UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
/X/ Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934
For the fiscal year ended December 31, 2004; or
/ / Transition report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
Commission file number 000-29829
PACIFIC FINANCIAL CORPORATION
(Exact Name of Registrant as specified in its Charter)
Washington 91-1815009
(State or Other Jurisdiction of (IRS Employer Identification No.)
Incorporation or Organization)
300 East Market Street
Aberdeen, Washington 98520-5244
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (360) 533-8870
Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, par value $1.00 per share
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 periods that the Registrant was
required to file such reports), and (2) has been subject to such requirements
for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the Registrant is an accelerated filer (as
defined by Exchange Act Rule 12b-2). Yes [X] No [ ]
The aggregate market value of the common stock held by non-affiliates of the
registrant at June 30, 2004, was $109,163,732
The number of shares outstanding of the registrant's common stock, $1.00 par
value as of February 28, 2005, was 3,210,698 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement filed in connection with its annual
meeting of shareholders to be held April 20, 2005 are incorporated by reference
into Part III of this Form 10-K.
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PACIFIC FINANCIAL CORPORATION
ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR
ENDED DECEMBER 31, 2004
TABLE OF CONTENTS
PART I Page
Forward Looking Information 3
Stock Split 4
Item 1. Business 4
Item 2. Properties 12
Item 3. Legal Proceedings 13
Item 4. Submission of Matters to a Vote of Security Holders 13
PART II
Item 5. Market for Registrant's Common Equity, 14
Related Stockholder Matters and Issuer and
Purchases of Equity Securities
Item 6. Selected Financial Data 15
Item 7. Management's Discussion and Analysis of 17
Financial Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures About 33
Market Risk
Item 8. Financial Statements and Supplementary Data 35
Item 9. Changes in and Disagreements with Accountants 35
on Accounting and Financial Disclosure
Item 9A. Controls and Procedures 35
Item 9B. Other Information 36
PART III
Item 10. Directors and Executive Officers of the Registrant 37
Item 11. Executive Compensation 37
Item 12. Security Ownership of Certain Beneficial Owners 38
and Management And Related Stockholder Matters
Item 13. Certain Relationships and Related Transactions 38
Item 14. Principal Accountant Fees and Services 38
PART IV
Item 15. Exhibits and Financial Statement Schedules 39
SIGNATURES 74
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PART I
Forward Looking Information
This document contains forward-looking statements that are subject to risks and
uncertainties. These statements are based on the beliefs and assumptions of our
management, and on information currently available to them. Forward-looking
statements include the information concerning our possible future results of
operations set forth under "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and statements preceded by, followed by or
that include the words "believes," "expects," "anticipates," "intends," "plans,"
"estimates" or similar expressions.
Any forward-looking statements in this document are subject to risks
relating to, among other things, the following:
1. competitive pressures among depository and other financial
institutions that may impede our ability to attract and retain borrowers,
depositors and other customers, retain our key employees, and/or maintain
our interest margins and fee income;
2. changes in the interest rate environment that may reduce our
margins, decrease demand for our products and services, and adversely
effect the value of our investment securities;
3. our growth strategy, particularly if accomplished through
acquisitions, which may not be successful if we fail to accurately assess
market opportunities, asset quality, anticipated cost savings, and
transaction costs, or experience significant difficulty integrating
acquired businesses or assets or opening new branches or lending offices;
4. our acquisition of BNW Bancorp Inc. which may be dilutive to
earnings per share, or less beneficial than expected, if we do not realize
expected cost savings or successfully integrate BNW Bancorp into the
Company in a timely manner and without significant customer or employee
disruptions or losses;
5. expenses and dedication of management resources in connection
with our efforts to comply with changing laws, regulations, and standards
arising primarily out of the Sarbanes-Oxley Act of 2002, including as a
result of internal control requirements thereunder, that may significantly
increase our costs and ongoing compliance expenditures and place
additional burdens on our limited management resources;
6. general economic or business conditions, either nationally or in
the state or regions in which we do business, that may be less favorable
than expected, resulting in, among other things, a deterioration in credit
quality, and/or a reduced demand for credit;
7. any failure to comply with developing and changing standards of
corporate governance and disclosure and internal control that could result
in negative publicity, leading to declines in our stock price;
8. decreases in real estate prices, whether or not due to changes
in economic conditions, that may reduce the value of our security for many
of our loans; and
9. a lack of liquidity in the market for our common stock that may
make it difficult or impossible for you to liquidate your investment in
our stock or lead to distortions in the market price of our stock.
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Our management believes the forward-looking statements are reasonable;
however, you should not place undue reliance on them. Forward-looking statements
are not guarantees of performance. They involve risks, uncertainties and
assumptions. Many of the factors that will determine our future results and
share value are beyond our ability to control or predict. We undertake no
obligation to update forward-looking statements.
Stock Split
All per share amounts and numbers of shares of our common stock included
in this report (except on the cover page) have been retroactively adjusted for a
two-for-one stock split declared on February 16, 2005, to be paid on April 4,
2005, to shareholders of record on March 15, 2005.
ITEM 1. Business
Pacific Financial Corporation (the Company or Pacific) is a financial holding
company headquartered in Aberdeen, Washington. The Company owns one bank, Bank
of the Pacific (sometimes referred to as the "Bank"), which is also located in
Washington. The Company was incorporated in the State of Washington on February
12, 1997, pursuant to a holding company reorganization of the Bank.
The Company conducts its banking business through 15 branches located in
communities throughout Grays Harbor County, Pacific County, and Wahkiakum County
in Southwest Washington, and Whatcom County in Northwest Washington. The Company
also operates loan production offices in Gearhart, Oregon and Burlington,
Washington. The five locations in Whatcom County, which includes Bellingham,
Washington, were acquired as part of Pacific's acquisition of BNW Bancorp, Inc.
(BNW) completed on February 27, 2004.
The BNW acquisition was accomplished through a merger in which each share of BNW
common stock was converted into 0.85 shares of Pacific common stock (before the
2005 split), resulting in the issuance of 1,271,904 shares of Pacific stock
(post-split). Simultaneous with the merger of BNW into Pacific, BNW's subsidiary
Bank NorthWest was merged into Bank of the Pacific, although Whatcom County
branches continue to conduct business under the name "Bank Northwest." The
merger was accounted for as a purchase transaction.
Pacific Financial Corporation is a reporting company with the Securities and
Exchange Commission (SEC), and the Company's common stock is listed on the OTC
Bulletin Board(TM) under the symbol "PFLC.OB". At December 31, 2004, the Company
had total consolidated assets of $441.8 million, total loans, including loans
held for sale, of $347.8 million, total deposits of $363.5 million, and total
shareholders' equity of $45.3 million. To give you a reference point as to the
effect of the BNW acquisition on these figures, at the time of the BNW
acquisition, BNW had total assets of approximately $120.0 million, total loans
of approximately $110.7 million, total deposits of approximately $87.8 million
and total shareholders' equity of approximately $7.2 million.
The Company has not made any significant changes in products and services
offered to customers of Bank of the Pacific following the merger, but it is able
to offer higher lending limits to its customers, particularly those who were
formerly BNW customers.
Pacific's filings with the SEC, including its annual report on Form 10-K,
quarterly reports on Form 10-Q, periodic current reports on Form 8-K and
amendments to these reports, are available free of charge through links from our
website at http://www.thebankofpacific.com to the SEC's site at
http://www.sec.gov, as soon as reasonably practicable after filing with the SEC.
You may also access our filings with the SEC directly from the Edgar database
found on the SEC's website. By making reference
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to our website above and elsewhere in this report, we do not intend to
incorporate any information from our site into this report.
The Bank
Bank of the Pacific was organized in 1978 and opened for business in 1979 to
meet the need for a regional community bank with local interests to serve the
small to medium-sized local businesses and professionals in the coastal region
of Western Washington. Services offered by the Bank include commercial loans,
agriculture loans, installment loans, real estate loans, residential mortgage
loans and personal and business deposit products.
The Bank originates loans primarily in its local markets. Its underwriting
policies focus on assessment of each borrower's ability to service and repay the
debt, and the availability of collateral that can be used to secure the loan.
Depending on the nature of the borrower and the purpose and amount of the loan,
the Bank's loans may be secured by a variety of collateral, including business
assets, real estate, and personal assets.
The Bank's commercial and agricultural loans consist primarily of secured
revolving operating lines of credit and business term loans, some of which may
be partially guaranteed by the Small Business Administration or the U.S.
Department of Agriculture.
Consumer installment loans and other loans represent a small percentage of total
outstanding loans and include home equity loans, auto loans, boat loans, and
personal lines of credit.
The Bank's primary sources of deposits are from individuals and businesses in
its local markets. A concerted effort has been made to attract deposits in the
local market areas through competitive pricing and delivery of quality products.
These products include demand accounts, negotiable order of withdrawal accounts,
money market investment accounts, savings accounts and time deposits. The Bank
traditionally has not sought brokered deposits and does not intend to do so in
the future.
The Bank provides 24 hour online banking to its customers with access to account
balances and transaction histories, plus an electronic check register to make
account management and reconciliation simple. The online banking system is
compatible with budgeting software like Intuit's Quicken or Microsoft's Money.
In addition, the online banking system includes the ability to transfer funds,
make loan payments, reorder checks, and request statement reprints, provides
loan calculators and allows for e-mail exchanges with representatives of the
Bank. Also for a nominal fee, customers can request stop payments and pay an
unlimited number of bills online. These services along with rate information and
other information can be accessed through the Bank's website at
http://www.thebankofpacific.com.
The Bank's deposits are insured by the Federal Deposit Insurance Corporation
(FDIC) up to applicable legal limits under the Bank Insurance Fund. The Bank is
a member of the Federal Home Loan Bank (FHLB) and is regulated by the Washington
Department of Financial Institutions, Division of Banks (Division), and the
FDIC.
Competition
Competition in the banking industry is significant and has intensified as the
regulatory environment has grown more permissive. Banks face a growing number of
competitors and greater degree of competition with respect to the provision of
banking services and the attracting of deposits. The Company competes in Grays
Harbor County with well-established thrifts which are headquartered in the area
along with branches of large banks with headquarters outside the area. The
Company competes with well-established small community banks, branches of large
banks, thrifts and credit unions in Pacific and
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Wahkiakum Counties in the state of Washington and Clatsop County in the state of
Oregon. Other non-bank and non-depository institutions can be expected to
increase competition further as they offer bank type products.
As a result of its acquisition of BNW in February 2004, the Company entered a
new market in Whatcom County, Washington, including the Bellingham area. This
market is very competitive and includes large regional and super-regional
financial institutions that do not have a significant presence in the Company's
historical market areas. The Company believes its newest territory provides
opportunities for expansion, but in pursuing that expansion it faces greater
competitive challenges than it faces in its historical market areas.
The adoption of the Gramm-Leach-Bliley Act of 1999 (the Financial Services
Modernization Act) eliminated many of the barriers to affiliation among
providers of financial services and further opened the door to business
combinations involving banks, insurance companies, securities or brokerage
firms, and others. This regulatory change has led to further consolidation in
the financial services industry and the creation of financial conglomerates
which frequently offer multiple financial services, including deposit services,
brokerage and others. When combined with technological developments such as the
Internet that have reduced barriers to entry faced by companies physically
located outside the Company's market area, changes in the market have resulted
in increased competition and can be expected to result in further increases in
competition in the future.
Although it cannot guarantee that it will continue to do so, the Company has
been able to maintain a competitive advantage in its historical markets as a
result of its status as a local institution, offering products and services
tailored to the needs of the community. Further, because of the extensive
experience of management in its market area and the business contacts of
management and the Company's directors, management believes the Company can
continue to compete effectively.
According to the Market Share Report compiled by the FDIC, as of June 30, 2004,
the Company held a deposit market share of 28.1% in Pacific County, 45.8% in
Wahkiakum County, 17.2% in Grays Harbor County, and 3.6% in Whatcom County.
Employees
As of December 31, 2004, the Bank employed 157 full time equivalent employees.
The Bank acquired 52 employees in the merger with BNW completed in February
2004. Management believes relations with its employees are good.
SUPERVISION AND REGULATION
The following is a general description of certain significant statutes and
regulations affecting the banking industry. This regulation is intended
primarily for the protection of depositors and not for the benefit of the
Company's shareholders. The following discussion is intended to provide a brief
summary and, therefore, is not complete and is qualified by the statutes and
regulations referenced. Changes in applicable laws or regulations may have a
material effect on the business and prospects of the Company.
The operations of the Company may also be affected by changes in the policies of
banking and other government regulators. The Company cannot accurately predict
the nature or extent of the effects on its business and earnings that fiscal or
monetary policies, or new federal or state laws or regulations, may have in the
future.
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The Company
General
As a financial holding company, the Company is subject to the Bank Holding
Company Act of 1956, as amended (BHCA), which places the Company under the
supervision of the Board of Governors of the Federal Reserve System (the Federal
Reserve). The Company must file annual reports with the Federal Reserve and must
provide it with such additional information as it may require. In addition, the
Federal Reserve periodically examines the Company and the Bank.
Bank Holding Company Regulation
In general, the BHCA limits a bank holding company to owning or controlling
banks and engaging in other banking-related activities. Bank holding companies
must obtain approval of the Federal Reserve before they: (1) acquire direct or
indirect ownership or control of any voting shares of any bank that results in
total ownership or control, directly or indirectly, of more than 5% of the
voting shares of such bank; (2) merge or consolidate with another bank holding
company; or (3) acquire substantially all of the assets of another bank or bank
holding company.
Control of Nonbanks. With certain exceptions, the BHCA prohibits bank holding
companies from acquiring direct or indirect ownership or control of more than 5%
of the voting shares in any company that is not a bank or a bank holding company
unless the Federal Reserve determines that the activities of such company are
incidental or closely related to the business of banking. If a bank holding
company is well-capitalized and meets certain criteria specified by the Federal
Reserve, it may engage de novo in certain permissible nonbanking activities
without prior Federal Reserve approval.
Control Transactions. The Change in Bank Control Act of 1978, as amended,
requires a person (or group of persons acting in concert) acquiring control of a
bank holding company to provide the Federal Reserve with 60 days' prior written
notice of the proposed acquisition. Following receipt of this notice, the
Federal Reserve has 60 days within which to issue a notice disapproving the
proposed acquisition, but the Federal Reserve may extend this time period for up
to another 30 days. An acquisition may be completed before expiration of the
disapproval period if the Federal Reserve issues written notice of its intent
not to disapprove the transaction. In addition, any company must obtain approval
of the Federal Reserve before acquiring 25% (5% if the company is a bank holding
company) or more of the outstanding shares or otherwise obtaining control over
the Company.
Source of Strength Requirements. Under Federal Reserve policy, the Company is
expected to act as a source of financial and managerial strength to the Bank.
This means that the Company is required to commit, as necessary, resources to
support the Bank. Any capital loans made by the Company to the Bank would be
subordinate in priority to deposits and to certain other indebtedness of the
Bank.
Financial Services Modernization Act
On November 12, 1999, the Financial Services Modernization Act (the "FSMA") was
signed into law. The FSMA repeals the two affiliation provisions of the
Glass-Steagall Act: Section 20, which restricted the affiliation of Federal
Reserve member banks with firms "engaged principally" in specified securities
activities; and Section 32, which restricts officer, director, or employee
interlocks between a member bank and any company or person "primarily engaged"
in specified securities activities. In addition, the FSMA contains provisions
that expressly preempt any state law restricting the establishment of financial
affiliations, primarily related to insurance. The general effect of the law is
to establish a comprehensive framework to permit affiliations among commercial
banks, insurance companies, securities firms, and other financial service
providers by revising and expanding the bank holding company framework to permit
a holding
7
company system to engage in a full range of financial activities through a new
entity known as a financial holding company.
The Company received approval to become a financial holding company during 2000.
Bank holding companies that elect to become a financial holding company may
affiliate with securities firms and insurance companies and engage in other
activities that are financial in nature or are incidental or complementary to
activities that are financial in nature. "Financial in nature" activities
include securities underwriting, dealing, and market marking, sponsoring mutual
funds and investment companies, insurance underwriting and agency, merchant
banking, and activities that the Federal Reserve, in consultation with the
Secretary of the Treasury, determines from time to time to be so closely related
to banking or managing or controlling banks as to be a proper incident thereto.
The law and related regulations also:
o broadened the activities that may be conducted by national banks and
by banking subsidiaries of bank holding companies, and their financial
subsidiaries;
o provided an enhanced framework for protecting the privacy of consumer
information; and
o modified the laws governing the implementation of the Community
Reinvestment Act.
The Company does not believe that the FSMA has had a material effect on its
operations. However, to the extent that the legislation permits banks,
securities firms, and insurance companies to affiliate, the financial services
industry may experience further consolidation. The Financial Services
Modernization Act is intended to grant to community banks certain powers as a
matter of right that larger institutions have accumulated on an ad hoc basis.
Nevertheless, this legislation may have the result of increasing the amount of
competition that the Company faces from larger institutions and other types of
companies with substantially greater resources than the Company and offering a
wider variety of financial products than the Bank currently offers.
Pursuant to the requirements of the FSMA, federal banking regulators adopted
certain privacy and information security requirements for financial
institutions, together with certain consumer protection rules for the sale of
insurance products. Privacy and security rules require, among other things,
disclosure of privacy policies to consumers and implementation of information
security programs designed to identify and assess the risks that may threaten
customer information. Insurance related rules require that certain oral and
written disclosures be made before the completion of the sale of an insurance
product. The Company believes that it is in compliance with these rules and that
they do not adversely affect its operations.
USA Patriot Act of 2001
On October 26, 2001, President Bush signed the Uniting and Strengthening America
by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA
Patriot Act) of 2001. Among other things, the USA Patriot Act (1) prohibits
banks from providing correspondent accounts directly to foreign shell banks; (2)
imposes due diligence requirements on banks opening or holding accounts for
foreign financial institutions or wealthy foreign individuals; (3) requires
financial institutions to establish an anti-money-laundering compliance program,
and (4) eliminates civil liability for persons who file suspicious activity
reports. The USA Patriot Act also increases governmental powers to investigate
terrorism, including expanded government access to account records. The
Department of the Treasury is empowered to administer and make rules to
implement the act. We do not believe that compliance with the USA Patriot Act
has had a material effect on our business and operations.
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Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 was adopted in response to public concerns
regarding corporate accountability in connection with the recent accounting
scandals at various large publicly traded companies. The stated goals of the act
are to increase corporate responsibility, to provide for enhanced penalties for
accounting and auditing improprieties at publicly traded companies, and to
protect investors by improving the accuracy and reliability of corporate
disclosures pursuant to the securities laws. The Sarbanes-Oxley Act generally
applies to all companies such as the Company that file periodic reports with the
SEC under the Securities Exchange Act of 1934, as amended (Exchange Act).
The Sarbanes-Oxley Act includes additional disclosure requirements and new
corporate governance rules, and has resulted in significant rulemaking by the
SEC and the securities exchanges relating to corporate governance, independence
of board members, internal control over financial reporting, disclosure
controls, and other matters. Most rulemaking initiatives were completed by the
close of 2003. Sarbanes-Oxley represents significant federal involvement in
matters traditionally left to state regulatory systems, such as the regulation
of the accounting profession, and to state corporate law, such as the
relationship between a board of directors and management and between a board of
directors and its committees.
The Sarbanes-Oxley Act addresses, among other matters, (1) board audit
committees; (2) certification of Exchange Act reports by the chief executive
officer and the chief financial officer; (3) the forfeiture of bonuses or other
incentive-based compensation and securities trading profits by directors and
executive officers in the twelve-month period following initial publication of
any financial statements that later require restatement; (4) disclosure of
off-balance sheet transactions; (5) expedited reporting of stock transactions by
insiders; (6) disclosure of whether an issuer has a code of ethics, and changes
or waivers of such code; (7) the formation of a Public Company Accounting
Oversight Board; (8) auditor independence; and (9) increased criminal penalties
for violations of securities laws.
The Sarbanes-Oxley Act has resulted in significantly increased reporting
expenses and audit and audit related costs and demands on our senior management.
Transactions With Affiliates
The Company and the Bank are deemed affiliates within the meaning of the Federal
Reserve Act, and transactions between affiliates are subject to certain
restrictions. Accordingly, the Company and the Bank must comply with Sections
23A and 23B of the Federal Reserve Act. Generally, Sections 23A and 23B (1)
limit the extent to which a financial institution or its subsidiaries may engage
in covered transactions with an affiliate, as defined, to an amount equal to 10%
of such institution's capital and surplus and an aggregate limit on all such
transactions with all affiliates to an amount equal to 20% of such capital and
surplus, and (2) require all transactions with an affiliate to be on terms
substantially the same, or at least as favorable to the institution or
subsidiary, as those provided to a non-affiliate. Regulation W, which collected
many existing interpretations of provisions of the Federal Reserve Act, became
effective in April 2003. The regulation restricts loans, asset purchases and
other transactions between a depository institution and its affiliated entities.
Regulation of Management
Federal law (1) sets forth the circumstances under which officers or directors
of a financial institution may be removed by the institution's federal
supervisory agency; (2) places restraints on lending by an institution to its
executive officers, directors, principal shareholders, and their related
interests; and (3) prohibits management personnel from serving as a director or
in other management positions with another financial institution which has
assets exceeding a specified amount or which has an office within a specified
geographic area.
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Tie-In Arrangements
The Company and the Bank cannot engage in certain tie-in arrangements in
connection with any extension of credit, sale or lease of property or furnishing
of services. For example, with certain exceptions, neither the Company nor the
Bank may condition an extension of credit to a customer on either (1) a
requirement that the customer obtain additional services provided by it or (2)
an agreement by the customer to refrain from obtaining other services from a
competitor.
State Law Restrictions
As a Washington business corporation, the Company may be subject to certain
limitations and restrictions as provided under applicable Washington corporate
law. In addition, Washington banking law restricts and governs certain
activities of the Bank.
The Bank
General
The Bank, as an FDIC insured state-chartered bank, is subject to regulation and
examination by the FDIC and the Department of Financial Institutions of the
State of Washington. The federal laws that apply to the Bank regulate, among
other things, the scope of its business, its investments, its reserves against
deposits, the timing of the availability of deposited funds and the nature and
amount of and collateral for loans.
CRA. The Community Reinvestment Act (the CRA) requires that, in connection with
examinations of financial institutions within their jurisdiction, the FDIC
evaluate the record of the financial institutions in meeting the credit needs of
their local communities, including low and moderate income neighborhoods,
consistent with the safe and sound operation of those banks. These factors are
also considered in evaluating mergers, acquisitions, and applications to open a
branch or facility. In connection with the FDIC's assessment of the record of
financial institutions under the CRA, it assigns a rating of either,
"outstanding," "satisfactory," "needs to improve," or "substantial
noncompliance" following an examination. The Bank received a CRA rating of
"satisfactory" during its most recent examination.
Insider Credit Transactions. Banks are also subject to certain restrictions
imposed by the Federal Reserve Act on extensions of credit to executive
officers, directors, principal shareholders, or any related interests of such
persons. Extensions of credit (i) must be made on substantially the same terms,
including interest rates and collateral, and follow credit underwriting
procedures that are not less stringent than those prevailing at the time for
comparable transactions with persons not covered above and who are not employees
and (ii) must not involve more than the normal risk of repayment or present
other unfavorable features. Banks are also subject to certain lending limits and
restrictions on overdrafts to such persons. A violation of these restrictions
may result in the assessment of substantial civil monetary penalties on the
affected bank or any officer, director, employee, agent, or other person
participating in the conduct of the affairs of that bank, the imposition of a
cease and desist order, and other regulatory sanctions.
FDICIA. Under the Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA), each federal banking agency has prescribed, by regulation, noncapital
safety and soundness standards for institutions under its authority. These
standards cover internal controls, information systems, and internal audit
systems, loan documentation, credit underwriting, interest rate exposure, asset
growth, compensation, fees and benefits, such other operational and managerial
standards as the agency determines to be appropriate, and standards for asset
quality, earnings and stock valuation. An institution which fails to meet these
standards must develop a plan acceptable to the agency, specifying the steps
that the institution will take to meet the standards. Failure to submit or
implement such a plan may subject the institution to regulatory sanctions.
Management believes that the Bank meets all such standards and,
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therefore, does not believe that these regulatory standards will materially
affect the Company's business or operations.
Interstate Banking and Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the
Interstate Act) permits nationwide interstate banking and branching under
certain circumstances. This legislation generally authorizes interstate
branching and relaxes federal law restrictions on interstate banking. Currently,
bank holding companies may purchase banks in any state, and states may not
prohibit such purchases. Additionally, banks are permitted to merge with banks
in other states as long as the home state of neither merging bank has opted out.
The Interstate Act requires regulators to consult with community organizations
before permitting an interstate institution to close a branch in a low-income
area.
With regard to interstate bank mergers, Washington has opted in to the
Interstate Act and allows in-state banks to merge with out-of-state banks
subject to certain aging requirements. Washington law generally authorizes the
acquisition of an in-state bank by an out-of-state bank through merger with a
Washington financial institution that has been in existence for at least 5 years
prior to the acquisition. With regard to interstate bank branching, out-of-state
banks that do not already operate a branch in Washington may not establish de
novo branches in Washington or establish and operate a branch by acquiring a
branch in Washington. Under FDIC regulations, banks are prohibited from using
their interstate branches primarily for deposit production. The FDIC has
accordingly implemented a loan-to-deposit ratio screen to ensure compliance with
this prohibition.
Deposit Insurance
The deposits of the Bank are currently insured to a maximum of $100,000 per
depositor through the Bank Insurance Fund administered by the FDIC. All insured
banks are required to pay semi-annual deposit insurance premium assessments to
the FDIC.
FDICIA included provisions to reform the Federal deposit insurance system,
including the implementation of risk-based deposit insurance premiums. FDICIA
also permits the FDIC to make special assessments on insured depository
institutions in amounts determined by the FDIC to be necessary to give it
adequate assessment income to repay amounts borrowed from the U.S. Treasury and
other sources, or for any other purpose the FDIC deems necessary. The FDIC has
implemented a risk-based insurance premium system under which banks are assessed
insurance premiums based on how much risk they present to the insurance fund.
Banks with higher levels of capital and a low degree of supervisory concern are
assessed lower premiums than banks with lower levels of capital or a higher
degree of supervisory concern. The Bank presently qualifies for the lowest
premium level.
Dividends
The principal source of the Company's cash revenues is dividends received from
the Bank. The payment of dividends is subject to government regulation, in that
regulatory authorities may prohibit banks and bank holding companies from paying
dividends in a manner that would constitute an unsafe or unsound banking
practice. In addition, a bank may not pay cash dividends if that payment could
reduce the amount of its capital below that necessary to meet minimum applicable
regulatory capital requirements. Other than the laws and regulations noted
above, which apply to all banks and bank holding companies, neither the Company
nor the Bank are currently subject to any regulatory restrictions on their
dividends. Under applicable restrictions, as of December 31, 2004, the Bank
could declare dividends totaling $5,707,000 without obtaining prior regulatory
approval.
11
Capital Adequacy
Federal bank regulatory agencies use capital adequacy guidelines in the
examination and regulation of bank holding companies and banks. If capital falls
below minimum guideline levels, the holding company or bank may be denied
approval to acquire or establish additional banks or non-bank businesses or to
open new facilities.
The FDIC and Federal Reserve use risk-based capital guidelines for banks and
bank holding companies. These are designed to make such capital requirements
more sensitive to differences in risk profiles among banks and bank holding
companies, to account for off-balance sheet exposure and to minimize
disincentives for holding liquid assets. Assets and off-balance sheet items are
assigned to broad risk categories, each with appropriate weights. The resulting
capital ratios represent capital as a percentage of total risk-weighted assets
and off-balance sheet items. The guidelines are minimums, and the Federal
Reserve has noted that bank holding companies contemplating significant
expansion programs should not allow expansion to diminish their capital ratios
and should maintain ratios well in excess of the minimum. The current guidelines
require all bank holding companies and federally-regulated banks to maintain a
minimum risk-based total capital ratio equal to 8%, of which at least 4% must be
Tier I capital. Tier I capital for bank holding companies includes common
shareholders' equity, certain qualifying perpetual preferred stock and minority
interests in equity accounts of consolidated subsidiaries, less intangibles
except as described above and accumulated other comprehensive income (loss).
The Federal Reserve also employs a leverage ratio, which is Tier I capital as a
percentage of total assets less intangibles, to be used as a supplement to
risk-based guidelines. The principal objective of the leverage ratio is to
constrain the maximum degree to which a bank holding company may leverage its
equity capital base. The Federal Reserve requires a minimum leverage ratio of
3%. However, for all but the most highly rated bank holding companies and for
bank holding companies seeking to expand, the Federal Reserve expects an
additional cushion of at least 1% to 2%.
FDICIA created a statutory framework of supervisory actions indexed to the
capital level of the individual institution. Under regulations adopted by the
FDIC, an institution is assigned to one of five capital categories depending on
its total risk-based capital ratio, Tier I risk-based capital ratio, and
leverage ratio, together with certain subjective factors. Institutions which are
deemed to be undercapitalized depending on the category to which they are
assigned are subject to certain mandatory supervisory corrective actions. The
Company does not believe that these regulations had a material effect on its
operations.
Effects of Government Monetary Policy
The earnings and growth of the Company are affected not only by general economic
conditions, but also by the fiscal and monetary policies of the federal
government, particularly the Federal Reserve. The Federal Reserve can and does
implement national monetary policy for such purposes as curbing inflation and
combating recession, but its open market operations in U.S. government
securities, control of the discount rate applicable to borrowings from the
Federal Reserve, and establishment of reserve requirements against certain
deposits, influence the growth of bank loans, investments and deposits, and also
affect interest rates charged on loans or paid on deposits. The nature and
impact of future changes in monetary policies and their impact on the Company
and the Bank cannot be predicted with certainty.
ITEM 2. Properties
The Company's administrative offices are located in Aberdeen, Washington. The
building located at 300 East Market Street is owned by the Bank and houses the
main branch and the administrative and operations offices of the Bank and the
Company. The Bank completed construction and occupied the building in December
of 1979.
12
Pacific owns the land and buildings occupied by its nine branches in Grays
Harbor, Pacific and Wahkiakum Counties, as well as its data processing
operations in Long Beach, Washington. Three of the five branches located in
Whatcom County operate in leased facilities, and the Bellingham and Everson, WA
branch land and building is owned.
In addition to the land and buildings owned by Pacific, it also owns all of its
furniture, fixtures and equipment, including data processing equipment, at
December 31, 2004. The net book value of the Company's premises and equipment
was $6.8 million at that date.
Management believes that the facilities are of sound construction and in good
operating condition, are appropriately insured and are adequately equipped for
carrying on the business of the Bank.
ITEM 3. Legal Proceedings
The Company and the Bank from time to time are party to various legal
proceedings arising in the ordinary course of business. Management believes that
there are no threatened or pending proceedings against the Company or the Bank
which, if determined adversely, would have a material effect on its business or
financial condition.
ITEM 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders in the fourth quarter of
2004.
13
PART II
ITEM 5. Market for Registrant's Common Equity, Related Stockholder Matters, and
Issuer Purchases of Equity Securities
The Company's common stock is presently traded on the OTC Bulletin Board under
the trading symbol "PFLC.OB". Prior to March 2004, our common stock was not
listed and was only traded in private transactions. Accordingly, the prices
reported and listed below for periods prior to the second quarter of the 2004
fiscal year reflect only transactions known and reported to management. Because
only limited information is available, the data may not accurately reflect all
trades that occurred. Historically, trading in our stock has been very limited
and the trades that have occurred cannot be characterized as amounting to an
established public trading market, even since March 2004. As a result, the
trading prices of our common stock may not reflect the price that would result
if our stock was actively traded at high volumes.
Effective January 1, 2005, the Company appointed Mellon Investor Services LLC to
serve as the transfer agent for our common stock. Prior to that date, the
Company served as its own transfer agent.
2004 2003
Shares Traded(1) High(1) Low(1) Shares Traded(1) High(1) Low(1)
First Quarter 23,970 $ 17.25 $ 17.00 11,774 $ 13.50 $ 12.38
Second Quarter 85,362 $ 17.50 $ 15.25 10,973 $ 15.00 $ 14.00
Third Quarter 79,510 $ 17.50 $ 16.25 8,220 $ 15.50 $ 15.00
Fourth Quarter 8,638 $ 17.50 $ 17.00 3,730 $ 16.75 $ 15.50
(1) All prices and numbers of shares have been retroactively adjusted for a
two-for-one stock split to be paid on April 4, 2005.
As of December 31, 2004, there were approximately 1,229 shareholders of record
of the Company's common stock.
The Company's Board of Directors declared dividends on its common stock in
December 2004 and 2003 in the amounts per share of $.72 and $.70,
respectively. The Board of Directors has adopted a dividend policy which is
reviewed annually. There can be no assurance the Company will continue to
increase its dividend or declare and pay dividends at historical rates.
Payment of dividends is subject to regulatory limitations. Under federal banking
law, the payment of dividends by the Company and the Bank is subject to capital
adequacy requirements established by the Federal Reserve and the FDIC. Under
Washington general corporate law as it applies to the Company, no cash dividend
may be declared or paid if, after giving effect to the dividend, the Company is
insolvent or its liabilities exceed its assets. Payment of dividends on the
Common Stock is also affected by statutory limitations, which restrict the
ability of the Bank to pay upstream dividends to the Company. Under Washington
banking law as it applies to the Bank, no dividend may be declared or paid in an
amount greater than net profits then available, and after a portion of such net
profits have been added to the surplus funds of the Bank. Under applicable
restrictions, as of December 31, 2004, the Bank could declare dividends totaling
$5,707,000 without obtaining prior regulatory approval.
14
ITEM 6. Selected Financial Data
On February 27, 2004, the Company completed its acquisition of BNW. BNW, through
its operating subsidiary Bank NorthWest, operated five banking locations in
Whatcom County, Washington, including its largest city, Bellingham, Washington,
and as of the date of acquisition had total assets of approximately $120.0
million, total loans of approximately $110.7 million, total deposits of
approximately $87.8 million, and total shareholders' equity of approximately
$7.2 million.
The historical information in the selected consolidated financial data below
reflects major variances for the year 2004 compared to the prior year due to the
inclusion of assets acquired in the BNW merger. For instance, the loan portfolio
acquired in the acquisition contributed approximately $7.5 million in interest
income since the February 27th acquisition date, while the increased interest
expense associated with acquired loans totaled approximately $1.2 million,
meaning approximately $6.3 million in 2004 net interest income can be attributed
to loans acquired in the BNW acquisition. Noninterest income increased
approximately $1.2 million due to the acquisition, while noninterest expense
increased approximately $5.6 million.
The acquisition was accounted for using the purchase method of accounting and,
accordingly, the assets and liabilities of BNW were recorded at their respective
fair value. Goodwill, the excess of the purchase price over the net fair value
of the assets and liabilities acquired, was recorded at $11.3 million. As part
of the accounting for the acquisition, the Company recorded a core deposit
identifiable intangible asset of $993,000. The core deposit intangible recorded
as part of the acquisition has an estimated life of seven years. Estimated
amortization expense was approximately $118,000 for the year ended December 31,
2004 and is estimated to total $142,000 annually for the years ended December
31, 2005 through 2010, and $23,000 for the year ended December 31, 2011.
The following table sets forth certain selected consolidated financial data of
the Company at and for the years ended December 31:
2004 2003 2002 2001 2000
------------------------------------------------------
($ in thousands, except per share data)
Operations Data
Net interest income $ 19,520 $ 12,541 $ 11,788 $ 11,572 $ 11,675
Provision for credit losses 970 -- 954 580 635
Noninterest income 3,162 1,846 2,059 1,529 1,217
Noninterest expense 13,555 7,945 7,414 7,193 7,530
Provision for income taxes 2,450 1,863 1,563 1,521 1,424
Net income 5,707 4,579 3,916 3,807 3,303
Net income per share:
Basic .93(1) .91(1) .79(1) .77(1) .67(1)
Diluted .91(1) .90(1) .78(1) .76(1) .66(1)
Dividends declared 4,624 3,530 3,392 3,289 3,204
Dividends declared per share .72(1) .70(1) .68(1) .66(1) .64(1)
Dividends paid ratio 81% 77% 87% 86% 97%
(1) Retroactively adjusted for a two-for-stock split to be paid April 4, 2005.
15
Performance Ratios
Interest rate spread 5.34% 4.89% 5.18% 5.28% 5.24%
Net interest margin (1) 5.25% 4.75% 5.05% 5.16% 5.14%
Efficiency ratio (2) 59.76% 55.22% 53.54% 54.90% 58.41%
Return on average assets 1.41% 1.61% 1.54% 1.55% 1.34%
Return on average equity 14.21% 17.10% 15.81% 15.57% 14.95%
Balance Sheet Data
Total assets $ 441,791 306,715 268,534 243,617 253,313
Loans, net 341,671 197,500 183,031 174,495 175,142
Total deposits 363,501 260,800 225,254 214,644 213,511
Other borrowings 25,233 14,500 12,800 -- 11,358
Shareholders' equity 45,303 25,650 24,683 23,514 22,743
Book value per share (3) 7.06(1) 5.09(1) 4.91(1) 4.72(1) 4.55(1)
Equity to assets ratio 10.25% 8.36% 9.19% 9.65% 8.98%
(1) Retroactively adjusted for a two-for-stock split to be paid April 4, 2005.
Asset Quality Ratios
Nonperforming loans to total loans .15% .27% 1.00% .71% 1.93%
Allowance for loan losses
to total loans 1.23% 1.12% 1.33% 1.19% 1.14%
Allowance for loan losses
to nonperforming loans 832.22% 411.40% 132.67% 168.18% 59.24%
Nonperforming assets to
total assets .12% .18% .69% .51% 1.35%
(1) Net interest income divided by average earning assets.
(2) Non-interest expense divided by the sum of net interest income and
non-interest income.
(3) Shareholder equity divided by shares outstanding.
16
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with Pacific's audited
consolidated financial statements and related notes appearing elsewhere in this
report. In addition, please refer to Pacific's forward-looking statement
disclosure included in Part I of this report.
RESULTS OF OPERATIONS
Years ended December 31, 2004, 2003, and 2002
General. The Company's net income for 2004 was $5,707,000, a 24.6% increase
compared to $4,579,000 in 2003, and an increase of 16.9% from $3,916,000 in
2002. Basic earnings per share were $.93, $.91, and $.79 for 2004, 2003, and
2002, respectively. Return on average assets was 1.41%, 1.61%, and 1.54% in
2004, 2003, and 2002, respectively. Return on average equity was 14.21%, 17.10%,
and 15.81%, respectively, in 2004, 2003, and 2002. The increase in net income
for the current year is primarily due to the acquisition of BNW Bancorp, Inc.
effective February 27, 2004, coupled with increased lending volume. Reductions
in return on average assets and return on average equity can be attributed to
the costs of the acquisition, as well as the addition of goodwill associated
with the purchase accounting treatment of the transaction.
The following table presents condensed consolidated statements of income for the
Company for each of the years in the three-year period ended December 31, 2004.
Increase Increase
(Decrease) (Decrease)
---------- ----------
(Dollars in thousands) 2004 Amount % 2003 Amount % 2002
- ---------------------------------------------------------------------------------------------
Interest income $24,138 $8,189 51.3 $15,949 $170 1.1 $15,779
Interest expense 4,618 1,210 35.5 3,408 (583) (14.6) 3,991
Net interest income 19,520 6,979 55.6 12,541 753 6.4 11,788
Provision for credit losses 970 970 100.0 -- (954) (100.0) 954
Net interest income after
provision for credit losses 18,550 6,009 47.9 12,541 1,707 15.8 10,834
Other operating income 3,162 1,316 71.3 1,846 (213) (10.3) 2,059
Other operating expense 13,555 5,610 70.6 7,945 531 7.2 7,414
Income before income taxes 8,157 1,715 26.6 6,442 963 17.6 5,479
Income taxes 2,450 587 31.5 1,863 300 19.2 1,563
Net income 5,707 1,128 24.6 4,579 663 16.9 3,916
Net Interest Income. The Company derives the majority of its earnings from net
interest income, which is the difference between interest income earned on
interest earning assets and interest expense incurred on interest bearing
liabilities. The following table sets forth information with regard to average
balances of the interest earning assets and interest bearing liabilities and the
resultant yields or cost, net interest income, and the net interest margin.
17
Year Ended December 31,
-----------------------
2004 2003 2002
---- ---- ----
Interest Interest Interest
Average Income Avg Average Income Avg Average Income Avg
Balance (Expense) Rate Balance (Expense) Rate Balance (Expense) Rate
(dollars in thousands)
Assets
Earning assets:
Loans $315,364 $ 21,881* 6.94% $188,267 $ 13,381* 7.11% $178,765 $ 13,212* 7.39%*
Investment Securities:
Taxable 34,174 1,415 4.14% 48,206 1,738 3.61% 32,991 1,541 4.67%
Tax-Exempt 17,795 1,165* 6.55% 14,721 1,050* 7.13% 14,510 1,165* 8.03%
Total investment
securities 51,969 2,580 4.96% 62,927 2,788 4.43% 47,501 2,706 5.70%
Federal Home Loan Bank Stock 1,114 60 5.39% 887 49 5.52% 3,102 186 6.01%
Federal funds sold and
deposits in banks 3,329 44 1.32% 11,855 118 1.00% 5,644 107 1.90%
Total earning assets/interest
income $371,776 $ 24,565 6.61% $263,936 $ 16,336 6.18% $235,013 $ 16,211 6.90%
Cash and due from banks 9,866 7,930 8,331
Bank premises and equipment
(net) 6,200 3,780 3,930
Other assets 21,087 10,448 9,552
Allowance for credit losses (3,555) (2,357) (2,515)
Total assets $405,374 $283,737 $254,310
Liabilities and Shareholders' Equity
Interest bearing liabilities:
Deposits:
Savings and interest-
bearing demand $155,846 $ (1,273) .82% $112,129 $ (827) .74% $104,111 $ (1,080) 1.04%
Time 112,078 (2,461) 2.20% 86,634 (2,096) 2.42% 79,664 (2,667) 3.35%
Total deposits 267,924 (3,734) 1.39% 198,763 (2,923) 1.47% 183,775 (3,747) 2.04%
Short-term borrowings 7,825 (96) 1.23% -- -- -- 174 (4) 2.48%
Long-term borrowings 17,000 (549) 3.23% 14,071 (485) 3.45% 6,548 (240) 3.67%
Secured borrowings 4,078 (239) 5.86% -- -- -- -- -- --
Total interest-bearing liabilities/
Interest expense $296,827 $ (4,618) 1.56% $212,834 $ (3,408) 1.60% $190,497 $ (3,991) 2.10%
Demand deposits 66,135 42,864 36,180
Other liabilities 2,258 1,253 2,867
Shareholders' equity 40,154 26,786 24,766
Total liabilities and shareholders'
equity $405,374 $283,737 $254,310
Net interest income $ 19,947* $ 12,928* $ 12,220*
Net interest income as a percentage of
average earning assets
Interest income 6.61% 6.18% 6.90%
Interest expens 1.24% 1.29% 1.72%
Net interest income 5.37% 4.89% 5.18%
Net interest margin (1) 5.25% 4.75% 5.05%
* Tax equivalent basis - 34% tax rate used
(1) Net interest income divided by average interest earning assets
Nonaccrual loans are included in "loans."
Interest income on loans include loan fees of $1,572,500, $1,003,182, and
$778,605 in 2004, 2003, and 2002, respectively.
For purposes of computing the average yield, the Company used historical cost
balances which do not give effect to changes in fair value that are reflected as
a component of shareholders' equity.
Net interest income increased 55.6% to $19,520,000 in 2004 compared to 2003. The
increase is primarily the result of the acquisition of BNW. The Company's
interest income increased 51.3% to $24,138,000 in
18
2004 from $15,949,000 in 2003. This increase is due to the increased balances in
loans. The continued low interest rates for most of 2004 allowed the Company to
maintain a reasonable cost of funds ratio. Although interest expense increased
to $4,618,000 in 2004, compared to $3,408,000 in 2003 due primarily to the BNW
acquisition, the cost of funds ratio decreased slightly to 1.24% in 2004
compared to 1.29% in 2003. Net interest income increased 6.4% to $12,541,000 in
2003 compared to 2002. The increase was primarily the result of no provision for
credit losses as a result of an improvement in the quality of the credit
portfolio. The Company's interest income increased 1.1% to $15,949,000 in 2003
from $15,779,000 in 2002. The increase was due to increased balances in interest
bearing deposits in banks, fed funds sold, securities and loans.
The Company's average loan portfolio increased $127,097,000, or 67.5%, from year
end 2003 to year end 2004, and increased $9,502,000, or 5.3%, from 2002 to 2003.
The growth in 2004 is primarily due to the acquisition of BNW effective February
27, 2004. Growth during 2003 was primarily due to opening of a loan production
office on August 1, 2003 in Gearhart, Oregon. A large portion of the Company's
loan portfolio rates are tied to variable rate indexes. Given the unprecedented
low interest rate environment since 2002, the Company is positioned well for
rate increases the Federal Reserve has indicated will continue.
The Company's average investment portfolio decreased $10,958,000 or 17.4% from
2003. The decrease was due to maturing investments being utilized to fund loan
production. The Company's average investment portfolio increased $15,426,000, or
32.5%, during 2003 from 2002. The changes in 2003 were invested in various
long-term investment products, resulting in an increase in earnings.
The Company's average deposits increased $69,161,000 or 34.8% from 2003, and
increased $14,988,000 or 8.2% in 2003 from 2002. The primary reason for the
increase in 2004 is due to the acquisition of BNW and continuation of its
targeted marketing program after the acquisition. Deposit growth in Pacific's
historical markets during 2004 totaled $20.7 million, or 8%.
The Company increased its average borrowings during 2004 by $10,754,000 or
76.4%. These borrowings consist of advances from the Federal Home Loan Bank of
Seattle. The proceeds were used to fund loan growth. The Company increased its
average borrowings during 2003 by $7,523,000 or 114.9%. Secured borrowings
increased to $3,733,000 compared to none the previous year. The secured
borrowings at December 31, 2004 represent borrowings collateralized by
participation interests in loans originated by the Company. These borrowings are
repaid as payments are made on the underlying loans, bearing interest rates
ranging from 5.75% to 8.5%.
Net interest margins were 5.25%, 4.75%, and 5.05%, for the years ended December
31, 2004, 2003, and 2002, respectively.
19
The following table presents changes in net interest income attributable to
changes in volume or rate. Changes not solely due to volume or rate are
allocated to volume and rate based on the absolute values of each.
2004 compared to 2003 2003 compared to 2002
-------------------------- --------------------------
Increase (decrease) due to Increase (decrease) due to
(dollars in thousands) -------------------------- --------------------------
Volume Rate Net Volume Rate Net
------ ---- --- ------ ---- ---
Interest earned on:
Loans $8,798 $(298) $8,500 $687 $(518) $169
Securities:
Taxable (582) 259 (323) 602 (405) 197
Tax-exempt 206 (91) 115 17 (132) (115)
Total securities (376) 168 (208) 619 (537) 82
Federal Home Loan Bank Stock 32 (21) 11 (123) (14) (137)
Fed funds sold and
interest bearing deposits
in other banks (104) 30 (74) 79 (68) 11
Total interest earning assets 8,350 (121) 8,229 1,262 (1,137) 125
Interest paid on:
Savings and interest bearing
demand deposits (350) (96) (446) (78) 331 253
Time deposits (572) 207 (365) (218) 789 571
Other borrowings (299) 139 (160) (254) 13 (241)
Secured borrowings (239) -- (239) -- -- --
Total interest bearing liabilities (1,221) 250 (1,210) (550) 1,133 583
Change in net interest income 6,890 129 7,019 712 (4) 708
Non-Interest Income. Non-interest income was $3,162,000 for 2004, an increase of
$1,316,000 or 71.3% from 2003 when it totaled $1,846,000. The 2003 amount was a
decrease of $213,000 or 10.3% compared to the 2002 total of $2,059,000.
The following table represents the principal categories of non-interest income
for each of the years in the three-year period ended December 31, 2004.
Increase Increase
(Decrease) (Decrease)
---------- ----------
(Dollars in thousands) 2004 Amount % 2003 Amount % 2002
- -----------------------------------------------------------------------------------------------------
Service charges on
deposit accounts $1,297 $270 26.3% $1,027 $(42) (3.9%) $1,069
Mortgage broker fees 12 (89) (88.1%) 101 98 326.7% 3
Income from and gains on sale of
foreclosed real estate 77 51 196.2% 26 (266) (91.1%) 292
Net gains from sales of loans 1,026 992 2917.7% 34 34 100.0% --
Net gain on sale of securities 3 (1) (25.0%) 4 4 100.0% --
Earnings on bank owned life insurance 378 50 15.2% 328 (22) (6.3%) 350
Other operating income 369 45 13.2% 326 (19) (5.5%) 345
Total non-interest income 3,162 1,316 71.3% 1,846 (213) (10.3%) 2,059
20
In 2004, service charges on deposit accounts increased $270,000 or 26.3% to a
total of $1,297,000 compared to $1,027,000 in 2003. The 2003 total was down
$42,000 or 3.9% compared to the 2002 total of $1,069,000. The increase in 2004
was attributable primarily to the BNW acquisition.
Income from sources other than service charges on deposit accounts totaled
$1,865,000 in 2004, an increase of $1,046,000 from 2003, or 127.7%. The primary
reason for the increase was the acquisition of BNW and gains on sale of loans,
which totaled $1,026,000 during 2004. Other major components of non-interest
income were gains on sale of foreclosed real estate and bank owned life
insurance income. Income from other sources for 2003 was $819,000, a decrease of
$171,000 or 17.3% compared to 2002, primarily due to a decrease from foreclosed
real estate income and gain on sale of foreclosed real estate.
Non-Interest Expense. Total non-interest expense in 2004 was $13,555,000, an
increase of $5,610,000 or 70.6% compared to $7,945,000 in 2003. In 2003
non-interest expense increased $531,000 or 7.2% compared to $7,414,000 in 2002.
The following table represents the principal categories of non-interest expense
for each of the years in the three-year period ended December 31, 2004.
Increase Increase
(Decrease) (Decrease)
---------- ----------
(Dollars in thousands) 2004 Amount % 2003 Amount % 2002
- -----------------------------------------------------------------------------------------------
Salaries and employee benefits $ 8,134 $ 3,370 70.7% $ 4,764 $ 568 13.5% $ 4,196
Occupancy and equipment 1,588 623 64.6% 965 (19) (1.9%) 984
State taxes 306 237 343.5% 69 (137) (66.5%) 206
Data processing 614 309 101.3% 305 37 13.8% 268
Other expense 2,913 1,071 58.1% 1,842 82 4.7% 1,760
Total non-interest expense $13,555 $ 5,610 70.6% $ 7,945 $ 531 7.2 $ 7,414
Salary and employee benefits increased by $3,370,000, or 70.7%, in 2004 to
$8,134,000 and increased by $568,000, or 13.5%, in 2003 compared to 2002. Salary
and benefits increased primarily due to a larger employee base in 2004, the
result of the BNW acquisition, in addition to normal merit increases. At the
time of acquisition, the Company had 96 full time equivalent employees and BNW
employed 52 full time equivalent employees. At year end, the Bank had 157 full
time equivalent employees.
Occupancy and equipment expense increased $623,000 or 64.6% in 2004 and
decreased $19,000 or 1.9% in 2003. The increase in 2004 relates directly to the
BNW acquisition. BNW operated five locations in its market area. Three of the
branches, including the Barkley branch, Birch Bay branch and Lynden branch
operate in leased facilities. Two branches, the Bellingham branch and Everson
branch, are owned by the Company. The decrease in 2003 was due to reduced
equipment depreciation expenses.
State taxes paid in 2004 totaled $306,000, an increase of $237,000 or 343.5% due
to increased revenues. State taxes paid in 2003 decreased $137,000 or 66.5%
compared to 2002. This was the result of a tax refund pertaining to an
application filed by the Company with the Washington State Department of Revenue
for overpayment of business and occupation tax.
Data processing expense increased $309,000 or 101.3% in 2004 due to the BNW
acquisition. Although it was planned to consolidate BNW data processing
operations into the Company's systems during 2004, the conversion was delayed
into 2005. Accordingly, the Company was not able to realize the savings
associated with the conversion during 2004.
21
The $1,071,000 or 58.1% increase in other expense in 2004 was due primarily to
the BNW acquisition, including travel expense, core deposit intangible
amortization expense, loan expense and marketing expense. In addition, costs
associated with implementing section 404 of the Sarbanes-Oxley Act resulted in a
direct increase in compliance expense of approximately $170,000.
CRITICAL ACCOUNTING POLICIES
The Company's consolidated financial statements are prepared in accordance with
accounting principles generally accepted in the United States of America. The
financial information contained within these statements is, to a significant
extent, financial information that is based on approximate measures of the
financial effects of transactions and events that have already occurred. Based
on its evaluation of accounting policies that involve the most complex and
subjective decisions and assessments, management has identified its most
critical accounting policy as related to the allowance for credit losses. The
Company's allowance for credit loss methodology incorporates a variety of risk
considerations, both quantitative and qualitative, in establishing an allowance
for credit losses that management believes is appropriate at each reporting
date. Quantitative factors include the Company's historical loss experience,
delinquency and charge-off trends, collateral values, changes in nonperforming
loans, and other factors. Quantitative factors also incorporate known
information about individual loans, including borrowers' sensitivity to interest
rate movements. Qualitative factors include the general economic environment in
the Company's markets, including economic conditions and, in particular, the
state of certain industries. Size and complexity of individual credits in
relation to loan structure, existing loan policies and pace of portfolio growth
are other qualitative factors that are considered in the methodology. As the
Company adds new products and increases the complexity of its loan portfolio, it
intends to enhance its methodology accordingly. A materially different amount
could be reported for the provision for credit losses in the statement of
operations to change the allowance for credit losses if management's assessment
of the above factors were different. This discussion and analysis should be read
in conjunction with the Company's financial statements and the accompanying
notes presented elsewhere herein, as well as the portion of this Management's
Discussion and Analysis section entitled "LENDING - Allowance and Provision for
Credit Losses." Although management believes the levels of the allowance as of
both December 31, 2004 and 2003 were adequate to absorb losses inherent in the
loan portfolio, a decline in local economic conditions, or other factors, could
result in increasing losses that cannot reasonably be predicted at this time.
Goodwill is initially recorded when the purchase price paid for an acquisition
exceeds the estimated fair value of the net identified tangible and intangible
assets acquired. Goodwill is presumed to have an indefinite useful life and is
tested, at least annually, for impairment at the reporting unit level. The
Company performs an annual review each year, or more frequently if indicators of
potential impairment exists, to determine if the recorded goodwill is impaired.
The Company's impairment review process compares the fair value of the Company
to its carrying value, including the goodwill related to the Company. If the
fair value exceeds the carrying value, goodwill of the Company is not considered
impaired and no additional analysis is necessary. As of December 31, 2004, there
have been no events or changes in circumstances that would indicate a potential
impairment.
ASSET AND LIABILITY MANAGEMENT
The largest component of the Company's earnings is net interest income. Interest
income and interest expense are affected by general economic conditions,
competition in the market place, market interest rates and repricing and
maturity characteristics of the Company's assets and liabilities. Exposure to
interest rate risk is primarily a function of differences between the maturity
and repricing schedules of assets (principally loans and investment securities)
and liabilities (principally deposits). Assets and liabilities are described as
interest sensitive for a given period of time when they mature or can reprice
within that period. The difference between the amount of interest sensitive
assets
22
and interest sensitive liabilities is referred to as the interest sensitive
"GAP" for any given period. The "GAP" may be either positive or negative. If
positive, more assets reprice than liabilities. If negative, the reverse is
true.
Certain shortcomings are inherent in the interest sensitivity "GAP" method of
analysis. Complexities such as prepayment risk and customer responses to
interest rate changes are not taken into account in the "GAP" analysis.
Accordingly, management also utilizes a net interest income simulation model to
measure interest rate sensitivity. Simulation modeling gives a broader view of
net interest income variability, by providing various rate shock exposure
estimates. Management regularly reviews the interest rate risk position and
provides measurement reports to the Board of Directors.
The following table shows the dollar amount of interest sensitive assets and
interest sensitive liabilities at December 31, 2004 and differences between them
for the maturity or repricing periods indicated.
Due after
Due in one one through Due after
(dollars in thousands) year or less five years five years Total
- -------------------------------------------------------------------------------------------------
Interest earning assets
Loans, including loans held for sale $ 165,783 $ 96,443 $ 85,533 $ 347,759
Investment securities 9,329 18,935 14,726 42,990
Fed Funds and interest
bearing balances with banks 11,494 -- -- 11,494
Federal Home Loan Bank Stock -- -- 1,850 1,850
Total interest earning assets $ 186,606 $ 115,378 $ 102,109 $ 404,093
Interest bearing liabilities
Interest bearing demand deposits $ 55,650 $ -- $ -- $ 55,650
Savings deposits 123,784 -- -- 123,784
Time deposits 84,076 28,280 -- 112,356
Long term borrowings 5,000 16,500 -- 21,500
Secured borrowings -- -- 3,733 3,733
Total interest bearing liabilities $ 268,510 $ 44,780 $ 3,733 $ 317,023
Net interest rate sensitivity GAP $ (81,904) $ 70,598 $ 98,376 $ 87,070
Cumulative interest rate sensitivity GAP $ (11,306) $ 87,070 $ 87,070
Cumulative interest rate sensitivity GAP
as a % of earning assets (2.8%) 21.5% 21.5%
The following table shows the dollar amount of interest sensitive assets and
interest sensitive liabilities at December 31, 2003 and difference between them
for the maturity or repricing periods indicated.
Due after
Due in one one through Due after
(dollars in thousands) year or less five years five years Total
- -------------------------------------------------------------------------------------------------
Loans $ 78,261 $ 43,407 $ 78,070 $ 199,738
Investment securities 27,136 21,652 16,673 65,461
Fed Funds and interest
bearing balances with banks 20,392 -- -- 20,392
Federal Home Loan Bank Stock -- -- 915 915
Total interest earning assets $ 125,789 $ 65,059 $ 95,658 $ 286,506
23
Interest bearing liabilities
Interest bearing demand deposits $ 47,388 $ -- $ -- $ 47,388
Savings deposits 84,105 -- -- 84,105
Time deposits 59,040 26,405 -- 85,445
Long term borrowings 2,000 6,500 6,000 14,500
Total interest bearing liabilities $ 192,533 $ 32,905 $ 6,000 $ 231,438
Net interest rate sensitivity GAP $ (66,744) $ 32,154 $ 89,658 $ 55,068
Cumulative interest rate sensitivity GAP $ (34,590) $ 55,068 $ 55,068
Cumulative interest rate sensitivity GAP
as a % of earning assets (12.1%) 19.2% 19.2%
Effects of Changing Prices. The results of operations and financial conditions
presented in this report are based on historical cost information, and are
unadjusted for the effects of inflation. Since the assets and liabilities of
financial institutions are primarily monetary in nature, the performance of the
Company is affected more by changes in interest rates than by inflation.
Interest rates generally increase as the rate of inflation increases, but the
magnitude of the change in rates may not be the same.
The effects of inflation on financial institutions is normally not as
significant as its influence on businesses which have investments in plants and
inventories. During periods of high inflation there are normally corresponding
increases in the money supply, and financial institutions will normally
experience above-average growth in assets, loans and deposits. Inflation does
increase the price of goods and services, and therefore operating expenses
increase during inflationary periods.
INVESTMENT PORTFOLIO
The Company's investment securities portfolio decreased $22,471,000, or 34.3%
during 2004 to $42,990,000 at year end from $65,461,000 in 2003, which was a
$2,869,000 increase over 2002. The changes in 2004 were primarily in other
securities as the Company liquidated the majority of the mutual funds it held.
Proceeds from sales were used to fund loans. The changes in 2003 were primarily
in U.S. Government agency mortgaged backed securities.
The carrying values of investment securities at December 31 in each of the last
three years are as follows:
HELD TO MATURITY
(dollars in thousands) 2004 2003 2002
- --------------------------------------------------------------------------------
U.S. Agencies securities $1,714 $2,944 $ 6,611
Obligations of states and political subdivisions 5,496 5,044 3,751
Total $7,210 $7,988 $10,362
AVAILABLE FOR SALE
(dollars in thousands) 2004 2003 2002
- --------------------------------------------------------------------------------
U.S. Agencies securities $14,778 $18,030 $19,164
Obligations of states and political subdivisions 12,942 14,751 12,098
Other securities 8,060 24,692 20,968
Total $35,780 $57,473 $52,230
24
The following table presents the maturities of investment securities at December
31, 2004. Taxable equivalent values are used in calculating yields assuming a
tax rate of 34%.
HELD TO MATURITY
Due after Due after
Due in one one through five through Due after
(dollars in thousands) year or less five years ten years ten years Total
- -----------------------------------------------------------------------------------------------
U.S. Agency securities $ -- $ -- $ -- $1,714 $ 1,714
Weighted average yield -- -- -- 4.82%
Obligations of states and political
subdivisions $ -- $ 2,371 $1,205 $1,920 $ 5,496
Weighted average yield -- 4.41% 6.91% 6.89%
Total $ -- $ 2,371 $1,205 $3,634 $ 7,210
AVAILABLE FOR SALE
Due after Due after
Due in one one through five through Due after
(dollars in thousands) year or less five years ten years ten years Total
- -----------------------------------------------------------------------------------------------
U.S. Agency securities $1,606 $ 5,033 $3,289 $4,850 $14,778
Weighted average yield 3.05% 3.16% 4.75% 4.66%
Obligations of states and political
subdivisions $1,773 $ 5,662 $3,361 $2,146 $12,942
Weighted average yield 7.08% 7.75% 8.99% 8.34%
Other securities $5,950 $ 2,111 -- -- $ 8,060
Weighted average yield 4.43% 4.54% -- --
Total $9,329 $12,806 $6,650 $6,995 $35,780
LENDING
General. The Company's policy is to originate loans primarily in its local
markets. Depending on the purpose of the loan, the loans may be secured by a
variety of collateral, including business assets, real estate, and personal
assets.
The following table sets forth the composition of the Company's loan portfolio
at December 31 in each of the past five years.
(dollars in thousands) 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------
Commercial $111,050 $ 64,344 $ 69,794 $ 72,427 $ 68,827
Real Estate Construction 49,347 11,894 9,697 6,554 6,118
Real Estate Mortgage 176,011 117,940 101,151 91,714 96,334
Installment 9,653 4,625 4,114 4,941 4,612
Credit cards and overdrafts 1,979 935 1,034 968 1,277
Less unearned income (281) -- -- -- --
Total $347,759 $199,738 $185,790 $176,604 $177,168
25
Loan Maturities and Sensitivity in Interest Rates. The following table presents
information related to maturity distribution and interest rate sensitivity of
commercial and real estate construction loans outstanding, based on scheduled
repayments at December 31, 2004.
Due after
Due in one one through Due after
(dollars in thousands) year or less five years five years Total
- -------------------------------------------------------------------------------
Commercial $ 33,132 $ 35,966 $ 41,952 $111,050
Real estate construction 29,612 10,016 9,719 49,347
Total $ 62,744 $ 45,982 $ 51,671 $160,397
Total loans maturing after one year with
Predetermined interest rates (fixed) $ 31,903 $ 73,355 $105,258
Floating or adjustable rates (variable) 64,784 5,446 70,230
Total $ 96,687 $ 78,801 $175,488
At December 31, 2004, 22.1% of the total loan portfolio presented above was due
in one year or less.
Risk Elements. Risk elements include accruing loans past due ninety days or
more, non-accrual loans, and loans which have been restructured to provide
reduction or deferral of interest or principal for reasons related to the
debtor's financial difficulties. The Company's policy for placing loans on
non-accrual status is based upon management's evaluation of the ability of the
borrower to meet both principal and interest payments as they become due.
Generally, loans with interest or principal payments which are ninety or more
days past due are placed on non-accrual, unless they are well-secured and in the
process of collection, and the interest accrual is reversed against income.
The following table presents information related to the Company's non-accrual
loans and other non-performing assets at December 31 in each of the last five
years.
(dollars in thousands) 2004 2003 2002 2001 2000
- -------------------------------------------------------------------------------
Non-accrual loans $ 470 $ 465 $ 1,864 $ 1,254 $3,128
Accruing loans past due
90 days or more -- -- 2 79 292
Restructured loans -- -- -- -- --
Foreclosed real estate owned 40 98 686 1,040 --
Non-accrual loans increased approximately $5,000 to $470,000 in 2004 from 2003.
The total is net of charge-offs based on management's estimate of fair market
value or the result of appraisals. The balance consists of real estate and a
commercial loan guaranteed by the SBA. During 2004, sales of foreclosed real
estate owned totaled $58,000.
Non-accrual loans decreased $1,399,000 to $465,000 at year-end 2003 after
increasing to $1,864,000 in 2002 from $1,254,000 in 2001. The non-accrual loans
in 2000 were attributable to the decline in the regional and national economies
and the local agriculture economy. Interest income on non-accrual loans that
would have been recorded had those loans performed in accordance with their
initial terms, as of December 31, was $8,000 for 2004, $37,000 for 2003,
$118,000 for 2002, $75,000 for 2001, and $168,000 for 2000. Interest income
recognized on impaired loans for 2004 was $16,000, for 2003 was $19,000, for
2002 was $13,000, for 2001 was $2,000, and for 2000 was $31,000.
26
Loan Concentrations. The Company has credit risk exposure related to real estate
loans. The Company makes real estate loans for construction and loans for other
purposes which are secured by real estate. At December 31, 2004, loans secured
by real estate totaled $225,358,000, which represents 64.8% of the total loan
portfolio. Real estate construction loans comprised $49,347,000 of that amount,
while real estate loans secured by residential properties totaled $52,339,000.
As a result of these concentrations of loans, the loan portfolio is susceptible
to changes in economic and market conditions in the Company's market areas. The
Company generally requires collateral on all real estate exposures and typically
maintains loan-to-value ratios of no greater than 80%.
Allowance and Provision for Credit Losses. The allowance for credit losses
reflects management's current estimate of the amount required to absorb losses
on existing loans and commitments to extend credit. Loans deemed uncollectible
are charged against and reduce the allowance. Periodically, a provision for
credit losses is charged to current expense. This provision acts to replenish
the allowance for credit losses and to maintain the allowance at a level that
management deems adequate. There is no precise method of predicting specific
loan losses or amounts that ultimately may be charged off on segments of the
loan portfolio. The determination that a loan may become uncollectible, in whole
or in part, is a matter of judgment. Similarly, the adequacy of the allowance
for credit losses can be determined only on a judgmental basis, after full
review, including (a) consideration of economic conditions and the effect on
particular industries and specific borrowers; (b) a review of borrowers'
financial data, together with industry data, the competitive situation, the
borrowers' management capabilities and other factors; (c) a continuing
evaluation of the loan portfolio, including monitoring by lending officers and
staff credit personnel of all loans which are identified as being of less than
acceptable quality; (d) an in-depth appraisal, on a monthly basis, of all loans
judged to present a possibility of loss (if, as a result of such monthly
appraisals, the loan is judged to be not fully collectible, the carrying value
of the loan is reduced to that portion considered collectible); and (e) an
evaluation of the underlying collateral for secured lending, including the use
of independent appraisals of real estate properties securing loans. A formal
analysis of the adequacy of the allowance is conducted quarterly and is reviewed
by the Board of Directors. Based on this analysis, management considers the
allowance for credit losses to be adequate.
Periodic provisions for loan losses are made to maintain the allowance for
credit losses at an appropriate level. The provisions are based on an analysis
of various factors including historical loss experience based on volumes and
types of loans, volumes and trends in delinquencies and non-accrual loans,
trends in portfolio volume, results of internal and independent external credit
reviews, and anticipated economic conditions. Transactions in the allowance for
credit losses for the five years ended December 31, 2004 are as follows:
(dollars in thousands) 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------
Balance at beginning of year $2,238 $2,473 $2,109 $2,026 $1,930
Charge-offs:
Commercial 235 17 131 170 554
Real estate loans 18 239 461 366 --
Credit card 11 6 16 13 6
Installment 11 3 24 15 8
Total charge-offs $ 275 $ 265 $ 632 $ 564 $ 568
27
Recoveries:
Commercial $ 7 $ 5 $ 11 $ 54 $ 15
Real estate loans 123 23 28 12 11
Credit card 1 1 2 -- --
Installment -- 1 1 1 3
Total recoveries $ 131 $ 30 $ 42 $ 67 $ 29
Net charge-offs (recoveries) 144 235 590 497 539
Provision for credit losses 970 -- 954 580 635
BNW Bancorp, Inc. acquisition 1,172 -- -- -- --
Balance at end of year $4,236 $2,238 $2,473 $2,109 $2,026
Ratio of net charge-offs (recoveries)
to average loans outstanding .05% .12% .33% .29% .33%
The allowance for credit losses was $4,236,000 at year-end 2004, compared with
$2,238,000 at year-end 2003, an increase of $1,998,000 or 89.3%. The aggregate
increase resulted from the BNW acquisition and a provision of $970,000 in 2004.
The increased level of allowance for credit losses was primarily due to the
growth of the loan portfolio. Changes in the composition of the loan portfolio
included a 72.6% increase in commercial loans, while real estate construction
and real estate mortgage loans increased 73.7%. Estimated loss factors used in
the allowance for credit loss analysis are established based in part on historic
charge-off data by loan category and economic conditions. Based on the trends in
historical charge-offs analysis, the loss factors used in the allowance for
credit loss analysis for commercial loans and real estate loans were increased
during the year ended December 31, 2004.
Based on the methodology used for credit loss analysis, management deemed the
allowance for credit losses of $4,236,000 at December 31, 2004 (1.23% of total
loans outstanding and 832.22% of non-performing loans) adequate to provide for
probable losses based on an evaluation of known and inherent risks in the loan
portfolio at that date.
In May 1993, the Financial Accounting Standards Board (FASB) issued SFAS No.
114, "Accounting by Creditors for Impairment of a Loan" and in October 1996,
issued SFAS No. 118, "Accounting by Creditors for Impairment of a Loan--Income
Recognition Disclosures, an amendment to SFAS No. 114". The Company measures
impaired loans based on the present value of expected future cash flows
discounted at the loan's effective interest rate or, as a practical expedient,
at the loan's observable market price or the fair market value of the collateral
if the loan is collateral dependent. The Company excludes loans that are
currently measured at fair value or at the lower of cost or fair value, and
certain large groups of smaller balance homogeneous loans that are collectively
measured for impairment.
The following table summarizes the Bank's impaired loans at December 31:
(dollars in thousands) 2004 2003 2002 2001 2000
- ---------------------------------------------------------------------------------------------------
Total Impaired Loans $7,934 $ 588 $ 2,314 $ 1,662 $ 3,128
Total Impaired Loans with Valuation Allowance 7,464 123 18 1,180 1,114
Valuation Allowance related to Impaired Loans 200 23 2 143 412
No allocation of the allowance for credit losses was considered necessary for
the remaining impaired loans. The balance of the allowance for credit losses in
excess of these specific reserves is available to absorb losses from all loans.
28
It is the Company's policy to charge-off any loan or portion of a loan that is
deemed uncollectible in the ordinary course of business. The entire allowance
for credit losses is available to absorb such charge-offs. The Company allocates
its allowance for credit losses primarily on the basis of historical data. Based
on certain characteristics of the portfolio, losses can be anticipated for major
loan categories.
The following table presents the allocation of the allowance for credit losses
among the major loan categories based primarily on their historical net
charge-off experience and other business considerations at December 31 in each
of the last five years.
% of % of % of % of % of
2004 Total 2003 Total 2002 Total 2001 Total 2000 Total
(Dollars in thousands) Reserve Loans Reserve Loans Reserve Loans Reserve Loans Reserve Loans
- ------------------------------------------------------------------------------------------------------
Commercial loans $1,680 32% 764 32% $ 967 37% $ 548 41% $ 689 39%
Real estate loans 2,432 65% 1,399 65% 1,406 60% 1,413 56% 1,256 58%
Consumer loans 124 3% 75 3% 100 3% 148 3% 81 3%
Total allowance $4,236 100% 2,238 100% $2,473 100% $2,109 100% $2,026 100%
Ratio of allowance for credit
losses to loans outstanding
at end of year 1.23% 1.12% 1.33% 1.19% 1.14%
The table indicates an increase of $916,000 in the allowance related to
commercial loans from December 31, 2003 to December 31, 2004, an increase of
$1,033,000 relating to real estate loans, and an increase of $49,000 related to
consumer loans. The primary reason for the increases and changes in percentage
allocations are due to the acquisition of BNW and the resulting changes in
portfolio mix. There was a decrease of $203,000 from December 31, 2002 to
December 31, 2003 in the allowance related to commercial loans, with additional
decreases of $7,000 in real estate loans and $25,000 in consumer loans during
the same period.
DEPOSITS
The Company's primary source of funds has historically been customer deposits. A
variety of deposit products are offered to attract customer deposits. The
products include non-interest bearing demand accounts, negotiable order of
withdrawal (NOW) accounts, savings accounts, and time deposits. Interest-bearing
accounts earn interest at rates established by management, based on competitive
market factors and the need to increase or decrease certain types of maturities
of deposits. The Company has succeeded in growing its deposit base over the last
three years despite increasing competition for deposits in our markets. The
Company believes that it has benefited from its local identity and superior
customer service. Attracting deposits remains integral to the Company's business
as it is the primary source of funds for loans and a major decline in deposits
or failure to attract deposits in the future could have an adverse effect on
operations.
29
The following table sets forth the average balances for each major category of
deposits and the weighted average interest rate paid for deposits for the
periods indicated.
(dollars in thousands) 2004 RATE 2003 RATE 2002 RATE
- --------------------------------------------------------------------------------------
Demand deposits $ 66,135 0.00% $ 42,864 0.00% $ 36,180 0.00%
Interest bearing demand deposits 49,547 .42% 33,251 .42% 29,137 .76%
Savings deposits 106,299 .87% 78,878 .87% 74,974 1.15%
Time deposits 112,078 2.20% 86,634 2.42% 79,664 3.35%
Total $334,059 1.39% $241,627 1.20% $219,955 1.70%
Maturities of time certificates of deposit as of December 31, 2004 are
summarized as follows:
Under Over
(dollars in thousands) $100,000 $100,000 Total
-------- -------- -----
3 months or less $26,928 $30,655 $57,583
Over 3 through 6 months 11,940 8,365 20,305
Over 6 through 12 months 5,185 1,003 6,188
Over 12 months 13,309 14,971 28,280
Total 57,362 54,994 112,356
Deposit growth in 2004 was largely attributable to the BNW acquisition. At
acquisition, BNW demand deposits totaled $16.3 million, interest bearing demand
deposits totaled $8.1 million, savings deposits totaled $25.6 million and time
deposits totaled $37.8 million for a total of $87.8 million. Since the
acquisition, demand deposits in the Whatcom market area have increased $5.6
million, interest bearing demand deposits have increased $751,000, savings
deposits have decreased $3 million and time deposits have decreased $15.5
million. The decrease in time deposits is primarily due to the non-renewal of
brokered time deposits acquired from BNW, as the Company traditionally has not
sought brokered deposits.
SHORT-TERM BORROWINGS
The following is information regarding the Company's short-term borrowings for
the years ended December 31, 2004, 2003 and 2002.
(dollars in thousands) 2004 2003 2002
- ---------------------------------------------------------------------------------------
Amount outstanding at end of period $ -- $-- $1,800
Weighted average interest rate thereon 0% 0% 1.35%
Maximum amount outstanding at any month end during period $22,313 $-- $2,790
Average amounts outstanding during the period 7,825 -- 174
Weighted average interest rate during period 1.23% 0% 2.48%
30
CONTRACTUAL OBLIGATIONS
The following is information regarding the Company's long-term obligations,
which consist of borrowings from the Federal Home Loan Bank of Seattle, premises
under operating leases and construction contract to build a branch for the year
ended December 31, 2004.
Payments due by Period
-------------------------------------------
Less than 1-3 3-5 More than
Total 1 year years years 5 years
Contractual obligations
- --------------------------------------------------------------------------------
Federal Home Loan Bank borrowings $21,500 $5,000 $7,000 $9,500 $--
Operating leases 648 -- 462 186 --
Construction contract 1,086 -- 1,086 -- --
Total long-term obligations $23,234 $5,000 $8,548 $9,686 $--
COMMITMENTS AND CONTINGENCIES
The Bank is party to financial instruments with off-balance-sheet risk in the
normal course of business to meet the financing needs of their customers. These
financial instruments include commitments to extend credit and standby letters
of credit, and involve, to varying degrees, elements of credit risk in excess of
the amount recognized on the consolidated balance sheets.
The Bank's exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit and standby
letters of credit is represented by the contractual amount of those instruments.
The Bank uses the same credit policies in making commitments and conditional
obligations as they do for on-balance-sheet instruments. A summary of the Bank's
commitments at December 31 is as follows:
2004 2003
Commitments to extend credit $75,188 $44,044
Standby letters of credit 3,997 2,715
KEY FINANCIAL RATIOS
Year ended December 31, 2004 2003 2002 2001 2000
- ---------------------------------------------------------------------------------------------
Return on average assets 1.41% 1.61% 1.54% 1.55% 1.34%
Return on average equity 14.21% 17.10% 15.81% 15.57% 14.95%
Average equity to average assets ratio 9.91% 9.44% 9.74% 9.96% 8.96%
Dividend payout ratio 81% 77% 87% 86% 97%
LIQUIDITY AND CAPITAL RESOURCES
Liquidity. The primary concern of depositors, creditors and regulators is the
Company's ability to have sufficient funds readily available to repay
liabilities as they mature. In order to ensure adequate funds are available at
all times, the Company monitors and projects the amount of funds required on a
daily basis. Through the Bank, the Company obtains funds from its customer base,
which provides a stable source of "core" demand and consumer deposits.
Other sources are available with borrowings from the Federal Home Loan Bank of
Seattle and correspondent banks. Liquidity requirements can also be met through
disposition of short-term assets. In management's opinion, the Company maintains
an adequate level of liquid assets, consisting of cash and
31
due from banks, interest bearing deposits with banks, and federal funds sold to
support the daily cash flow requirements.
Management expects to continue to rely on customer deposits as the primary
source of liquidity, but may also obtain liquidity from maturity of its
investment securities, sale of securities currently available for sale, net
income, and other borrowings. Although deposit balances have shown historical
growth, deposit habits of customers may be influenced by changes in the
financial services industry, interest rates available on other investments,
general economic conditions, consumer confidence, and competition. Borrowings
may be used on a short-term basis to compensate for reductions in deposits, but
are generally not considered a long term solution to liquidity issues.
Therefore, reductions in deposits could adversely affect the Company's results
of operations.
Capital. The Company endeavors to maintain equity capital at an adequate level
to support and promote investor confidence. The Company conducts its business
through the Bank. Thus, the Company needs to be able to provide capital and
financing to the Bank should the need arise. The primary sources for obtaining
capital are additional stock sales and retained earnings. Total shareholders'
equity averaged $40,154,000 in 2004, which includes $11,282,000 of goodwill
associated with the BNW acquisition. Shareholders' equity averaged $26,786,000
in 2003, compared to $24,766,000 in 2002, an increase of 8.2%.
The Company's Board of Directors considers financial results, growth plans, and
anticipated capital needs in formulating its dividend policy. The payment of
dividends is subject to adequate financial results of the Bank, and limitations
imposed by law and governmental regulations.
The Federal Reserve has established guidelines that mandate risk-based capital
requirements for bank holding companies. Under the guidelines, one of four risk
weights is applied to balance sheet assets, each with different capital
requirements based on the credit risk of the asset. The Company's capital ratios
include the assets of the Bank on a consolidated basis in accordance with the
requirements of the Federal Reserve. The Company's capital ratios have exceeded
the minimum required to be classified "well capitalized" for each of the past
three years.
The following table sets forth the minimum required capital ratios and actual
ratios for December 31, 2004 and 2003.
Capital
Adequacy
Actual Purposes
(dollars in thousands) Amount Ratio Amount Ratio
- --------------------------------------------------------------------------------
December 31, 2004
Tier 1 capital (to average assets)
Consolidated $32,899 7.83% $16,790 4.00%
Bank 32,197 7.76% 16.601 4.00%
Tier 1 capital (to risk-weighted assets)
Consolidated 32,899 9.00% 14,636 4.00%
Bank 32,197 8.81% 14,624 4.00%
Total capital (to risk-weighted assets)
Consolidated 37,135 10.15% 29,273 8.00%
Bank 36,433 9.97% 29,247 8.00%
32
December 31, 2003
Tier 1 capital (to average assets)
Consolidated $25,190 8.49% $11,864 4.00%
Bank 24,651 8.31% 11.864 4.00%
Tier 1 capital (to risk-weighted assets)
Consolidated 25,190 11.62% 8,675 4.00%
Bank 24,651 11.37% 8,675 4.00%
Total capital (to risk-weighted assets)
Consolidated 27,428 12.65% 17,350 8.00%
Bank 26,889 12.40% 17,350 8.00%
OTHER EVENTS
On February 16, 2005, the Board of Directors approved a two-for-one stock split
for shareholders of record as of March 15, 2005, payable April 4, 2005.
Additionally, in February 2005 the Company entered into a construction contract
to build a new branch facility in Lynden, Washington, a town in Whatcom County.
Construction costs are estimated at $1 million.
ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk
The Company's results of operations are largely dependent upon its ability to
manage interest rate risk. Management considers interest rate risk to be a
significant market risk that could have a material effect on the Company's
financial condition and results of operations. The Company does not currently
use derivatives to manage market and interest rate risks. All of the Company's
transactions are denominated in U.S. dollars. Approximately 62% of the Company's
loans have interest rates that float with the Company's reference rate. Fixed
rate loans generally are made with a term of five years or less.
In the Asset and Liability section of the Management's Discussion and Analysis
in Item 7 is a table presenting estimated maturity or pricing information
indicating the Company's exposure to interest rate changes. The assumptions and
description of the process used to manage interest rate risk is further
discussed in the Asset and Liability Management section. The following table
discloses the balances of financial instruments held by the Company, including
the fair value as of December 31, 2004.
The expected maturities are disclosed based on contractual schedules. Principal
repayments are not considered. The expected maturities for financial liabilities
with no stated maturity reflect estimated future roll-off rates. The roll-off
rates for non-interest bearing deposits, interest bearing demand deposits, money
market accounts, and savings deposits are 15%, 25%, 25% and 20%, respectively.
The interest rates disclosed are based on rates in effect at December 31, 2004.
Fair values are estimated in accordance with generally accepted accounting
principles as disclosed in the financial statements.
33
Expected Maturity
Year ended December 31, 2004 there Fair
(dollars in thousands) 2005 2006 2007 2008 2009 after Total Value
- ------------------------------------------------------------------------------------------------------------------------------------
Financial Assets
Cash and cash equivalents
Non-interest bearing $ 10,213 -- -- -- -- -- $ 10,213 $ 10,213
Interest bearing deposits in banks $ 5,460 -- -- -- -- -- $ 5,460 $ 5,460
Weighted average interest rate 2.14%
Federal funds sold
Fixed rate $ 6,034 -- -- -- -- -- $ 6,034 $ 6,034
Weighted average interest rate 2.01%
Securities available for sale
Fixed rate $ 9,329 $ 3,431 $ 3,399 $1,088 $ 4,863 $13,670 $ 35,780 $ 35,780
Weighted average interest rate 5.82% 4.30% 2.91% 4.06% 4.56% 4.43%
Securities held to maturity
Fixed rate -- -- $ 619 $1,047 $ 420 $ 5,124 $ 7,210 $ 7,312
Weighted average interest rate -- -- 2.50% 2.99% 3.45% 3.71%
Loans receivable
Fixed rate $ 34,904 $ 4,973 $ 6,598 $4,950 $ 8,194 $68,876 $128,495 $131,056
Weighted average interest rate 6.49% 6.89% 7.17% 6.88% 6.24% 6.92%
Adjustable rate $149,033 $ 4,883 $39,257 $4,917 $15,727 $ 5,447 $219,264 $219,264
Weighted average interest rate 6.39% 6.03% 6.23% 5.35% 6.38% 5.25%
Federal Home Loan Bank stock -- -- -- -- -- $ 1,850 $ 1,850 $ 1,850
Weighted average interest rate 2.96%
Expected Maturity
Year ended December 31, 2004 there Fair
(dollars in thousands) 2005 2006 2007 2008 2009 after Total Value
- ------------------------------------------------------------------------------------------------------------------------------------
Financial Liabilities
Non-interest bearing deposits $ 10,756 $15,238 $11,429 $8,915 $ 7,132 $18,241 $ 71,711 $ 71,711
Interest bearing checking accounts $ 8,291 $11,747 $ 8,810 $5,286 $ 4,228 $16,915 $ 55,277 $ 55,277
Weighted average interest rate .35% .35% .35% .35% .35% .35%
Money Market accounts $ 10,109 $14,321 $10,740 $6,445 $ 5,156 $20,621 $ 67,392 $ 67,392
Weighted average interest rate 1.67% 1.67% 1.67% 1.67% 1.67% 1.67%
Savings accounts $ 8,515 $11,312 $ 8,485 $5,090 $ 4,072 $19,290 $ 56,765 $ 56,765
Weighted average interest rate .35% .35% .35% .35% .35% .35%
Certificates of deposit
Fixed rate $ 39,956 $ 9,486 $25,189 $7,550 $ 1,451 -- $ 83,632 $ 83,671
Weighted average interest rate 1.72% 2.59% 3.47% 3.92% 3.64%
Variable rate $ 24,752 3,972 -- -- -- -- $ 28,724 $ 28,724
Weighted average interest rate 3.33% 3.23%
Borrowings
Fixed rate $ 5,000 $ 5,000 $ 2,000 $3,500 $ 6,000 -- $ 21,500 $ 21,370
Weighted average interest rate 3.21% 2.69% 3.57% 2.97% 3.49%
Secured borrowings -- -- -- -- -- $ 3,733 $ 3,733 $ 3,733
Weighted average interest rate 5.86%
As illustrated in the table above, our balance sheet is currently sensitive to
decreasing interest rates, meaning that more interest bearing assets mature or
re-price than interest earning liabilities. Therefore, if our asset and
liability mix were to remain unchanged, and there was a decrease in market rates
of interest, the Company would expect that its net income would be adversely
affected. In contrast, an increasing interest rate environment would positively
affect income. While the table presented above provides
34
information about the Company's interest sensitivity, it does not predict the
trends of future earnings. For this reason, financial modeling is used to
forecast earnings under varying interest rate projections. While this process
assists in managing interest rate risk, it does require significant assumptions
for the projection of loan prepayments, loan origination volumes and liability
funding sources that may prove to be inaccurate.
ITEM 8. Financial Statements and Supplementary Data
Information required for this item is included in Item 15 of this report.
ITEM 9. Changes in and disagreements with accountants on accounting and
financial disclosure
Not applicable.
ITEM 9A. Controls and Procedures
Disclosure Controls and Procedures. Pacific's disclosure controls and procedures
are designed to ensure that information the Company must disclose in its reports
filed or submitted under the Exchange Act is recorded, processed, summarized,
and reported on a timely basis. Our management has evaluated, with the
participation and under the supervision of our chief executive officer (CEO) and
chief financial officer (CFO), the effectiveness of our disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act) as
of the end of the period covered by this report. Based on this evaluation, our
CEO and CFO have concluded that, as of such date, the Company's disclosure
controls and procedures are effective in ensuring that information relating to
the Company, including its consolidated subsidiaries, required to be disclosed
in reports that it files under the Exchange Act is (1) recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms, and (2) accumulated and communicated to our management, including our CEO
and CFO, as appropriate to allow timely decisions regarding required
disclosures.
Management's Report on Internal Control Over Financial Reporting. Pursuant to
Securities and Exchange Commission Release No. 34-50754 (the "Release"), the
Company is not at this time filing management's annual report on internal
control over financial reporting required by Item 308(a) of Regulation S-K, and
the related attestation report of the independent registered public accounting
firm, as required by Item 308(b) of Regulation S-K. Under the conditions of the
Release, we have up to 45 additional days beyond the due date of this Form 10-K
(March 16, 2005) for the filing of management's report on internal control over
financial reporting and the associated report on the audit of management's
assessment of the effectiveness of the Company's internal control over financial
reporting as of December 31, 2004. We expect to file our assessment of our
internal control and the associated report by our independent auditors no later
than May 2, 2005.
The Company's management is responsible for establishing and maintaining
adequate internal control over financial reporting, as that term is defined in
Exchange Act Rules 13a-15(f) and 15d-15(f). Under the supervision and with the
participation of the Company's management, including the principal executive
officer and principal financial officer, the Company is in the process of
conducting an assessment of its internal control over financial reporting using
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission in Internal Control--Integrated Framework.
At this time, no material weaknesses in our internal control have been
identified. There is no assurance that as a result of the ongoing evaluation of
our internal control over financial reporting, we will not identify significant
deficiencies that either alone or in combination with others, amount to a
material weakness in our internal control.
35
Changes in Internal Control Over Financial Reporting. There have not been any
changes in the Company's internal control over financial reporting, as such term
is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act during the
Company's fiscal quarter ended December 31, 2004 that have materially affected,
or are reasonable likely to materially affect, the Company's internal control
over financial reporting.
ITEM 9B. Other Information
None.
36
Part III
ITEM 10. Directors and Executive Officers of the Registrant
Information concerning directors and executive officers requested by this item
is contained in the Company's 2005 Proxy Statement for its annual meeting of
shareholders to be held on April 20, 2005 ("2005 Proxy Statement"), in the
sections entitled "MANAGEMENT-Certain Executive Officers," "Proposal No. 1 -
Election of Directors," and "Compliance with Section 16(a) of the Exchange Act"
and is incorporated into this report by reference.
The Board of Directors adopted a Code of Ethics for the Company's executive
officers that requires the Company's officers to maintain the highest standards
of professional conduct. A copy of the Executive Officer Code of Ethics is
available on the Company's Web site www.thebankofpacific.com under the link for
Stockholder Info and CEO's Newsletter.
The Company has a separately designated Audit Committee established in
accordance with Section 3(a)(58)(A) of the Exchange Act. The committee is
composed of Directors Duane E. Hagstrom, Gary C. Forcum, G. Dennis Archer,
Walter Westling and David Woodland, each of whom is independent as that term is
used in Item 7(d)(3)(iv) of Schedule 14A under the Exchange Act. In determining
independence of board members, the Company's board of directors has applied the
definition of independence found in the Nasdaq listing standards.
The Company's Board of Directors has determined that Duane E. Hagstrom, Gary C.
Forcum and G. Dennis Archer are audit committee financial experts as defined in
Item 401(h) of the SEC's Regulation S-K. Directors Hagstrom, Forcum and Archer
are independent as that term is used in Item 7(d)(3)(iv) of Schedule 14A.
ITEM 11. Executive Compensation
Information concerning executive compensation requested by this item is
contained in the registrant's 2005 Proxy Statement in the sections entitled
"DIRECTOR COMPENSATION" and "EXECUTIVE COMPENSATION" (not including "Audit
Committee Report," "Report of the Compensation Committee" and "Stock Performance
Graph"), and is incorporated into this report by reference.
37
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
Information concerning security ownership of certain beneficial owners and
management requested by this item is contained in the registrant's 2005 Proxy
Statement in the section entitled "MANAGEMENT - Security Ownership of Certain
Beneficial Owners and Management," and is incorporated into this report by
reference.
Equity Compensation Plan Information. The following table summarizes share and
exercise price information about the Company's equity compensation plans as of
December 31, 2004.
(a) (b) (c)
Number of securities Weighted-average Number remaining
to be issued upon exercise price available for future
exercise of of outstanding issuance under equity
outstanding options, options, warrants compensation plans
warrants and rights and rights (excluding securities
reflected in column (a))
Plan Category
-------------
Equity compensation plans approved
by security holders: 619,794(1) $12.51(1) 449,900(1)
Equity compensation plans not approved
by security holders: -- -- --
------- -------
Total 619,794 449,900
(1) Retroactively adjusted for a two-for-one stock split to be paid April 4,
2005.
ITEM 13. Certain Relationships and Related Transactions
Information concerning certain relationships and related transactions requested
by this item is contained in the registrant's 2005 Proxy Statement in the
section entitled "Compensation Committee Interlocks and Insider Participation"
and is incorporated into this report by reference.
ITEM 14. Principal Accountant Fees and Services
Information concerning fees paid to our accountants required by this item is
included under the heading "AUDITORS - Fees Paid to Auditors" in the
registrant's 2004 Proxy Statement and is incorporated into this report by
reference.
38
Part IV
ITEM 15. Exhibits and Financial Statement Schedules
(a) (1) The following financial statements are filed below:
Independent Auditor's Report
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Shareholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(a) (2) Schedules: None
(a) (3) Exhibits: See Exhibit Index immediately following the signature
page.
39
McGladrey & Pullen
Certified Public Accountants
Report of Independent Registered Public Accounting Firm
Board of Directors
Pacific Financial Corporation
Aberdeen, Washington
We have audited the accompanying consolidated balance sheets of PACIFIC
FINANCIAL CORPORATION AND SUBSIDIARY as of December 31, 2004 and 2003, and the
related consolidated statements of income, shareholders' equity and cash flows
for each of the three years in the period ended December 31, 2004. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of PACIFIC FINANCIAL
CORPORATION AND SUBSIDIARY as of December 31, 2004 and 2003, and the results of
their operations and their cash flows for each of the three years in the period
ended December 31, 2004, in conformity with accounting principles generally
accepted in the United States of America.
/s/ McGladrey & Pullen, LLP
Tacoma, Washington
February 9, 2005
McGladrey & Pullen, LLP is a member firm of RSM International --
an affiliation of separate and independent legal entities.
40
Consolidated Balance Sheets
- --------------------------------------------------------------------------------
(Dollars in Thousands)
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
2004 2003
Assets
Cash and due from banks $ 10,213 $ 9,280
Interest bearing deposits in banks 5,460 15,392
Federal funds sold 6,034 5,000
Securities available for sale 35,780 57,473
Securities held to maturity (market value 2004
- $7,312; and 2003 - $8,097) 7,210 7,988
Federal Home Loan Bank stock, at cost 1,850 915
Loans held for sale 1,852 --
Loans 345,907 199,738
Allowance for credit losses 4,236 2,238
Loans - net 341,671 197,500
Premises and equipment 6,833 3,967
Foreclosed real estate 40 98
Accrued interest receivable 1,873 1,275
Cash surrender value of life insurance 9,037 6,193
Goodwill 11,282 --
Other intangible assets 887 --
Other assets 1,769 1,634
Total assets $441,791 $306,715
Liabilities and Shareholders' Equity
Liabilities
Deposits:
Demand, non-interest bearing $ 71,711 $ 43,862
Savings and interest-bearing demand 179,434 131,493
Time, interest-bearing 112,356 85,445
Total deposits 363,501 260,800
Accrued interest payable 385 234
Secured borrowings 3,733 --
Long-term borrowings 21,500 14,500
Other liabilities 7,369 5,531
Total liabilities 396,488 281,065
Commitments and Contingencies -- --
Shareholders' Equity
Common stock (par value $1); authorized: 25,000,000
shares; issued and outstanding: 2004 - 6,421,396
shares; 2003 - 5,043,078 shares 6,421 2,522
Additional paid-in capital 25,003 10,005
Retained earnings 13,746 12,663
Accumulated other comprehensive income 133 460
Total shareholders' equity 45,303 25,650
Total liabilities and shareholders' equity $441,791 $306,715
See notes to consolidated financial statements.
41
Consolidated Statements of Income
- --------------------------------------------------------------------------------
(Dollars in Thousands, Except Per Share Amounts)
Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2004, 2003 and 2002
2004 2003 2002
Interest and Dividend Income
Loans $21,850 $13,350 $13,175
Federal funds sold and deposits in banks 44 118 107
Securities available for sale:
Taxable 1,318 1,570 1,401
Tax-exempt 526 484 501
Securities held to maturity:
Taxable 97 168 139
Tax-exempt 243 210 270
Federal Home Loan Bank stock dividends 60 49 186
Total interest and dividend income 24,138 15,949 15,779
Interest Expense
Deposits 3,734 2,923 3,747
Short-term borrowings 97 -- 4
Long-term borrowings 548 485 240
Secured borrowings 239 -- --
Total interest expense 4,618 3,408 3,991
Net interest income 19,520 12,541 11,788
Provision for Credit Losses 970 -- 954
Net interest income after provision for credit losses 18,550 12,541 10,834
Non-Interest Income
Service charges on deposit accounts 1,297 1,027 1,069
Mortgage broker fees 12 101 3
Income from and gains on sale of foreclosed real estate 77 26 292
Net gains from sales of loans 1,026 34 --
Net gains on sales of securities available for sale 3 4 --
Earnings on bank owned life insurance 378 328 350
Other operating income 369 326 345
Total non-interest income 3,162 1,846 2,059
Non-Interest Expense
Salaries and employee benefits 8,134 4,764 4,196
Occupancy 763 433 419
Equipment 825 532 565
State taxes 306 69 206
Data processing 614 305 268
Professional services 307 137 158
Other 2,606 1,705 1,602
Total non-interest expense 13,555 7,945 7,414
Income before income taxes 8,157 6,442 5,479
Income Taxes 2,450 1,863 1,563
Net income $ 5,707 $ 4,579 $ 3,916
Earnings Per Share
Basic $ 0.93 $ 0.91 $ 0.79
Diluted 0.91 0.90 0.78
See notes to consolidated financial statements.
42
Consolidated Statements of Shareholders' Equity
- --------------------------------------------------------------------------------
(Dollars in Thousands)
Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2004, 2003 and 2002
Accumulated
Shares of Additional Other
Common Common Paid-in Retained Comprehensive
Stock Stock Capital Earnings Income (Loss) Total
Balance at December 31, 2001 4,983,258 $4,983 $ 7,033 $11,090 $408 $23,514
Comprehensive income:
Net income -- -- -- 3,916 -- 3,916
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale -- -- -- -- 309 309
Comprehensive income 4,225
Stock options exercised 42,000 42 254 -- -- 296
Issuance of common stock 60 -- 1 -- -- 1
Cash dividends declared
($0.68 per share) -- -- -- (3,392) -- (3,392)
Tax benefit from exercise of
stock options -- -- 39 -- -- 39
Balance at December 31, 2002 5,025,318 5,025 7,327 11,614 717 24,683
Comprehensive income:
Net income -- -- -- 4,579 -- 4,579
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale -- -- -- -- (257) (257)
Comprehensive income 4,322
Stock options exercised 17,700 18 156 -- -- 174
Issuance of common stock 60 -- 1 -- -- 1
Cash dividends declared
($0.70 per share) -- -- -- (3,530) -- (3,530)
Balance at December 31, 2003 5,043,078 5,043 7,484 12,663 460 25,650
Comprehensive income:
Net income -- -- -- 5,707 -- 5,707
Other comprehensive income,
net of tax:
Change in fair value of
securities available for sale -- -- -- -- (327) (327)
Comprehensive income 5,380
Stock options exercised 106,414 106 676 -- -- 782
Issuance of common stock 1,271,904 1,272 16,641 -- -- 17,913
Stock compensation expense -- -- 60 -- -- 60
Cash dividends declared
($0.72 per share) -- -- -- (4,624) -- (4,624)
Tax benefit from exercise of
stock options -- -- 142 -- -- 142
Balance at December 31, 2004 6,421,396 $6,421 $25,003 $13,746 $133 $45,303
See notes to consolidated financial statements.
43
Consolidated Statements of Cash Flows
- --------------------------------------------------------------------------------
(Dollars in Thousands)
Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2004, 2003 and 2002
2004 2003 2002
Cash Flows from Operating Activities
Net income $ 5,707 $ 4,579 $ 3,916
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 655 404 433
Provision for credit losses 970 -- 954
Deferred income tax (benefit) (97) (144) (82)
Originations of loans held for sale (66,639) - - (548)
Proceeds from sales of loans held for sale 66,550 286 262
FHLB Stock dividends received (60) (49) (186)
Gains on sales of loans (1,026) (34) --
Gains on sale of securities available for sale (3) (4) --
Gains on sales of foreclosed real estate (71) (10) (178)
Loss on sale of premises and equipment 35 11 --
Earnings on bank owned life insurance (378) (328) (350)
(Increase) decrease in accrued interest receivable (192) 218 (88)
increase (decrease) in accrued interest payable 81 (84) (123)
Write-down of foreclosed real estate -- 173 420
Other - net 524 (49) 929
Net cash provided by operating activities 6,056 4,969 5,359
Cash Flows from Investing Activities
Net (increase) decrease in interest bearing deposits in banks 10,124 (15,019) 1,095
Net (increase) decrease in federal funds sold (1,034) (5,000) 3,505
Activity in securities available for sale:
Sales 19,055 2,994 --
Maturities, prepayments and calls 9,651 12,343 14,109
Purchases (3,090) (21,275) (34,338)
Activity in securities held to maturity:
Maturities 1,910 3,919 3,481
Purchases (1,169) (1,654) (8,920)
Federal Home Loan Bank stock redemption -- -- 3,133
Proceeds from sales of SBA loan pools 5,735 2,006 --
Increase in loans made to customers, net of principal collections (42,313) (16,709) (10,046)
Purchases of premises and equipment (2,379) (511) (261)
Proceeds from sales of premises and equipment -- 2 --
Additions to foreclosed real estate -- (21) --
Proceeds from sales of foreclosed real estate 478 734 707
Purchase of bank owned life insurance (2,500) -- --
Cash paid for acquisition, net of cash acquired 3,146 -- --
Net cash used in investing activities (2,386) (38,191) (27,535)
(continued)
See notes to consolidated financial statements.
44
Consolidated Statements of Cash Flows
- --------------------------------------------------------------------------------
(concluded) (Dollars in Thousands)
Pacific Financial Corporation and Subsidiary
Years Ended December 31, 2004, 2003 and 2002
2004 2003 2002
Cash Flows from Financing Activities
Net increase in deposits $14,611 $35,546 $10,610
Net increase (decrease) in short-term borrowings (25,333) (1,800) 1,800
Net increase in secured borrowings 3,733 -- --
Proceeds from issuance of long-term borrowings 9,000 3,500 11,000
Repayments of long-term borrowings (2,000) -- --
Common stock issued 782 175 297
Cash dividends paid (3,530) (3,392) (3,289)
Net cash provided by (used in) financing activities (2,737) 34,029 20,418
Net change in cash and due from banks 933 807 (1,758)
Cash and Due from Banks
Beginning of year 9,280 8,473 10,231
End of year $10,213 $ 9,280 $ 8,473
Supplemental Disclosures of Cash Flow Information
Interest paid $ 4,467 $ 3,492 $ 4,114
Income taxes paid 2,113 2,087 1,260
Supplemental Disclosures of Non-Cash Investing Activities
Fair value adjustment of securities available for sale, net of tax $ (327) $ (257) $ 309
Transfer of loans to foreclosed real estate 349 1,127 1,198
Financed sales of foreclosed real estate -- 839 629
Common stock issued upon business combination 17,913 -- --
See notes to consolidated financial statements.
45
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Pacific Financial
Corporation (the Company) and its wholly owned subsidiary, The Bank of the
Pacific (the Bank). All significant intercompany transactions and balances have
been eliminated.
Nature of Operations
The Company is a holding company which operates primarily through its subsidiary
bank. The Bank operates fifteen branches located in Grays Harbor, Pacific,
Whatcom and Wahkiakum Counties in western Washington and two loan production
offices in Burlington, Washington and Clatsop County Oregon. The Bank provides
loan and deposit services to customers, who are predominately small- and
middle-market businesses and middle-income individuals in western Washington and
Oregon.
Consolidated Financial Statement Presentation
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America and
practices within the banking industry. The preparation of consolidated financial
statements requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities, as of the date of the balance sheet, and the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates. Material estimates that are particularly
susceptible to significant change in the near term relate to the determination
of the allowance for credit losses and the valuation of foreclosed real estate
and deferred tax assets.
Certain prior year amounts have been reclassified, with no change to net income
or shareholders' equity, to conform to the 2004 presentation. All dollar
amounts, except per share information, are stated in thousands.
Securities Available for Sale
Securities available for sale consist of debt securities, marketable equity
securities and mutual funds that the Company intends to hold for an indefinite
period, but not necessarily to maturity. Such securities may be sold to
implement the Company's asset/liability management strategies and in response to
changes in interest rates and similar factors. Securities available for sale are
reported at fair value. Unrealized gains and losses, net of the related deferred
tax effect, are reported as a net amount in a separate component of
shareholders' equity entitled "accumulated other comprehensive income (loss)."
Realized gains and losses on securities available for sale, determined using the
specific identification method, are included in earnings. Amortization of
premiums and accretion of discounts are recognized in interest income over the
period to maturity.
(continued)
46
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies (continued)
Securities Held to Maturity
Debt securities for which the Company has the positive intent and ability to
hold to maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts, which are recognized in interest income over the period
to maturity.
Declines in the fair value of individual securities held to maturity and
available for sale below their cost that are other than temporary result in
write-downs of the individual securities to their fair value. Such write-downs
are included in earnings as realized losses.
Federal Home Loan Bank Stock
The Company, as a member of the Federal Home Loan Bank (FHLB) system, is
required to maintain an investment in capital stock of the FHLB in an amount
equal to the greater of 1% of its outstanding home loans or 5% of advances from
the FHLB.
The recorded amount of FHLB stock equals its fair value because the shares can
only be redeemed by the FHLB at the $100 per share par value.
Loans Held for Sale
Mortgage loans originated for sale in the foreseeable future in the secondary
market are carried at the lower of aggregate cost or estimated market value.
Gains and losses on sales of loans are recognized at settlement date and are
determined by the difference between the sales proceeds and the carrying value
of the loans. All sales are made without recourse. Net unrealized losses are
recognized through a valuation allowance established by charges to income.
Loans
Loans are stated at the amount of unpaid principal, reduced by deferred loan
fees and an allowance for credit losses. Interest on loans is accrued daily
based on the principal amount outstanding.
Generally, the accrual of interest on loans is discontinued when, in
management's opinion, the borrower may be unable to meet payments as they become
due or when they are past due 90 days as to either principal or interest, unless
they are well secured and in the process of collection. When interest accrual is
discontinued, all unpaid accrued interest is reversed against current income. If
management determines that the ultimate collectibility of principal is in doubt,
cash receipts on nonaccrual loans are applied to reduce the principal balance on
a cash-basis method, until the loans qualify for return to accrual status. Loans
are returned to accrual status when all principal and interest amounts
contractually due are brought current and future payments are reasonably
assured. The interest on these loans is accounted for on the cash-basis method,
until qualifying for return to accrual.
(continued)
47
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies (continued)
Allowance for Credit Losses
The allowance for credit losses is maintained at a level sufficient to provide
for probable credit losses based on evaluating known and inherent risks in the
loan portfolio. The allowance is provided based upon management's continuing
analysis of the pertinent factors underlying the quality of the loan portfolio.
These factors include changes in the size and composition of the loan portfolio,
delinquency levels, actual loan loss experience, current economic conditions,
and detailed analysis of individual loans for which full collectibility may not
be assured. The detailed analysis includes techniques to estimate the fair value
of loan collateral and the existence of potential alternative sources of
repayment. The allowance consists of specific, general and unallocated
components. The specific component relates to loans that are classified as
either doubtful, substandard or special mention. For such loans that are also
classified as impaired, an allowance is established when the discounted cash
flows (or collateral value or observable market price) of the impaired loan is
lower than the carrying value of that loan. The general component covers
non-classified loans and is based on historical loss experience adjusted for
qualitative factors. An unallocated component is maintained to cover
uncertainties that could affect management's estimate of probable losses. The
unallocated component of the allowance reflects the margin of imprecision
inherent in the underlying assumptions used in the methodologies for estimating
specific and general losses in the portfolio. The appropriateness of the
allowance for losses on loans is estimated based upon these factors and trends
identified by management at the time consolidated financial statements are
prepared.
When available information confirms that specific loans or portions thereof are
uncollectible, identified amounts are charged against the allowance for credit
losses. The existence of some or all of the following criteria will generally
confirm that a loss has been incurred: the loan is significantly delinquent and
the borrower has not demonstrated the ability or intent to bring the loan
current; the Bank has no recourse to the borrower, or if it does, the borrower
has insufficient assets to pay the debt; the estimated fair value of the loan
collateral is significantly below the current loan balance, and there is little
or no near-term prospect for improvement.
A loan is considered impaired when it is probable that a creditor will be unable
to collect all amounts (principal and interest) due according to the contractual
terms of the loan agreement. Smaller balance homogenous loans, such as
residential mortgage loans and consumer loans, are collectively evaluated for
potential loss. When a loan has been identified as being impaired, the amount of
the impairment is measured by using discounted cash flows, except when, as a
practical expedient, the current fair value of the collateral, reduced by costs
to sell, is used. When the measurement of the impaired loan is less than the
recorded investment in the loan including accrued interest and net deferred loan
fees, an impairment is recognized by creating or adjusting an allocation of the
allowance for credit losses.
A provision for credit losses is charged against income and is added to the
allowance for credit losses based on quarterly assessments of the loan
portfolio. The allowance for credit losses is allocated to certain loan
categories based on the relative risk characteristics, asset classifications and
actual loss experience of the loan portfolio. While management has allocated the
allowance for credit losses to various loan portfolio segments, the allowance is
general in nature and is available for the loan portfolio in its entirety.
The ultimate recovery of all loans is susceptible to future market factors
beyond the Bank's control. These factors may result in losses or recoveries
differing significantly from those provided in the consolidated financial
statements. In addition, regulatory agencies, as an integral part of their
examination process, periodically review the Bank's allowance for credit losses,
and may require the Bank to make additions to the allowance based on their
judgment about information available to them at the time of their examinations.
(continued)
48
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies (continued)
Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation, which
is computed on the straight-line method over the estimated useful lives of the
assets. Asset lives range from 3 to 39 years. Leasehold improvements are
amortized over the terms of the respective leases or the estimated useful lives
of the improvements, whichever is less. Gains or losses on dispositions are
reflected in earnings.
Foreclosed Real Estate
Real estate properties acquired through, or in lieu of, foreclosure are to be
sold and are initially recorded at the lower of cost or fair value of the
properties less estimated costs of disposal. Any write-down to fair value at the
time of transfer to other real estate owned is charged to the allowance for
credit losses. Properties are evaluated regularly to ensure that the recorded
amounts are supported by their current fair values, and that valuation
allowances to reduce the carrying amounts to fair value less estimated costs to
dispose are recorded as necessary. Any subsequent reductions in carrying values,
and revenue and expense from the operations of properties, are charged to
operations.
Goodwill and other intangible assets
Goodwill is initially recorded when the purchase price paid for an acquisition
exceeds the estimated fair value of the net identified tangible and intangible
assets acquired. Goodwill is presumed to have an indefinite useful life and is
tested, at least annually or more frequently if indicators of potential
impairment exist, for impairment at the reporting unit level. Our impairment
review process compares the fair value of the Bank to its carrying value,
including the goodwill related to the Bank. If the fair value exceeds the
carrying value, goodwill of the Bank unit is not considered impaired and no
additional analysis is necessary. As of December 31, 2004, there have been no
events or changes in circumstances that would indicate a potential impairment.
Other intangible assets consisting of core deposit intangibles are amortized to
non-interest expense using a straight line method over seven years.
Impairment of long-lived assets
Management periodically reviews the carrying value of its long-lived assets to
determine if an impairment has occurred or whether changes in circumstances have
occurred that would require a revision to the remaining useful life. In making
such determination, management evaluates the performance, on an undiscounted
basis, of the underlying operations or assets which give rise to such amount.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales when control over the
assets has been surrendered. Control over transferred assets is deemed to be
surrendered when (1) the assets have been isolated from the Bank, (2) the
transferee obtains the right (free of conditions that constrain it from taking
advantage of that right) to pledge or exchange the transferred assets, and (3)
the Bank does not maintain effective control over the transferred assets through
an agreement to repurchase them before their maturity.
(continued)
49
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies (continued)
Income Taxes
Deferred tax assets and liabilities result from differences between the
financial statement carrying amounts and the tax bases of assets and
liabilities, and are reflected at currently enacted income tax rates applicable
to the period in which the deferred tax assets or liabilities are expected to be
realized or settled. Deferred tax assets are reduced by a valuation allowance
when management determines that it is more likely than not that some portion or
all of the deferred tax assets will not be realized. As changes in tax laws or
rates are enacted, deferred tax assets and liabilities are adjusted through the
provision for income taxes.
The Bank provides for income taxes separately and remits to the Company amounts
currently due.
Stock-Based Compensation
At December 31, 2004, the Company has three stock-based employee compensation
plans, which are described more fully in Note 13. The Company accounts for those
plans under the recognition and measurement principles of APB No. 25, Accounting
for Stock Issued to Employees, and related interpretations. Accordingly, no
stock-based compensation cost is reflected in net income, 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 grant. See recent account pronouncements
section which discuss future impacts of new accounting guidance. The following
illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of SFAS No. 123, Accounting for
Stock-Based Compensation, to stock-based compensation awards for the effects of
all options granted on or after January 1, 1995 for the years ended December 31:
2004 2003 2002
Net income, as reported $5,707 $4,579 $3,916
Add stock compensation expensed 36 -- --
Less total stock-based compensation expense determined
under fair value method for all qualifying awards, net of tax 157 86 93
Pro forma net income $5,586 $4,493 $3,823
Earnings Per Share
Basic:
As reported $ 0.93 $ 0.91 $ 0.79
Pro forma 0.91 0.90 0.77
Diluted:
As reported 0.91 0.90 0.78
Pro forma 0.89 0.88 0.77
(continued)
50
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies (continued)
Fair Values of Financial Instruments
The following methods and assumptions were used by the Company in estimating the
fair values of financial instruments disclosed in these consolidated financial
statements:
Cash, Interest Bearing Deposits at Other Financial Institutions, and
Federal Funds Sold
The carrying amounts of cash, interest bearing deposits at other financial
institutions, and federal funds sold approximate their fair value.
Securities Available for Sale and Held to Maturity
Fair values for securities are based on quoted market prices.
Federal Home Loan Bank Stock
The carrying value of Federal Home Loan Bank stock approximates its fair
value.
Loans
For variable rate loans that reprice frequently and have no significant
change in credit risk, fair values are based on carrying values. Fair
values for fixed rate loans are estimated using discounted cash flow
analysis, using interest rates currently being offered for loans with
similar terms to borrowers of similar credit quality. Fair values of loans
held for sale are based on their estimated market prices. Fair values for
impaired loans are estimated using discounted cash flow analyses or
underlying collateral values, where applicable.
Deposit Liabilities
The fair value of deposits with no stated maturity date is included at the
amount payable on demand. Fair values for fixed rate certificates of
deposit are estimated using a discounted cash flow calculation based on
interest rates currently offered on similar certificates.
Secured borrowings
For variable rate secured borrowings that reprice frequently and have no
significant change in credit risk, fair values are based on carrying
values.
Long-Term Borrowings
The fair values of the Company's long-term borrowings are estimated using
discounted cash flow analyses based on the Company's incremental borrowing
rates for similar types of borrowing arrangements.
Accrued Interest Receivable and Payable
The carrying amounts of accrued interest receivable and payable
approximate their fair values.
(continued)
51
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies (continued)
Fair Values of Financial Instruments (concluded)
Off-Balance-Sheet Instruments
The fair value of commitments to extend credit and standby letters of
credit was estimated using the fees currently charged to enter into
similar agreements, taking into account the remaining terms of the
agreements and the present creditworthiness of the customers. Since the
majority of the Company's off-balance-sheet instruments consist of non-fee
producing, variable-rate commitments, the Company has determined they do
not have a distinguishable fair value.
Cash Equivalents and Cash Flows
The Company considers all amounts included in the balance sheet caption "Cash
and due from banks" to be cash equivalents. Cash flows from loans, interest
bearing deposits in banks, federal funds sold, short-term borrowings, and
deposits are reported net.
The Company maintains balances in depository institution accounts which, at
times, may exceed federally insured limits. The Company has not experienced any
losses in such accounts.
Earnings Per Share
Basic earnings per share excludes dilution and is computed by dividing net
income by the weighted average number of common shares outstanding. Diluted
earnings per share reflect the potential dilution that could occur if common
shares were issued pursuant to the exercise of options under the Company's stock
option plans.
All per share amounts and numbers of shares have been retroactively adjusted for
a two-for-one stock split to be paid on April 4, 2005, to shareholders of record
on March 15, 2005.
Comprehensive Income
Accounting principles generally require that recognized revenue, expenses, gains
and losses be included in net income. Although certain changes in assets and
liabilities, such as unrealized gains and losses on securities available for
sale, are reported as a separate component of the equity section of the
consolidated balance sheets, such items, along with net income, are components
of comprehensive income. Gains and losses on securities available for sale are
reclassified to net income as the gains or losses are realized upon sale of the
securities. Other-than-temporary impairment charges are reclassified to net
income at the time of the charge.
Recent Accounting Pronouncements
In December 2003, the FASB issued a revision to Interpretation No. 46,
"Consolidation of Variable Interest Entities," ("FIN 46") which established
guidance for determining when an entity should consolidated another entity that
meets the definition of a variable interest entity. FIN 46 requires a variable
interest entity to be consolidated by a company if that company will absorb a
majority of the expected losses, will receive a majority of the expected
residual return, or both. FASB deferred the effective date of FIN 46 to no later
than the end of the first reporting period that ends after March 15, 2004. The
Interpretation and the revision had no material effect on the Company's
consolidated financial statements.
(continued)
52
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies (continued)
Recent Accounting Pronouncements (continued)
In December 2003, the Accounting Standards Executive Committee of the AICPA
issued Statement of Position No. 03-3 ("SOP 03-3"), Accounting for Certain Loans
or Debt Securities Acquired in a Transfer. SOP 03-3 addresses the accounting for
differences between contractual cash flows and the cash flows expected to be
collected from purchased loans or debt securities if those differences are
attributable, in part, to credit quality. SOP 03-3 requires purchased loans or
debt securities to be recorded initially at fair value based on the present
value of the cash flows expected to be collected with no carryover of any
valuation allowance previously recognized by the seller. Interest income should
be recognized based on the effective yield from the cash flows expected to be
collected. To the extent that the purchased loans or debt securities experience
subsequent deterioration in credit quality, a valuation allowance would be
established for any additional cash flows that are not expected to be received.
However, if more cash flows subsequently are expected to be received than
originally estimated, the effective yield would be adjusted on a prospective
basis. SOP 03-3 will be effective for loans and debt securities acquired after
December 31, 2004. Management does not expect the adoption of this statement to
have a material impact on the Company's consolidated financial statements.
On December 16, 2004, the FASB issued SFAS No. 123R, "Share-Based Payment",
which is an amendment of FASB Statement Nos. 123 and 95. SFAS No. 123R changes,
among other things, the manner in which share-based compensation, such as stock
options, will be accounting for by both public and non-public companies, and
will be effective as of the beginning of the first interim or annual reporting
period that begins after June 15, 2005. For public companies, the cost of
employee services received in exchange for equity instruments including options
and restricted stock awards generally will be measured at fair value at the
grant date. The grant date fair value will be estimated using option-pricing
models adjusted for the unique characteristics of those options and instruments,
unless observable market prices for the same or similar options are available.
The cost will be recognized over the requisite service period, often the vesting
period, and will be remeasured subsequently at each reporting date through
settlement date.
The changes in accounting will replace existing requirements under SFAS No. 123,
"Accounting for Stock-Based Compensation," and will eliminate the ability to
account for share-based compensation transactions using APB Opinion No. 25,
"Accounting for Stock Issued to Employees," which does not require companies to
expense options if the exercise price is equal to the trading price at the date
of grant. The accounting for similar transactions involving parties other than
employees or the accounting for employee stock ownership plans that are subject
to AICPA Statement of Position 93-6, "Employers' Accounting for Employee Stock
Ownership Plans," would remain unchanged.
In March 2004, the Securities and Exchange Commission ("SEC") issued Staff
Accounting Bulletin ("SAB") No. 105, Application of Accounting Principles to
Loan Commitments, which provides guidance regarding loan commitments that are
accounting for as derivative instruments. In this SAB, the SEC determined that
an interest rate lock commitment should generally be valued at zero at
inception. The rate locks will continue to be adjusted for changes in value
resulting form changes in market interest rates. This SAB did not have a
material effect on the Company's financial position or results of operations.
(continued)
53
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 1 - Summary of Significant Accounting Policies (concluded)
Recent Accounting Pronouncements (concluded)
On September 30, 2004, the Financial Accounting Standards Board ("FASB") issued
FASB Staff Position ("FSP") Emerging Issues Task Force ("EITF") Issue No. 03-1-1
delaying the effective date of paragraphs 10-20 of EITF 03-1, "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments",
which provides guidance for determining the meaning of "other-than-temporary
impaired" and its application to certain debt securities within the scope of
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities", and investments accounted for under the cost method. The guidance
requires that investments which have declined in value due to credit concerns or
solely due to changes in interest rates must be recorded as other-than-temporary
impaired unless the Company can assert and demonstrate its intention to hold the
security for a period of time sufficient to allow for a recovery of fair value
up to or beyond the cost of the investment which might mean maturity. The delay
of the effective date of EITF 03-1 will be superseded concurrent with the final
issuance of proposed FSP Issue 03-1-a. Proposed FSP Issue 03-1-a is intended to
provide implementation guidance with respect to all securities analyzed for
impairment under paragraphs 10-20 of EITF 03-1. Management continues to closely
monitor and evaluate how the provisions of ETIF 03-1 and proposed FSP Issue
03-1-a will affect the Company.
Note 2 - Business Combination
On February 27, 2004, the Company effected a business combination with BNW
Bancorp, Inc. Each share of BNW Bancorp, Inc. stock was exchanged for 0.85
shares of Pacific Financial Corporation's common stock resulting in the issuance
of 1,271,904 new shares. Total stock and cash consideration for BNW Bancorp,
Inc. was $18.2 million. The acquisition was accounted for using the purchase
method of accounting and, accordingly, the assets and liabilities of BNW
Bancorp, Inc. were recorded at their respective fair value. Goodwill, the excess
of the purchase price over the net fair value of the assets and liabilities
acquired, was recorded at $11,282. As part of the accounting for the
acquisition, the Company recorded an identifiable intangible asset. A core
deposit intangible of $993 was recorded and is being amortized using the
straight-line method over seven years. The goodwill is not tax deductible
because this was a nontaxable transaction. The purchased assets and assumed
liabilities were recorded as follows:
Assets
Cash $ 3,465
Investments 5,507
Premises and equipment 1,102
Loans 109,635
Core deposit intangible 993
Goodwill 11,282
Other, net 850
Total Assets $132,834
Liabilities
Deposits $ 88,281
Borrowings 25,333
Other, net 988
Total Liabilities $114,602
Assets acquired less liabilities assumed $ 18,232
Stock consideration 17,913
Cash consideration $ 319
(continued)
54
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 2 - Business Combination (concluded)
The following unaudited pro forma financials for the twelve months ended
December 31, 2004 and 2003 assumes that the BNW acquisition occurred as of
January of each fiscal year, after giving effect to certain adjustments. The pro
forma results have been prepared for comparative purposes only and are not
necessarily indicative of the results of operations which may occur in the
future or that would have occurred had the BNW acquisition been consummated on
the date indicated.
2004 2003
Net interest income $20,404 $17,638
Non-interest income 3,275 3,106
Non-interest expense 15,120 13,166
Net income $ 5,246 $ 5,009
Earings per share:
Basic $ 0.80 $ 0.80
Diluted 0.78 0.78
Note 3 - Restricted Assets
Federal Reserve Board regulations require that the Bank maintain certain minimum
reserve balances in cash on hand and on deposit with the Federal Reserve Bank,
based on a percentage of deposits. The average amount of such balances for the
years ended December 31, 2004 and 2003 were approximately $675 and $650,
respectively.
Note 4 - Securities
Investment securities have been classified according to management's intent. The
carrying amounts of securities and their approximate fair values are as follows:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
Securities Available for Sale
December 31, 2004
U.S. Government agency securities $ 4,567 $ 42 $ 65 $ 4,544
Obligations of states and political subdivisions 12,632 346 36 12,942
Mortgage-backed securities 10,270 64 100 10,234
Corporate bonds 4,096 59 7 4,148
Mutual funds 4,014 -- 102 3,912
$35,579 $511 $310 $35,780
(continued)
55
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 4 - Securities (continued)
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
December 31, 2003
U.S. Government agency securities $ 1,738 $ 81 $ -- $ 1,819
Obligations of states and political subdivisions 14,239 600 88 14,751
Mortgage-backed securities 16,121 181 91 16,211
Corporate bonds 4,122 122 11 4,233
Mutual funds 20,556 -- 97 20,459
$56,776 $ 984 $287 $57,473
Securities Held to Maturity
December 31, 2004
State and municipal securities $ 5,496 $ 84 $ 13 $ 5,567
Mortgage-backed securities 1,714 31 -- 1,745
$ 7,210 $ 115 $ 13 $ 7,312
December 31, 2003
State and municipal securities $ 5,044 $ 75 $ 20 $ 5,099
Mortgage-backed securities 2,944 54 -- 2,998
$ 7,988 $ 129 $ 20 $ 8,097
Unrealized losses and fair value, aggregated by investment category and length
of time that individual securities have been in continuous unrealized loss
position, as of December 31, 2004 and 2003 are summarized as follows:
Less than 12 Months More than 12 Months Total
Fair Unrealized Fair Unrealized Fair Unrealized
Value Loss Value Loss Value Loss
December 31, 2004
Available for Sale
U.S. Government agency securities $ 4,081 $ 65 $ -- $-- $ 4,081 $ 65
Obligations of states and
political subdivisions 1,952 20 1,104 16 3,056 36
Mortgage-backed securities 3,808 23 1,390 77 5,198 100
Corporate bonds 993 7 -- -- 993 7
Mutual funds 3,912 102 -- -- 3,912 102
Total $14,746 $217 $2,494 $93 $17,240 $310
Held to Maturity
State and municipal securities $ 338 $ 6 $ 383 $ 7 $ 721 $ 13
(continued)
56
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 4 - Securities (concluded)
Less than 12 Months More than 12 Months Total
Fair Unrealized Fair Unrealized Fair Unrealized
Value Loss Value Loss Value Loss
December 31, 2003
Available for Sale
Obligations of states and
political subdivisions $ 1,546 $ 88 $ -- $-- $ 1,546 $ 88
Mortgage-backed securities 3,375 67 2,942 24 6,317 91
Corporate bonds 1,094 11 -- -- 1,094 11
Mutual funds 3,855 44 16,604 53 20,459 97
Total $ 9,870 $210 $19,546 $77 $29,416 $287
Held to Maturity
State and municipal securities $ 374 $ 16 $ 912 $ 4 $ 1,286 $ 20
For all the above investment securities, the unrealized losses are generally due
to changes in interest rates and, as such, are considered to be temporary by the
Company. The Company has evaluated the securities shown above and anticipates
full recovery of amortized cost with respect to these securities at maturity or
sooner in the event of a more favorable market interest rate environment.
Additionally, the contractual cash flows of mortgage-backed securities are
guaranteed by an agency of the U.S. Government.
The contractual maturities of investment securities held to maturity and
available for sale at December 31, 2004 are shown below. Maturities may differ
from contractual maturities because borrowers have the right to call or prepay
obligations, with or without call or prepayment penalties. Investments in mutual
funds are shown separately due to the short-term nature of the investments and
because mutual funds do not have a stated maturity date.
Held to Maturity Available for Sale
Amortized Fair Amortized Fair
Cost Value Cost Value
Due in one year or less $ -- $ -- $ 3,738 $ 3,810
Due from one year to five years 2,371 2,392 11,718 11,833
Due from five to ten years 1,205 1,241 3,213 3,339
Due after ten years 1,920 1,934 2,626 2,652
Mortgage-backed securities 1,714 1,745 10,270 10,234
Mutual funds -- -- 4,014 3,912
Total $7,210 $7,312 $35,579 $35,780
Gross gains realized on sales of securities were $30 and $9 and gross losses
realized were $27 and $5 in 2004 and 2003, respectively. There were no sales of
securities in 2002.
Securities carried at approximately $27,374 at December 31, 2004 and $18,691 at
December 31, 2003 were pledged to secure public deposits, borrowings at the
Federal Home Loan Bank of Seattle, for other purposes required or permitted by
law.
(continued)
57
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 5 - Loans
Loans (including loans held for sale) at December 31 consist of the following:
2004 2003
Commercial and agricultural $111,050 $ 64,344
Real estate:
Construction 49,347 11,894
Residential 1-4 family 43,183 24,418
Multi-family 9,156 2,197
Commercial 112,743 85,933
Farmland 10,929 5,268
Consumer 11,632 5,684
348,040 199,738
Less unearned income (281) --
$347,759 $199,738
Changes in the allowance for credit losses for the years ended December 31 are
as follows:
2004 2003 2002
Balance at beginning of year $2,238 $2,473 $2,109
BNW Bancorp, Inc. acquisition 1,172 -- --
Provision for credit losses 970 -- 954
Charge-offs (275) (265) (632)
Recoveries 131 30 42
Net charge-offs (144) (235) (590)
Balance at end of year $4,236 $2,238 $2,473
Following is a summary of information pertaining to impaired loans:
2004 2003 2002
December 31
Impaired loans without a valuation allowance $470 $ 342 $2,296
Impaired loans with a valuation allowance -- 123 18
Total impaired loans $470 $ 465 $2,314
Valuation allowance related to impaired loans $ -- $ 23 $ 2
Years Ended December 31
Average investment in impaired loans $255 $1,412 $2,390
Interest income recognized on a cash basis on 16 12 13
impaired loans
58
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 5 - Loans
At December 31, 2004, there were no commitments to lend additional funds to
borrowers whose loans have been modified. There were no loans 90 days and over
past due and still accruing interest at December 31, 2004 and 2003.
Certain related parties of the Company, principally directors and their
affiliates, were loan customers of the Bank in the ordinary course of business
during 2004 and 2003. Total loans outstanding at December 31, 2004 and 2003 to
key officers and directors were $9,796 and $6,857, respectively. During 2004,
new loans of $17,084 were made, and repayments totaled $14,145. In management's
opinion, these loans and transactions were on the same terms as those for
comparable loans and transactions with non-related parties. No loans to related
parties were on non-accrual, past due or restructured at December 31, 2004.
Note 6 - Premises and Equipment
The components of premises and equipment at December 31 are as follows:
2004 2003
Land $2,825 $1,125
Premises 5,412 4,309
Equipment, furniture and fixtures 5,668 4,122
13,905 9,556
Less accumulated depreciation and amortization 7,072 5,589
Total premises and equipment $6,833 $3,967
The Bank leases premises under operating leases. Rental expense of leased
premises was $191, $7 and $3 for 2004, 2003 and 2002, respectively, which is
included in occupancy expense.
Minimum net rental commitments under noncancelable leases having an original or
remaining term of more than one year for future years ending December 31 are as
follows:
2005 $182
2006 140
2007 140
2008 98
2009 88
Total minimum payments required $648
Certain leases contain renewal options from five to ten years and escalation
clauses based on increased in property taxes and other costs.
59
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 7 - Deposits
The composition of deposits at December 31 is as follows:
2004 2003
Demand deposits, non-interest bearing $ 71,711 $ 43,862
NOW and money market accounts 123,042 79,185
Savings deposits 56,392 52,308
Time certificates, $100,000 or more 54,994 43,608
Other time certificates 57,362 41,837
Total $363,501 $260,800
Scheduled maturities of time certificates of deposit are as follows for future
years ending December 31:
2005 $ 84,076
2006 11,551
2007 7,837
2008 7,496
2009 1,396
$112,356
Note 8 - Borrowings
Long-term borrowings at December 31, 2004 represent advances from the Federal
Home Loan Bank of Seattle bearing interest at 1.81% to 4.41% and maturing in
various years as follows: 2005 - $5,000; 2006 - $5,000; 2007 - $2,000; 2008 -
$3,500; and 2009 - $6,000. The Bank has pledged $53,156 of securities and loans
as collateral for these borrowings at December 31, 2004.
Secured borrowings at December 31, 2004 represent borrowings collateralized by
participation interests in loans originated by the Bank. These borrowings are
repaid as payments (normally monthly) are made on the underlying loans, bearing
interest ranging from 5.75% to 8.5%. Original maturities range from June 2005 to
November 2018.
Note 9 - Income Taxes
Income taxes are comprised of the following for the years ended December 31:
2004 2003 2002
Current $2,547 $1,719 $1,645
Deferred (benefit) (97) 144 (82)
Total income taxes $2,450 $1,863 $1,563
(continued)
60
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 9 - Income Taxes (concluded)
The tax effects of temporary differences that give rise to significant portions
of deferred tax assets and liabilities at December 31 are:
2004 2003
Deferred Tax Assets
Allowance for credit losses $1,287 $ 634
Deferred compensation 161 159
Other 54 12
Total deferred tax assets 1,502 805
Deferred Tax Liabilities
Unrealized gain on securities available for sale $ 68 $ 237
Depreciation 202 167
Deferred revenue 1,150 886
Core deposit intangible 301 --
Total deferred tax liabilities 1,721 1,290
Net deferred tax liabilities $ (219) $ (485)
Net deferred tax liabilities are included in other liabilities on the
consolidated balance sheets.
The following is a reconciliation between the statutory and effective federal
income tax rate for the years ended December 31:
2004 2003 2002
Percent Percent Percent
of Pre-tax of Pre-tax of Pre-tax
Amount Income Amount Income Amount Income
Income tax at statutory rate $2,855 35.0% $2,255 35.0% $1,918 35.0%
Adjustments resulting from:
Tax-exempt income (276) (3.4) (232) (3.6) (276) (5.0)
Net earnings on life insurance
policies (121) (1.5) (103) (1.6) (111) (2.0)
Other (8) (.1) (57) (.9) 32 .5
Total income tax expense $2,450 30.0% $1,863 28.9% $1,563 28.5%
61
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 10 - Employee Benefits
Incentive Compensation Plan
The Bank has a plan that provides incentive compensation to key employees if the
Bank meets certain performance criteria established by the Board of Directors.
The cost of this plan was $919, $602, and $435 in 2004, 2003 and 2002,
respectively.
401(k) Plans
The Bank has established a 401(k) profit sharing plan for those employees who
meet the eligibility requirements set forth in the plan. Eligible employees may
contribute up to 15% of their compensation. Matching contributions by the Bank
are at the discretion of the Board of Directors. Contributions totaled $234,
$129 and $126 for 2004, 2003 and 2002, respectively.
Director and Employee Deferred Compensation Plans
The Company has director and employee deferred compensation plans. Under the
terms of the plans, a director or employee may participate upon approval by the
Board. The participant may then elect to defer a portion of his or her earnings
(directors' fees or salary) as designated at the beginning of each plan year.
Payments begin upon retirement, termination, death or permanent disability, sale
of the Company, the ten-year anniversary of the participant's participation
date, or at the discretion of the Company. There are currently two participants
in the plans. Total deferrals plus earnings were $113, $105 and $110 at December
31, 2004, 2003 and 2002, respectively. There is no expense to the Company for
this plan.
The directors of a bank acquired by the Company in 1999 adopted two deferred
compensation plans for directors - one plan providing retirement income benefits
for all directors and the other, a deferred compensation plan, covering only
those directors who have chosen to participate in the plan. At the time of
adopting these plans, the Bank purchased life insurance policies on directors
participating in both plans which may be used to fund payments to them under
these plans. Cash surrender values on these policies were $2,923 and $2,819 at
December 31, 2004 and 2003, respectively. In 2004, 2003 and 2002, the net
(benefit)/cost recorded from these plans, including the cost of the related life
insurance, was $(322), ($271) and ($315), respectively. Both of these plans were
fully funded and frozen as of September 30, 2001. Plan participants were given
the option to either remain in the plan until reaching the age of 70 or to
receive a lump-sum distribution. Participants electing to remain in the plan
will receive annual payments over a ten-year period upon reaching 70 years of
age.
Non-Qualified Deferred Compensation Plan
The Company has a non-qualified deferred compensation plan to cover selected
employees. Its annual contributions to the plan totaled $5, $6 and $6 in 2004,
2003 and 2002, respectively. Covered employees may also contribute to the plan.
62
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 11 - Commitments and Contingencies
The Bank is party to financial instruments with off-balance-sheet risk in the
normal course of business to meet the financing needs of their customers. These
financial instruments include commitments to extend credit and standby letters
of credit, and involve, to varying degrees, elements of credit risk in excess of
the amount recognized on the consolidated balance sheets.
The Bank's exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit and standby
letters of credit is represented by the contractual amount of those instruments.
The Bank uses the same credit policies in making commitments and conditional
obligations as they do for on-balance-sheet instruments. A summary of the Bank's
commitments at December 31 is as follows:
2004 2003
Commitments to extend credit $75,188 $44,044
Standby letters of credit 3,997 2,715
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Since many
of the commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. The
Bank's experience has been that approximately 67% of loan commitments is drawn
upon by customers. The Bank evaluates each customer's creditworthiness on a
case-by-case basis. The amount of collateral obtained, if deemed necessary by
the Bank upon extension of credit, is based on management's credit evaluation of
the party. Collateral held varies, but may include accounts receivable,
inventory, property and equipment, residential real estate, and income-producing
commercial properties.
Standby letters of credit are conditional commitments issued by the Bank to
guarantee the performance of a customer to a third party. Those guarantees are
primarily issued to support public and private borrowing arrangements. The
credit risk involved in issuing letters of credit is essentially the same as
that involved in extending loan facilities to customers. Collateral held varies
as specified above, and is required in instances where the Bank deems necessary.
Certain executive officers have entered into employment contracts with the Bank
which provide for contingent payments subject to future events.
The Bank has agreements with commercial banks for lines of credit totaling
$21,000, none of which was used at December 31, 2004. In addition, the Bank has
a credit line with the Federal Home Loan Bank of Seattle totaling 20% of assets,
$21,500 of which was used at December 31, 2004. These borrowings are
collateralized under blanket pledge and custody agreements.
Because of the nature of its activities, the Company is subject to various
pending and threatened legal actions which arise in the ordinary course of
business. In the opinion of management, liabilities arising from these claims,
if any, will not have a material effect on the financial position of the
Company.
63
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 12 - Significant Concentrations of Credit Risk
Most of the Bank's business activity is with customers and governmental entities
located in the state of Washington, including investments in state and municipal
securities. Loans are generally limited by state banking regulations to 20% of
the Bank's shareholder's equity, excluding accumulated other comprehensive
income (loss). As of December 31, 2004 the Bank's loans to borrowers in the
hotel\motel industry totaled $36,209 or 10.53% of total loans. The Bank did not
experience any loan losses to borrowers in the hotel/motel industry in 2004.
Standby letters of credit were granted primarily to commercial borrowers. The
Bank, as a matter of practice, generally does not extend credit to any single
borrower or group of borrowers in excess of $5.5 million.
Note 13 - Stock Options
The Company's three stock incentive plans provide for granting incentive stock
options, as defined under current tax laws, to key personnel and under the plan
adopted in 2000, options not qualified for favorable tax treatment and other
types of stock based awards. Under the first plan, options are exercisable 90
days from the date of grant. These options terminate if not exercised within ten
years from the date of grant. If after six years from the date of grant fewer
than 20% of the options have been exercised, they will expire at a rate of 20%
annually. Under the second plan, the options are exercisable one year from the
date of grant, at a rate of 10% annually. Options terminate if not exercised
when they become available, and no additional grants will be made under these
two plans. The plan adopted in 2000 authorizes the issuance of up to a total of
1,000,000 shares, (449,900 shares are available for grant at December 31, 2004).
Under the 2000 plan, options either become exercisable ratably over five years
or vest fully five years from the date of grant. Under the 2000 plan, the
Company may grant up to 150,000 options for its common stock to a single
individual in a calendar year.
The fair value of each option grant is estimated on the date of grant, based on
the Black-Scholes option pricing model and using the following weighted-average
assumptions:
2004 2003 2002
Dividend yield 4.07% 5.31% 5.67%
Expected life 10 years 10 years 10 years
Risk-free interest rate 4.71% 4.38% 5.49%
Expected volatility 16.97% 17.73% 18.99%
The weighted average fair value of options granted during 2004 and 2003 was
$2.77 and $1.43, respectively.
The Black-Scholes model used by the Company to calculate option values, as well
as other currently accepted option valuation models, were developed to estimate
the fair value of freely tradable, fully transferable options without vesting
restrictions, which significantly differ from the Company's stock option awards.
These models also require highly subjective assumptions, including future stock
price volatility and expected time until exercise, which greatly affect the
calculated values. Accordingly, management believes that this model does not
necessarily provide a reliable single measure of the fair value of the Company's
option awards.
(continued)
64
Notes to Consolidated Financial Statements
- ------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 13 - Stock Options (concluded)
A summary of the status of the Company's stock option plans as of December 31,
2004, 2003 and 2002, and changes during the years ending on those dates, is
presented below:
2004 2003 2002
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
Outstanding at beginning of year 465,900 $11.63 359,592 $11.13 368,600 $10.60
BNW Bancorp, Inc. acquisition 117,208 5.83 -- -- -- --
Granted 143,100 17.03 124,008 12.81 47,992 11.67
Exercised (106,414) 11.09 (17,700) 9.83 (42,000) 7.05
Forfeited -- -- -- -- (15,000) 11.11
Outstanding at end of year 619,794 $12.51 465,900 $11.63 359,592 $11.13
Exercisable at end of year 257,690 $10.50 153,998 $11.03 106,600 $10.54
The following information summarizes information about stock options outstanding
and exercisable at December 31, 2004:
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Prices Outstanding Life (Years) Price Exercisable Price
$ 5.88 - $6.18 44,594 6 $ 6.17 44,594 $ 6.17
7.65 20,000 2 7.65 20,000 7.65
11.11 - 12.00 297,600 6 11.28 145,596 11.20
12.50 54,000 8 12.50 3,000 12.50
13.50 40,500 5 13.50 40,500 13.50
15.50 20,000 8 15.50 4,000 15.50
16.05 - 17.50 143,100 9 17.03 -- 17.03
619,794 257,690
65
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 14 - Regulatory Matters
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on the Company's consolidated financial statements. Under
capital adequacy guidelines on the regulatory framework for prompt corrective
action, the Bank must meet specific capital adequacy guidelines that involve
quantitative measures of the Bank's assets, liabilities and certain
off-balance-sheet items as calculated under regulatory accounting practices. The
Bank's capital classification is also subject to qualitative judgments by the
regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios (set
forth in the table below) of Tier 1 capital (as defined in the regulations) to
total average assets (as defined), and minimum ratios of Tier 1 and total
capital (as defined) to risk-weighted assets (as defined).
As of December 31, 2004, the most recent notification from the Bank's regulator
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. To be categorized as well capitalized, the Bank must
maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios
as set forth in the table. There are no conditions or events since that
notification that management believes have changed the institution's category.
The Company and the Bank's actual capital amounts and ratios are also presented
in the table. Management believes, as of December 31, 2004, the Company and the
Bank meet all capital requirements to which they are subject.
To be Well Capitalized
Under Prompt
Capital Adequacy Corrective Action
Actual Purposes Provisions
Amount Ratio Amount Ratio Amount Ratio
December 31, 2004
Tier 1 capital (to average assets):
Company $32,899 7.83% $16,790 4.00% NA NA
Bank 32,197 7.76 16,601 4.00 $20,751 5.00%
Tier 1 capital (to risk-weighted assets):
Company 32,899 9.00 14,636 4.00 NA NA
Bank 32,197 8.81 14,624 4.00 21,935 6.00
Total capital (to risk-weighted assets):
Company 37,135 10.15 29,273 8.00 NA NA
Bank 36,433 9.97 29,247 8.00 36,559 10.00
(continued)
66
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 14 - Regulatory Matters (concluded)
To be Well Capitalized
Under Prompt
Capital Adequacy Corrective Action
Actual Purposes Provisions
Amount Ratio Amount Ratio Amount Ratio
December 31, 2003
Tier 1 capital (to average assets):
Company $25,190 8.49% $11,864 4.00% N/A N/A
Bank 24,651 8.31 11,864 4.00 $14,830 5.00%
Tier 1 capital (to risk-weighted assets):
Company 25,190 11.62 8,675 4.00 N/A N/A
Bank 24,651 11.37 8,675 4.00 13,012 6.00
Total capital (to risk-weighted assets):
Company 27,428 12.65 17,350 8.00 N/A N/A
Bank 26,889 12.40 17,350 8.00 21,687 10.00
Note 15 - Comprehensive Income
Net unrealized gains and losses include, net of tax, $325 of unrealized losses
arising during 2004, $254 of unrealized gains arising during 2003 and $309 of
unrealized gains arising during 2002, less reclassification adjustments of $3,
$4 and $0 for gains included in net income in 2004, 2003 and 2002, respectively,
as follows:
Before- Tax
Tax Benefit Net-of-Tax
Amount (Expense) Amount
2004
Unrealized holding losses arising during the year $(492) $ 167 $(325)
Reclassification adjustments for gains realized in net income (3) 1 (2)
Net unrealized losses $(495) $ 168 $(327)
2003
Unrealized holding losses arising during the year ($384) $ 130 $(254)
Reclassification adjustments for gains realized in net income (4) 1 (3)
Net unrealized losses $(388) $ 131 ($257)
2002
Unrealized holding losses arising during the year $ 467 $(158) $ 309
Reclassification adjustments for gains realized in net income -- -- --
Net unrealized gains $ 467 $(158) $ 309
67
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 16 - Fair Values of Financial Instruments
The estimated fair values of the Company's financial instruments at December 31
are as follows:
2004 2003
Carrying Fair Carrying Fair
Amount Value Amount Value
Financial Assets
Cash and due from banks,
interest-bearing deposits with
banks, and federal funds sold $ 21,707 $ 21,707 $ 29,672 $ 29,672
Securities available for sale 35,780 35,780 57,473 57,473
Securities held to maturity 7,210 7,312 7,988 8,097
Federal Home Loan Bank stock 1,850 1,850 915 915
Loans receivable, net 341,671 344,234 197,500 200,449
Loans held for sale 1,852 1,852 -- --
Accrued interest receivable 1,873 1,873 1,275 1,275
Financial Liabilities
Deposits $363,501 $363,540 $260,800 $261,516
Long-term borrowings 21,500 21,370 14,500 14,319
Secured borrowings 3,733 3,733 -- --
Accrued interest payable 385 385 234 234
The Bank assumes interest rate risk (the risk that general interest rate levels
will change) as a result of its normal operations. As a result, the fair values
of the Bank's financial instruments will change when interest rate levels change
and that change may either be favorable or unfavorable to the Bank. Management
attempts to match maturities of assets and liabilities to the extent believed
necessary to minimize interest rate risk. However, borrowers with fixed rate
obligations are less likely to prepay in a rising rate environment and more
likely to prepay in a falling rate environment. Conversely, depositors who are
receiving fixed rates are more likely to withdraw funds before maturity in a
rising rate environment and less likely to do so in a falling rate environment.
Management monitors rates and maturities of assets and liabilities, and attempts
to minimize interest rate risk by adjusting terms of new loans, and deposits and
by investing in securities with terms that mitigate the Bank's overall interest
rate risk.
68
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 17 - Earnings Per Share Disclosures
Following is information regarding the calculation of basic and diluted earnings
per share for the years indicated.
Net Income Shares Per Share
(Numerator) (Denominator) Amount
Year Ended December 31, 2004
Basic earnings per share:
Net income $5,707 6,140,482 $0.93
Effect of dilutive securities:
Options -- 166,542 (.02)
Diluted earnings per share:
Net income $5,707 6,307,024 $0.91
Year Ended December 31, 2003
Basic earnings per share:
Net income $4,579 5,025,688 $0.91
Effect of dilutive securities:
Options -- 94,006 (.01)
Diluted earnings per share:
Net income $4,579 5,119,694 $0.90
Year Ended December 31, 2002
Basic earnings per share:
Net income $3,916 4,985,052 $0.79
Effect of dilutive securities:
Options -- 35,738 (.01)
Diluted earnings per share:
Net income $3,916 5,020,790 $0.78
The number of shares shown for "options" is the number of incremental shares
that would result from the exercise of options and use of the proceeds to
repurchase shares at the average market price during the year.
69
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 18 - Condensed Financial Information - Parent Company Only
Condensed Balance Sheets - December 31
2004 2003
Assets
Cash $ 5,011 $ 3,699
Investment in the Bank 44,600 25,208
Due from the Bank 316 89
Other assets -- 184
Total assets $49,927 $29,180
Liabilities and Shareholders' Equity
Dividends payable $ 4,624 $ 3,530
Shareholders' equity 45,303 25,650
Total liabilities and shareholders' equity $49,927 $29,180
Condensed Statements of Income - Years Ended December 31
2004 2003 2002
Dividend Income from the Bank $ 4,200 $ 3,729 $ 3,200
Expenses (255) (96) (59)
Income before income tax benefit 3,945 3,633 3,141
Income Tax Benefit 85 30 20
Income before equity in undistributed income of the Bank 4,030 3,663 3,161
Equity in Undistributed Income of the Bank 1,677 916 755
Net income $ 5,707 $ 4,579 $ 3,916
(continued)
70
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 18 - Condensed Financial Information - Parent Company Only (concluded)
Condensed Statements of Cash Flows - Years Ended December 31
2004 2003 2002
Operating Activities
Net income $ 5,707 $ 4,579 $ 3,916
Adjustments to reconcile net income to
net cash provided by operating activities:
Equity in undistributed income of subsidiary (1,677) (916) (755)
Net change in other assets (218) -- --
Other - net 60 (214) (19)
Net cash provided by operating activities 3,872 3,449 3,142
Investing Activities
Increase in amounts due from the Bank -- -- --
Financing Activities
Common stock issued 782 175 297
Dividends paid (3,530) (3,392) (3,289)
Other, net 188 -- --
Net cash used in financing activities (2,560) (3,217) (2,992)
Net increase in cash 1,312 232 150
Cash
Beginning of year 3,699 3,467 3,317
End of year $ 5,011 $ 3,699 $ 3,467
71
Notes to Consolidated Financial Statements
- --------------------------------------------------------------------------------
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 19 - Subsequent Events
In February 2005, the Board of Directors approved a two-for-one stock split to
be paid April 4, 2005, to shareholders of record on March 15, 2005. The impact
of this event has been retroactively reflected in the accompanying consolidated
financial statements as of December 31, 2001, which is the earliest period
presented. Additionally, in February 2005 the Company entered into a
construction contract to build a branch facility in Lynden, Washington.
Construction costs are estimated at $1,000,000.
Note 20 - Quarterly Data (Unaudited)
First Second Third Fourth
Quarter Quarter Quarter Quarter
Year Ended December 31, 2004
Interest income $4,837 $6,180 $6,251 $6,631
Interest expense 879 1,077 1,150 1,273
Net interest income 3,958 5,103 5,101 5,358
Provision for credit losses 70 300 300 300
Non-interest income 571 903 892 796
Non-interest expenses 2,606 3,599 3,642 3,708
Income before income taxes 1,853 2,107 2,051 2,146
Income taxes 479 680 616 675
Net income $1,374 $1,427 $1,435 $1,471
Earnings per common share:
Basic $ .25 $ .23 $ .23 $ .22
Diluted .25 .22 .22 .22
(continued)
72
- --------------------------------------------------------------------------------
Notes to Consolidated Financial Statements
Pacific Financial Corporation and Subsidiary
December 31, 2004 and 2003
Note 20 - Quarterly Data (Unaudited) (concluded)
First Second Third Fourth
Quarter Quarter Quarter Quarter
Year Ended December 31, 2003
Interest income $3,922 $3,991 $3,982 $4,054
Interest expense 899 896 824 789
Net interest income 3,023 3,095 3,158 3,265
Provision for credit losses -- -- -- --
Non-interest income 444 457 539 406
Non-interest expenses 1,910 1,931 2,003 2,101
Income before income taxes 1,557 1,621 1,694 1,570
Income taxes 445 470 500 448
Net income $1,112 $1,151 $1,194 $1,122
Earnings per common share:
Basic $ .22 $ .23 $ .24 $ .22
Diluted .22 .23 .24 .21
73
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, on the 16th day of March,
2005.
PACIFIC FINANCIAL CORPORATION
(Registrant)
/s/ Dennis A. Long /s/ John Van Dijk
- --------------------------------- ------------------------------------
Dennis A. Long, President and CEO John Van Dijk, CFO and Secretary
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities indicated, on the 16th day of March, 2005.
Principal Executive Officer and Director Principal Financial and Accounting
Officer
/s/ Dennis A. Long /s/ John Van Dijk
- ----------------------------------- ----------------------------------
Dennis A. Long, President and CEO John Van Dijk, Treasurer (CFO)
and Director Principal Financial and Accounting
Principal Executive Officer Officer
Remaining Directors
/s/ Joseph A. Malik /s/ G. Dennis Archer
- --------------------------- ----------------------------------
Joseph A. Malik (Chairman of the Board) G. Dennis Archer
- -------------------------- ----------------------------------
Gary C. Forcum Duane E. Hagstrom
- -------------------------- ----------------------------------
Walter L. Westling John Ferlin
/s/ David L. Woodland /s/ Robert J. Worrell
- -------------------------- ----------------------------------
David L. Woodland Robert J. Worrell
/s/ Susan C. Freese /s/ Randy W. Rognlin
- -------------------------- ----------------------------------
Susan C. Freese Randy W. Rognlin
/s/ Randy Rust
- -------------------------- ----------------------------------
Randy Rust Edwin Ketel
/s/ Douglas M. Schermer /s/ Stewart L. Thomas
- -------------------------- ----------------------------------
Douglas M. Schermer Stewart L. Thomas
74
Exhibit Index
EXHIBIT NO. EXHIBIT
- ----------- -------
2.1 Agreement and Plan of Merger between the Company and BNW
Bancorp, Inc. dated as of October 22, 2003 (1)
3.1 Restated Articles of Incorporation (2)
3.2 Bylaws (3)
10 Executive Compensation Plans and Arrangements and Other
Management Contracts
10.1 Employment Agreement with Dennis A. Long dated January 27,
2004 (4)
10.2 Employment Agreement with John Van Dijk dated January 2,
2003 (5)
10.3 Employment Agreement with Bruce D. MacNaughton dated
January 2, 2003 (5)
10.4 Bank of the Pacific Incentive Stock Option Plan (6)
10.5 The Bank of Grays Harbor Incentive Stock Option Plan (6)
10.6 2000 Stock Incentive Compensation Plan (7)
10.7 Bonus Program for Officers (7)
10.8 The Bank of Grays Harbor Employee Deferred Compensation
Plan (8)
21 Subsidiaries of Registrant - Bank of the Pacific, organized
under Washington law
23 Consent of McGladrey & Pullen, LLP, Independent Auditors
31.1 Certification of Chief Executive Officer Pursuant to Rule
13a-14(a)
31.2 Certification of Chief Financial Officer Pursuant to Rule
13a-14(a)
32 Certification Pursuant to 18 U.S.C. 1350
99 Description of common stock of the Company (9)
(1) Incorporated by reference to Exhibit 99.1 to the Company's current report on
Form 8-K dated October 22, 2003.
(2) Incorporated by reference to Exhibit 3.2 to the Company's Quarterly Report
on Form 10-Q for the quarter ended June 30, 2000.
(3) Incorporated by reference to Exhibit 2b to Form 8-A filed by the Company and
declared effective on March 7, 2000 (Registration No. 000-29329)
(4) Incorporated by reference to Exhibit 10.1 to the Company's Annual Report on
Form 10-K for the year ended December 31, 2003.
(5) Incorporated by reference to Exhibits 10.2, and 10.3 to the Company's Annual
Report on Form 10-K for the year ended December 31, 2002.
(6) Incorporated by reference to Exhibits 10.7 and 10.8 to the Company's Annual
Report on Form 10-K for the year ended December 31, 1999.
(7) Incorporated by reference to Exhibits 10.1 and 10.2 to the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2000.
(8) Incorporated by reference to Exhibit 10.10 to the Company's Annual Report on
Form 10-K for the year ended December 31, 2000.
(9) Incorporated by reference to Exhibit 99 to the Company's Quarterly Report on
Form 10-Q for the quarter ended September 30, 2000.