UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____ TO _____
COMMISSION FILE NUMBER: 000-31825
HERITAGE FINANCIAL HOLDING CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
Delaware 63-1259533
- ------------------------------- ----------------------------------
(State of Incorporation) (IRS Employer Identification No.)
1323 Stratford Road, S.E.
Decatur, Alabama 35601
(Address of principal executive office)
(256) 355-9500
(Issuer's telephone number, including area code)
(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 past 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 by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes No X
----- -----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock, $0.01 par value Outstanding at August 13, 2003: 10,408,948 Shares
FORM 10-Q
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
TABLE OF CONTENTS
PAGE NO.
---------
PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements (Unaudited)
Consolidated Statements of Financial Condition as of
June 30, 2003 and December 31, 2002 . . . . . . . . . . . . 3
Consolidated Statements of Income for the Three Months
Ended June 30, 2003 and 2002 . . . . . . . . . . . . . . . . 4
Consolidated Statements of Comprehensive Income For the
Three Months Ended June 30, 2003 and 2002 . . . . . . . . 5
Consolidated Statements of Income for the Six Months
Ended June 30, 2003 and 2002 . . . . . . . . . . . . . . . . 6
Consolidated Statements of Comprehensive Income For the
Six Months Ended June 30, 2003 and 2002. . . . . . . . . . 7
Consolidated Statements of Cash Flows For the
Six Months Ended June 30, 2003 and 2002. . . . . . . . . . 8
Notes to Consolidated Financial Statements . . . . . . . . . 9
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations . . . . . . . 15
Item 3 - Quantitative and Qualitative Disclosures about Market Risk . . . 25
Item 4 - Controls and Procedures . . . . . . . . . . . . . . . . . . . . 26
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . 27
Item 4 - Submission of Matters to a Vote of Security Holders. . . . . 27
Item 6 - Exhibits and Reports on Form 8-K . . . . . . . . . . . . . 28
SIGNATURES
CERTIFICATION OF PERIODIC FINANCIAL REPORTS
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
JUNE 30, 2003 (UNAUDITED) AND DECEMBER 31, 2002
JUNE 30,
2003 December 31,
(UNAUDITED) 2002
------------ --------------
ASSETS
Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,380,595 $ 4,759,310
Interest bearing deposits with other banks. . . . . . . . . . . . . . . . 6,494 97,707
Federal funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,047,083 14,681,498
------------- --------------
CASH AND CASH EQUIVALENTS 21,434,172 19,538,515
Securities available-for-sale . . . . . . . . . . . . . . . . . . . . . . 41,078,503 36,761,802
Mortgage loans held-for-sale. . . . . . . . . . . . . . . . . . . . . . . 19,497,078 12,343,440
Loans, net of unearned income . . . . . . . . . . . . . . . . . . . . . . 450,417,279 523,849,502
Allowance for loan losses . . . . . . . . . . . . . . . . . . . . . . . . (22,189,287) (26,990,594)
Premises and equipment, net . . . . . . . . . . . . . . . . . . . . . . . 7,030,281 7,105,706
Accrued interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,415,902 3,404,344
Foreclosed real estate. . . . . . . . . . . . . . . . . . . . . . . . . . 5,280,698 5,428,047
Other assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,420,415 11,501,035
------------- --------------
TOTAL ASSETS $535,385,041 $ 592,941,797
============= ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
DEPOSITS
Noninterest bearing . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,384,090 $ 21,961,197
Interest-bearing. . . . . . . . . . . . . . . . . . . . . . . . . . . . 426,699,653 503,669,662
------------- --------------
TOTAL DEPOSITS. . . . . . . . . . . . . . . . . . . . . . . . . . . . 462,083,743 525,630,859
Short-term borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . 7,480,000 6,650,000
Accrued interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,023, 018 3,288,749
FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000,000 23,000,000
Trust preferred securities. . . . . . . . . . . . . . . . . . . . . . . . 10,000,000 10,000,000
Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,264,354 669,143
------------- --------------
TOTAL LIABILITIES . . . . . . . . . . . . . . . . . . . . . . . . . . 505,851,115 569,238,751
------------- --------------
STOCKHOLDERS' EQUITY
Preferred stock - par value $0.01 per share; 10,000,000
authorized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - -
Common stock ($.001 par value; 40,000,000 shares authorized,
10,408,900 and 8,821,144 shares issued and outstanding at June 30, 2003
and December 31, 2002 . . . . . . . . . . . . . . . . . . . . . . . . . 104,089 88,211
Additional Paid-in capital. . . . . . . . . . . . . . . . . . . . . . . . 37,014,482 32,234,654
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . (7,641,878) (8,676,525)
Accumulated other comprehensive income. . . . . . . . . . . . . . . . . . 57,233 56,706
------------- --------------
TOTAL STOCKHOLDERS' EQUITY. . . . . . . . . . . . . . . . . . . . . . 29,533,926 23,703,046
------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY. . . . . . . . . . . . . . $535,385,041 $ 592,941,797
============= ==============
See notes to unaudited consolidated financial statements
3
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED JUNE 30, 2003 AND 2002
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30,
-------------------------
2003 2002
----------- ------------
INTEREST INCOME
Interest and fees on loans. . . . . . . . . . . . . . . . . . . $7,223,426 $ 9,873,994
Interest and dividends on securities:
Taxable securities . . . . . . . . . . . . . . . . . . . . . 330,519 350,009
Nontaxable securities . . . . . . . . . . . . . . . . . . . . 17,058 31,167
Interest on deposits with other banks . . . . . . . . . . . . . 1,262 1,696
Interest earned on federal funds sold and securities purchased. 38,117 86,449
----------- ------------
TOTAL INTEREST INCOME . . . . . . . . . . . . . . . . . . . . 7,610,382 10,343,315
----------- ------------
INTEREST EXPENSE
Interest on deposits. . . . . . . . . . . . . . . . . . . . . . 3,438,018 4,738,730
Interest on FHLB borrowings . . . . . . . . . . . . . . . . . . 244,500 244,500
Interest on short-term borrowings . . . . . . . . . . . . . . . 59,560 -
Interest on trust preferred securities. . . . . . . . . . . . . 270,810 255,000
----------- ------------
TOTAL INTEREST EXPENSE. . . . . . . . . . . . . . . . . . . . 4,012,888 5,238,230
----------- ------------
NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . . 3,597,494 5,105,085
Provision for loan losses . . . . . . . . . . . . . . . . . . . (616,200) 3,086,592
----------- ------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES . . . . . . . 4,213,694 2,018,493
NONINTEREST INCOME
Customer service fees . . . . . . . . . . . . . . . . . . . . . 286,090 251,012
Mortgage banking fee income . . . . . . . . . . . . . . . . . . 949,474 396,318
Investment security gains (losses). . . . . . . . . . . . . . . (37,580) (3,641)
Gains (losses) on sale of foreclosed real estate. . . . . . . . (93,950) 6,136
Other operating income. . . . . . . . . . . . . . . . . . . . . 250,144 56,955
----------- ------------
TOTAL NONINTEREST INCOME. . . . . . . . . . . . . . . . . . . 1,354,178 706,780
----------- ------------
NONINTEREST EXPENSES
Salaries and employee benefits. . . . . . . . . . . . . . . . . 2,358,290 1,579,486
Occupancy and equipment expense . . . . . . . . . . . . . . . . 562,175 388,088
Other operating expenses . . . . . . . . . . . . . . . . . . . 1,873,581 1,048,492
----------- ------------
TOTAL NONINTEREST EXPENSES. . . . . . . . . . . . . . . . . . 4,794,046 3,016,066
----------- ------------
Income before income taxes. . . . . . . . . . . . . . . . . . . . 773,826 (290,793)
Provision for income tax expense (benefit). . . . . . . . . . . . 289,238 (58,642)
----------- ------------
NET INCOME (LOSS) . . . . . . . . . . . . . . . . . . . . . . . . $ 484,588 $ (232,151)
=========== ============
BASIC AND DILUTED EARNINGS (LOSS) PER COMMON SHARE. . . . . . . . $ 0.05 $ (0.03)
=========== ============
See notes to unaudited consolidated financial statements
4
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
THREE MONTHS ENDED JUNE 30, 2003 AND 2002
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30,
------------------------
2003 2002
----------- -----------
NET INCOME (LOSS ). . . . . . . . . . . . . . . . . . . . . . . . . $ 484,588 $ (232,151)
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains (losses) arising during the period,
net of tax of ($20,589) and $219,663 . . . . . . . . . . . . . (39,967) 426,404
Reclassification adjustments for losses included in net income,
net of tax of $12,777 and $1,238 . . . . . . . . . . . . . . . 24,803 2,403
----------- -----------
Other comprehensive income (loss). . . . . . . . . . . . . . . (15,164) 428,807
----------- -----------
COMPREHENSIVE INCOME (LOSS). . . . . . . . . . . . . . . . . . . . . $ 469,424 $ 196,656
=========== ===========
See notes to unaudited consolidated financial statements
5
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
SIX MONTHS ENDED JUNE 30, 2003 AND 2002
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
--------------------------
2003 2002
------------ ------------
INTEREST INCOME
Interest and fees on loans . . . . . . . . . . . . . . . . . . $15,547,344 $19,709,881
Interest and dividends on securities:
Taxable securities . . . . . . . . . . . . . . . . . . . . . 700,005 650,463
Nontaxable securities . . . . . . . . . . . . . . . . . . . . 34,127 66,005
Interest on deposits with other banks . . . . . . . . . . . . . 2,762 3,263
Interest earned on federal funds sold and securities purchased. 80,859 132,899
------------ ------------
TOTAL INTEREST INCOME . . . . . . . . . . . . . . . . . . . . 16,365,097 20,562,511
------------ ------------
INTEREST EXPENSE
Interest on deposits. . . . . . . . . . . . . . . . . . . . . . 7,382,068 9,760,717
Interest on FHLB borrowings . . . . . . . . . . . . . . . . . . 489,000 467,349
Interest on short-term borrowings . . . . . . . . . . . . . . . 116,148 -
Interest on trust preferred securities. . . . . . . . . . . . . 525,810 502,029
------------ ------------
TOTAL INTEREST EXPENSE. . . . . . . . . . . . . . . . . . . . 8,513,026 10,730,095
------------ ------------
NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . . 7,852,071 9,832,416
Provision for loan losses . . . . . . . . . . . . . . . . . . . (516,200) 3,695,486
------------ ------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES . . . . . . . 8,368,271 6,136,930
NONINTEREST INCOME
Customer service fees . . . . . . . . . . . . . . . . . . . . . 515,375 483,262
Mortgage banking fee income . . . . . . . . . . . . . . . . . . 1,437,763 834,027
Investment security gains . . . . . . . . . . . . . . . . . . . 184,765 71,761
Gains (losses) on sale of foreclosed real estate. . . . . . . . (221,600) 37,922
Other operating income. . . . . . . . . . . . . . . . . . . . . 320,276 99,033
------------ ------------
TOTAL NONINTEREST INCOME. . . . . . . . . . . . . . . . . . . 2,236,579 1,526,005
------------ ------------
NONINTEREST EXPENSES
Salaries and employee benefits. . . . . . . . . . . . . . . . . 4,352,926 4,928,861
Occupancy and equipment expense . . . . . . . . . . . . . . . . 1,119,751 708,231
Other operating expenses . . . . . . . . . . . . . . . . . . . 3,478,321 2,263,856
------------ ------------
TOTAL NONINTEREST EXPENSES. . . . . . . . . . . . . . . . . . 8,950,998 7,900,948
------------ ------------
Income (loss) before income taxes . . . . . . . . . . . . . . . . 1,653,852 (238,013)
Provision for income tax expense (benefit). . . . . . . . . . . . 619,205 (76,439)
------------ ------------
NET INCOME (LOSS) . . . . . . . . . . . . . . . . . . . . . . . . $ 1,034,647 $ (161,574)
============ ============
BASIC AND DILUTED EARNINGS (LOSS) PER COMMON SHARE. . . . . . . . $ 0.11 $ (0.02)
============ ============
See notes to unaudited consolidated financial statements
6
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
SIX MONTHS ENDED JUNE 30, 2003 AND 2002
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
------------------------
2003 2002
----------- -----------
NET INCOME (LOSS ) . . . . . . . . . . . . . . . . . . . . . . . . $1,034,647 $ (161,574)
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during the period,
net of taxes of $63,092 and $111,089 . . . . . . . . . . . . 122,472 215,644
Reclassification adjustments for gains included in net income,
net of taxes of $62,820 and $24,399 . . . . . . . . . . . . . (121,945) (47,362)
----------- -----------
Other comprehensive income 527 168,282
----------- -----------
COMPREHENSIVE INCOME. . . . . . . . . . . . . . . . . . . . . . . . $1,035,174 $ 6,708
=========== ===========
See notes to unaudited consolidated financial statements
7
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 2003 AND 2002
(UNAUDITED)
Six Months Ended
June 30
----------------------------
2003 2002
------------- -------------
OPERATING ACTIVITIES
Net Income (Loss) . . . . . . . . . . . . . . . . . . . $ 1,034,647 $ (161,574)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Provision for loan losses . . . . . . . . . . . . . . (516,200) 3,695,486
Depreciation, amortization, and accretion, net. . . . 550,602 261,223
Loss(gain) on sale of other real estate . . . . . . . 221,600 (9,665)
Realized investment security gains . . . . . . . . . (184,765) (71,761)
Decrease in accrued interest receivable . . . . . . . 988,442 300,509
Decrease in accrued interest payable. . . . . . . . . (1,265,731) (1,152,215)
Change in mortgage loans held-for-sale. . . . . . . . (7,153,638) 5,960,702
Decrease (increase) in other assets . . . . . . . . . 1,080,348 (1,061,651)
Increase (decrease) in other liabilities. . . . . . . 595,211 (73,048)
Other, net. . . . . . . . . . . . . . . . . . . . . . - (35,396)
------------- -------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES (4,649,484) 7,652,610
------------- -------------
INVESTING ACTIVITIES
Purchases of securities available-for-sale. . . . . . . (77,197,843) (22,868,952)
Proceeds from sales of securities available for sale. . 14,487,862 15,408,606
Proceeds from calls, paydowns and maturities of
securities available for sale . . . . . . . . . . . . 58,416,492 3,554,240
Net (increase) decrease in loans to customers . . . . . 65,809,094 (41,027,049)
Purchases of premises and equipment . . . . . . . . . . (321,299) (594,749)
Proceeds from disposition of fixed assets . . . . . . . 8,474 ---
Proceeds from disposition of foreclosed real estate . . 2,498,729 1,735,004
Writedowns of other real estate 765,042 ---
------------- -------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES 64,466,551 (43,792,900)
------------- -------------
FINANCING ACTIVITIES
Compensatory options (tax benefit forfeited). . . . . . (5,803) 1,113,057
Net (decrease) increase in deposits . . . . . . . . . . (63,547,116) 29,141,866
Net proceeds from issuance of stock . . . . . . . . . . 2,200,209 785,147
Net proceeds from FHLB advances . . . . . . . . . . . . - 10,000,000
Net proceeds from short-term debt . . . . . . . . . . . 830,000 -
Net proceeds from exercise of stock options . . . . . . 2,601,300 -
------------- -------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES (57,921,410) 41,040,070
------------- -------------
NET INCREASE IN CASH AND CASH EQUIVALENTS . . . . . . . . 1,895,657 4,899,780
Cash and Cash Equivalents at Beginning of Period. . . . . 19,538,515 13,701,768
------------- -------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD. . . . . . . . $ 21,434,172 $ 18,601,548
============= =============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest . . . . . . . . . . . . . . . . . . . . . . $ 9,778,757 $ 11,882,310
Taxes . . . . . . . . . . . . . . . . . . . . . . . . - 305,256
Noncash investing and financing activities:
Change in other comprehensive income, net. . . . . . $ 527 $ 168,282
Transfer of loans to other real estate . . . . . . . $ 3,338,022 $ 670,791
See notes to unaudited consolidated financial statements
8
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
NOTE A - BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Heritage Financial
Holding Corporation and its subsidiaries Heritage Bank (the "Bank") and Heritage
Financial Statutory Trust I ("Heritage Trust"), collectively, the Company. The
accompanying unaudited consolidated financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the 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 generally accepted accounting principles 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 six-month period ended June 30, 2003 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2003.
The consolidated statement of financial condition at December 31, 2002 has been
derived from the audited consolidated financial statements at that date, but
does not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements.
CRITICAL ACCOUNTING POLICIES
The accounting and financial reporting policies of the Company conform to
accounting principles generally accepted in the United States of America and to
general practices within the banking industry. Following is a description of the
accounting policies applied by the Company which are deemed critical. In
determining which accounting policies are critical in nature, the Company has
identified the policies that require significant judgment or involve complex
estimates. The application of these policies has a significant impact on the
Company's financial statements. Financial results could differ significantly if
different judgments or estimates are applied.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established through provisions for loan losses
charged to operations. Loans are charged against the allowance for loan losses
when management believes that the collection of principal is unlikely.
Subsequent recoveries are added to the allowance. Management's evaluation of the
adequacy of the allowance for loan losses is based on a formal analysis which
assesses the risk within the loan portfolio. This analysis includes
consideration of historical performance, current economic conditions, levels of
nonperforming loans, loan concentrations and review of certain individual loans.
Management believes that the allowance for loan losses is adequate. While
management uses available information to recognize losses on loans, future
additions to the allowance for loan losses may be necessary based on changes in
economic conditions and the results of management's ongoing review of the loan
portfolio. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the bank's allowance for loan
losses. Such agencies may require the bank to recognize additions to the loan
losses based on their judgment.
9
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
USE OF ESTIMATES
- ------------------
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from these estimates.
For further information, refer to the consolidated financial statements and
footnotes thereto for Heritage Financial Holding Corporation and subsidiaries
for the year ended December 31, 2002, included in the Company's Annual Report on
Form 10-K.
NOTE B - INCOME TAXES
The effective tax rates of approximately 37.4% and 32.1% for the six months
ended June 30, 2003 and 2002, respectively, differ from the statutory rate
principally because of the effect of state income taxes.
NOTE C - SECURITIES
The Company applies the accounting and reporting requirements of Statement of
Financial Accounting Standards No. 115, Accounting for Certain Investments in
Debt and Equity Securities ("SFAS 115"). This pronouncement requires that all
investments in debt securities be classified as either "held-to-maturity"
securities, which are reported at amortized cost; "trading" securities, which
are reported at fair value, with unrealized gains and losses included in
earnings; or "available-for-sale" securities, which are reported at fair value,
with unrealized gains and losses excluded from earnings and reported in a
separate component of stockholders' equity (net of deferred tax effect).
At June 30, 2003, the Company had net unrealized gains of approximately $86,715
in available-for-sale securities which are reflected in the presented assets and
resulted in an increase in stockholders' equity of $57,233, net of deferred tax
liability. There were no held-to-maturity or trading securities at June 30, 2003
or December 31, 2002.
10
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
NOTE D - STOCKHOLDERS' EQUITY
Equity increased by $5,828,000 primarily due to a net income of $1,035,000 stock
option exercise totaling a net increase of $2,601,000 and the issuance of shares
generating $ 2,200, 000.
On March 31, 2003, certain directors of the Company exercised options on 720,000
shares of Company common stock, at an exercise price of $3.34 per share, for net
proceeds of approximately $2.4 million. Additionally, in April 2003, a director
of the Company exercised options on 60,000 shares of Company common stock at an
exercise price of $3.34 per share, generating net proceeds of approximately
$200,000. These options had all been granted in 1998 or 1999.
As previously reported on Form 8-K, the Company commenced a private placement of
up to 1,000,000 shares on March 26, 2003. The offering expired on April 14,
2003, with a total of 688,825 shares subscribed. The common stock was issued at
a purchase price of $3.34 per share pursuant to an independent third party
appraisal, which was a premium over the $2.69 book value per share at December
31, 2002. The offering resulted in net proceeds of approximately $2.2 million.
The majority of these shares were issued to senior management of the Company and
its subsidiary, with the remainder being issued to accredited investors.
NOTE E - RECENT DEVELOPMENTS
Management recently conducted an extensive review of the Bank's loan portfolio.
In connection with such review, the Company and the Bank took steps to charge
off or establish additional loan loss reserves for specified assets and to
adjust the Bank's levels of loan loss provisions.
The Board of Directors of the Company and the Bank have imposed certain
restriction on the operations of the Company and the Bank in order to address
asset quality concerns, operational controls and procedures, and capital
deficiencies. The Bank has also committed to take certain actions including not
to declare or pay cash dividends without the prior written approval of its
regulators and to meet certain
capital guidelines. In addition, the Bank has undertaken to hire and retain
qualified lending and operational personnel with specific written authority
granted by the Board of Directors to implement sound lending, recordkeeping and
accounting practices. The Bank also has undertaken to develop an educational
program for board members and to create a written review of the Bank's staffing
requirements. Our management and staff are working toward meeting all of these
requirements and implementing policies which will make the Company and the Bank
stronger and more efficient.
The Board of Directors of the Bank has determined to improve and increase the
capital ratios of the Bank, which have declined as a result of the increase in
the Bank's loan loss reserves. The Board of Directors of the Company took steps
to attain and maintain a Tier 1 leverage ratio of 8 percent and to be
"well-capitalized" as defined by the FDIC by March 31, 2003. After failing to
achieve this level at March 31,
11
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
NOTE E - RECENT DEVELOPMENTS - CONTINUED
2003, (the Bank's Tier 1 leverage ratio was 7.43% percent at March 31 30, 2003)
measures were taken to achieve this goal at June 30, 2003. The Bank's Tier 1
leverage ratio was 8.24% percent at June 30, 2003.
The management of the Company and the Bank has aggressively addressed asset
quality, loan and audit issues. The Bank has charged off the balance of any
assets classified Loss and one-half of those assets classified Doubtful by any
of the regulatory authorities, and has gone further by conducting additional
reviews of the Bank's loan portfolio to increase management's knowledge of the
Bank's asset quality issues. The Bank must reduce the balance of assets
classified Substandard or Doubtful in accordance with a specific timetable, and
may not extend additional credit to any borrower obligated to the Bank on any
extension of credit that has been charged off by the Bank or classified Loss or
Doubtful as long as such credit remains uncollected. In addition, the Bank is
obligated to review its existing written loan policies and to adopt new internal
loan review systems to address problems with the Bank's loan portfolio.
As a result of the declining quality of the Bank's loan portfolio, related
reductions in the capital levels of the Bank, and other operational factors, the
Board of Directors and management is re-evaluating its lending strategy. The
Board of Directors and management are actively taking steps to improve the
underwriting and credit administration practices of the Bank in order to improve
overall asset quality. In
addition, in October 2002 the Bank hired a new chief lending officer to oversee
the administration of the Bank's loan portfolio with primary emphasis on
improving overall credit quality of the portfolio. New policies with respect to
loan originations have been formulated which management believes should enhance
the quality of future loan production. Management intends to continue efforts
to originate new loans consistent with improving overall credit quality,
although significant emphasis is now being given to problem loan administration.
In light of the increased level of classified assets of the Bank and
management's decision to increase its allowance for loan losses, the Company is
taking steps to implement enhanced risk management and internal control
procedures. These steps include increasing the Company's investment in its
infrastructure to enhance its technology, its management information systems,
its internal audit function and the formal documentation of its policies and
procedures. In this regard, the Company is taking steps to expand its
internal audit function and has engaged an outside consulting firm to assist the
Company to ensure that the Company's policies, procedures, systems and controls
are appropriate to its operations. Such review and enhancement of the policies,
procedures, systems and controls of the Company and the Bank are being overseen
by the Audit Committee, Larry R. Mathews, the new President and Chief Executive
Officer of the Bank and William M. Foshee, the new Chief Financial Officer of
the Company and the Bank.
Management has commenced a comprehensive review of the Company's and the Bank's
internal control structures and procedures. In the course of this review,
management has identified significant weaknesses in the Company's internal
controls and procedures, particularly with respect to the Bank's lending
functions, including credit underwriting and loan review. Furthermore,
management has determined that certain internal controls and procedures relating
to loan policies and procedures have not been followed by Bank personnel. This
review is ongoing and further adjustments to loan loss reserves may be made as
12
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
NOTE E - RECENT DEVELOPMENTS - CONTINUED
a result of the continuation of management's review and assessment of the Bank's
loan portfolio and the adequacy of the allowance for loan losses.
NOTE F - STOCK-BASED COMPENSATION
The Company has long-term incentive stock option plans and an employee stock
purchase plan. The Company accounts for those plans under the recognition and
measurement principles of APB Opinion 25, Accounting for Stock Issued to
Employees, and related interpretations using the intrinsic value based method,
as permitted by Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-based Compensation. In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure.
This statement amends SFAS No. 123 to provide alternative methods of transition
for an entity that voluntarily changes to the fair value based method of
accounting for stock-based employee compensation. It amends the disclosure
provisions of that Statement to require prominent disclosure about the effects
on reported net income of an entity's accounting policy decisions with respect
to stock-based employee compensation. This Statement also amends APB Opinion
No. 28 to require disclosure about those effects in interim financial
information. This Statement is effective for financial statements for fiscal
years ending after December 15, 2002 and for financial reports containing
condensed financial statements for interim periods beginning after December 15,
2002. No stock-based employee compensation cost is reflected in net income for
these plans. Net income (loss) and earnings per share would not be materially
different during the three and six month periods ended June 30, 2003 and 2002 if
the Company had applied the fair value based method of SFAS No. 123.
The fair value for these options was estimated at the dates of grant using the
Black-Scholes option pricing model. The Black-Scholes option valuation model
was developed for use in estimating the fair value of traded options that have
no vesting restrictions and are fully transferable. In addition, option
valuation models require the input of highly subjective assumptions including
the expected stock price volatility. Because the Company's employee stock
options have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can materially
affect the fair value estimate, the existing models do not necessarily provide a
reliable single measure of the fair value of its employee stock options.
[The remainder of this page intentionally left blank]
13
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
NOTE G - COMMITMENTS
In the normal course of business, the Company enters into commitments to extend
credit which are agreements to lend to customers as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and generally require a
payment of fees. Since many of the commitments are expected to expire without
being drawn upon, the total amounts do not necessarily represent expected future
cash flows.
Standby letters of credit are commitments issued by the Company to guarantee the
performance of a customer to a third party. These guarantees are primarily
issued to support public and private borrowing arrangements, including
commercial paper, bond financing and similar transactions, and expire in
decreasing amounts with terms ranging from one to four years. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to customers.
The following represents the Company's commitments to extend credit and standby
letters of credit as of June 30, 2003 and December 31, 2002:
JUNE 30, December 31,
2003 2002
----------- -------------
Commitments to extend credit . . . . . . $49,599,000 $ 75,574,000
Standby and commercial letters of credit 1,458,000 3,259,000
----------- -------------
Total commitments . . . . . . . . . . . $51,057,000 $ 78,833,000
=========== =============
NOTE H - EARNINGS PER SHARE
The Company is required to report earnings per common share with and without the
dilutive effects of potential common stock issuances from instruments such as
options, convertible securities and warrants on the face of the statements of
operations. Basic earnings per common share are based on the weighted average
number of common shares outstanding during the period while the effects of
potential common shares outstanding during the period are included in diluted
earnings per share. Additionally, the Company must reconcile the amounts used
in the computation of both "basic earnings per share" and "diluted earnings per
share". Antidilutive stock options and warrants have not been included in the
diluted earnings per share calculations. For the three and six months ended
June 30, 2003 and 2002, the potential effect of outstanding options and warrants
would be antidilutive, and therefore is not presented. Earnings (loss) per
common share amounts for the three months ended June 30, 2003 and 2002 are based
on weighted average shares outstanding of 10,408,868 and 8,712,174,
respectively. Earnings (loss) per common share for the six months ended June
30, 2003 and 2002 are based on weighted average shares outstanding of 9,677,464
and 8,614,340, respectively.
14
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
ITEM 2. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Heritage Financial Holding Corporation (the "Company") is primarily engaged in
the business of directing and planning the activities of its wholly owned
subsidiary, Heritage Bank (the "Bank"). The Company's primary asset is
comprised of its investment in the Bank.
The consolidated operating results of the Company include those of the Bank.
All significant intercompany transactions and balances have been eliminated in
consolidation. The operating results of the Company depend primarily on net
interest income, which is the difference between interest income on
interest-earning assets, primarily loans and investment securities, and interest
expense on interest-bearing liabilities, primarily deposits and advances from
the Federal Home Loan Bank ("FHLB") and other sources. Net earnings are also
affected by non-interest income and non-interest expenses, such as loan fees,
compensation and benefits, building and occupancy expense, and other expenses.
The discussion and analysis included herein covers material changes in financial
condition, liquidity and capital resources that have occurred since December 31,
2002, as well as certain material changes in results of operations during the
three months and six months ended June 30, 2003 as compared to the same period
in 2002.
This discussion is intended to assist in an understanding of the Company and its
subsidiaries' financial condition and results of operations. Unless the context
otherwise indicates, "the Company" shall include the Company and its
subsidiaries. This analysis should be read in conjunction with the consolidated
financial statements and related notes appearing in Item 1 of the Company's
Quarterly Report on Form 10-Q for the period ended June 30, 2003, and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," appearing in the Company's Annual Report on Form 10-K for the year
ended December 31, 2002.
FINANCIAL CONDITION
JUNE 30, 2003 COMPARED TO DECEMBER 31, 2002
LOANS
Loans comprised the largest single category of the Company's earning assets on
June 30, 2003. Loans, net of unearned income and allowance for loan losses, were
83.6% of total assets at June 30, 2003, and 85.9% of total assets at December
31, 2002. Total net loans were $447,725,000 at June 30, 2003, representing a
12.1% decrease from the December 31, 2002 total of $509,202,000. This decrease
was the result of management's intentional reduction in non-performing and total
assets. Management intends to continue efforts to originate new loans
consistent with the Bank's strengthened credit standards.
15
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
ALLOWANCE FOR LOAN LOSSES
When determining the adequacy of the allowance for loan losses, management
considers changes in the size and character of the loan portfolio, changes in
non-performing and past due loans, regulatory classification of assets,
historical loan loss experience, the existing risk of individual loans,
concentrations of loans to specific borrowers or industries, existing and
prospective economic conditions, and other factors. The allowance for loan
losses decreased $4,801,000 during the six months ended June 30, 2003 to
$22,189,000 at June 30, 2003 from $26,991,000 at December 31, 2002. Charge offs
in an aggregate amount of $4.5 million accounted for the bulk of the decrease in
the allowance for loan losses. The allowance for loan losses represented 4.72%
and 5.03% of loans receivable at June 30, 2003 and December 31, 2002,
respectively. (See further discussion in "Provision for Loan Losses" below.) In
the second quarter of 2003, loans totaling $13.7 million were sold to Bayview
Financial. These loans were sold at a net price of 93.7% of the outstanding
balance. In recording this transaction, the allowance allocated to these loans
was reversed resulting in a negative provision for loan losses for the quarter
and six months ending June 30, 2003.
In the opinion of management, the allowance for loan losses was adequate at June
30, 2003 to provide for potential loan losses in the loan portfolio at that
date. Management is concerned about the results of its continuing review of the
loan portfolio, as well as the impact a decline in the local economy could have
upon the Bank's ability to improve the quality of its loan portfolio. While
management believes it has established its existing allowance for loan losses in
accordance with generally accepted accounting principles, there can be no
assurance that the Bank will not be required to increase the allowance in the
future. Such increases could have a material adverse affect on the Bank's
financial condition and results of operations. Losses ultimately confirmed will
vary from original estimates as adjustments are made in the period in which
these factors and other considerations become known.
Changes in the allowance for loan losses for the six months ended June 30, 2003
were as follows:
Balance at beginning of the year $26,991,000
Charge-offs (4,467,000)
Recoveries 181,000
------------
Net charge-offs (4,286,000)
Provision for loan losses (516,000)
------------
Balance as of June 30, 2003 $22,189,000
============
INVESTMENT SECURITIES AND OTHER EARNING ASSETS
The investment securities portfolio is used to make various term investments, to
provide a source of liquidity and to serve as collateral to secure certain
government deposits. Federal funds sold are a tool in managing the daily cash
position of the Company. Investment securities and federal funds sold increased
$1,682,000 from December 31, 2002 to $53,126,000 at June 30, 2003.
16
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
ASSET QUALITY
Between December 31, 2002 and June 30, 2003, the Company experienced a decrease
in nonperforming assets (defined as nonaccrual loans, loans past due 90 days or
greater, restructured loans, nonaccruing securities and other real estate).
Total nonperforming assets decreased from $26,698,000 to $26,410,000 during this
period. The ratio of nonperforming assets to total assets increased from 4.5% to
4.9% and the ratio of nonperforming loans to total loans increased from 5.0% to
5.6% during the first six months of 2003. The ratio of loan loss allowance to
total nonperforming assets decreased from 101.1% to 84.0% during this same
period. The Company believes that due to a continuing weak economy both on a
national and statewide basis, these ratios could further erode over the next
several quarters. Moreover, the Company competes for loans, and has made certain
loans to businesses, along the Birmingham-Huntsville-Decatur, Alabama high-tech
corridor. During the past year, the high tech industry segment has experienced
and continues to experience a more significant downturn compared with other
sectors of the economy. The Company and the Bank have taken steps to intensively
monitor its overall loan portfolio; including the hiring of additional personnel
to monitor credit quality and adherence to credit policies and procedures. The
Bank has hired a seasoned bank executive as its chief lending officer, and has
retained a manager of loan review. Management believes that these additions, as
well as additional recently retained personnel, will provide the Bank with the
necessary resources to improve controls over the lending functions, identify any
potential areas of concern in a more timely manner, and ensure that future loans
comply with the Bank's lending policies and procedures.
DEPOSITS
Total deposits of $462,084,000 at June 30, 2003 decreased $63,547,000, or 12.1%,
over total deposits of $525,631,000 at year-end 2002 primarily due to a
reduction in brokered deposits. Deposits are the Company's primary source of
funds with which to support its earning assets. Noninterest-bearing deposits
increased $13,423,000, or 61.1%, from year-end 2002 to June 30, 2003, and
interest-bearing deposits decreased $76,970,000, or 15.2%, from year-end 2002.
STOCKHOLDERS' EQUITY
Stockholders' equity increased $5,831,000 from December 31, 2002 to June 30,
2003, primarily due to net earnings of $1,035,000, the exercise of stock
options, net of shares surrendered, of $2,595,000, and the stock offering
proceeds of $2,200,000.
On March 31, 2003, certain directors of the Company exercised options on 720,000
shares of Company common stock, at an exercise price of $3.34 per share, for net
proceeds of approximately $2.4 million. Additionally, in April 2003, a director
of the Company exercised options on 60,000 shares of Company common stock at an
exercise price of $3.34 per share, generating net proceeds of approximately
$200,000. These options had all been granted in 1998 or 1999.
As previously reported on Form 8-K, the Company commenced a private placement of
up to 1,000,000 shares on March 26, 2003. The offering expired on April 14,
2003, with a total of 688,825 shares subscribed. The common stock was issued at
a purchase price of $3.34 per share pursuant to an independent third party
appraisal, which was a premium over the $2.69 book value per share at December
17
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
31, 2002. The offering resulted in net proceeds of approximately $2.2 million.
The majority of these shares were issued to senior management of the Company and
its subsidiary, with the remainder being issued to accredited investors.
LIQUIDITY MANAGEMENT
Liquidity is defined as the ability of a company to convert assets into cash or
cash equivalents without significant loss. Liquidity management involves
maintaining the Company's ability to meet the day-to-day cash flow requirements
of its customers, whether they are depositors wishing to withdraw funds or
borrowers requiring funds to meet their credit needs. Without proper liquidity
management, the Company would not be able to perform the primary function of a
financial intermediary and would not, therefore, be able to meet the production
and growth needs of the communities it serves.
The primary function of asset and liability management is not only to assure
adequate liquidity in order for the Company to meet the needs of its customer
base, but to maintain an appropriate balance between interest-sensitive assets
and interest-sensitive liabilities so that the Company can also meet the
investment requirements of its stockholders. Daily monitoring of the sources and
uses of funds is necessary to maintain an acceptable cash position that meets
both requirements. In the banking environment, both assets and liabilities are
considered sources of liquidity funding and both are, therefore, monitored on a
daily basis.
The asset portion of the balance sheet provides liquidity primarily through loan
principal repayments and sales, and maturities and sales of investment
securities. Loans that mature in one year or less equaled approximately
$144,849,000 or 32.2% of the total loan portfolio at June 30, 2003. Other
sources of liquidity include short-term investments such as federal funds sold
which amounted to $12,047,000 at June 30, 2003.
The liability portion of the balance sheet provides liquidity through various
customers' interest-bearing and noninterest-bearing deposit accounts. At June
30, 2003, funds were also available through the purchase of federal funds from
correspondent commercial banks from available lines of up to an aggregate of
$13,500,000. The Bank is also a member of the Federal Home Loan Bank of Atlanta.
Such membership provides the Bank with additional lines of credit for liquidity
needs. This line of credit with the Federal Home Loan Bank of Atlanta is
collateralized by a blanket lien on the Bank's single-family mortgage portfolio,
as well as certain commercial real estate mortgages. As of June 30, 2003, the
Federal Home Loan Bank line of credit permitted borrowings of up to
approximately $65 million and as of June 30, 2003, the Bank had borrowed $23
million.
CAPITAL RESOURCES
A strong capital position is vital to the profitability of the Company and the
Bank because it promotes depositor and investor confidence and provides a solid
foundation for future growth of the organization.
On February 22, 2001, Heritage Financial Statutory Trust I ("Heritage Trust"), a
Connecticut statutory trust established by the Company, received $10,000,000 in
proceeds in exchange for $10,000,000 principal amount of Heritage Trust's 10.20%
cumulative trust preferred securities (the "preferred securities") in a pooled
trust preferred private placement. The proceeds of that transaction were then
18
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
used by Heritage Trust to purchase an equal amount of 10.20% subordinated
debentures (the "subordinated debentures") of the Company. The Company has fully
and unconditionally guaranteed all obligations of Heritage Trust on a
subordinated basis with respect to the preferred securities. Subject to certain
limitations, the preferred securities qualify as Tier 1 capital and are
presented in the Consolidated Statements of Financial Condition as "Guaranteed
preferred beneficial interests in the Company's subordinated debentures." The
sole asset of Heritage Trust is the subordinated debentures issued by the
Company. Both the preferred securities of Heritage Trust and the subordinated
debentures of the Company each have 30-year lives. However, both the Company and
Heritage Trust have a call option of ten years, subject to regulatory approval,
or earlier, depending upon certain changes in tax or investment company laws, or
regulatory capital requirements.
Regulatory authorities are placing increased emphasis on the maintenance of
adequate capital. Capital strength is measured in two tiers that are used in
conjunction with risk-adjusted assets to determine the risk-based capital
ratios. The Company's Tier 1 capital, which consists of common equity less
goodwill and the newly issued guaranteed preferred beneficial interest in the
Company's subordinated debentures, subject to limitations, amounted to
approximately $39,474,000 at June 30, 2003. The Company's Tier 2 capital
components are comprised solely of the allowance for loan losses subject to
certain limitations. Tier 1 capital plus the Tier 2 capital components is
referred to as Total Risk-Based capital and was approximately $46,522,000 at
June 30, 2003.
The Company has taken steps to attain and maintain a Tier 1 capital ratio at the
Bank of 8%. As of June 30, 2003, the Bank's Tier 1 capital ratio was 8.22%.
Although the Company cannot assure that it will be successful in maintaining
this capital ratio, management believes that the steps it is taking to access
additional capital, implement management changes and enhance internal controls
and procedures will enable the Company to achieve these objectives. The Board
of Directors and management of the Company and the Bank are actively engaged in
the preparation and implementation of strategic business plans for the Company
and the Bank, to address, among other things, the immediate and anticipated
future capital requirements of the Company and the Bank, taking into account the
mix of loans in the Bank's loan portfolio, earnings, and alternative sources of
capital.
As of June 30, 2003 and December 31, 2002, the capital ratios of the Bank were
as follows:
Regulatory June 30, December 31,
Minimum 2003 2002
----------- --------- -------------
Tier 1 leverage ratio 4% 8.22% 5.99%
Tier 1 Risk-based capital ratio 6% 9.95% 7.68%
Total Risk-based capital ratio 8% 11.20% 8.98%
19
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2003 AND 2002
SUMMARY
Net earnings of the Company for the quarter ended June 30, 2003 were $485,000,
compared to a net loss of $232,000 for the same period in 2002, representing a
$717,000 increase from prior period income. The earnings for the quarter ended
June 30, 2002 were negatively impacted by expenses associated with poor asset
quality.
NET INTEREST INCOME
Net interest income, the difference between interest earned on assets and the
cost of interest-bearing liabilities, is the largest component of the Company's
net income. Revenue from earning assets of the Company during the three months
ended June 30, 2003 decreased $2,733,000, or 26.4%, from the same period in
2002. This decrease was largely a result of the decrease in interest and fee
income on loans. Interest expense for the three months ended June 30, 2003
decreased $1,225,000, or 23.4%, over the corresponding period of 2002 due to
decreases in interest expense paid on interest-bearing deposits. These decreases
were due to decreasing asset and liability balances and the impact of declining
interest rates. As a result of these factors, net interest income decreased
$1,508,000, or 29.5%, for the three months ended June 30, 2003, compared to the
same period of 2002. The Bank's net interest margin was 3.46 % for the quarter
ended June 30, 2003 compared to 3.83 % for the quarter ended June 30, 2002.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents the charge against current earnings
necessary to maintain the allowance for loan losses at a level which management
considers appropriate. This level is determined based upon the Bank's historical
charge-offs, management's assessment of current economic conditions, the
composition of the loan portfolio and the levels of nonaccruing and past due
loans. The Bank recorded a negative provision for loan losses of $616,000 for
the three months ended June 30, 2003, compared to a positive provision of
$3,087,000 for the same period of 2002. The allowance for loan losses as a
percent of outstanding loans, net of unearned income, was 4.72 % at June 30,
2003 compared to 5.03% at year-end 2002. In the second quarter of 2003, loans
totaling $13.7 million were sold to Bayview Financial. These loans were sold at
a net price of 93.7% of the outstanding balance. In recording this transaction,
the allowance allocated to these loans was reversed resulting in a negative
provision for loan losses for the period ended June 30, 2003.
NONINTEREST INCOME
Noninterest income for the three months ended June 30, 2003 was $1,354,000
compared to $707,000 for the same period of 2002. This increase primarily was
due to an increase in mortgage banking fee income of $553,000.
20
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
NONINTEREST EXPENSES
Noninterest expenses for the three months ended June 30, 2003 were $4,794,000,
reflecting a 59.0% increase over the same period of 2002. The primary component
of noninterest expenses is salaries and employee benefits, which increased to
$2,358,000 for the three months ended June 30, 2003, 49.3% higher than in the
same period of 2002. This increase was primarily due to the increases relating
to staffing and commissions for the mortgage banking division. Occupancy costs
increased $174,000, or 44.9%, and other operating expenses increased $825,000,
or 78.9%, from the same period of 2002. Salaries and benefits expense increased
due to a pre-tax expense of approximately $2.0 million attributable to the
retirement agreement with the former president and chief executive officer of
the Company, which included a retirement obligation in the form of salary and
compensatory stock option expense. Occupancy costs for the current period have
increased primarily due to the addition of three new facilities.
INCOME TAXES
The Company attempts to maximize its net income through active tax planning. The
provision for income taxes of $289,000 for the three months ended June 30, 2003
increased $348,000 compared to the same period of 2002. Taxes as a percent of
earnings before income taxes increased from 20.2% to 37.4%. The effective tax
rate of approximately 37.4% for the three months ended June 30, 2003, is more
than the federal statutory rate principally because of state income taxes.
RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 2003 AND 2002
SUMMARY
Net earnings of the Company for the six months ended June 30, 2003 was
$1,035,000, compared to a net loss of $162,000 for the same period in 2002,
representing a $1,196,000 increase from prior period income. Earnings for the
prior year were impacted by severance and retirement payments and benefits to
the former chief executive officer of the Company, which resulted in a pre-tax
charge to the Company in 2002 of approximately $2.0 million and by expenses
associated with poor asset quality.
NET INTEREST INCOME
Net interest income, the difference between interest earned on assets and the
cost of interest-bearing liabilities, is the largest component of the Company's
net income. Revenue from earning assets of the Company during the six months
ended June 30, 2003 decreased $4,197,000, or 20.4%, from the same period in
2002. This decrease was largely a result of the decrease in interest and fee
income on loans. Interest expense for the six months ended June 30, 2003
decreased $2,217,000, or 20.7%, over the corresponding period of 2002 due to
decreases in interest expense paid on interest-bearing deposits. These decreases
were due to the impact of rapidly declining interest rates which outpaced the
related loan and deposit volume growth. As a result of these factors, net
interest income decreased $1,980,000, or 20.1%, for the six months ended June
30, 2003, compared to the same period of 2002. The Bank's net interest margin
was 3.47% for the six months ended June 30, 2003 compared to 3.83% for the six
months ended June 30, 2002.
21
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
PROVISION FOR LOAN LOSSES
The provision for loan losses represents the charge against current earnings
necessary to maintain the allowance for loan losses at a level which management
considers appropriate. This level is determined based upon the Bank's historical
charge-offs, management's assessment of current economic conditions, the
composition of the loan portfolio and the levels of nonaccruing and past due
loans. The provision for loan losses was $100,000 for the six months ended June
30, 2003, compared to $3,695,000 for the same period of 2002. In the second
quarter of 2003, loans totaling approximately $13.7 million were sold to Bayview
Financial. These loans were sold at a net price of 93.7% of the outstanding
balance. In recording this transaction, the allowance allocated to these loans
was reversed resulting in a negative provision for loan losses for the period
ended June 30, 2003.
NONINTEREST INCOME
Noninterest income for the six months ended June 30, 2003 was $2,237,000
compared to $1,526,000 for the same period of 2002. This increase primarily was
due to an increase in mortgage banking fee income of $604,000.
NONINTEREST EXPENSES
Noninterest expenses for the six months ended June 30, 2003 were $8,951,000,
reflecting a 13.3% increase over the same period of 2002. The primary component
of noninterest expenses is salaries and employee benefits, which decreased to
$4,353,000 for the six months ended June 30, 2003, 11.7% lower than in the same
period of 2002. This decrease was primarily due to severance and retirement
payments and benefits paid to the former chief executive officer of the Company,
which resulted in a pre-tax charge to the Company in 2002 of approximately $2.0
million. Occupancy costs increased $411,000, or 58.1%, and other operating
expenses increased $1,214,000, or 53.6%, from the same period of 2002. Occupancy
costs for the current period have increased primarily due to the addition of
three new facilities. The increase in other operating expenses was the result of
a $320,000 increase in FDIC insurance expense, a $430,000 increase in
professional fees and a $150,000 charge for the settlement of a lawsuit.
INCOME TAXES
The Company attempts to maximize its net income through active tax planning. The
provision for income taxes of $619,000 for the six months ended June 30, 2003
increased $696,000 compared to the same period of 2002. Taxes as a percent of
earnings before income taxes increased from 32.1% to 37.4%. The effective tax
rate of approximately 37.4% for the six months ended June 30, 2003 is more than
the federal statutory rate principally because of state income taxes.
22
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
RECENTLY ISSUED ACCOUNTING STANDARDS
In January 2003, the FASB issued FIN 46, which clarifies the application of
Accounting Research Bulletin ("ARB") 51, Consolidated Financial Statements, to
certain entities (called variable interest entities) in which equity investors
do not have the characteristics of a controlling financial interest or do not
have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support from other parties. The disclosure
requirements of this Interpretation are effective for all financial statements
issued after January 31, 2003. The consolidation requirements apply to all
variable interest entities created after January 31, 2003. In addition, public
companies must apply the consolidation requirements to variable interest
entities that existed prior to February 1, 2003 and remain in existence as of
the beginning of annual or interim periods beginning after June 15, 2003.
Management is currently assessing the impact of FIN 46, and does not expect this
Interpretation to have a material effect on the Company's consolidated financial
statements.
On April 30, 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on
Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies
financial accounting and reporting for derivative instruments, including certain
derivative instruments embedded in other contracts and for hedging activities
under SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities. The provisions of SFAS No. 149 are effective for fiscal quarters
beginning after June 15, 2003. Management does not believe the provisions of
this standard will have a material effect on the Company's consolidated
financial statements.
CRITICAL ACCOUNTING POLICIES
The accounting and financial reporting policies of the Company conform to
accounting principles generally accepted in the United States of America and to
general practices within the banking industry. Following is a description of
the accounting policies applied by the Company which are deemed "critical." In
determining which accounting policies are "critical" in nature, the Company has
identified the policies that require significant judgment or involve complex
estimates. The application of these policies has a significant impact on the
Company's financial statements. Financial results could differ significantly if
different judgments or estimates are applied.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established through provisions for loan losses
charged to operations. Loans are charged against the allowance for loan losses
when management believes that the collection of principal is unlikely.
Subsequent recoveries are added to the allowance. Management's evaluation of
the adequacy of the allowance for loan losses is based on a formal analysis
which assesses the risk within the loan portfolio. This analysis includes
consideration of historical performance, current economic conditions, level of
nonperforming loans, loan concentrations, and review of certain individual
loans. Management believes that the allowance for loan losses is adequate.
While management uses available information to recognize losses on loans, future
additions to the allowance for loan losses may be necessary based on changes in
economic conditions and the results of management's ongoing review of the loan
portfolio. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the bank's allowances for loan
losses. Such agencies may require the Bank to recognize additions to the
allowance for loan losses based on their judgments.
23
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
FORWARD-LOOKING INFORMATION
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for
forward-looking statements made by us or on our behalf. Some of the disclosures
in this Quarterly Report on Form 10-Q, including any statements preceded by,
followed by or which include the words "may," "could," "should," "will,"
"would," "hope," "might," "believe," "expect," "anticipate," "estimate,"
"intend," "plan," "assume" or similar expressions constitute forward-looking
statements.
These forward-looking statements, implicitly and explicitly, include the
assumptions underlying the statements and other information with respect to our
beliefs, plans, objectives, goals, expectations, anticipations, estimates,
intentions, financial condition, results of operations, future performance and
business, including our expectations and estimates with respect to our revenues,
expenses, earnings, return on equity, return on assets, efficiency ratio, asset
quality and other financial data and capital and performance ratios.
Any forward-looking statements are subject to numerous assumptions, risks and
uncertainties because of the possibility of changes in underlying factors and
assumptions. Actual results could differ materially from those contained in or
implied by such forward-looking statements for a variety of factors including:
recommendations made by or actions taken by banking regulatory authorities;
significant changes in the economic scenario from the current anticipated
scenario which could materially change anticipated credit quality trends; the
value of investment securities and the ability to generate loans; significant
delay in or inability to execute strategic initiatives designed to increase
capital, reduce non-performing loans and classified assets, grow revenues and
control expenses; ability to maintain sufficient liquidity and cash flow and
significant changes in accounting, tax or regulatory practices or requirements;
changes in interest rates; financial, legal, regulatory or other changes
affecting the banking and financial services industries in general; continued
intense competition from numerous providers of products and services which
compete with the Company's businesses, and other factors listed from time to
time in the Company's SEC reports, including, but not limited to, the Annual
Report on Form 10-K for the year ended December 31, 2002.
Whenever possible, the Company has identified these forward-looking statements
(as defined in Section 21E of the Securities Exchange Act of 1934) by words such
as "anticipates," "may," "believes," "estimates," "projects," "expects,"
"intends," and words of similar import. In addition to the statements included
in this Quarterly Report on Form 10-Q, the Company and its representatives may
from time to time make other oral or written statements that are also
forward-looking statements.
The Company expressly disclaims any obligation to update publicly any
forward-looking statements, whether as a result of new information, future
events or otherwise.
If one or more of the factors affecting our forward-looking information and
statements proves incorrect, then our actual results, performance or
achievements could differ materially from those expressed in, or implied by,
forward-looking information and statements contained in this Quarterly Report.
Therefore, we caution you not to place undue reliance on our forward-looking
information and statements. We do not intend to update our forward-looking
information and statements, whether written or oral, to reflect change. All
forward-looking statements attributable to us are expressly qualified by these
cautionary statements.
24
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk arising from adverse changes in the fair value of
financial instruments due to a change in interest rates, exchange rates and
equity prices. The Company's primary market risk is interest rate variations in
the short-term time horizons also known as interest rate risk.
The primary objective of Asset/Liability Management at the Company is to manage
interest rate risk and achieve reasonable stability in net interest income
throughout interest rate cycles. This is achieved by maintaining the proper
balance of rate sensitive earning assets and rate sensitive liabilities. The
relationship of rate sensitive earning assets to rate sensitive liabilities is
the principal factor in projecting the effect that fluctuating interest rates
will have on future net interest income. Rate sensitive earning assets and
interest-bearing liabilities are those that can be repriced to current market
rates within a relatively short time period. Management monitors the rate
sensitivity of securities over the entire life of these instruments, but places
particular emphasis on the first year. The Company's Asset/Liability Management
policy requires risk assessment relative to interest pricing and related terms.
The Company uses additional tools to monitor and manage interest rate
sensitivity. One of the primary tools is simulation analysis. Simulation
analysis is the primary method of estimating earnings at risk and capital at
risk under varying interest rate conditions. Simulation analysis is used to
test the sensitivity of the Company's net interest income and stockholders'
equity to both the level of interest rates and the slope of the yield curve.
Simulation analysis accounts for the expected timing and magnitude of assets and
liability cash flows, as well as the expected timing and magnitude of deposits
that do not reprice on a contractual basis. In addition, simulation analysis
includes adjustments for the lag between movements in market interest rates on
loans and interest-bearing deposits. These adjustments are made to reflect more
accurately possible future cash flows, repricing behavior and ultimately net
interest income.
As of June 30, 2003, there were no substantial changes in the composition of the
Company's market-sensitive assets and liabilities or their related market values
from that reported as of December 31, 2002. The foregoing disclosures related
to the market risk of the Company should be read in conjunction with the
Company's audited consolidated financial statements, related notes and
management's discussion and analysis of financial condition and results of
operations for the year ended December 31, 2002 included in the Company's Annual
Report on Form 10-K.
[The remainder of this page intentionally left blank]
25
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
ITEM 4. CONTROLS AND PROCEDURES
(a) The Company carried out an evaluation, under the supervision and
participation of its management, including the Chief Executive Officer and
the Chief Financial Officer, of the effectiveness of the design and
operation of the Company's disclosure controls and procedures (as defined
in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period
covered by this Quarterly Report on Form 10-Q. Based on that evaluation,
the Chief Executive Officer and the Chief Financial Officer concluded that
the Company's disclosure controls and procedures are effective in timely
alerting them to material information relating to the Company (including
its consolidated subsidiaries) required to be included in the Company's
periodic SEC filings. However, the Company recently has experienced several
changes in top management, and the effectiveness of such disclosure
controls and procedures is dependent on the Company's personnel to report
any issues or matters required to be disclosed in the Company's SEC filings
to the appropriate management personnel on a timely basis.
(b) During the period covered by this quarterly report, there were no changes
in the Company's internal control over financial reporting that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
26
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
PART II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
Reference is made to the legal proceedings previously reported in the
Company's Annual Report on Form 10-K for the fiscal year ended December 31,
2002, under the heading "Item 3 - Legal Proceedings." Subsequent to the
filing of the Company's Form 10-K, the Company received notice that a suit
had been filed by a second former officer and director in the Circuit Court
of Jefferson County, Alabama, alleging similar causes of action against the
Bank. Both of these suits have since been removed to the United States
District Court for the Northern District of Alabama, and the Bank intends
to vigorously defend this and any other action brought against the Bank by
either of the officers, and does not believe that the final outcome will
have a material impact on the Bank or the Company.
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Stockholders of Heritage Financial Holding
Corporation was held on May 20, 2003, and the stockholders elected five (5)
directors. The following is a tabulation of the voting on this matter.
NAMES VOTES FOR VOTES WITHHELD
Lenny L. Hayes 5,495,226 213,797
Harold B. Jeffreys 5,446,401 255,279
Vernon A. Lane 5,481,544 227,479
Neal A. Holland, Jr. 5,442,183 259,997
Larry E. Landman 5,481,376 227,647
Larry R. Mathews 5,497,601 211,422
The following directors continued in office following the Annual Meeting:
John T. Moss, T. Gerald New, M. D., Betty B. Sims, R. Jeron Witt, Bingham
D. Edwards, Gregory B. Parker and Timothy A. Smalley.
The stockholders also ratified the appointment of Schauer, Taylor, Cox,
Vise, Moran & Fowler, P. C. as independent auditors of the Company for the
year ending December 31, 2003. The following is a tabulation of the voting:
FOR AGAINST ABSTAIN
5,505,157 61,831 149,317
The audit committee, subsequent to the Annual Meeting, determined to
dismiss Schauer, Taylor, Cox, Vise, Morgan & Fowler, P. C., and to retain
Porter Keadle Moore, LLP as the Company's independent auditors for the year
ending December 31, 2003.
27
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit No. Exhibit Page
- ------------ -------------------------------------------------- ------
31.1 Certification of principal executive officer pursuant
to Exchange Act Rule 13a - 14(d) or 15d - 14a 32
31.2 Certification of principal financial officer pursuant
to Exchange Act Rule 13a - 14(d) or 15d - 14a 33
32.1 Chief Executive Officer - Certification pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002 34
32.2 Chief Financial Officer - Certification pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906
of the Sarbanes-Oxley Act of 2002 35
(b) REPORTS ON FORM 8-K
During the quarter ended June 30, 2003, the Company filed the
following Current Report on Form 8-K:
On April 23, 2003, the Company filed a Current Report on Form 8-K with
respect to a press release announcing its financial results for the
quarter ended March 31, 2003.
28
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2003
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.
HERITAGE FINANCIAL HOLDING CORPORATION
By: /s/Harold B. Jeffreys August 14, 2003
---------------------------- -----------------
Harold B. Jeffreys Date
Interim President and
Chief Executive Officer
By: /s/William M. Foshee August 14, 2003
---------------------------- -----------------
William M. Foshee Date
Chief Financial Officer
29