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 SEPTEMBER 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.)
211 Lee Street , N.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 November 7, 2003:
10,502,098 Shares
FORM 10-Q
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
SEPTEMBER 30, 2003
TABLE OF CONTENTS
PAGE NO.
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PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements (Unaudited)
Consolidated Statements of Financial Condition as of
September 30, 2003 and December 31, 2002. . . . . . . . . . . . . . 3
Consolidated Statements of Income for the three months
ended September 30, 2003 and 2002 . . . . . . . . . . . . . . . . . 4
Consolidated Statements of Comprehensive Income for the
three months ended September 30, 2003 and 2002. . . . . . . . . . . 5
Consolidated Statements of Income for the nine months
ended September 30, 2003 and 2002 . . . . . . . . . . . . . . . . . 6
Consolidated Statements of Comprehensive Income for the
nine months ended September 30, 2003 and 2002 . . . . . . . . . . . 7
Consolidated Statements of Cash Flows for the
nine months ended September 30, 2003 and 2002 . . . . . . . . . . . 8
Notes to Consolidated Financial Statements . . . . . . . . . . . . 10
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations . . . . . . . . . . . 15
Item 3 - Quantitative and Qualitative Disclosures about Market Risk. . . . . 24
Item 4 - Controls and Procedures . . . . . . . . . . . . . . . . . . . . . . 25
PART II - OTHER INFORMATION
Item 1 - Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . 25
Item 6 - Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . 26
SIGNATURES
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30, 2003 (UNAUDITED) AND DECEMBER 31, 2002
SEPTEMBER 30,
2003 December 31,
(UNAUDITED) 2002
--------------- --------------
ASSETS
Cash and due from banks. . . . . . . . . . . . . . . . . . . $ 7,939,210 $ 4,759,310
Interest bearing deposits with other banks . . . . . . . . . 25,558 97,707
Federal funds. . . . . . . . . . . . . . . . . . . . . . . . 24,366,940 14,681,498
--------------- --------------
CASH AND CASH EQUIVALENTS. . . . . . . . . . . . . . . . 32,331,708 19,538,515
Securities available-for-sale. . . . . . . . . . . . . . . . 57,893,003 35,125,841
Other Investments. . . . . . . . . . . . . . . . . . . . . . 1,986,561 1,635,961
Mortgage loans held-for-sale . . . . . . . . . . . . . . . . 5,222,555 12,343,440
Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . 402,747,479 523,849,502
Allowance for loan losses. . . . . . . . . . . . . . . . . . (18,254,044) (26,990,594)
Premises and equipment, net. . . . . . . . . . . . . . . . . 7,512,898 7,105,706
Accrued interest . . . . . . . . . . . . . . . . . . . . . . 2,125,419 3,404,344
Foreclosed real estate . . . . . . . . . . . . . . . . . . . 6,287,236 5,428,047
Other assets . . . . . . . . . . . . . . . . . . . . . . . . 10,711,495 11,501,035
--------------- --------------
TOTAL ASSETS . . . . . . . . . . . . . . . . . . . . . . $ 508,564,310 $ 592,941,797
=============== ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
DEPOSITS
Noninterest bearing. . . . . . . . . . . . . . . . . . . . $ 26,471,162 $ 21,961,197
Interest-bearing . . . . . . . . . . . . . . . . . . . . . 409,540,976 503,669,662
--------------- --------------
TOTAL DEPOSITS . . . . . . . . . . . . . . . . . . . . . 436,012,138 525,630,859
Short-term borrowings. . . . . . . . . . . . . . . . . . . . 7,480,000 6,650,000
Accrued interest . . . . . . . . . . . . . . . . . . . . . . 1,376,844 3,288,749
FHLB advances. . . . . . . . . . . . . . . . . . . . . . . . 23,000,000 23,000,000
Trust preferred securities . . . . . . . . . . . . . . . . . 10,000,000 10,000,000
Other liabilities. . . . . . . . . . . . . . . . . . . . . . 750,263 669,143
--------------- --------------
TOTAL LIABILITIES. . . . . . . . . . . . . . . . . . . . 478,619,245 569,238,751
--------------- --------------
STOCKHOLDERS' EQUITY
Preferred stock - par value $0.01 per share; 10,000,000
Authorized . . . . . . . . . . . . . . . . . . . . . . . . - -
Common stock ($.01 par value; 40,000,000 shares authorized,
10,502,098 and 8,821,144 shares issued and outstanding at
September 30, 2003 and December 31, 2002). . . . . . . . . 105,021 88,211
Additional paid-in capital . . . . . . . . . . . . . . . . . 37,322,794 32,234,654
Accumulated deficit. . . . . . . . . . . . . . . . . . . . . (7,441,579) (8,676,525)
Accumulated other comprehensive income (loss). . . . . . . . (41,171) 56,706
--------------- --------------
TOTAL STOCKHOLDERS' EQUITY . . . . . . . . . . . . . . . 29,945,065 23,703,046
--------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY . . . . . . . $ 508,564,310 $ 592,941,797
=============== ==============
See notes to consolidated financial statements
3
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(UNAUDITED)
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2003 2002
----------- ------------
INTEREST INCOME
Interest and fees on loans. . . . . . . . . . . . . . . . . . . $7,025,574 $ 9,702,930
Interest and dividends on securities:
Taxable securities. . . . . . . . . . . . . . . . . . . . . . 270,157 340,147
Nontaxable securities . . . . . . . . . . . . . . . . . . . . 17,063 39,154
Interest on deposits with other banks . . . . . . . . . . . . . 1,130 1,500
Interest earned on federal funds sold and securities purchased. 48,799 130,756
----------- ------------
TOTAL INTEREST INCOME . . . . . . . . . . . . . . . . . . . . 7,362,723 10,214,487
----------- ------------
INTEREST EXPENSE
Interest on deposits. . . . . . . . . . . . . . . . . . . . . . 2,956,899 4,904,736
Interest on FHLB borrowings . . . . . . . . . . . . . . . . . . 250,038 244,500
Interest on short-term borrowings . . . . . . . . . . . . . . . 69,049 -
Interest on trust preferred securities. . . . . . . . . . . . . 262,905 255,000
----------- ------------
TOTAL INTEREST EXPENSE. . . . . . . . . . . . . . . . . . . . 3,538,891 5,404,236
----------- ------------
NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . . 3,823,832 4,810,251
Provision for loan losses . . . . . . . . . . . . . . . . . . . (48,393) 9,380,339
----------- ------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES . . . . . . . 3,872,225 (4,570,088)
NONINTEREST INCOME
Customer service fees . . . . . . . . . . . . . . . . . . . . . 306,450 295,199
Mortgage banking fee income . . . . . . . . . . . . . . . . . . 1,011,346 540,335
Investment security gains (losses). . . . . . . . . . . . . . . 21,036 1,133
Gains (losses) on sale of foreclosed real estate. . . . . . . . (465,077) 10,733
Other operating income. . . . . . . . . . . . . . . . . . . . . 233,866 66,447
----------- ------------
TOTAL NONINTEREST INCOME. . . . . . . . . . . . . . . . . . . 1,107,621 913,847
----------- ------------
NONINTEREST EXPENSES
Salaries and employee benefits. . . . . . . . . . . . . . . . . 2,542,633 1,659,380
Occupancy and equipment expense . . . . . . . . . . . . . . . . 536,674 411,780
Other operating expenses. . . . . . . . . . . . . . . . . . . . 1,583,170 1,321,015
----------- ------------
TOTAL NONINTEREST EXPENSES. . . . . . . . . . . . . . . . . . 4,662,477 3,392,175
----------- ------------
Income before income taxes. . . . . . . . . . . . . . . . . . . . 317,369 (7,048,416)
Provision for income tax expense (benefit). . . . . . . . . . . . 117,071 (2,626,161)
----------- ------------
NET INCOME (LOSS) . . . . . . . . . . . . . . . . . . . . . . . . $ 200,298 $(4,422,255)
=========== ============
BASIC AND DILUTED EARNINGS (LOSS) PER COMMON SHARE. . . . . . . . $ .02 $ (0.50)
=========== ============
See notes to consolidated financial statements
4
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
THREE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(UNAUDITED)
THREE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2003 2002
----------- ------------
NET INCOME (LOSS ). . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,298 $(4,422,255)
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains (losses) arising during the period,
net of tax of $43,541 and $72,636. . . . . . . . . . . . . . . . . . . (84,520) 108,954
Reclassification adjustments for losses (gains) included in net income,
net of tax of $7,152 and $453. . . . . . . . . . . . . . . . . . . . . (13,884) (680)
----------- ------------
Other comprehensive income (loss). . . . . . . . . . . . . . . . . . . (98,404) 108,274
----------- ------------
COMPREHENSIVE INCOME (LOSS). . . . . . . . . . . . . . . . . . . . . . . . . $ 101,894 $(4,313,981)
=========== ============
See notes to consolidated financial statements
5
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------------
2003 2002
------------ ------------
INTEREST INCOME
Interest and fees on loans. . . . . . . . . . . . . . . . . . . $22,572,918 $29,412,843
Interest and dividends on securities:
Taxable securities. . . . . . . . . . . . . . . . . . . . . . 970,162 990,610
Nontaxable securities . . . . . . . . . . . . . . . . . . . . 51,190 105,159
Interest on deposits with other banks . . . . . . . . . . . . . 3,892 4,763
Interest earned on federal funds sold and securities purchased. 129,658 263,655
------------ ------------
TOTAL INTEREST INCOME . . . . . . . . . . . . . . . . . . . . 23,727,820 30,777,030
------------ ------------
INTEREST EXPENSE
Interest on deposits . . . . . . . . . . . . . . . . . . . . . 10,338,967 14,665,453
Interest on FHLB borrowings . . . . . . . . . . . . . . . . . . 739,038 711,849
Interest on short-term borrowings . . . . . . . . . . . . . . . 185,196 -
Interest on trust preferred securities. . . . . . . . . . . . . 788,715 757,029
------------ ------------
TOTAL INTEREST EXPENSE. . . . . . . . . . . . . . . . . . . . 12,051,916 16,134,331
------------ ------------
NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . . 11,675,904 14,642,699
Provision for loan losses . . . . . . . . . . . . . . . . . . . (564,593) 13,075,825
------------ ------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES . . . . . . . 12,240,497 1,566,874
NONINTEREST INCOME
Customer service fees . . . . . . . . . . . . . . . . . . . . . 821,825 778,461
Mortgage banking fee income . . . . . . . . . . . . . . . . . . 2,449,109 1,374,730
Investment security gains . . . . . . . . . . . . . . . . . . . 205,801 72,894
Gains (losses) on sale of foreclosed real estate. . . . . . . . (686,677) 48,653
Other operating income. . . . . . . . . . . . . . . . . . . . . 554,142 165,082
------------ ------------
TOTAL NONINTEREST INCOME. . . . . . . . . . . . . . . . . . . 3,344,200 2,439,820
------------ ------------
NONINTEREST EXPENSES
Salaries and employee benefits. . . . . . . . . . . . . . . . . 6,895,559 6,588,241
Occupancy and equipment expense . . . . . . . . . . . . . . . . 1,656,425 1,120,011
Other operating expenses. . . . . . . . . . . . . . . . . . . . 5,061,492 3,584,871
------------ ------------
TOTAL NONINTEREST EXPENSES. . . . . . . . . . . . . . . . . . 13,613,476 11,293,123
------------ ------------
Income (loss) before income taxes . . . . . . . . . . . . . . . . 1,971,221 (7,286,429)
Provision for income tax expense (benefit). . . . . . . . . . . . 736,276 (2,702,600)
------------ ------------
NET INCOME (LOSS) . . . . . . . . . . . . . . . . . . . . . . . . $ 1,234,945 $(4,583,829)
============ ============
BASIC AND DILUTED EARNINGS (LOSS) PER COMMON SHARE. . . . . . . . $ 0.12 $ (0.53)
============ ============
See notes to consolidated financial statements
6
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2003 2002
----------- ------------
NET INCOME (LOSS ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,234,945 $(4,583,829)
Other comprehensive income, net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during the period,
net of taxes of $19,551 and $167,252. . . . . . . . . . . . . . . . . 37,952 324,666
Reclassification adjustments for gains (losses) included in net income,
net of taxes of $69,972 and $24,784. . . . . . . . . . . . . . . . . . (135,829) (48,110)
----------- ------------
Other comprehensive income . . . . . . . . . . . . . . . . . . . . . . . . (97,877) 276,556
----------- ------------
COMPREHENSIVE INCOME (LOSS) . . . . . . . . . . . . . . . . . . . . . . . . $1,137,068 $(4,307,273)
=========== ============
See notes to consolidated financial statements
7
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(UNAUDITED)
Nine Months Ended
September 30
-----------------------------
2003 2002
-------------- -------------
OPERATING ACTIVITIES
Net Income (Loss). . . . . . . . . . . . . . . . . . . . $ 1,234,945 $ (4,583,829)
Adjustments to reconcile net income to net cash
provided by operating activities:
Provision for loan losses. . . . . . . . . . . . . . . (564,593) 13,075,825
Depreciation, amortization, and accretion, net . . . . 830,235 354,654
Loss (gain) on sale of other real estate . . . . . . . 365,483 (20,380)
Realized investment security gains . . . . . . . . . . (205,801) (72,894)
Decrease in accrued interest receivable. . . . . . . . 1,278,925 317,599
Decrease in accrued interest payable . . . . . . . . . (1,911,905) (1,252,632)
Decrease (increase) in mortgage loans held-for-sale. . 7,120,885 (1,274,951)
Decrease (increase) in other assets. . . . . . . . . . 839,961 (4,063,222)
Increase (decrease) in other liabilities . . . . . . . 81,120 (235,587)
Writedowns of foreclosed real estate . . . . . . . . . 321,194 ---
Other, net . . . . . . . . . . . . . . . . . . . . . . --- (34,104)
-------------- -------------
NET CASH PROVIDED BY OPERATING ACTIVITIES. . . . . . 9,390,449 2,210,479
-------------- -------------
INVESTING ACTIVITIES
Purchases of securities available-for-sale . . . . . . . (115,256,894) (69,758,283)
Proceeds from sales of securities available for sale . . 16,523,898 15,408,606
Proceeds from calls, paydowns and maturities of
securities available for sale. . . . . . . . . . . . . 75,775,863 12,098,811
Purchases of other investments . . . . . . . . . . . . . (350,600) -
Net (increase) decrease in loans to customers. . . . . . 102,621,864 (48,220,178)
Purchases of premises and equipment. . . . . . . . . . . (998,694) (1,006,873)
Proceeds from disposition of fixed assets. . . . . . . . 8,741 ---
Proceeds from disposition of foreclosed real estate. . . 8,762,336 1,138,134
-------------- -------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES. 87,086,514 (90,339,783)
-------------- -------------
FINANCING ACTIVITIES
Compensatory options (tax benefit forfeited) . . . . . . (5,803) 1,119,986
Net (decrease) increase in deposits. . . . . . . . . . . (89,618,721) 81,864,430
Net proceeds from issuance of stock. . . . . . . . . . . 2,309,054 811,171
Net proceeds from FHLB loans . . . . . . . . . . . . . . - 10,000,000
Net proceeds from short-term debt. . . . . . . . . . . . 830,000 -
Net proceeds from exercise of stock options. . . . . . . 2,801,700 -
-------------- -------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES. . . (83,683,770) 93,795,587
-------------- -------------
NET INCREASE IN CASH AND CASH EQUIVALENTS . . . . . . . . 12,793,193 5,666,283
Cash and Cash Equivalents at Beginning of Period . . . . . 19,538,515 13,701,768
-------------- -------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD . . . . . . . . $ 32,331,708 19,368,051
============== =============
See notes to consolidated financial statements
8
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
(UNAUDITED)
Nine Months Ended
September 30
-------------------------
2003 2002
------------ -----------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest. . . . . . . . . . . . . . . . . . . $13,963,821 $18,046,236
Taxes . . . . . . . . . . . . . . . . . . . . - 645,436
Noncash investing and financing activities:
Change in other comprehensive, net . . . . . $ (97,877) $ 276,556
Transfer of loans to other real estate. . . . $10,308,202 $ 0
See notes to consolidated financial statements
9
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
SEPTEMBER 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 nine-month period ended September 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 by Company
management. 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
allowance for loan losses based on their judgment.
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
10
USE OF ESTIMATES, CONTINUED
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 37.1 % for the nine months
ended September 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 September 30, 2003, the Company had net unrealized losses of approximately
$62,380 in available-for-sale securities which are reflected in the presented
assets and resulted in a decrease in stockholders' equity of $41,171, net of
deferred taxes. There were no held-to-maturity or trading securities at
September 30, 2003 or December 31, 2002.
NOTE D - STOCKHOLDERS' EQUITY
Equity has increased by $6,242,000 from December 31, 2002 to September 30, 2003.
The major components of this increase were: (1) Nine months ended September 30,
2003, net income of $1,235,000, (2) stock option exercise totaling a net
increase of $2,801,000 and (3) the issuance of shares generating $ 2,300,000.
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 and July 2003,
certain directors of the Company exercised options on 120,000 shares of Company
common stock at an exercise price of $3.34 per share, generating net proceeds of
approximately $400,000. 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.
11
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
Over the course of the past twelve months, management has 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 each have imposed certain
restriction on the operations of the Company and the Bank, respectively, in
order to address asset quality concerns, operational controls and procedures,
and capital deficiencies. Management, staff and the Board of Directors of the
Bank have worked together to revise the lending policies of the Bank, and to
implement new lending, recordkeeping and accounting practices.
The Board of Directors of the Bank took steps to improve and increase the
capital ratios of the Bank, including attaining and maintaining a Tier 1
leverage ratio of 8 percent and requiring the Bank to be "well-capitalized" as
defined by the FDIC. Management's efforts to achieve these goals have been
largely successful, as the Bank's Tier 1 leverage ratio increased to 8.77%
percent at September 30, 2003.
The management of the Company and the Bank has aggressively addressed loan and
other asset quality 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. Current management also undertook additional reviews and
assessments of a substantial portion of the Bank's loan portfolio to increase
management's knowledge of the Bank's overall asset quality issues, in light of
the changes in management and personnel during the past twelve months. The Bank
continues to 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 has reviewed and amended its written
loan policies and adopted new internal loan review systems in an effort to
ensure that going forward, new assets and loans garnered by the Bank comply with
the loan policies and underwriting criteria of the Bank.
As a result of the quality issues associated with 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-evaluated the Bank's
lending strategy. The Board of Directors and management have implemented new
policies with respect to loan originations 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 previous decision to increase the allowance for loan losses as a
result of the level of classified assets, 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 Larry R. Mathews, the President
and Chief Executive Officer of the Company and the Bank and William M. Foshee,
the Chief Financial Officer of the Company and the Bank.
12
In the second quarter of 2003, loans totalling $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 was allocated
to these loans was reversed from the allowance resulting in a negative provision
for loan losses.
Management conducted a comprehensive review of the Company's and the Bank's
internal control structures and procedures. In the course of this review,
management 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
determined that certain internal controls and procedures relating to loan
policies and procedures had not been followed by Bank personnel. This review is
ongoing and further adjustments to loan loss reserves may be made as 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 and SFAS No. 148, Accounting for
Stock-Based Compensation - Transition and Disclosure. No stock-based employee
compensation cost has been reflected in net income for these plans. Net
income (loss) and earnings per share would not be materially different during
the three and nine month periods ended September 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.
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13
NOTE G - COMMITMENTS AND CONTINGENCIES
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 September 30, 2003 and December 31, 2002:
SEPTEMBER 30, December 31
2003 2002
-------------- ------------
Commitments to extend credit . . . . . . $ 55,312,000 $ 75,574,000
Standby and commercial letters of credit 3,540,000 3,259,000
-------------- ------------
Total commitments and contingencies . . $ 58,852,000 $ 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 is 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 nine months ended
September 30, 2003 and 2002, the potential effect of outstanding options and
warrants would have been antidilutive, and therefore diluted earnings per
share is not presented. Earnings (loss) per common share amounts for the three
months ended September 30, 2003 and 2002 are based on weighted average shares
outstanding of 10,464,924 and 8,816,300, respectively. Earnings (loss) per
common share for the nine months ended September 30, 2003 and 2002 are based on
weighted average shares outstanding of 9,942,835 and 8,682,310, respectively.
14
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 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 nine months ended September 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 September 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
SEPTEMBER 30, 2003 COMPARED TO DECEMBER 31, 2002
LOANS
Loans comprised the largest category of the Company's earning assets on
September 30, 2003. Loans, net of allowance for loan losses, were 75.6% of total
assets at September 30, 2003, and 83.8% of total assets at December 31, 2002.
Total net loans were $384,493,000 at September 30, 2003, representing a 22.6%
decrease from the December 31, 2002 total of $496,859,000. During 2003, the
Company sold $13.7 million of loans to Bayview Financial, $12.6 million of loans
were transferred to foreclosed real estate, $8.2 million in net loans were
charged off and net paydowns have totaled $88.9 million. 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. Mortgage loans held for sale decreased
from $12.3 million at December 31, 2003, to $5.2 million at September 30, 2003.
This decrease in outstandings of $7.1 million resulted from a reduction in new
mortgage originations due to the increasing mortgage interest rates during the
third quarter of 2003.
15
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 $8,737,000 during the nine months ended September 30, 2003 to
$18,254,000 at September 30, 2003 from $26,991,000 at December 31, 2002. Charge
offs in an aggregate amount of $8.6 million accounted for the decrease in the
allowance for loan losses. The allowance for loan losses represented 4.53% and
5.15% of loans receivable at September 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 reserve allocated to these loans was
reversed from the allowance for loan losses resulting in a negative provision
for loan losses.
In the opinion of management, the allowance for loan losses was adequate at
September 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 effect 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 nine months ended September 30,
2003 and 2002 were as follows:
2003 2002
------------ ------------
Balance at beginning of the year $26,991,000 $ 6,074,000
Charge-offs (8,589,000) (5,606,000)
Recoveries 417,000 211,000
------------ ------------
Net charge-offs (8,172,000) (5,395,000)
Provision for loan losses (565,000) 13,076,000
------------ ------------
Balance as of September 30 18,254,000 13,755,000
------------ ------------
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 increased $21,131,000 from
December 31, 2002 to $57,893,000 at September 30, 2003. Federal funds sold
increased $9,685,000 from December 31, 2002 to $24,367,000 at September 30,
16
2003. Funds have been deployed in these two earning asset categories during 2003
as loan production decreased due to changes in the Bank's credit standards.
ASSET QUALITY
Between December 31, 2002 and September 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 $16,993,000
during this period. The ratio of nonperforming assets to total assets decreased
from 4.5% to 4.2% and the ratio of nonperforming loans to total loans decreased
from 5.0% to 3.35% during the first nine months of 2003. The ratio of loan loss
allowance to total nonperforming assets increased from 101.1% to 107.4% 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 timelier manner,
and ensure that future loans comply with the Bank's lending policies and
procedures.
NONPERFORMING ASSETS
9/30/2003 12/31/2002
----------- -----------
Nonaccruing loans $ 9,673,000 $15,794,000
Loans past due 90 days or more $ 1,033,000 $ 8,560,000
Foreclosed real estate $ 6,287,000 $ 5,428,000
----------- -----------
Totals $16,993,000 $29,782,000
----------- -----------
DEPOSITS
Total deposits of $436,012,000 at September 30, 2003 decreased $89,619,000, or
17.1%, from total deposits of $525,631,000 at year-end 2002 primarily due to a
reduction in brokered deposits. The reduction in brokered deposits resulted from
early redemptions of $22 million that were initiated by the Bank and $49 million
that matured during 2003. Deposits are the Company's primary source of funds
with which to support its earning assets. Noninterest-bearing deposits increased
$4,510,000, or 21.0%, from year-end 2002 to September 30, 2003, and
interest-bearing deposits decreased $94,129,000, or 18.7%, from year-end 2002.
STOCKHOLDERS' EQUITY
Equity has increased by $6,242,000 from December 31, 2002 to September 30, 2003.
The major components of this increase were: (1) Nine months ended September 30,
2003, net income of $1,235,000, (2) stock option exercise totaling a net
17
increase of $2,801,000 and (3) the issuance of shares generating $2,300,000.
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 and July 2003,
certain directors of the Company exercised options on 120,000 shares of Company
common stock at an exercise price of $3.34 per share, generating net proceeds of
approximately $400,000. 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.
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
$135,341,000 or 33.6% of the total loan portfolio at September 30, 2003. Other
sources of liquidity include short-term investments such as federal funds sold
which amounted to $24,367,000 at September 30, 2003.
The liability portion of the balance sheet provides liquidity through various
customers' interest-bearing and noninterest-bearing deposit accounts. At
September 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
September 30, 2003, the Federal Home Loan Bank line of credit permitted
borrowings of up to approximately $53 million and as of September 30, 2003, the
Bank had borrowed $23 million.
18
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
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 guaranteed preferred beneficial interest in the Company's
subordinated debentures, subject to limitations, amounted to approximately
$39,659,000 at September 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 $45,090,000 at September 30,
2003.
The Company has taken steps to attain and maintain a Tier 1 capital ratio at the
Bank of 8%. As of September 30, 2003, the Bank's Tier 1 capital ratio was 8.77%.
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 September 30, 2003 and December 31, 2002, the capital ratios of the Bank
were as follows:
Regulatory September 30, December 31,
Minimum 2003 2002
------- ---- ----
Tier 1 leverage ratio 4% 8.77% 5.99%
Tier 1 Risk-based capital ratio 6% 10.77% 7.68%
Total Risk-based capital ratio 8% 12.06% 8.98%
19
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
SUMMARY
Net earnings of the Company for the quarter ended September 30, 2003 were
$200,000, compared to a net loss of $4,422,000 for the same period in 2002,
representing a $4,622,000 increase from prior period income. The earnings for
the quarter ended September 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 September 30, 2003 decreased $2,852,000, or 27.9%, from the same period in
2002. A decrease in the average balances of earning assets accounted for
$2,331,000 of this decrease and the decrease in the average rate earned on these
assets accounted for $521,000 of the decrease. Interest expense for the three
months ended September 30, 2003 decreased $1,865,000, or 34.5%, over the
corresponding period of 2002 due to decreases in interest expense paid on
interest-bearing deposits. A decrease in the average balances of interest
bearing liabilities accounted for $1,147,000 of this decrease and the decrease
in the average rate paid on these liabilities accounted for $718,000 of this
decrease. As a result of these factors, net interest income decreased $986,000,
or 20.5%, for the three months ended September 30, 2003, compared to the same
period of 2002. The Bank's net interest margin was 3.06% for the quarter ended
September 30, 2003 compared to 2.79% for the quarter ended September 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 $48,000 for the
three months ended September 30, 2003, compared to a positive provision of
$9,380,000 for the same period of 2002. The 2002 provision resulted from
additional reserves needed as the result of the increases in classified assets
identified in reviews of the Bank's loan portfolio conducted in the third
quarter of 2002. The allowance for loan losses as a percent of outstanding
loans, net of unearned income, was 4.53% at September 30, 2003 compared to
2.45% at September 30, 2002.
NONINTEREST INCOME
Noninterest income for the three months ended September 30, 2003 was $1,108,000
compared to $914,000 for the same period of 2002. This increase primarily was
due to an increase in mortgage banking fee income of $654,000. The volume of
mortgage loans sold in 2003 has increased as a result of the low interest rate
environment in 2003.
20
NONINTEREST EXPENSES
Noninterest expenses for the three months ended September 30, 2003 were
$4,662,000, reflecting a 37.5% increase over the same period of 2002. The
primary component of noninterest expenses is salaries and employee benefits,
which increased $883,000, or 53.2%, during the three months ended September 30,
2003, compared to the same period in 2002. This increase was primarily due to
the increases relating to staffing and commissions for the mortgage banking
division. Occupancy costs increased $125,000, or 30.3%, and other operating
expenses increased $262,000, or 19.8%, from the same period in 2002. The
increase in occupancy primarily resulted from increased rates on lease
facilities and an increase in depreciation as a result of capital expenditures
of $1.3 million since September 30, 2002. The increase in other operating
expenses primarily resulted from increases in legal fees as a result of loan
credit and collection issues and as a result of outsourcing of the internal
audit function in 2003.
INCOME TAXES
The Company attempts to maximize its net income through active tax planning. The
provision for income taxes of $117,000 for the three months ended September 30,
2003 increased $2,743,000 compared to the same period of 2002. Taxes as a
percent of earnings before income taxes were 37.3% for the quarter ended
September 30, 2002, and 36.9% for the quarter ended September 30, 2003. The
effective tax rate of approximately 36.9% for the three months ended September
30, 2003, is more than the federal statutory rate principally because of state
income taxes.
RESULTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2003 AND 2002
SUMMARY
Net earnings of the Company for the nine months ended September 30, 2003 was
$1,235,000, compared to a net loss of $4,584,000 for the same period in 2002,
representing a $5,819,000 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 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 nine months
ended September 30, 2003 decreased $7,049,000, or 22.9%, from the same period in
2002. A decrease in the average balances of earning assets accounted for
$2,879,000 of this decrease and the decrease in the average rate earned on these
assets accounted for $4,170,000 of the decrease. Interest expense for the nine
months ended September 30, 2003 decreased $4,082,000, or 25.3%, over the
corresponding period of 2002. A decrease in the average balances of interest
bearing liabilities accounted for $1,628,000 of this decrease and the decrease
in the average rate paid on these liabilities accounted for $2,454,000 of this
decrease. As a result of these factors, net interest income decreased
$2,967,000, or 20.3%, for the nine months ended September 30, 2003, compared to
the same period of 2002. The Bank's net interest margin was 3.17 % for the nine
months ended September 30, 2003 compared to 3.59 % for the nine months ended
September 30, 2002.
21
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 a negative $565,000 for the nine months
ended September 30, 2003, compared to $13,076,000 for the same period of 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 September 30, 2003.
NONINTEREST INCOME
Noninterest income for the nine months ended September 30, 2003 was $3,344,000
compared to $2,440,000 for the same period of 2002. This increase primarily was
due to an increase in mortgage banking fee income of $1,074,000. The volume of
mortgage loans sold in 2003 has increased as a result of the low interest rate
environment in 2003.
NONINTEREST EXPENSES
Noninterest expenses for the nine months ended September 30, 2003 were
$13,613,000, reflecting a 20.6% increase over the same period of 2002. The
primary component of noninterest expenses is salaries and employee benefits,
which increased to $6,896,000 for the nine months ended September 30, 2003, 4.7%
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. The 2002 total included 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 $536,000, or 47.8%, and other operating expenses increased
$1,477,000, or 41.2%, from the same period of 2002. Occupancy costs for the
current period have increased primarily due increased rates on lease facilities
and an increase in depreciation as a result of capital expenditures of $1.3
million since September 30, 2002. The increase in other operating expenses was
the result of a $299,000 increase in FDIC insurance expense, a $515,000 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 $736,000 for the nine months ended September 30,
2003 increased $3,439,000 compared to the same period of 2002. Taxes as a
percent of earnings before income taxes increased from 37.1% to 37.4%. The
effective tax rate of approximately 37.4% for the nine months ended September
30, 2003 is more than the federal statutory rate principally because of state
income taxes.
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
22
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.
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
23
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.
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
24
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 September 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.
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 pursuant to Exchange
Act Rules 13a-15(c) 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) Management has previously conducted a comprehensive review of the
Company's internal control over financial reporting which identified significant
weaknesses in the Company's and the Bank's internal control over financial
reporting. While management continues to review and modify the Bank's internal
controls over financial reporting to remediate those weaknesses there have been
no significant changes in either Company's or the Bank's internal control over
financial reporting during the third quarter of 2003 that has materially
affected, or is reasonably likely to materially affect, the Company's internal
control over financial reporting.
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.
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ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit No. Exhibit Page
- ----------- ------- ----
10.1 Employment Contract for William M. Foshee 28
31.1 Certification of principal executive officer pursuant
to Exchange Act Rule 13a - 14(a) or 15d - 14a 42
31.2 Certification of principal financial officer pursuant
to Exchange Act Rule 13a - 14(a) or 15d - 14a 43
32.1 Chief Executive Officer - Certification required by
Exchange Act Rule 13a - 14 (b) or Rule 15d - 14(b) and 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 44
32.2 Chief Financial Officer - Certification required by
Exchange Act Rule 13a - 14 (b) or Rule 15d - 14(b) and 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002 45
(b) REPORTS ON FORM 8-K
During the quarter ended September 30, 2003, the Company filed the
following Current Reports on Form 8-K:
On July 18, 2003, the Company filed a Current Report on Form 8-K with
respect to a change in the Company's certifying accountants.
On July 30, 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 June 30, 2003.
On July 31, 2003, the Company filed an Amended Current Report on Form
8-K with respect to a change in the Company's certifying accountants.
On September 17, 2003, the Company filed a Current Report on Form 8-K
with respect to the appointment of Larry R. Mathews as President and
Chief Executive Officer of the Company.
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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/Larry R. Mathews 11/07/03
---------------------- -----------------------
Larry R. Mathews Date
President and
Chief Executive Officer
By: /s/William M. Foshee 11/07/03
----------------------- -----------------------
William M. Foshee Date
Chief Financial Officer
27