated financial statements reflect all adjustments, consisting only of normal and recurring adjustments, necessary for a fair statement of the Company’s financial position at September 30, 2006, results of operations for the three and nine months ended September 30, 2006 and 2005, changes in shareholders’ equity for the nine months ended September 30, 2006, and cash flows for the nine months ended September 30, 2006 and 2005. Interim period results are not necessarily indicative of results for a full-year period. The year-end condensed balance sheet was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These condensed consolidated financial statements and the notes thereto should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

2. STOCK SPLIT

     On August 4, 2006, the Company’s Board of Directors approved a three-for-two stock split of the common stock effected in the form of a 50% stock dividend that was paid on September 1, 2006 to holders of record as of August 18, 2006. Cash was paid in lieu of fractional shares.

     The Company retained the current par value of $1.00 per share for all shares of common stock. All references in the financial statements regarding share data and shareholders’ equity have been adjusted to reflect the effect of the stock split for all periods presented, except those on the Balance Sheet and the Statement of Changes in Shareholders’ Equity as of December 31, 2005. As of September 30, 2006, shareholders’ equity reflects the stock split by a reduction in additional paid-in capital of $3.7 million and an increase common stock of $3.7 million.

3. ACQUISITION

     On September 8, 2006, Metro United completed its acquisition of a branch of Omni Bank, N.A. (the “Branch”) located in Irvine, California. In connection with the acquisition, Metro United purchased certain assets, excluding loans, and assumed certain liabilities for a cash purchase price of $500,000. The addition of the Branch extends Metro United’s presence in the California market. The acquisition was accounted for as a business combination. The purchase price has been allocated to the assets acquired and the liabilities assumed based on their fair value at the date of the acquisition. The excess of the purchase price over the

METROCORP BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

estimated fair value of the net assets acquired was recorded as goodwill, which is not expected to be deductible for tax purposes. The results of operations for this acquisition are included in the Company’s financial results beginning September 9, 2006. Pro forma results for the two years preceding the acquisition are not material and as a result have not been presented.

          The following table summarizes the estimated fair value of the assets acquired and the liabilities assumed at the date of the acquisition (in thousands):

Cash		$	17,603
Premises and equipment, net			220
Goodwill			220
Core deposit intangibles			170
Other assets			9
Deposits			(17,536	)
Accrued interest payable			(76	)
Deferred taxes and other liabilities			(72	)
Purchase price including capitalized costs		$	538

4. STOCK-BASED COMPENSATION

          The Company issues stock options to employees under the Company’s 1998 Stock Incentive Plan (“Incentive Plan”). The Company also has an employee stock purchase plan (“Purchase Plan”). The Company adopted the provisions of Statement of Financial Accounting Standards No. 123R “Share-Based Payments,” (“SFAS No. 123R”) on January 1, 2006 using the modified prospective transition method. Under this method, prior periods are not restated. Under SFAS No. 123R, the Company values unvested stock options granted prior to its adoption of SFAS 123R and expenses these amounts in the income statement over the stock option’s remaining vesting period. In addition, the fair value of options granted subsequent to adoption of this statement are expensed ratably over the vesting period. In 2005, the Company rewarded the outstanding performance of certain employees by accelerating the vesting of certain stock options that were previously granted. There were 301,800 shares accelerated in 2005 which represented approximately 64% of total outstanding unvested shares as of December 31, 2005. Prior to January 1, 2006, the Company accounted for awards granted under those plans following the recognition and measurement principles of Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees,” (“APB No. 25”), and related interpretations. No compensation cost was reflected in the income statement for stock options, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of the grant.

          The adoption of this statement did not have a material effect on the Company’s financial statements and, as such, no cumulative effect of change in accounting principle was recorded. For the three and nine months ended September 30, 2006, total stock-based compensation cost recognized in the Company’s Condensed Consolidated Statements of Income was $146,000 and $257,000, respectively.

          Prior to the adoption of SFAS No. 123R, the Company presented the tax savings from tax deductions resulting from the exercise of stock options as an operating cash flow. SFAS No. 123R requires the Company to reflect the tax savings resulting from tax deductions in excess of expense reflected in its financial statements as a financing cash flow.

          In November 2005, the FASB issued Staff Position No. FAS 123R-3, “Transition Election Related to Accounting for the Tax Effects of the Share-Based Payment Awards”. The Company has adopted the transition guidance for the additional paid-in-capital pool (“APIC pool”) in paragraph 81 of SFAS No. 123R. The prescribed transition method is a detailed method to establish the beginning balance of the APIC pool related to the tax effects of stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statement of Cash Flows of the tax effects of stock-based compensation awards that are

METROCORP BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

outstanding upon adoption of SFAS No. 123R. The total tax benefit derived from the windfall associated with the exercise of non-qualified options was approximately $12,000 for the nine months ended September 30, 2006. There were no such options exercised for the three months ended September 30, 2006.

          As required under SFAS No. 123R, the pro forma net income and earnings per share for the three and nine months ended September 30, 2005 have been presented below to reflect the impact had the Company been required to recognize compensation cost based on the fair value at the grant date for stock options (in thousands, except per share amounts):

		For the Three				For the Nine
		Months Ended				Months Ended
		September 30,				September 30,
		2005				2005
Net income:
As reported		$	2,836			$	7,866
Pro forma			2,742				7,585
Stock-based compensation cost, net of income taxes:
As reported			—				—
Pro forma			94				281
Basic earnings per common share:
As reported			0.26				0.73
Pro forma			0.25				0.70
Diluted earnings per common share:
As reported			0.26				0.72
Pro forma			0.25				0.69

          The Company classifies all share-based awards as equity instruments and recognizes the vesting of the awards ratably over their respective terms. As of September 30, 2006, compensation cost not yet recognized for unvested share-based awards was approximately $1.5 million, which is expected to be recognized over a weighted average period of 1.53 years.

          Stock Incentive Plan. The Incentive Plan authorizes the issuance of up to 1,050,000 shares of Common Stock under both “non-qualified” and “incentive” stock options and performance shares of Common Stock. Non-qualified options and incentive stock options will be granted at no less than the fair market value of the Common Stock and must be exercised within ten years unless the applicable award agreement specifies a shorter term. Performance shares are certificates representing the right to acquire shares of Common Stock upon the satisfaction of performance goals established by the Company. Holders of performance shares have all of the voting, dividend and other rights of shareholders of the Company, subject to the terms of the award agreement relating to such shares. If the performance goals are achieved, the performance shares will vest and may be exchanged for shares of Common Stock. If the performance goals are not achieved, the performance shares may be forfeited. No performance shares have been awarded under the Incentive Plan since inception. As of September 30, 2006, there were 111,710 options available for future grant under the Incentive Plan.

          There were 62,500 and 238,000 options granted during the three and nine months ended September 30, 2006, respectively. Options granted during the nine months ended September 30, 2006 under the Incentive Plan vest 30% in each of the two years following the date of the grant and 40% in the third year following the date of the grant and have contractual terms of seven years. All options are granted at a fixed exercise price. The fair value of stock awards was estimated at the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions for the three and nine months ended September 30, 2006:

		For the Three Months				For the Nine Months
		Ended September 30,				Ended September 30,
Assumptions		2006				2006
Expected term (in years)			4.55				4.55
Expected stock price volatility			23.54	%			22.73	%
Expected dividend yield			0.80	%			0.80	%
Risk-free interest rate			5.01	%			4.94	%
Estimated fair value per option granted		$	5.58			$	4.90

METROCORP BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

          The expected term of the options was derived using the “simplified” method as allowed under the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 107. Expected stock price volatility is based on historical volatility of the Company’s stock that covers a period which corresponds to the expected life of the options. The risk-free interest rate for the expected life of the options granted is based on the U.S. Treasury yield curve in effect as of the grant date.

          The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, the existing model does not necessarily provide a reliable single measure of the fair value of its employee stock options.

          A summary of activity for the Company’s stock options for the nine months ended September 30, 2006 is presented below:

										Weighted
										Average
		Number of				Weighted				Remaining				Aggregate
		Options				Average				Contractual				Intrinsic Value
		Outstanding				Exercise Price				Life				(in thousands)
Outstanding options at December 31, 2005			673,725			$	12.12
Options granted			238,000				18.71
Options exercised			(60,225	)			10.55
Options forfeited			(30,000	)			16.22
Outstanding options at September 30, 2006			821,500				13.99				5.81			$	7,144
Exercisable options at September 30, 2006			468,150			$	11.37				5.28			$	6,300

          During the three and nine months ended September 30, 2006, the total intrinsic value of options exercised was approximately $36,000 and $522,000, respectively. The total intrinsic value of options outstanding and exercisable at September 30, 2006 was $7.1 million and $6.3 million, respectively. There were 24,300 options which vested during the nine months ended September 30, 2006.

          Stock Purchase Plan. The Purchase Plan authorizes the offer and sale of up to 300,000 shares of Common Stock to employees of the Company and its subsidiaries. The Purchase Plan is implemented through ten annual offerings. Each year the Board of Directors determines the number of shares that may be offered under the Purchase Plan; provided that in any one year the offering may not exceed 30,000 shares plus any unsubscribed shares from prior years. In 2005, the Compensation Committee recommended, and the Board of Directors approved, changes to the Purchase Plan to (1) include employees of all of the Company’s subsidiaries, rather than employees of MetroBank only, (2) reduce the total value of shares of Common Stock an employee is allowed to purchase in any calendar year from $25,000 to $10,000, (3) allow the Board flexibility in determining the date of each offering, (4) increase the discount on the price per share from 10% to 15%, and (5) modify the payroll deduction period to one year or less.

          The offering price per share, subsequent to the changes authorized by the Board of Directors in 2005, is an amount equal to 85% of the closing price of a share of Common Stock on the business day immediately prior to the commencement of such offering. In each offering, an employee may purchase a number of whole shares of Common Stock with an aggregate value equal to 20% of the employee’s base salary, but not in excess of $10,000, divided by the offering price. Pursuant to the Purchase Plan, the employee pays for the Common Stock either immediately or through a payroll deduction program over a period of up to one year, at the employee’s option. The first annual offering under the Purchase Plan began in the second quarter of 1999. As of September 30, 2006, 56,542 shares had been issued under the Purchase Plan since inception. During 2005, 28,646 shares were subscribed to, of which 16,343 shares were issued. Information regarding share activity under the Purchase Plan for the nine months ended September 30, 2006 is as follows:

METROCORP BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

		Number of Subscribed
		Shares Outstanding
Outstanding subscribed shares at December 31, 2005			12,303
Subscribed shares issued			(4,584	)
Subscribed shares withdrawn from plan			(599	)
Fractional shares adjustment			(3	)
Outstanding subscribed shares at September 30, 2006			7,117

          The adoption of SFAS No. 123R resulted in a charge to compensation expense under the Purchase Plan that was not material. The Board of Directors has determined that no new shares will be offered in connection with the Purchase Plan in 2006.

5. SECURITIES AVAILABLE-FOR-SALE

          The amortized cost and approximate fair value of securities classified as available-for-sale is as follows:

		As of September 30, 2006																As of December 31, 2005
						Gross				Gross												Gross				Gross
		Amortized				Unrealized				Unrealized				Fair				Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value				Cost				Gains				Losses				Value
														(In thousands)
U.S. Government agencies		$	29			$	1			$	—			$	30			$	32			$	—			$	—			$	32
U.S. Government sponsored enterprises			36,896				—				(594	)			36,302				36,869				—				(526	)			36,343
Obligations of state and political subdivisions			7,425				186				—				7,611				17,162				551				—				17,713
Mortgage-backed securities and collateralized mortgage obligations			129,760				48				(3,968	)			125,840				162,294				112				(3,974	)			158,432
Other debt securities			182				2				(1	)			183				292				3				—				295
Investment in ARM and CRA funds			19,609				—				(432	)			19,177				19,419				17				(412	)			19,024
FHLB/Federal Reserve Bank stock			3,811				—				—				3,811				3,178				—				—				3,178
Investment in subsidiary trust			1,083				—				—				1,083				1,083				—				—				1,083
Total securities		$	198,795			$	237			$	(4,995	)		$	194,037			$	240,329			$	683			$	(4,912	)		$	236,100

          The following table displays the gross unrealized losses and fair value of investments as of September 30, 2006 that were in a continuous unrealized loss position for the periods indicated:

		Less Than 12 Months								Greater Than 12 Months								Total
						Gross								Gross								Gross
						Unrealized								Unrealized								Unrealized
		Fair Value				Losses				Fair Value				Losses				Fair Value				Losses
		(In thousands)
U. S. Government sponsored enterprises.		$	—			$	—			$	36,302			$	(594	)		$	36,302			$	(594	)
Mortgage-backed securities and collateralized mortgage obligations			36,655				(798	)			85,023				(3,170	)			121,678				(3,968	)
Other debt securities			45				(1	)			—				—				45				(1	)
Investment in ARM and CRA funds			4,417				(15	)			14,761				(417	)			19,178				(432	)
Total securities		$	41,117			$	(814	)		$	136,086			$	(4,181	)		$	177,203			$	(4,995	)

METROCORP BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

          Declines in the fair value of individual securities below their cost that are other than temporary would result in realized losses as the individual securities are written down to their fair value. Management believes that based upon the credit quality of the debt securities and the Company’s intent and ability to hold the securities until their recovery, none of the unrealized losses should be considered other than temporary.

6. ALLOWANCE FOR LOAN LOSSES

          The following table presents an analysis of the allowance for loan losses as of and for the periods indicated:

		As of and for the Three Months								As of and for the Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
						(In thousands)
Allowance for loan losses at beginning of period		$	12,905			$	10,372			$	13,169			$	10,501
Provision for loan losses			114				468				560				1,396
Charge-offs			(1,251	)			(72	)			(3,488	)			(1,266	)
Recoveries			84				38				1,611				175
Allowance for loan losses at end of period		$	11,852			$	10,806			$	11,852			$	10,806

7. EARNINGS PER COMMON SHARE

          Basic earnings per share (“EPS”) is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income available to common shareholders by the weighted-average number of common shares and potentially dilutive common shares outstanding during the period. Stock options, as well as common stock offered under the Stock Purchase Plan, may be dilutive common shares and are therefore considered in the earnings per share calculation, if dilutive. Stock options that are antidilutive are excluded from the earnings per share calculation. Stock options are antidilutive when the exercise price is higher than the current market price of the Company’s common stock. For the nine months ended September 30, 2006, there were 42,392 antidilutive stock options, and for the nine months ended September 30, 2005, there were no antidilutive stock options. The number of potentially dilutive common shares is determined using the treasury stock method. The following table provides a reconciliation of income available to common shareholders and the average number of shares outstanding for the periods below:

		As of and for the Three Months								As of and for the Nine Months
		Ended September 30,								Ended September 30,
		2006				2005				2006				2005
						(In thousands, except per share amounts)
Net income available to common shareholders		$	3,546			$	2,836			$	10,169			$	7,866
Weighted average common shares outstanding:
Basic			10,924				10,814				10,895				10,805
Shares issuable under stock option and purchase plans			229				154				202				133
Diluted			11,153				10,968				11,097				10,938
Earnings per common share:
Basic		$	0.32			$	0.26			$	0.93			$	0.73
Diluted		$	0.32			$	0.26			$	0.92			$	0.72

8. LITIGATION

          The Company is involved in various litigation that arises from time to time in the normal course of business. In the opinion of management, after consultations with its legal counsel, such litigation is not expected to have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.

METROCORP BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

9. OFF-BALANCE SHEET ACTIVITIES

          The Company is 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 various guarantees, commitments to extend credit and standby letters of credit. Additionally, these instruments may involve, to varying degrees, credit risk in excess of the amount recognized in the statement of financial condition. The Company’s maximum exposure to credit loss under such arrangements is represented by the contractual amount of those instruments. The Company applies the same credit policies and collateralization guidelines in making commitments and conditional obligations as it does for on-balance sheet instruments. Off-balance sheet financial instruments include commitments to extend credit and guarantees under standby and other letters of credit.

          The contractual amount of the Company’s financial instruments with off-balance sheet risk at September 30, 2006 and December 31, 2005 is presented below (in thousands):

		As of				As of
		September 30, 2006				December 31, 2005
Unfunded loan commitments including unfunded lines of credit		$	202,529			$	152,190
Standby letters of credit			7,542				4,589
Commercial letters of credit			12,437				6,593
Operating leases			10,045				5,467
Total financial instruments with off-balance sheet risk		$	232,553			$	168,839

10. OPERATING SEGMENT INFORMATION

          In October 2005, the Company acquired Metro United and continued its operation as a separate subsidiary. As a result of the acquisition, the Company manages its operations and prepares management reports and other information with a primary focus on geographical areas. The Company operates two community banks in distinct geographical areas. Since October 2005, performance assessment and resource allocation are based upon this geographical structure. The operating segment identified as “Other” includes the parent company and eliminations of transactions between segments. The accounting policies of the individual operating segments are the same as those of the Company as described in Note 1 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. Transactions between operating segments are primarily conducted at fair value, resulting in profits that are eliminated for reporting consolidated results of operations.

          The following is a summary of selected operating segment information as of and for the three and nine months ended September 30, 2006 (in thousands):

		For the three months ended September 30, 2006
														Consolidated
		MetroBank				Metro United				Other				Company
Total interest income		$	18,429			$	4,119			$	18			$	22,566
Total interest expense			6,442				1,983				532				8,957
Net interest income			11,987				2,136				(514	)			13,609
Provision for loan losses			105				9				—				114
Net interest income after provision for loan losses			11,882				2,127				(514	)			13,495
Noninterest income			1,818				85				—				1,903
Noninterest expense			8,387				1,715				(282	)			9,820
Income before income tax provision			5,313				497				(232	)			5,578
Provision for income taxes			1,881				227				(76	)			2,032
Net income		$	3,432			$	270			$	(156	)		$	3,546

METROCORP BANCSHARES, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

		For the nine months ended September 30, 2006
														Consolidated
		MetroBank				Metro United				Other				Company
Total interest income		$	52,128			$	11,153			$	51			$	63,332
Total interest expense			17,107				5,093				1,577				23,777
Net interest income			35,021				6,060				(1,526	)			39,555
Provision for loan losses			441				119				—				560
Net interest income after provision for loan losses			34,580				5,941				(1,526	)			38,995
Noninterest income			5,553				231				—				5,784
Noninterest expense			24,456				4,102				427				28,985
Income before income tax provision			15,677				2,070				(1,953	)			15,794
Provision for income taxes			5,475				806				(656	)			5,625
Net income		$	10,202			$	1,264			$	(1,297	)		$	10,169

		As of September 30, 2006
														Consolidated
		MetroBank				Metro United				Other				Company
Net loans		$	671,467			$	156,953			$	—			$	828,420
Assets			975,177				249,727				1,197				1,226,101
Deposits			840,229				206,505				(2,503	)			1,044,231

11. NEW ACCOUNTING PRONOUNCEMENTS

          In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement No. 157, “Fair Value Measurements”. Statement No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. Statement No. 157 is effective for the Company beginning January 1, 2008. The Company is in the process of determining the impact of adoption of this statement.

          In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of a Prior Year Misstatements When Quantifying Misstatements in Current Year Financial Statements.” SAB 108 addresses how the effects of prior year uncorrected errors must be considered in quantifying misstatements in the current year financial statements. The effects of prior year uncorrected errors include the potential accumulation of improper amounts that may result in a material misstatement on the balance sheet or the reversal of prior period errors in the current period that result in a material misstatement of the current period income statement amounts. Adjustments to current or prior period financial statements would be required in the event that after application of various approaches for assessing materiality of a misstatement in current period financial statements and consideration of all relevant quantitative and qualitative factors, a misstatement is determined to be material. SAB 108 will be applicable to all financial statements issued by the Company after November 15, 2006. Adoption of this bulletin is not expected to have a material effect on the Company’s consolidated results of operations or financial condition.

          In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement 109” (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. This Interpretation provides that the tax effects from an uncertain tax position can be recognized in the financial statements, only if the position is more likely than not of being sustained on examination by taxing authorities, based on the technical merits of the position. The provisions of FIN 48 are effective for the Company beginning January 1, 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. Management is in the process of determining the impact of adoption of this statement.

          In March 2006, the FASB issued Statement No. 156, “Accounting for Servicing of Financial Assets.” Statement No. 156, which is an amendment to FAS No. 140, simplifies the accounting for servicing assets and liabilities, such as those common with mortgage securitization activities. The new Standard clarifies when an obligation to service financial assets should be separately recognized as a servicing asset or a servicing liability, requires that a separately recognized servicing asset or servicing liability be initially measured at fair value, if practicable; and permits an entity with a separately recognized servicing asset or servicing liability to choose either the Amortization Method or Fair Value Method for subsequent measurement. Statement No. 156 is effective for separately recognized servicing assets and liabilities acquired or issued and is applicable to all financial statements issued by the

Company after January 1, 2007. Adoption of this statement is not expected to have a material effect on the Company’s consolidated results of operations or financial condition.

          In February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid Instruments”, which is an amendment of Statements No. 133 and 140. Statement No. 155 allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. The statement also clarifies which interest-only strips and principal-only strips are not subject to the requirements of Statement No. 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends Statement No. 140 to eliminate the prohibition of a qualifying special purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. Statement No. 155 is effective for all financial instruments acquired or issued after January 1, 2007. Adoption of this statement is not expected to have a material effect on the Company’s consolidated results of operations or financial condition.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

          Special Cautionary Notice Regarding Forward-looking Statements

          The statements and financial discussion and analysis contained in this Quarterly Report on Form 10-Q that are not historical facts are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Company intends such forward-looking statements to be covered by the safe harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995 and is including this statement for purposes of invoking these safe harbor provisions. These forward-looking statements include information about possible or assumed future results of the Company’s operations or performance. Words such as “believe”, “expect”, “anticipate”, “estimate”, “continue”, “intend”, “may”, “will”, “should”, or similar expressions, are intended to identify these forward-looking statements. Many possible factors or events could affect the future financial results and performance of the Company and could cause those financial results or performance to differ materially from those expressed in the forward-looking statement. These possible events or factors include, without limitation:

	•		changes in interest rates and market prices, which could reduce the Company’s net interest margins, asset valuations and expense expectations;
	•		changes in the levels of loan prepayments and the resulting effects on the value of the Company’s loan portfolio;
	•		changes in local economic and business conditions which adversely affect the ability of the Company’s customers to transact profitable business with the Company, including the ability of borrowers to repay their loans according to their terms or a change in the value of the related collateral;
	•		increased competition for deposits and loans adversely affecting rates and terms;
	•		the Company’s ability to identify suitable acquisition candidates;
	•		the timing, impact and other uncertainties of the Company’s ability to enter new markets successfully and capitalize on growth opportunities;
	•		increased credit risk in the Company’s assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of the total loan portfolio;
	•		the failure of assumptions underlying the establishment of and provisions made to the allowance for loan losses;
	•		changes in the availability of funds resulting in increased costs or reduced liquidity;
	•		increased asset levels and changes in the composition of assets and the resulting impact on our capital levels and regulatory capital ratios;
	•		the Company’s ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes;
	•		the loss of senior management or operating personnel and the potential inability to hire qualified personnel at reasonable compensation levels; and
	•		changes in statutes and government regulations or their interpretations applicable to bank holding companies and our present and future banking and other subsidiaries, including changes in tax requirements and tax rates.

          All written or oral forward-looking statements attributable to the Company are expressly qualified in their entirety by these cautionary statements. The Company undertakes no obligation to publicly update or otherwise revise any forward-looking statements, whether as a result of new information, future events or otherwise.

          Management’s Discussion and Analysis of Financial Condition and Results of Operations of the Company analyzes the major elements of the Company’s balance sheets and statements of income. This section should be read in conjunction with the Company’s Condensed Consolidated Financial Statements and accompanying notes and other detailed information appearing elsewhere in this document.

Overview

          The Company recorded net income of $3.5 million for the three months ended September 30, 2006, up approximately $710,000 compared with net income of $2.8 million for the same quarter in 2005. The Company’s diluted earnings per share (“EPS”) for the three months ended September 30, 2006 was $0.32, up $0.06 per diluted share compared with diluted EPS of $0.26 for the same quarter in 2005. Net income for the nine months ended September 30, 2006 was $10.2 million, up approximately $2.3 million compared with $7.9 million for the same period in 2005. The Company’s diluted EPS for the nine months ended September 30, 2006 was $0.92 up $0.20 compared with $0.72 for the same period in 2005.

          Total assets were $1.23 billion at September 30, 2006, up approximately $97.9 million or 8.7% compared with $1.13 billion at December 31, 2005. Investment securities at September 30, 2006 were $194.0 million, down approximately $42.1 million or 17.8% compared with $236.1 million at December 31, 2005. Net loans at September 30, 2006 were $828.4 million, up approximately $70.1 million or 9.3% compared with $758.3 million at December 31, 2005. Total deposits at September 30, 2006 were $1.04 billion, up approximately $82.5 million or 8.6% compared with $961.8 million at December 31, 2005. The Company’s return on average assets (“ROAA”) for the three months ended September 30, 2006 and 2005 was 1.17% and 1.22%, respectively. The Company’s ROAA for both the nine months ended September 30, 2006 and 2005 was 1.16%.

          Shareholders’ equity at September 30, 2006 was $102.1 million compared with $92.2 million at December 31, 2005, an increase of approximately $9.9 million or 10.7%. The Company’s return on average equity (“ROAE”) for the three months ended September 30, 2006 and 2005 was 14.05% and 12.48%, respectively. The Company’s ROAE for the nine months ended September 30, 2006 and 2005 was 13.99% and 11.90%, respectively.

          On August 4, 2006 the Company’s Board of Directors approved a three-for-two stock split effected in the form of a 50% stock dividend. As a result of the stock split, shareholders received one share of common stock for every two shares they held at the close of business on the record date of August 18, 2006. The stock dividend was paid on September 1, 2006. All references in the financial statements regarding share data and shareholders’ equity have been adjusted to reflect the effect of the stock split for all periods presented, except those in the Balance Sheet and the Statement of Changes in Shareholders’ Equity as of December 31, 2005. As of September 30, 2006, shareholders’ equity reflects the stock split by a reduction in additional paid-in capital of $3.7 million and an increase common stock of $3.7 million.

          During the third quarter of 2006, the Company expanded its presence in other cities. Metro United completed the acquisition and integration of the Irvine, California branch that was acquired from Omni Bank, N.A. and opened a loan production office in San Mateo, which is expected to become a full service branch in the fourth quarter of 2006. Metro United also entered into a lease for a location in the City of Industry, California which will have the capacity to serve as another branch in the future. In addition to California, the Company completed the staffing and leasing of office space for the representative office in Xiamen, China, and expects to commence operations during the fourth quarter of 2006. Technology alliances were also formed with two companies that management believes can provide state of the art on-line products to support the Company’s growth and enhance customer service in terms of new products.

Results of Operations

          Net Interest Income and Net Interest Margin. For the three months ended September 30, 2006, net interest income, before the provision for loan losses, was $13.6 million, up approximately $3.5 million or 34.3% compared with $10.1 million for the same quarter in 2005. The increase was primarily due to the effect of the Metro United acquisition in October 2005 (see Note 10 – Operating Segment Information), and organic growth in loans. The increase reflects a $8.2 million increase in interest income that was partially offset by a $4.7 million increase in interest expense. Average interest-earning assets for the three months ended September 30, 2006 were $1.13 billion, up approximately $251.8 million or 28.6% compared with $880.2 million for the same quarter in 2005. The weighted average yield on interest-earning assets for the three months ended September 30, 2006 was 7.91%, up 144 basis points compared with 6.47% for the same quarter in 2005. The yield on average earning assets increased primarily due to the Federal Reserve’s six interest rate increases over the last 12 months. Average interest-bearing liabilities for the three months ended September 30, 2006 were $895.5 million, up approximately $250.2 million or 38.8% compared with $645.3 million for the same quarter in 2005. The weighted average rate paid on interest-bearing liabilities for the three months ended September 30, 2006 was 3.97%, up 138 basis points compared with 2.59% for the same quarter in 2005.

          For the nine months ended September 30, 2006, net interest income, before the provision for loan losses, was $39.6 million, up approximately $10.3 million or 35.1% compared with $29.3 million for the same period in 2005. The increase was primarily due to organic growth and the effect of the Metro United acquisition in October 2005. The increase reflects a $22.9 million increase in