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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from to
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Commission file number 0-16276
STERLING FINANCIAL CORPORATION
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(Exact name of registrant as specified in its charter)
Pennsylvania 23-2449551
- -------------------------------------------- -------------------
State or other jurisdiction of incorporation (I.R.S. Employer
or organization) Identification No.)
101 North Pointe Boulevard
Lancaster, Pennsylvania 17601-4133
- ---------------------------------------- ----------
(Address of principal executive offices) (Zip Code)
(717) 581-6030
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(Registrant's telephone number including area code)
Not Applicable
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(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practical date.
Common Stock, $5.00 Par Value - 16,875,469 shares outstanding as of July 31,
2002.
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1
Sterling Financial Corporation and Subsidiaries
Index
Page
----
PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements (Unaudited)
Consolidated Balance Sheets
as of June 30, 2002 and December 31, 2001. 3
Consolidated Statements of Income
for the Three Months and Six Months ended
June 30, 2002 and 2001. 4
Consolidated Statements of Comprehensive Income
for the Three Months and Six Months ended
June 30, 2002 and 2001. 4
Consolidated Statements of Cash Flows
for the Six Months ended June 30, 2002 and 2001. 5
Notes to Consolidated Financial Statements. 6
Item 2 - Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
Item 3 - Quantitative and Qualitative Disclosure about Market Risk 20
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings 22
Item 2 - Changes in Securities and Use of Proceeds 22
Item 3 - Defaults Upon Senior Securities 22
Item 4 - Submission of Matters to a Vote of Security Holders 22
Item 5 - Other Information 22
Item 6 - Exhibits and Reports on Form 8-K 23
Signature Page 24
2
Part I - Financial Information
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (UNAUDITED)
June 30, December 31,
(Dollars in thousands) 2002 2001
---------- -------------
Assets:
Cash and due from banks $ 62,297 $ 68,926
Federal funds sold 86,257 25,606
---------- ----------
Cash and cash equivalents 148,554 94,532
Interest-bearing deposits in banks 3,010 2,367
Short-term investments 2,247 1,277
Mortgage loans held for sale 6,407 21,024
Securities held-to-maturity (fair value 2002 - $41,784; 2001 - $42,763) 40,349 41,788
Securities available-for-sale 511,830 490,955
Loans, net of allowance for loan losses 2002 - $12,632; 2001 - $11,071 1,227,485 1,087,102
Assets held for operating leases, net 61,132 58,996
Premises and equipment, net 32,514 32,186
Other real estate owned 326 74
Goodwill 18,314 1,228
Accrued interest receivable 12,441 12,116
Other assets 23,438 17,794
---------- ----------
TOTAL ASSETS $2,088,047 $1,861,439
========== ==========
Liabilities:
Deposits:
Non interest-bearing $ 196,250 $ 193,318
Interest-bearing 1,436,454 1,342,331
---------- ----------
Total deposits 1,632,704 1,535,649
---------- ----------
Short-term borrowings 50,587 20,285
Long-term debt 168,341 121,093
Company obligated mandatorily redeemable preferred
securities of subsidiary trust 20,000 --
Accrued interest payable . 8,469 8,747
Other liabilities 23,486 23,554
---------- -----------
TOTAL LIABILITIES 1,903,587 1,709,328
---------- -----------
STOCKHOLDERS' EQUITY
Common Stock - ($5.00 par value) 84,375 62,733
No. shares authorized: 70,000,000
No. shares issued: 2002 - 16,874,976; 2001 - 12,546,663
No. shares outstanding: 2002 - 16,868,723; 2001 - 12,511,953
Capital surplus 33,966 17,849
Retained earnings 56,210 66,823
Accumulated other comprehensive income 10,014 5,433
Common stock in treasury, at cost (2002 - 6,253; 2001 - 34,710) (105) (727)
---------- ----------
TOTAL STOCKHOLDERS' EQUITY 184,460 152,111
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $2,088,047 $1,861,439
========== ==========
The accompanying notes are an integral part of these consolidated financial
statements.
3
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME (UNAUDITED)
Three Months Ended Six Months Ended
June 30, June 30,
---------------------- ------------------------
(Dollars in thousands, except per share data) 2002 2001 2002 2001
------- ------- ------- -------
INTEREST AND DIVIDEND INCOME
Loans, including fees $23,743 $21,534 $45,538 $43,010
Debt securities
Taxable 4,869 4,173 9,732 9,019
Tax-exempt 2,232 2,725 4,481 4,776
Dividends 133 201 268 423
Federal funds sold 183 534 355 1,260
Deposits in other banks 12 26 23 41
------- ------- ------- -------
Total interest and dividend income 31,172 29,193 60,397 58,529
------- ------- ------- -------
INTEREST EXPENSE
Deposits 9,795 12,994 19,767 26,607
Short-term borrowings 400 210 658 435
Long-term debt 2,299 1,745 4,147 3,538
------- ------- ------- -------
Total interest expense 12,494 14,949 24,572 30,580
------- ------- ------- -------
Net interest income 18,678 14,244 35,825 27,949
------- ------- ------- -------
Provision for loan losses 582 495 800 797
------- ------- ------- -------
Net interest income after provision for loan losses 18,096 13,749 35,025 27,152
------- ------- ------- -------
NONINTEREST INCOME
Income from fiduciary activities 1,012 1,075 2,103 2,076
Service charges on deposit accounts 1,215 1,240 2,391 2,415
Other service charges, commissions and fees 1,392 935 2,513 1,882
Mortgage banking income 703 450 1,468 670
Rental income on operating leases 6,409 6,034 12,751 11,975
Other 598 402 1,027 633
Securities gains (losses) (407) 1,441 (391) 1,920
------- ------- ------- -------
Total noninterest income 10,922 11,577 21,862 21,571
------- ------- ------- -------
NONINTEREST EXPENSES
Salaries and employee benefits 9,693 7,390 18,530 14,498
Net occupancy 1,006 975 2,006 1,965
Furniture and equipment 1,364 1,273 2,702 2,438
Professional services 1,038 649 1,559 1,106
Depreciation on operating lease assets 5,185 4,750 10,280 9,428
Other 4,031 3,496 7,936 6,478
------- ------- ------- -------
Total noninterest expenses 22,317 18,533 43,013 35,913
------- ------- ------- -------
INCOME BEFORE INCOME TAXES 6,701 6,793 13,874 12,810
Income tax expense 542 1,555 2,193 2,828
------- ------- ------- -------
NET INCOME $ 6,159 $ 5,238 $11,681 $ 9,982
======= ======= ======= =======
Per share information:
Basic and diluted earnings per share $ .36 $ .33 $ .71 $ .64
Dividends declared .16 .15 .32 .30
OTHER COMPREHENSIVE INCOME (UNAUDITED)
Net income $ 6,159 $ 5,238 $11,681 $ 9,982
------- ------- ------- -------
Other comprehensive income, net of tax
Unrealized gains (losses) on securities
available for sale arising during the period 5,091 568 4,583 5,676
Reclassification adjustment for gains (losses)
included in net income 265 (937) 254 (1,248)
Unrealized loss on interest rate swap, net of
reclassification adjustment (256) - (256) -
------- ------- ------- -------
Other comprehensive income 5,100 (369) 4,581 4,428
------- ------- ------- -------
COMPREHENSIVE INCOME $11,259 $ 4,869 $16,262 $14,410
======= ======= ======= =======
The accompanying notes are an integral part of these consolidated financial
statements.
4
STERLING FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Six Months Ended June 30,
----------------------------
(Dollars in thousands) 2002 2001
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 11,681 $ 9,982
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 12,230 11,556
Accretion and amortization of investment securities 308 (100)
Provision for loan losses 800 797
(Gains) losses on sale of securities available-for-sale 391 (1,920)
(Gains) on sale of mortgage loans (512) (189)
Proceeds from sales of mortgage loans 79,949 44,620
Origination of mortgage loans held for sale (64,821) (59,939)
Change in operating assets and liabilities:
Increase in accrued interest receivable (325) (167)
Increase in other assets (5,497) (1,427)
Increase (decrease) in accrued interest payable (283) 339
Increase (decrease) in other liabilities (3,300) 1,858
-------- --------
Net cash provided by operating activities 30,621 5,410
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Net (increase) decrease in interest-bearing deposits in other banks (643) 281
Net increase in short-term investments (970) (345)
Proceeds from sales of securities available-for-sale 5,413 21,416
Proceeds from maturities or calls of securities
held-to-maturity 3,030 6,269
Proceeds from maturities or calls of securities
available-for-sale 44,326 65,474
Purchases of securities held-to-maturity (1,586) (1,331)
Purchases of securities available-for-sale (64,271) (85,760)
Net loans and direct finance leases made to customers (61,793) (35,183)
Purchases of equipment acquired for operating leases, net (12,485) (12,929)
Purchases of premises and equipment (2,232) (3,470)
Proceeds from sale of premises and equipment 98 231
Net cash paid for business combination (8,383) -
-------- --------
Net cash used by investing activities (99,496) (45,347)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits 97,055 51,357
Net decrease in short-term borrowings (36,688) (1,225)
Proceeds from issuance of long-term debt 50,250 17,600
Repayments of long-term debt (3,002) (20,894)
Proceeds from issuance of common stock - 3
Proceeds from issuance of trust preferred securities 20,000 -
Cash dividends (5,200) (4,768)
Purchase of treasury stock - (348)
Proceeds from issuance of treasury stock 513 108
Cash in lieu of fractional shares (31) -
-------- --------
Net cash provided by financing activities 122,897 41,833
-------- --------
Net change in cash and cash equivalents 54,022 1,896
-------- --------
CASH AND CASH EQUIVALENTS:
Beginning of period 94,532 103,567
-------- --------
End of period $148,554 $105,463
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
5
STERLING FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
Note 1 - Summary of Significant Accounting Policies
Basis of Presentation - The accompanying unaudited consolidated financial
statements of Sterling Financial Corporation and subsidiaries have been prepared
in accordance with accounting principles generally accepted in the United States
for interim financial information and instructions to Form 10-Q and Article 10
of Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States for complete financial statements. In the opinion of management, all
adjustments, consisting of normal recurring accruals, considered necessary for a
fair presentation have been included.
Operating results for the three months and six months ended June 30, 2002,
are not necessarily indicative of the results that may be expected for the year
ended December 31, 2002.
For further information, refer to the audited consolidated financial
statements, footnotes thereto, included in the Annual Report on Form 10-K, for
the year ended December 31, 2001.
The consolidated financial statements of Sterling Financial Corporation
include the accounts of its wholly-owned subsidiaries, Bank of Lancaster County,
N.A., First National Bank of North East, Bank of Hanover and Trust Company, HOVB
Investment Co., T&C Leasing, Inc., Pennbanks Insurance Company, Sterling
Financial Statutory Trust I and Sterling Mortgage Services, Inc. (inactive). The
consolidated financial statements also include Town & Country, LLC, Sterling
Financial Trust Company and Equipment Finance, Inc., all wholly-owned
subsidiaries of Bank of Lancaster County. All significant intercompany balances
and transactions have been eliminated in consolidation.
Earnings Per Common Share - Basic earnings per share represents income
available to common stockholders divided by the weighted-average number of
common shares outstanding during the period. Diluted earnings per share reflects
additional common shares that would have been outstanding if dilutive potential
common shares had been issued, as well as any adjustment to income that would
result from the assumed issuance. Potential common shares that may be issued by
Sterling consist solely of outstanding stock options, and are determined using
the treasury stock method.
Earnings per common share for the three months and six months ended June
30, 2002 and 2001 have been computed based on the following (dollars in
thousands):
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- ---------------------------
2002 2001 2002 2001
----------- ----------- ----------- ------------
Net income available to
stockholders $ 6,159 $ 5,238 $ 11,681 $ 9,982
=========== =========== =========== ===========
Average number of shares
outstanding 16,860,421 15,675,454 16,456,755 15,678,729
Effect of dilutive stock
options 126,070 74,571 110,327 42,651
----------- ----------- ----------- -----------
Average number of shares
outstanding used to
calculate diluted earnings
per share 16,986,491 15,750,025 16,567,082 15,721,380
=========== =========== =========== ===========
Earnings per share in formation has been restated to reflect the effect of
a 5-for-4 stock split effected in the form of a 25% stock dividend, declared
April 30, 2002 and payable June 3, 2002 to shareholders of record May 15, 2002.
Reclassifications - Certain items in the 2001 consolidated financial
statements have been reclassified to conform with 2002 presentation format.
6
Note 2 - Business Combination
On February 28, 2002, Sterling acquired 100 percent of the outstanding
common shares of Equipment Finance, Inc. (EFI), a Lancaster-based commercial
finance company. The results of EFI's operations have been included in the
consolidated financial statements since that date. EFI specializes in financing
forestry and land clearing equipment through more than 150 equipment dealer
locations ranging from Maine to Florida. As a result of the acquisition,
Sterling plans to enhance earnings and provide financial product
diversification.
The transaction was accounted for under the provisions of Statement No.
141, Business Combinations, which requires assets acquired and liabilities
assumed to be recorded at their fair value on the date of the acquisition. The
carrying amounts of the assets acquired and the liabilities assumed on February
28, 2002, approximated their fair value. The excess of the acquisition cost over
the fair value of the net assets acquired has been recorded as goodwill.
Goodwill recognized in this transaction was approximately $17 million, which was
assigned to the commercial finance segment. Consistent with the provisions of
Statement No. 142, Goodwill and Other Intangible Assets, goodwill will not be
amortized into net income over an estimated life but rather will be tested at
least annually for impairment based on the guidance provided in the statement.
The aggregate purchase price was $30,500,000 including $9,502,000 of cash
and common stock valued at $20,998,000. The value of the 954,452 common shares
issued was based on the closing price of Sterling Financial common stock at the
time of the Agreement and Plan of Reorganization (Merger Agreement) was entered
into. In accordance with the items of the Merger Agreement, there is no
contingent consideration associated with this transaction.
Note 3 - Segment Information
Changes in Sterling's organizational structure and acquisition during 2002
resulted in a modification to its reportable segments. During the first quarter
of 2002, Sterling acquired Equipment Finance, Inc. creating a new reportable
segment, commercial finance. On January 1, 2002, the wealth management division
of Bank of Lancaster County and the investment services division of Bank of
Hanover were combined into a single legal entity, Sterling Financial Trust
Company. In addition, during the second quarter of 2001, Pennbanks Insurance
Company's operations began, resulting in insurance-related activity. The trust
and the insurance segments of the corporation do not meet the thresholds for
reportable segment reporting; therefore, they are included in the all other
category. Prior to 2002, the trust and insurance segments were included in
community banking and related services.
Sterling, as a result of the modification in structure, now has three
reportable segments: 1) community banking and related services, 2) leasing
operations and 3) commercial finance. The community-banking segment provides
financial services to consumers, businesses and governmental units in south
central Pennsylvania and northeastern Maryland. These services include providing
various types of loans to customers, accepting deposits, and other typical
banking services. The leasing segment provides vehicle and equipment financing
alternatives to businesses primarily located in south central Pennsylvania and
northeastern Maryland, although assets are located throughout the United States.
The commercial finance segment specializes in financing forestry and
land-clearing equipment through more than 150 equipment dealer locations ranging
from Maine to Florida.
The June 30, 2001 segment information has been restated to conform with the
new segment reporting structure, with the exception of assets, which have not
been restated due to immateriality.
Information about reportable segments, and reconciliation of such
information to the consolidated financial statements as of the for the three and
six months ended June 30 is as follows (in thousands):
7
Community
Banking & Inter-
Related Commercial All Segment Consolidated
Services Leasing Finance Other Eliminations Totals
--------- ------- ---------- ------ ------------ ------------
THREE MONTHS ENDED JUNE 30, 2002
Interest and dividend income 27,724 1,816 3,327 8 (1,703) 31,172
Interest expense 11,676 1,895 626 - (1,703) 12,494
Provision for loan losses 185 310 87 - - 582
Noninterest income 2,689 6,682 36 1,515 - 10,922
Noninterest expenses 13,842 6,401 617 1,457 - 22,317
Income before income taxes 4,710 (108) 2,033 66 - 6,701
Income tax expense (benefit) 788 (1,141) 865 30 - 542
Net income 3,922 1,033 1,168 36 - 6,159
THREE MONTHS ENDED JUNE 30, 2001
Interest and dividend income 28,759 1,817 - 21 (1,404) 29,193
Interest expense 14,377 1,976 - - (1,404) 14,949
Provision for loan losses 275 220 - - - 495
Noninterest income 4,218 6,205 - 1,154 - 11,577
Noninterest expenses 11,933 5,495 - 1,105 - 18,533
Income before income taxes 6,392 331 - 70 - 6,793
Income tax expense (benefit) 1,415 141 - (1) - 1,555
Net income 4,977 190 - 71 - 5,238
SIX MONTHS ENDED JUNE 30, 2002
Interest and dividend income 55,377 3,665 4,341 17 (3,003) 60,397
Interest expense 23,055 3,710 810 - (3,003) 24,572
Provision for loan losses 241 450 109 - - 800
Noninterest income 5,819 13,170 44 2,829 - 21,862
Noninterest expenses 27,239 12,349 773 2,652 - 43,013
Income before income taxes 10,661 326 2,693 194 - 13,874
Income tax expense (benefit) 1,941 (959) 1,139 72 - 2,193
Net income 8,720 1,285 1,554 122 - 11,681
Assets 1,989,713 157,413 107,080 3,075 (169,234) 2,088,047
SIX MONTHS ENDED JUNE 30, 2001
Interest and dividend income 57,662 3,618 - 21 (2,772) 58,529
Interest expense 29,456 3,896 - - (2,772) 30,580
Provision for loan losses 470 327 - - - 797
Noninterest income 7,111 12,280 - 2,180 - 21,571
Noninterest expenses 22,769 10,903 - 2,241 - 35,913
Income before income taxes 12,078 772 - (40) - 12,810
Income tax expense 2,503 325 - - - 2,828
Net income 9,575 447 - (40) - 9,982
Assets 1,730,912 142,827 - - (86,777) 1,786,962
Sterling's reportable segments are strategic business units that offer
different products and services. They are managed separately because each
segment appeals to different markets and, accordingly, requires different
technology and marketing strategies. Sterling's chief operating decision maker
utilized interest income, interest expense, noninterest income, non-interest
expense and the provision for income taxes in making decisions and determining
resources to be allocated to the segments.
8
Sterling does not have operating segments other than those reported above.
Parent company and treasury function income is included in the community-banking
segment, as the majority of effort of these functions is related to this
segment.
Sterling does not have a single external customer from whom it derives 10%
or more of its revenue.
Note 4 - Restructuring Costs
During the third quarter of 2000, Sterling completed its merger with
Hanover Bancorp, Inc. and incurred restructuring costs totaling $1,472,000,
which primarily consisted of severance and related benefit, professional fees,
termination fees related to noncancellable service contracts and asset
write-offs related to conversion of the banking subsidiaries into a common core
processing system.
The following summarizes the restructuring expense charge to operations
during 2000, and the remaining balance in restructuring accrual at June 30,
2002. The remaining unpaid expenses are expected to be paid through 2002.
Initial Accrual at
(In thousands) Expense June 30, 2002
------- -------------
Employee termination $ 718 $103
Asset disposals/write-downs 334 -
Non-cancelable contracts 312 115
Professional fees 88 28
Other 20 -
------ ----
$1,472 $246
------ ----
Note 5 - Financial Derivatives
As part of the Corporation's asset/liability management, the Corporation
uses interest rate swaps and caps to manage interest rate risk associated with
variable-rate funding sources. All such derivatives are recognized on the
balance sheet at fair value in other assets or liabilities as appropriate. To
the extent the derivatives are effective and meet the requirements for hedge
accounting, changes in fair value are recognized in other comprehensive income
with income statement reclassification occurring as the hedged item affects
earnings. Conversely, changes in fair value attributable to ineffectiveness or
to derivatives that do not qualify as hedges are recognized as they occur in the
income statement's other expense account with the hedged item.
During the second quarter of 2002, the Corporation entered into an interest
rate swap transaction with an aggregate notional amount of $25 million with a
term of four years. According to the terms of the transaction, the Corporations
pays fixed-rate interest rate payments and receives floating-rate payments. The
swap was entered into to hedge the Corporation's exposure to higher interest
rates on it variable-rate funding sources. At June 30, 2002, the fair value of
the swap was a negative $438,000. The decrease in fair value, net of income
taxes, is included in comprehensive income.
Note 6 - Income Taxes
On June 28, 2002, a non banking affiliate of Sterling organized as a
C-corporation was converted to a single member limited liability company. As a
result of this conversion, the need for approximately $1.2 million in state
deferred tax liabilities, principally related to elapsing activities, was
eliminated and resulted in a reduction of income tax expense for the period.
9
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
In addition to historical information, this Quarterly Report on Form 10-Q
contains forward-looking statements. The forward-looking statements are subject
to risk and uncertainties. Forward-looking statements include the information
concerning possible or assumed future results of operations of Sterling
Financial Corporation, and its subsidiaries, or the combined company. When we
use words such as "believes", "expects", "anticipates" or similar expressions,
we are making forward-looking statements.
Shareholders should note that many factors, some of which are discussed
elsewhere in this report, could affect the future financial results of Sterling
Financial Corporation and its subsidiaries, both individually and collectively,
and could cause those results to differ materially from those expressed in this
report. These factors include the following:
- operating, legal and regulatory risks;
- economic, political and competitive forces impacting our various lines
of business;
- the risk that our analysis of these risks and forces could be
incorrect and/or that the strategies developed to address them could
be unsuccessful;
- the possibility that increased demand or prices for Sterling's
financial services and products may not occur;
- volatility in interest rates;
- the success of our merger of Hanover Bancorp, Inc. and acquisition of
Equipment Finance, Inc.; and
- other risks and uncertainties.
Sterling undertakes no obligation to publicly revise or update these
forward-looking statements to reflect events or circumstances that arise after
the date of this report. Readers should carefully review the risk factors
described in other documents Sterling files periodically with the Securities and
Exchange Commission, including Quarterly Reports on Form 10-Q, Annual Report on
Form 10-K, and any Current Reports on Form 8-K.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001
OVERVIEW
Net income for the quarter ended June 30, 2002 was $6,159,000 compared to
$5,238,000 in 2001, an increase of $921,000 or 17.6%. Basic and diluted earnings
per share were $.36 for the second quarter of 2002, an increase of $.03 or 9.1%
from $.33 for the same quarter in 2001. These earnings resulted in a return on
average assets of 1.22% compared to 1.19% for the same quarter in 2001. The
return on average realized equity was 14.93% for the second quarter of 2002,
versus 15.01% for the same period last year.
NET INTEREST INCOME
The primary component of Sterling's revenue is net interest income, which
is the difference between interest income and fees on interest-earning assets
and interest expense on deposits and borrowed funds. Net interest income, on a
tax equivalent basis, totaled $20,038,000 for the quarter ended June 30, 2002,
an increase of $4,297,000 or 27.3% from 2001. This increase in net interest
income reflects both a 14.7% increase in the average balance of interest-earning
assets as well as a 44 b.p. increase in net interest margin. Sterling's newest
subsidiary, Equipment Finance, Inc., added $2,683,000 of this increase.
The increase in interest-earning assets came primarily in the form of
loans. Strong growth in the commercial loan portfolio, in part due to the
acquisition of Equipment Finance, Inc., contributed to this increase. Funding
this growth in assets were increases in both deposits and borrowings, including
a trust-preferred issuance of $20 million. In addition, during the second
quarter of 2002, the
10
corporation leveraged the proceeds of the trust preferred by borrowing
$26,250,000 from the Federal Home Loan Bank and purchased securities with these
funds.
During the year ended 2001, the Federal Reserve Bank lowered the overnight
borrowing rate eleven times totaling 4.75%. This dramatic decrease in short-term
interest rates resulted in a significant reduction in the cost of funds for
Sterling. The rate paid on interest bearing liabilities declined 129 b.p. from
the second quarter of 2001 to the second quarter of 2002 resulting from:
- the reduction of rates paid on deposit accounts;
- the maturing of higher rate deposits and borrowings;
- deposit growth at low rates of interest.
At the same time, the rate earned on interest earning assets declined only
58 b.p. reflecting:
- a general lag in the effect of rapidly declining rates on loan and
securities portfolio yields due to the proportion of fixed rates of
interest in these portfolios;
- growth in loan portfolio, resulting in a shift in the mix to higher
yielding interest earning assets; and
- immediate decrease in rates of interest earned on federal funds sold,
other short-term investments and variable rate loans and securities.
PROVISION FOR LOAN LOSSES
The provision for loan losses increased $87,000 from $495,000 for the
quarter ended June 30, 2001 to $582,000 in 2002. The provision reflects the
amount deemed appropriate by management to provide an adequate reserve to meet
the present risk characteristics of the loan portfolio. See further discussion
in the allowance for loan losses section.
NONINTEREST INCOME
Total noninterest income totaled $10,922,000 for the three months ended
June 30, 2002 compared to $11,577,000 in 2001, a decrease of 5.6%.
Income from fiduciary activities decreased 5.8% from $1,075,000 for the
quarter ended June 30, 2001, to $1,012,000 for the comparable period in 2002.
The fair value of assets under management is directly related to the performance
of the stock market and interest rate environment. Continued pressure on the
stock market has resulted in lower fees for the trust company. As many fiduciary
fees are based on the fair value of assets managed, volatility in interest rates
and the stock market could impact income from fiduciary activities. Although,
Sterling Financial Trust Company has experienced lower revenues as a result of
the stock market, it has continued to gain new customers and fees to somewhat
neutralize the lost revenues from market declines.
Other service charges, commissions and fees increased $457,000, or 48.9%,
from $935,000 for the quarter ended June 30, 2001 to $1,392,000 for the same
period in 2002. Increased customer debit card usage, higher volumes of customers
enrolled in cash management programs and strong mutual fund sales have led to
the revenue increases in this category. Mutual fund sales during the quarter
were positively influenced by Sterling's termination of its defined benefit
plan, in which employees rolled these funds into their 401(k)/individual
retirement accounts.
Mortgage banking income totaled $703,000 for the three months ended June
30, 2002, a 56.2% increase from the same period in 2001. The financial services
industry has seen an increased volume of mortgage loan originations/refinancings
beginning in the second half of 2001, which has carried over into 2002, a direct
result of lower interest rates on mortgage loan products offered.
Rental income on operating leases has increased 6.2% from $6,034,000 for
the quarter ended June 30, 2001 to $6,409,000 in 2002. This increase is due
primarily to increases in the number of units under operating leases, which
totaled 6,054 as
11
of June 30, 2002, versus 5,693 at June 30, 2001.
Securities losses totaled $407,000 for the three months ended June 30, 2002
versus securities gains of $1,441,000 for the same period last year. During the
second quarter of 2002, Sterling's management conducted a review of its security
portfolio, and recorded a $541,000 "other than temporary" impairment charge
which offset securities gains to that point. Management concluded that the
impairment charge was warranted due to corporate bond exposure in the
telecommunications industry. The two specific securities that were written down
were later sold in July 2002 at a price consistent with the June 30, 2002 net
book value. Management continues to monitor its securities portfolio in light of
current market conditions to determine if additional "other than temporary"
impairment exists. In contrast, during the second quarter of 2001, management
elected to sell a portion of its debt security portfolio in order to shorten the
portfolios duration, which resulted in securities gains. Additionally, certain
financial institution sector stocks were sold in order to maximize earnings
potential on thee securities.
NONINTEREST EXPENSES
Noninterest expenses totaled $22,317,000 for the quarter ended June 30,
2002, compared to $18,533,000 for the same period in 2001. This represents an
increase of $3,784,000, or 20.4%.
Salaries and employee benefits totaled $9,693,000 for the quarter ended
June 30, 2002, a $2,303,000 or 31.2% increase from the same period in 2001. This
increase is attributable to the following factors:
- Unusual expenses of $937,000 for severance arrangements entered into
during the second quarter of 2002 with no similar charges taken during
the same period in 2001;
- Normal merit increases;
- Additional staff being hired for increased volume levels, including
two new branches;
- The addition of the salaries and benefits paid to employees of
Sterling's newest affiliate, EFI;
- Health and welfare benefits costs continue to increase, consistent
with national trends; and
- Higher incentive accruals as the Corporation's performance in the
second quarter of 2002 exceeded that in 2001;
The 7.1% or $91,000 increase in furniture and equipment expense for the
quarter ended June 30, 2002 versus the same period last year was the result of
an increase in the number of branches during the period and renovations and
expansion made at existing office locations.
Professional services increased to $1,038,000 for the quarter ended June
30, 2002, an increase of $389,000, or 59.9%, from the same period in 2001. The
primary reason for the increase can be attributed to $300,000 professional fees
related to the conversion of a non-bank affiliate to a limited liability
corporation. Additionally, professional fees included consulting costs
associated with review of operating procedures and other general corporate
matters.
Depreciation on operating lease assets increased from $4,750,000 for the
quarter ended June 30, 2001 to $5,185,000 for the same period in 2002. The
increase is consistent with the growth noted in rental income on operating
leases.
Other operating expenses totaled $4,031,000 for the quarter ending June 30,
2002, a 15.3% increase over the same period in 2001, which totaled $3,496,000.
The primary reason for the increase was due to increased volumes and assets. The
largest contributor to the increase was marketing and advertising costs which
were $120,000 higher in the second quarter of 2002 versus 2001, and was the
result of the timing of promotions and the continued emphasis on advertising
Sterling Financial Trust Company.
INCOME TAXES
Income tax expense for the quarter ended June 30, 2002 was $542,000
resulting
12
in an effective tax rate of 10.10% as compared to 22.9% in 2001. The significant
reduction in the effective tax rate is primarily the result of an approximate
$1.2 million state tax benefit that a non-bank affiliate of Sterling realized
upon the conversion from a C-Corporation to a limited liability corporation. The
remaining difference between the effective tax rate and the statutory federal
income tax rate of 35% is primarily the result of tax-exempt income.
SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001
OVERVIEW
Net income for the six months ended June 30, 2002 was $11,681,000 versus
$9,982,000 in 2001, an increase of $1,699,000 or 17.0%. Basic and diluted
earnings per share were $0.71 in 2002, an increase of $.07 or 10.9% from $0.64
for the same period in 2001. These earnings resulted in a return on average
assets of 1.19% and return on average realized equity of 14.40% for the six
months ended June 30, 2002, versus 1.16% and 14.51%, respectively, in the
corresponding period of 2001.
NET INTEREST INCOME
The following table summarizes, on a fully taxable equivalent basis, net
interest income and net interest margin for the six months ended June 30, 2002
and 2001:
(Dollars in thousands)
2002 2001
---------------------------------------- -----------------------------------------
Average Yield/ Average Yield/
Balance Interest Rate Balance Interest Rate
---------- -------- ------ ---------- -------- ------
Interest earnings assets:
Securities, federal funds sold
and short-term inv. $ 582,192 $17,273 5.93% $ 540,494 $18,091 6.75%
Loans 1,207,407 45,675 7.56% 1,049,568 43,571 8.37%
---------- ------- ---- ---------- ------- -----
1,789,599 62,948 7.03% 1,590,062 61,662 7.82%
---------- ------- ---- ---------- ------- -----
Interest bearing liabilities:
Deposits 1,382,967 19,767 2.88% 1,266,507 26,607 4.24%
Borrowings 193,642 4,807 4.99% 136,287 3,973 5.88%
---------- ------- ---- ---------- ------- -----
1,576,609 24,572 3.14% 1,402,794 30,580 4.40%
---------- ------- ---- ---------- ------- -----
Interest rate spread 3.89% 3.42%
Net interest income (FTE)/Net interest
margin 38,376 4.26% 31,082 3.94%
Taxable-equivalent adjustment (2,970) (3,133)
Interest recovery on charged-off loans 419 -
------- -------
Net interest income $35,825 $27,949
======= =======
Interest income, on a tax equivalent basis, totaled $62,948,000 for six
months ended June 30, 2002, an increase of $1,286,000 from 2001. This increase
in interest income was a result of a 12.6% increase in average interest earnings
assets, offset by a 79 b.p. reduction in yield earned on those assets. The
increase in average interest earning assets is due primarily to the acquisition
of Equipment Finance, Inc., strong commercial loan growth, and leveraging of the
trust preferred proceeds with investment securities. Contributing to the
decrease in the yield was significantly lower interest rates in the first half
of 2002 as compared to 2001. As discussed previously, the Federal Reserve
lowered interest rates 475 b.p. in 2001, including 275 b.p. in the first half of
2001. A decrease in rates immediately impacts the short-term investment
portfolio, including federal funds sold, as well
13
as the variable rate loan portfolio.
Interest expense amounted to $24,572,000 for the first six months of 2002,
reflecting a decrease of $6,008,000 from the $30,580,000 accrued in 2001. This
decrease resulted from a 126 b.p. decrease in rates paid on interest-bearing
liabilities, offset by a 12.3% increase in average interest bearing liabilities.
Sterling experienced a greater reduction in rates paid on interest bearing
liabilities as compared to interest bearing assets, as a greater portion of the
liabilities are variable rate, or reprice more frequently than the asset
portfolio.
As a result of the lower and more stable interest rate environment in 2002
compared to 2001, combined with the acquisition of Equipment Finance, Inc. whose
interest-earning assets yield higher returns than the banking and leasing
affiliates, Sterling's net interest margin was favorably impacted. Net interest
margin for the six months ended June 30, 2002 was 4.26%, as compared to 3.94% in
2001, a 32 b.p. increase.
PROVISION FOR LOAN LOSSES
The provision for loan losses increased $3,000 from $797,000 for the six
months ended June 30, 2001 to $800,000 for the comparable period in 2002. The
provision for loan losses is based upon the quarterly review of the loan
portfolio and reflects the amount deemed appropriate by management to provide an
adequate reserve to meet the present risk characteristics of the loan portfolio.
NONINTEREST INCOME
Total noninterest income amounted to $21,862,000 for the six months ended
June 30, 2002, reflecting an increase of $291,000 from $21,571,000 reported in
2001.
Other service charges, commission and fees increased from $1,882,000 for
the six months ended June 30, 2001 to $2,513,000 for the same period in 2002.
Increased customer debit card usage, higher volumes of customers enrolled in
cash management programs and strong mutual fund sales have lead to the revenue
increases in this category.
Mortgage banking income totaled $1,468,000 for the six months ended June
30, 2002, a 119.1% increase from the same period in 2001. The financial services
industry experienced increased volumes of mortgage loan originations/
refinancing activity during the second half of 2001, which has carried over into
2002. As rates have been relatively low for an extended period of time, Sterling
has experienced a slight slow down turn in mortgage refinancing volumes.
Rental income on operating leases has increased 6.5% from $11,975,000 for
the six months ended June 30, 2001 to $12,751,000 in 2002. The increase in
rental income is primarily due to an increase in the number of units under
operating leases, which totaled 6,054 as of June 30, 2002, versus 5,683 at June
30, 2001.
Other noninterest income has increased to $1,027,000 for the six months
ended June 30, 2002, as compared to $633,000 in 2001. The primary reason for the
increase is due to increased insurance related activities, as Sterling continues
to devote resources to increasing its credit life and disability premium income,
and equity in earnings from its interest in its commercial, personal and title
insurance agencies.
Securities losses totaled $391,000 for the six months ended June 30, 2002,
versus gains of $1,920,000 in 2001, a fluctuation of $2,311,000. As mentioned
previously, Sterling recorded "other than temporary" impairment expense on debt
securities within the telecommunications industry of $541,000 during second
quarter of 2002, which offset securities gains to that point. In contrast,
during 2001, management elected to sell a portion of its debt security portfolio
in order to shorten the portfolio's duration, which resulted in securities
gains. Additionally, certain financial institution sector stocks were sold in
order to maximize earnings potential on these securities.
NONINTEREST EXPENSES
Noninterest expenses totaled $43,013,000 for the six months ended June 30,
14
2002, an increase of $7,100,000, or 19.7%, from 2001.
Salaries and employee benefits totaled $18,530,000 for the six months ended
June 30, 2002, a $4,032,000, or 27.8% increase from the same period in 2001.
This increase is attributable to the following factors:
- Normal merit increases;
- Additional staff being hired for increased volume levels, including
two new branches;
- Addition of the salaries and benefits associated with the EFI
acquisition;
- Health and welfare benefits costs continue to increase, consistent
with national trends;
- Higher incentive accruals as the Corporation's performance in the
first half of 2002 exceeded that in 2001;
- Unusual expenses of $1,410,000 related to the termination of the
qualified non-contributory pension plan of $270,000 and severance
arrangements during the first half of 2002 totally $1,140,000.
Furniture and equipment expense increased from $2,438,000 for the six
months ended June 30, 2001 to $2,702,000 for the same period in 2002. The
increase in furniture and equipment expense was due primarily to several new
branches that were opened in 2001, being in operation for the entire six months
in 2002, but only a portion of the period in 2001. The increase in the number of
branches, as well as renovations and expansion made at existing office
locations, resulted in an increase in furniture and equipment expense.
Professional services totaled $1,559,000 for the six months ended June 30,
2002, versus $1,106,000 for six months ended June 30, 2001. This $453,000, or
41.0% increase can be primarily attributed to the professional fees related to
the conversion of a non-bank affiliate to a limited liability corporation, as
well as other general corporate matters.
Depreciation on operating lease assets totaled $10,280,000 for the six
months ended June 30, 2002 compared to $9,428,000 in 2001. The increase is
consistent with the growth noted in rental income on operating leases.
Depreciation expense on operating lease assets, as a percent of rental income,
has remained at approximately 80%.
The remaining increase in noninterest expenses is consistent with the
overall growth experienced by Sterling Financial Corporation.
Operating expense levels are often measured by the efficiency ratio, which
expresses noninterest expense, excluding unusual chares, as a percent of
tax-equivalent net interest income and other income, excluding securities gains
(losses) on non-investment company affiliates. In calculating its efficiency
ratio, Sterling nets depreciation on operating leases with the related rental
income to more consistently present operating results with the banking industry.
Despite the increases in operating expenses, Sterling was able to improve its
efficiency ratio from 63.5% for the six months ended at June 30, 2001 to 62.0%
during 2002.
INCOME TAXES
Income tax expense for the six months ended June 30, 2002 was $2,193,000,
resulting in an effective tax rate of 15.8%, compared to 22.1% in 2001. The
significant reduction in the effective tax rate is primarily the result of an
approximate $1.2 million state tax benefit that non-bank affiliate of Sterling
realized upon the conversion from a C-Corporation to a limited liability
corporation.
FINANCIAL CONDITION
Total assets at June 30, 2002 amounted to $2,088,047,000 compared to
$1,861,439,000 at December 31, 2001. This represents an increase of $226,608,000
or 12.2% over that period of time.
15
SECURITIES
As of June 30, 2002, securities totaled $552,179,000, which represents an
increase over the December 31, 2001 balance of $532,743,000. Sterling utilizes
investment securities to generate interest and dividend income, to manage
interest rate risk, and to provide liquidity. The growth in the security
portfolio during the six months ended June 30, 2002 was partially related to
unrealized gains on securities available for sale, supplemented with leveraging
of the trust preferred offering with investment securities.
LOANS
Net loans have grown by 12.9%, from $1,087,102,000 at December 31, 2001 to
$1,227,485,000 at June 30, 2002. This growth was primarily experienced in the
commercial loan portfolios, including the addition of $80,277,000 in finance
receivables associated with the acquisition of Equipment Finance, Inc.
ALLOWANCE FOR LOAN LOSSES
Sterling's allowance for loan losses was $12,632,000 at June 30, 2002, or
1.02% of loans outstanding compared to 1.01% at December 31, 2001.
The following table presents information concerning the aggregate amount of
nonaccrual, past due and restructured loans as of June 30, 2002 and December 31,
2001 (in thousands):
June 30, December 31,
2002 2001
-------- ------------
Nonaccrual loans $ 8,104 $6,707
Accruing loans, past due 90 days or more 1,236 1,562
Restructured loans 526 531
------- ------
Total non-performing loans 9,866 8,800
Foreclosed assets 600 74
------- ------
Total non-performing assets $10,466 $8,874
======= ======
Non-performing loans to total loans 0.80% 0.80%
Allowance for loan losses to non-performing loans 128% 126%
The restructured loans included in nonperforming loans represent a series
of loans to one borrower in the real estate business. Sterling has no commitment
to lend this customer additional funds related to the restructured notes. These
restructured loans are fully secured with real estate collateral, are current,
and have performed in accordance with the contractual terms, both prior to and
after the restructuring. Accrual of interest on the restructured loans
continues.
As of June 30, 2002, nonperforming assets totaled $10,466,000, an increase
of $1,592,000 from December 31, 2001. The increase in nonaccrual loans is
primarily the result of one substandard commercial loan relationship that
migrated to nonaccrual status during the second quarter of 2002. Additionally,
increased foreclosure activity on real estate combined with the addition of
Equipment Finance Inc.'s foreclosed equipment balance led to the increase in
foreclosed assets. Despite the increased nonaccrual loans and foreclosed assets,
non-performing loans to total loans and the allowance for loan losses to
non-performing loans ratios have remained consistent between the two periods, as
the loan portfolio has increased by 12.9%. These asset quality ratios are within
acceptable limits and consistent with Sterling's peer group.
Potential problem loans are defined as performing loans that have
characteristics that cause management to have doubts as to the ability of the
borrower to perform under present loan repayment terms and which may result in
the reporting of these loans as nonperforming loans in the future. Total
potential
16
problem loans approximated $9.3 million at June 30, 2002, including $6.7 million
in outstanding loans and outstanding credit commitments of $2.6 million. The
majority of these loans are secured by real estate with acceptable loan-to-value
ratios. Sterling's exposure to potential problem loans has increased since
December 31, 2001, which totaled $3.2 million, including $1.8 million in loans
outstanding and $1.4 million in outstanding credit commitments.
Sterling maintains the allowance for loan losses at a level believed
adequate by management to absorb potential losses in the loan portfolio both at
the consolidated level as well as each affiliate on a stand-alone basis. As a
result of each banking affiliate being subject to separate safety and soundness
examinations, the separate affiliate analysis in connection with the overall
consolidated analysis is necessary given these outside influences. The allowance
for loan losses is established through a provision for loan losses charged to
earnings. Quarterly, Sterling utilizes a defined methodology in determining the
adequacy of the allowance for loan losses that considers specific credit
reviews, historical loan loss experience, and qualitative factors. This
methodology, which has remained consistent for the past several years, results
in allowance consisting of two components, "allocated" and "unallocated". (For a
more thorough discussion of the allowance for loan losses methodology, please
refer to the Corporation's Annual Report on Form 10-K for the year ended
December 31, 2001).
As of June 30, 2002, the unallocated portion of the allowance for loan
losses, totaled approximately $3.0 million, an approximate 10% increase over the
December 31, 2001 unallocated balance of approximately $2.7 million. The
increase in the unallocated portion of the reserve is the result of an increase
in potential problem loans and loans outstanding, as well as the uncertain
national economy and the impact it will have on customers with Sterling's market
area. The unallocated portion continues to represent approximately 24% of the
reserve balance.
Management believes the above methodology accurately reflects losses
inherent in the portfolio. Management periodically updates the methodology
discussed above, which reduces the difference between actual losses and
estimated losses.
A rollforward of the allowance for loan losses for the six months ended
June 30, 2002 and 2001 were as follows (in thousands):
2002 2001
------- --------
Balance at January 1 $11,071 $11,716
Allowance acquired in acquisition 837 --
Provision for loan losses charged to income 800 797
Loans charged-off (969) (1,543)
Recoveries of loans previously charged off 893 235
------- -------
Balance at June 30 $12,632 $11,205
======= =======
Net charge-offs to average loans outstanding 0.01% .13%
The rollforward of the allowance for loan losses and related net
charge-offs to average loans outstanding ratio for the six months ended June 30,
2002 and 2001, reflects approximately $735,000 in charge-offs that occurred in
2001 pertaining to fraudulent loan activities, of which $598,000 was recovered
from insurance proceeds during 2002.
ASSETS HELD FOR OPERATING LEASES
During the first six months of 2002, Sterling increased the balance of
assets held for operating leases from $58,996,000 at year-end 2001 to
$61,132,000 at June 30, 2002. Sterling recognizes that leasing operations
represent a growth opportunity for Sterling and has committed resources to
expand this business. These resources include increased marketing efforts, not
only in developing customer relationships, but also in maintaining existing
customers. This approach has led to an increase in the number of new units
leased within our customer base.
17
DEPOSITS
Total deposits at June 30, 2002 totaled $1,632,704,000 compared to
$1,535,649,000 at December 31, 2001. This represents an increase of $97,055,000
or 6.3%, during this period of time. The increase in deposits is attributable to
successful marketing campaigns, particularly in time deposits and cash
management accounts, as well as overall consumer sentiment that bank certificate
of deposits are a safe investment, in light of the volatility experienced in the
stock market in 2002. Sterling continues to heavily market its time deposits and
cash management products in order to decrease its reliance in third-party
funding sources, which typically have high interest rates associated with them.
BORROWINGS
Short-term borrowings totaled $50,587,000 at June 30, 2002, an increase of
$30,302,000 from December 31, 2001. This increase is attributable to Sterling
borrowing approximately $38 million to fund finance receivables, along with a
decrease of approximately $6 million of floating short-term debt that was
converted to fixed long-term debt. Long-term debt increased by $47,248,000 from
December 31, 2001 to June 30, 2002, and totaled $168,341,000. $15 million of the
increase was the result of the Corporation's desire to lock in low interest
rates and provide liquidity to its affiliates. Additionally, during the second
quarter, the Corporation leveraged the proceeds of the trust preferred by
borrowing an additional $20 million, which was invested in securities to offset
the incremental cost of the trust preferred. Finally, to fund the $9 million
cash consideration portion of the acquisition of Equipment Finance, the
Corporation arranged a credit facility with a third party bank for the
financing.
As part of the Corporation's asset/liability management, the Corporation
uses interest rate swaps and caps to manage interest rate risk associated with
variable-rate funding sources. To the extent the derivatives are effective and
meet the requirements for hedge accounting, changes in fair value are recognized
in other comprehensive income with income statement reclassification occurring
as the hedged item affects earnings. Conversely, changes in fair value
attributable to ineffectiveness or to derivative that do not qualify as hedges
are recognized as they occur in the income statement's other expense account
with the hedged item.
During the second quarter of 2002, the Corporation entered into an interest
rate swap transaction with an aggregate notional amount of $25 million with a
term of four years. According to the terms of the transaction, the Corporations
pays fixed-rate interest rate payments and receives floating-rate payments. The
swap was entered into to hedge the Corporation's exposure to higher interest
rates on it variable-rate funding sources. At June 30, 2002, the fair value of
the swap was ($438,000).
On March 26, 2002, Sterling through its newly created financial subsidiary,
Sterling Financial Statutory Trust I, a Connecticut Business trust issued $20
million of trust preferred capital securities to investors. Dividends on the
securities are variable at a rate equal to 3-month LIBOR plus 360 basis points,
and adjusts quarterly. The initial dividend rate is 5.59%. Sterling Financial
Statutory Trust invested 100% of the proceeds into junior subordinated
debentures of Sterling Financial Corporation at the same terms of the preferred
securities. Sterling's obligation under the debentures and related documents
taken together, constitute a full and unconditional guarantee by Sterling of the
Trust's obligations under the preferred securities. The preferred securities
must be redeemed upon maturity of the subordinated debentures in March 2032.
CAPITAL
Total stockholder's equity increased $32,349,000 from December 31, 2001 to
June 30, 2002. This increase was primarily the result of the capitalization of
$20,998,000 related to the issuance of 954,452 shares of common stock as
consideration for the acquisition of Equipment Finance, Inc. The remainder of
the increase can be primarily attributed to operating activities, including net
income for the period of $11,681,000, less dividends declared of $5,393,000, and
other comprehensive income, consisting of unrealized gains on securities
available for sale and an unrealized loss on an interest rate swap, net of tax,
of $4,837,000.
18
During the first quarter of 2001, the Corporation announced the Board of
Directors authorized the repurchase of up to 187,500 shares of the outstanding
common stock. Through June 30, 2002, 66,346 shares have been repurchased under
this repurchase program. As of June 30, 2002, Sterling has treasury stock
totaling 6,253 shares. It is anticipated that the remaining treasury shares will
be issued in the third quarter to satisfy stock option exercises.
On April 30, 2002, the Board of Directors declared a five-for-four split
effected in the form of 25% stock dividend payable on June 3, 2002 to
shareholders of record on May 15, 2002. In connection with this dividend,
approximately 3.4 million shares of common stock were issued during the second
quarter of 2002.
Sterling and its banking subsidiaries 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 Sterling and the subsidiary banks' financial
statements. Under capital adequacy guidelines and the regulatory framework for
prompt corrective action, Sterling and its banking subsidiaries must meet
specific capital guidelines that involve quantitative measures of their assets,
liabilities and certain off-balance-sheet items as calculated under regulatory
accounting practices. The capital amounts and reclassifications are also subject
to qualitative judgments by the regulators about components, risk weightings,
and other factors. Prompt corrective action provisions are not applicable to
bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy
require Sterling and its banking subsidiaries to maintain minimum amounts and
ratios of total and Tier 1 capital to average assets. Management believes, as of
June 30, 2002 and December 31, 2001, that Sterling and the subsidiary banks met
all minimum capital adequacy requirements to which they are subject and are
categorized as "well capitalized".
Sterling's capital ratios as of June 30, 2002 and December 31, 2001 and
related regulatory minimum requirements are as follows:
Per Regulation
--------------------------
(1)
June 30, December 31, Minimum Well
2002 2001 Requirement Capitalized
-------- ------------ ----------- -----------
Total capital to
risk weighted assets 11.8% 11.0% 8.0% 10.0%
Tier 1 capital to
risk weighted assets 11.0% 10.1% 4.0% 6.0%
Tier 1 capital to
average assets 8.7% 7.8% 4.0% 5.0%
(1) represents amounts for the banking subsidiaries and not Sterling, as prompt
corrective action provisions are not applicable to bank holding companies.
LIQUIDITY
Effective liquidity management ensures the cash flow requirements of
depositors and borrowers, as well as the operating cash needs of Sterling are
met. Sterling's funds are available from a variety of sources, including assets
that are readily convertible to cash (federal funds sold, short-term
investments), securities portfolio, scheduled repayments of loans receivable,
core deposit base, short-term borrowings capacity with a number of correspondent
banks and the FHLB, and the ability to package residential mortgage loans
originated for sale.
The liquidity of the parent company also represents an important aspect of
liquidity management. The parent company's cash outflows consist principally of
dividends to shareholders and unallocated corporate expenses. The main source of
funding for the parent company is the dividends it receives from its banking
subsidiaries. Federal and state banking regulations place certain restrictions
on dividends paid to the parent company from the subsidiary banks.
19
Sterling manages liquidity by monitoring projected cash inflows and
outflows on a daily basis, and believes it has sufficient funding sources to
maintain sufficient liquidity under varying business conditions.
ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Financial institutions can be exposed to several market risks that may
impact the value or future earnings capacity of an organization. These risks
involve interest rate risk, foreign currency exchange risk, commodity price risk
and equity market price risk. Sterling's primary market risk is interest rate
risk. Interest rate risk is inherent because as a financial institution,
Sterling derives a significant amount of its operating revenue from "purchasing"
funds (customer deposits and borrowings) at various terms and rates. These funds
are then invested into earning assets (loans, leases, investments, etc.) at
various terms and rates. This risk is further discussed below.
Equity market risk is not a significant risk to the corporation, as equity
investments on a cost basis comprise less than 1% of corporate assets. Sterling
does not have any exposure to foreign currency exchange risk or commodity price
risk.
INTEREST RATE RISK
Interest rate risk is the exposure to fluctuations in the corporation's
future earnings (earnings at risk) and value (value at risk) resulting from
changes in interest rates. This exposure results from differences between the
amounts of interest earning assets and interest bearing liabilities that reprice
within a specified time period as a result of scheduled maturities and repayment
and contractual interest rate changes.
The primary objective of the corporation's asset/liability management
process is to maximize current and future net interest income within acceptable
levels of interest rate risk while satisfying liquidity and capital
requirements. Management recognizes that a certain amount of interest rate risk
is inherent and appropriate yet is not essential to the corporation's
profitability. Thus the goal of interest rate risk management is to maintain a
balance between risk and reward such that net interest income is maximized while
risk is maintained at a tolerable level.
Management endeavors to control the exposures to changes in interest rates
by understanding, reviewing and making decisions based on its risk position. The
corporate and bank subsidiary asset/liability committees are responsible for
these decisions. The corporation primarily uses the securities portfolios, FHLB
advances, and interest rate swaps/ceilings to manage its interest rate risk
position. Additionally, pricing, promotion and product development activities
are directed in an effort to emphasize the loan and deposit term or repricing
characteristics that best meet current interest rate risk objectives.
The committees operate under management policies defining guidelines and
limits on the level of risk. These policies are approved by the Boards of
Directors.
The corporation uses simulation analysis to assess earnings at risk and net
present value analysis to assess value at risk. These methods allow management
to regularly monitor both the direction and magnitude of the corporation's
interest rate risk exposure. These modeling techniques involve assumptions and
estimates that inherently cannot be measured with complete precision. Key
assumptions in the analyses include maturity and repricing characteristics of
both assets and liabilities, prepayments on amortizing assets, other imbedded
options, non-maturity deposit sensitivity and loan and deposit pricing. These
assumptions are inherently uncertain due to the timing, magnitude and frequency
of rate changes and changes in market conditions and management strategies,
among other factors. However, the analyses are useful in quantifying risk and
provide a relative gauge of the corporation's interest rate risk position over
time.
Earnings at Risk
Simulation analysis evaluates the effect of upward and downward changes in
20
market interest rates on future net interest income. The analysis involves
changing the interest rates used in determining net interest income over the
next twelve months. The resulting percentage change in net interest income in
various rate scenarios is an indication of the corporation's shorter-term
interest rate risk. The analysis utilizes a "static" balance sheet approach. The
measurement date balance sheet composition (or mix) is maintained over the
simulation time period, with maturing and repayment dollars being rolled back
into like instruments for new terms at current market rates. Additional
assumptions are applied to modify volumes and pricing under the various rate
scenarios. These include prepayment assumptions on mortgage assets, the
sensitivity of non-maturity deposit rates, and other factors deemed significant.
The simulation analysis results are presented in the graph in Table 15a.
These results as of June 30, 2002 indicate that the corporation would expect net
interest income to increase over the next twelve months by 2.3% assuming an
immediate upward shift in market interest rates of 2.00% and a decrease by 1.0%
if rates shifted downward in the same manner. This profile reflects a relatively
neutral short-term rate risk position and is with the guidelines set by policy.
At December 31, 2001, annual net interest income was expected to decrease
by 0.4% in the upward scenario and to increase by 0.4% in the downward scenario.
The change in the risk position from year to year reflects the acquisition of
Equipment Finance, Inc. and the use of the $25 million interest rate swap
discussed above, and the shift to a less liability sensitive position projected
over the next twelve months. The change in the earnings at risk position is in
part reflective of management's efforts throughout the year to extend liability
maturities and capitalize on the relatively low interest rate environment.
Value at Risk
The net present value analysis provides information on the risk inherent in
the balance sheet that might not be taken into account in the simulation
analysis due to the shorter time horizon used in that analysis. The net present
value of the balance sheet is defined as the discounted present value of
expected asset cash flows minus the discounted present value of the expected
liability cash flows. The analysis involves changing the interest rates used in
determining the expected cash flows and in discounting the cash flows. The
resulting percentage change in net present value in various rate scenarios is an
indication of the longer term repricing risk and options embedded in the balance
sheet.
The net present value analysis results are presented in the graph in Table
15b. These results as of June 30, 2002 indicate that the net present value would
decrease 6.8% assuming an immediate upward shift in market interest rates of
2.00% and to increase 6.5% if rates shifted downward in the same manner. The
risk position of Sterling is within the guidelines set by policy.
At December 31, 2001, the analysis indicated that the net present value
would decrease 11.6% assuming an immediate upward shift in market interest rates
of 2.00% and to increase 11.0% if rates shifted downward in the same manner. The
change in the analysis results from year to year highlight efforts to extend
liability maturities, which assisted in reducing the present value of equity at
risk.
TABLE 15A TABLE 15B
NET INTEREST INCOME PROJECTIONS PRESENT VALUE EQUITY
- ------------------------------- ---------------------------------
Changes in Changes in
Basis Points % Change Basis Points % Change
- ------------------------------- ------------ --------
-200 -1.1% -200 6.5%
-100 -0.4% -100 4.2%
0 0.0% 0 0.0%
100 1.0% 100 -3.2%
200 2.3% 200 -6.8%
21
PART II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
As of June 30, 2002, there were no material pending legal proceedings,
other than ordinary routine litigation incidental to business, to which Sterling
or its subsidiaries are a party or of which any of their property is the
subject.
ITEM 2 - CHANGES IN SECURITIES AND USE OF PROCEEDS
Not applicable.
ITEM 3 - DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Shareholders of Sterling Financial Corporation was
held on April 30, 2002.
The following individuals were elected to Sterling Financial Corporation's
Board of Directors for a term of three years:
Nominee Votes For Votes Withheld
------- ---------- --------------
Joan R. Henderson 10,058,549 127,279
Calvin G. High 10,055,670 130,158
Terrence L. Hormel 10,017,455 168,373
David E. Hosler 10,048,670 137,158
E. Glenn Nauman 10,055,710 130,118
There are nine continuing directors whose terms of office will expire at
the 2003 or 2004 annual meeting. They are as follows:
Richard H. Albright, Jr. S. Amy Argudo
Bertram F. Elsner Howard E. Groff, Jr.
J. Roger Moyer, Jr. J. Bradley Scovill
W. Garth Sprecher John E. Stefan
Glenn R. Walz
The following proposal were approved at Sterling Financial Corporation's
Annual Meeting:
Votes Votes Broker
Votes For Against Abstained Non-votes
--------- ------- --------- ---------
Proposal to adopt an amendment to the
Articles of Incorporation to increase
the authorized shares of common stock
and to permit the corporation to issue
preferred stock. 8,364,271 928,638 113,060 932,681
Proposal to adopt an amendment to
the 1996 Stock Incentive Plan to
increase, by 750,000 shares, the
shares available under the plan. 8,699,826 556,667 149,477 932,681
Proposal to ratify the selection
of Ernst & Young, LLP as the
corporation's independent certified
public accountants for the year
ending December 31, 2002. 10,047,105 57,619 81,104 156,911
ITEM 5 - OTHER INFORMATION
Not applicable.
22
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
10. Employment Agreement, dated July 23, 2002 between Sterling
Financial, Bank of Lancaster county, N.A. and Thomas P. Dautrich.
21. Subsidiaries of the Registrant
99.1 Certification of Principal Executive Officer
99.2 Certification of Principal Financial Officer
(b) Reports on Form 8-K
During the quarter ended June 30, 2002, the registrant filed the
following reports on Form 8-K.
Date of Report Item Description
-------------- ---- -------------------------------------
April 30, 2002 5 Numerous matters, including:
- Press release announcing 5-for-4
stock split in the form of a
stock dividend.
- Press release regarding the annual
meeting that highlighted Stefan's
leadership and new role.
- Filing of amended Articles of
Incorporation.
- Filing of Supplemental Executive
Agreement, dated April 22, 2002,
between the registrant and John
E. Stefan.
- Filing of Consulting Agreement
and General Release, dated April
22, 2002, between the registrant and
John E. Stefan.
May 28, 2002 5 Press release announcing the
declaration of a cash dividend.
23
Signatures
Pursuant to the requirements 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.
STERLING FINANCIAL CORPORATION
Date: August 13, 2002 By: /s/ J. Roger Moyer, Jr.
--------------- ------------------------------------
J. Roger Moyer, Jr.
President, Chief Executive Officer
and Assistant Secretary
Date: August 13, 2002 By: /s/ J. Bradley Scovill
--------------- ------------------------------------
J. Bradley Scovill
Senior Executive Vice President,
Chief Financial Officer and
Assistant Secretary
24
EXHIBIT INDEX
Page Number in
Manually Signed
Exhibit Original
- ------- ---------------
10 Employment Agreement, dated July 23, 2002, between
Sterling Financial Corporation, Bank of Lancaster
County, N.A. and Thomas P. Dautrich 26
21 Subsidiaries of the registrant 42
99.1 Certification of Principal Executive Officer 43
99.2 Certification of Principal Financial Officer 44
25