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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
_______________
FORM 10-K
_______________
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 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 specified in its charter)
DELAWARE 63-1259533
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
211 LEE STREET NE 35601
DECATUR, ALABAMA (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (256) 355-9500
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK - PAR VALUE $0.01 PER SHARE
(Title of Class)
Indicate by a check mark whether registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days.
Yes [X] No [ ]
Indicate by a check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes [ ] No [X]
State the aggregate market value of the voting and non-voting common
equity held by non-affiliates computed by reference to the price at which the
common equity was last sold, or the average bid and asked price of such common
equity, as of the last business day of the registrant's most recently completed
second fiscal quarter. Common Stock, par value $0.01 per share- $24,640,575.
Indicate the number of shares outstanding of each of the registrant's
classes of common stock as of March 24, 2003. Common Stock, par value $0.01 per
share - 10,510,791 shares
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the annual proxy statement for the annual meeting of
stockholders on May 18, 2004 incorporated by reference into Part III.
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HERITAGE FINANCIAL HOLDING CORPORATION
2003 FORM 10-K ANNUAL REPORT
Table of Contents
PART I. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS. . . . . . . . . . . . . 1
RISK FACTORS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
ITEM 1. BUSINESS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
ITEM 2. PROPERTIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
ITEM 3. LEGAL PROCEEDINGS. . . . . . . . . . . . . . . . . . . . . . . . . 12
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. . . . . . . . 12
PART II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS. . . . . . . . . . . . . . . . . . . . . . . . 12
ITEM 6. SELECTED FINANCIAL DATA. . . . . . . . . . . . . . . . . . . . . . 15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND. . 16
RESULTS OF OPERATIONS
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. . . . 37
ITEM 8. FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . 37
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.. . . . . . . . . . . . . . . . . . . . . . . 68
ITEM 9A. CONTROLS AND PROCEDURES . . . . . . . . . . . . . . . . . . . . . 68
PART III. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
ITEM 10, 11, 12, 13 AND 14. DIRECTORS AND EXECUTIVE OFFICERS OF THE
REGISTRANT; EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS; AND
PRINCIPAL ACCOUNTANT FEES AND SERVICES.. . . . . . . . . . . . . . 69
PART IV . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. 70
EXHIBIT 16 - LETTER FROM SCHAUER TAYLOR COX VICE MORGAN & FOWLER, P.C.. . . 74
EXHIBIT 21 - SUBSIDIARIES OF THE REGISTRANT . . . . . . . . . . . . . . . . 75
EXHIBIT 23.1 - CONSENT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS. . . . . 76
EXHIBIT 23.1 - CONSENT OF INDEPENDENT AUDITORS. . . . . . . . . . . . . . . 77
EXHIBIT 24 - POWER OF ATTORNEY. . . . . . . . . . . . . . . . . . . . . . . 78
EXHIBIT 31.1 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER . . . . . . . . . 80
EXHIBIT 31.2 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER . . . . . . . . . 81
EXHIBIT 32.1 CHIEF EXECUTIVE OFFICER CERTIFICATION UNDER 18 USC 1350. . . . 82
EXHIBIT 32.2 CHIEF FINANCIAL OFFICER CERTIFICATION UNDER 18 USC 1350. . . . 83
PART I
CAUTIONARY NOTICE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report and documents incorporated by reference herein, may
contain certain statements relating to our future results based on information
currently available. The presentations, and certain of the other disclosures in
this Annual Report, including any statements preceded by, followed by or which
include the words, "may," "could," "should," "will," "would," "believe,"
"expect," "anticipate," "estimate," "intend," "plan," "assume," or similar
expressions, constitute forward-looking statements within the meaning of Section
21E of the Securities Exchange Act of 1934, as amended. 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, return on
equity, return on assets, efficiency ratio, asset quality and other financial
data and capital and performance ratios.
Although we believe that the expectations reflected in our forward-looking
statements are reasonable, these statements involve risks and uncertainties
which are subject to change based on various important factors (some of which
are beyond our control). The following factors, among others, could cause our
financial performance to differ materially from our goals, plans, objectives,
intentions, expectations, and other forward-looking statements: (1) the extent
to which we are able to achieve and maintain certain capital ratios at the
Company and the Bank, as well as the effects of the inability or failure to
achieve such ratios; (2) the effects of certain operating restrictions on the
Company and the Bank, including, without limitation, the ability to declare or
pay dividends without prior regulatory approval; (3) the strength of the United
States economy in general and the strength of the regional and local economics
in which we conduct operations; (4) the effects of, and changes in, trade,
monetary and fiscal policies and laws, including interest rate policies of the
Board of Governors of the Federal Reserve System; (5) inflation, interest rate,
market and monetary fluctuations; (6) our timely development of new products and
services to a changing environment, including the features, pricing and quality
compared to the products and services of our competitors; (7) the willingness of
users to substitute competitors' products and services for our products and
services; (8) the impact of changes in financial services policies, laws and
regulations, including laws, regulations and policies concerning taxes, banking,
securities and insurance, and the application thereof by regulatory bodies; (9)
technological changes; (10) changes in consumer spending and savings habits;
(11) regulatory or judicial proceedings; and (12) the declaration of war and the
commencement of hostilities in Iraq and elsewhere. We also direct your attention
to the Risk Factors discussed immediately following this section under the
heading "Risk Factors."
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 Annual Report. We
do not intend to update or revise our forward-looking information and
statements, whether written or oral, to reflect any changes. All forward-looking
statements attributable to us are expressly qualified by these cautionary
statements.
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RISK FACTORS
THE COMPANY AND THE BANK ARE RESTRICTED FROM CERTAIN ACTIVITIES INCLUDING
PAYMENT OF DIVIDENDS TO STOCKHOLDERS.
During 2002, management of the Company identified significant operational
and asset quality deficiencies at the Bank. These deficiencies resulted in
material increases to the Bank's loan loss reserves, resulting in material
reductions in the capital levels of the Company and the Bank. As a result, the
Board of Directors and management of the Company and the Bank identified
specific corrective steps and actions to address capital deficiencies, improve
asset quality, and enhance operational controls and procedures. The Bank,
without the prior written approval of its regulators, may not declare or pay any
cash dividends. In addition, the Bank determined to hire and retain certain
personnel who were given specific written authority by the Board of Directors to
implement sound lending, recordkeeping and accounting practices. The Bank also
took steps to develop an educational program for board members and to create a
written review of the Bank's staffing requirements. During 2003, management's
actions to improve asset quality and enhance operational controls and procedures
resulted in the Bank's Tier 1 leverage ratio reaching 8.58% as of December 31,
2003. Additionally, both the Company and the Bank were considered "well
capitalized" as of December 31, 2003.
If the quality of the Company's assets does not continue to improve, or if
there is additional deterioration in the Bank's loan portfolio, the Company and
the Bank may be required to take additional remedial action that may further
restrict the Company's and the Bank's operations in future periods.
THE COMPANY AND THE BANK HAVE MADE SIGNIFICANT CHANGES TO THE BANK'S LOAN LOSS
RESERVES AS A RESULT OF REVIEWS OF THE BANK'S LOAN PORTFOLIO, AND THE BANK MAY
BE REQUIRED TO FURTHER INCREASE THE ALLOWANCE FOR LOAN AND LEASE LOSSES.
During the course of a targeted, limited scope review of the loan portfolio
of the Bank conducted in 2002, management identified certain assets in the
Bank's loan portfolio that management believed should be classified. Due to the
erosion in asset quality identified by the review, the Company increased the
allowance for loan losses by $2,000,000 during the quarterly period ended June
30, 2002. Additional review of the Bank's loan portfolio subsequently identified
additional asset quality problems, which resulted in the Company's increasing
the allowance for loan losses net of charge offs and recoveries by a total of
$20,916,364 for the year ending December 31, 2002.
Management of the Company and the Bank have taken corrective action to
improve asset quality and enhance operational controls and procedures.
Management, acting in concert with the Board of Directors, determined to charge
off $11,388,509 in loans during the course of 2003. As a result of management's
ongoing evaluation of the adequacy of the allowance for loan losses, a decline
in problem credits brought about by the implementation of new loan policies and
procedures and continued recoveries of loans previously charged off, management
decided to reduce the allowance for loan losses during 2003 to $14,562,283 at
December 31, 2003, compared to $26,990,594 at December 31, 2002.
Management continues to review the Bank's loan policies and procedures, as
well as the credit review process. Additional classifications of assets may
result in increases in the Bank's allowance for loan losses, and such increases
could have a material adverse effect on the Company's and the Bank's financial
condition and results of operations.
ITEM 1. BUSINESS
GENERAL
We are a Delaware-chartered bank holding company headquartered in Decatur,
Alabama. We offer a broad range of banking and related products and services in
ten locations in Northern Alabama through Heritage Bank, an Alabama banking
corporation and our principal subsidiary. We had assets of approximately $522
million, loans of approximately $386 million, deposits of approximately $416
million and stockholders' equity of approximately $30 million at December 31,
2003. Our principal executive offices are located at 211 Lee Street NE, Decatur,
Alabama 35601, and the telephone number is (256) 355-9500.
The Company's business is conducted primarily through the Bank. Although we
have no immediate plans to conduct any other business, the Company may engage
directly or indirectly in a number of activities which the
2
Federal Reserve has determined to be so closely related to banking or managing
or controlling banks as to be a proper incident thereto.
SUBSIDIARY BANK
At December 31, 2003, the Bank conducted business through nine locations in
Morgan, Madison, Marshall and Jefferson counties, Alabama. We offer a wide range
of commercial and retail banking services, including savings and time deposit
accounts, personal and commercial loans and personal and commercial checking
accounts. We seek to provide superior service to our customers and to become a
vital component of each of the communities that we serve.
SERVICES
We focus on commercial, consumer, residential mortgage and real estate
construction lending to customers in our local markets. Our retail loan products
include mortgage banking services, home equity lines of credit, consumer loans,
including automobile loans, and loans secured by certificates of deposit and
savings accounts. Our commercial loan products include working capital lines of
credit, term loans for both real estate and equipment, letters of credit and
Small Business Administration loans. We also offer a variety of deposit programs
to individuals and businesses and other organizations, including a variety of
personal checking, savings, money market and NOW accounts, as well as business
checking and saving accounts. In addition, we offer individual retirement
accounts, safe deposit and night depository facilities and additional services
such as internet banking and the sale of traveler's checks, money orders and
cashier's checks.
MARKET AREAS
The Company conducts its banking activities in Morgan, Madison, Marshall
and Jefferson counties in Alabama and in the surrounding vicinities. Within
those areas, the Company has banking offices located in the cities of Decatur,
Huntsville, Madison, Birmingham and Trussville, Alabama.
LENDING ACTIVITIES
We offer a range of lending services, including real estate, consumer and
commercial loans, primarily to individuals and businesses and other
organizations that are located in or conduct a substantial portion of their
business in our market areas. Our total loans at December 31, 2003 were $385.9
million, or 78.0% of total earning assets. The interest rates we charge on loans
vary with the risk, maturity and amount of the loan and are subject to
competitive pressures, money market rates, availability of funds and government
regulations. We do not have any foreign loans.
LOAN PORTFOLIO
Real Estate Loans - Loans secured by real estate are a significant
component of our loan portfolio, constituting $257.1 million, or 66.7% of total
loans at December 31, 2003. Our primary type of real estate loan is
single-family first mortgage loans, construction loans and acquisition and
development loans, typically structured with fixed or adjustable interest rates,
based on market conditions. Fixed rate loans usually have terms of five years or
less, with payments through the date of maturity generally based on a 15 to 30
year amortization schedule. Adjustable rate loans generally have a term of 5 to
30 years. We typically charge an origination fee on these mortgage loans.
Our nonresidential mortgage loans include commercial, industrial and land
loans. The commercial real estate loans are typically used to provide financing
for retail establishments, offices and manufacturing facilities. We generally
require nonresidential mortgage loans to have an 80% loan-to-value ratio and
usually underwrite commercial loans on the basis of the borrower's cash flow and
ability to service the debt from earnings, more than on the basis of the value
of the collateral. Terms are typically five years and may have payments through
the date of maturity based on a 15 to 30 year amortization schedule.
Construction loans usually have a term of twelve months and generally require
personal guarantees.
Commercial, Financial and Agricultural Loans - At December 31, 2003, we had
general commercial, financial and agricultural loans of $116.2 million,
comprising 30.1% of the total loan portfolio. Commercial loans consist primarily
of operating loans made to manufacturers, wholesalers and retailers of goods,
service companies
3
and other industries. We concentrate on making loans to small and medium size
companies. The primary repayment risk for commercial loans is the failure of the
borrower due to economic or financial factors. Although we typically look to a
commercial borrower's cash flow as the principal source of repayment, many
commercial loans are secured by inventory, equipment, accounts receivable and
other assets. These loans are typically made on terms up to five years at fixed
or variable rates and are secured by accounts receivable, inventory or, in the
case of equipment loans, the financed equipment. We attempt to reduce our credit
risk on commercial loans by limiting the loan to value ratio to 65% on loans
secured by accounts receivable or inventory and 75% on equipment loans.
Agricultural loans are comprised of loans to finance agricultural production,
loans to farmers and loans secured by farmland. We are able to manage the risks
inherent in these types of loans due to our small number of agricultural loans.
Consumer Loans - At December 31, 2003, loans to individuals for personal
expenditures totaled $12.5 million, comprising some 3.2% of our loan portfolio.
These consumer loans include loans to purchase automobiles, recreational
vehicles, mobile homes, appliances and boats, and the Bank continues to hold a
small amount of credit card loans. Consumer loans are underwritten based on the
borrower's income, current debt, credit history and collateral. Terms generally
range from four to five years on automobile loans and one to three years on
other consumer loans.
CREDIT PROCEDURES AND REVIEW
During 2002, we identified significant weaknesses in our loan policy,
including our loan approval process, credit analysis, loan review and other key
lending support functions. As part of our response to these issues, we have
revised the Bank's loan policy to address areas we believed to be inadequate,
and have hired additional personnel to upgrade our compliance in these areas.
Loan Approval - We attempt to minimize loan losses through various means
and use generally recognized underwriting criteria. In particular, on larger
credits, we generally rely on the cash flow of a debtor as the source of
repayment and secondarily on the value of the underlying collateral. In
addition, we attempt to utilize shorter loan terms in order to reduce the risk
of a decline in the value of such collateral. We have reduced the unsecured
lending authority of our officers and have reduced the overdraft authority of
our officers in order to address certain loan portfolio issues.
We address repayment risks by adhering to internal credit policies and
procedures that include officer and customer lending limits, a multi-layered
loan approval process for larger loans, periodic documentation examination and
follow-up procedures for any exceptions to credit policies. The point in our
loan approval process at which a loan is approved depends on the size of the
borrower's credit relationship with the Bank. We require approval by the Board
of Directors of the Bank for new advances of credit to any borrowers with loans
classified Substandard and prohibit the advance of additional credit to any
borrower with loans classified Doubtful or Loss.
Loan Review - The Bank has a loan review process designed to promote early
identification of credit quality problems. All lending officers are charged with
the responsibility of reviewing all past due loans in their respective
portfolios. Lending officers establish a watch list of loans to be reviewed by
management and the Board of Directors. Lending officers also conduct a regular
centralized internal review which tests compliance with loan policy and
documentation for all loans over $250,000 and a sampling of smaller loans.
The entire loan portfolio undergoes close scrutiny to maintain its quality
and diversity and to assure proper documentation. This policy also requires that
each loan have an agreed upon repayment schedule and gives individual lending
officers the responsibility of obtaining, and analyzing current credit
information. Maximum loan to value ratios and terms are established in the
policy for the various types of loans. The criteria outlined in the Bank's loan
policy follows guidelines provided by banking regulators. Through the Bank's
credit policy and credit review procedures, management believes that it is able
to identify areas of concern in the loan portfolio and to take corrective action
when necessary.
DEPOSITS
Core deposits are our principal source of funds, constituting approximately
80.3% of our total deposits as of December 31, 2003. Core deposits consist of
demand deposits, interest-bearing transaction accounts, savings deposits and
certificates of deposit (excluding certificates of deposit and other time
deposits over $100,000). Transaction accounts include checking, money market and
NOW accounts that provide the Bank with a source of fee income and
cross-marketing opportunities, as well as a low-cost source of funds. Time and
savings accounts also
4
provide a relatively stable and low-cost source of funding. The largest source
of funds for the Bank is certificates of deposit. Certificates of deposit in
excess of $100,000 are held primarily by customers outside of our market areas.
Deposit rates are reviewed weekly by senior management. We believe our
rates are competitive with those offered by competing institutions in our market
areas; however, we focus on customer service, not high rates, to attract and
retain deposits.
COMPETITION
The banking industry in Alabama is highly competitive, and our
profitability depends principally on our ability to compete in our market areas.
The area is dominated by a number of major banks and bank holding companies that
have substantially greater resources, and numerous offices and affiliates
operating over wide geographic areas. We encounter strong competition both in
making loans and attracting deposits. Competition among financial institutions
is based upon interest rates offered on deposit accounts, interest rates charged
on loans and other credit and service charges. Customers also consider the
quality and scope of the services rendered, the convenience of banking
facilities and, in the case of loans to commercial borrowers, relative lending
limits, and may also consider the fact that other banks offer different
services. Many of the large regional banks against which we compete have
significantly greater lending limits and may offer additional products; however,
we believe we have been able to compete effectively with other financial
institutions, regardless of their size, by emphasizing customer service and by
providing a wide array of services. In addition, most of our non-bank
competitors are not subject to the same extensive federal regulations that
govern bank holding companies and federally insured banks. See "Supervision and
Regulation." Competition may further intensify if additional financial services
companies enter markets in which we conduct business.
EMPLOYEES
As of December 31, 2003, the Company employed approximately 162 individuals
of which approximately 150 were full-time employees. The Company believes that
its relations with these employees are generally good.
SUPERVISION AND REGULATION
The Company, as a bank holding company under the Bank Holding Company Act
of 1956, as amended ("BHCA"), is subject to the supervision, examination and
reporting requirements of the Federal Reserve Board and the BHCA. The BHCA and
other federal laws subject bank holding companies to particular restrictions on
the types of activities in which they may engage and to a range of supervisory
requirements and activities, including regulatory enforcement actions for
violations of laws and regulations. The Company is required to file with the
Federal Reserve periodic reports and such other information as the Federal
Reserve may request. The Federal Reserve conducts examinations of the Company,
and also may examine its subsidiaries. The State of Alabama does not regulate
bank holding companies.
In November 1999, Congress enacted the Gramm-Leach-Bliley Act ("GLBA"),
which made substantial revisions to the statutory restrictions separating
banking activities from certain other financial activities. Under the GLBA, bank
holding companies that are "well-capitalized" and "well-managed" and whose
subsidiary banks have satisfactory or better ratings under the Community
Reinvestment Act of 1977, as amended (the "CRA"), and meet certain other
conditions can elect to become "financial holding companies." Financial holding
companies and their subsidiaries are permitted to acquire or engage in
previously impermissible activities, such as insurance underwriting, travel
agency activities, broad insurance agency activities, merchant banking, and
other activities that the Federal Reserve determines to be financial in nature
or complimentary to financial activities. In addition, under the merchant
banking authority added by the GLBA and Federal Reserve regulations, financial
holding companies are authorized to invest in companies that engage in
activities that are not financial in nature, as long as the financial holding
company makes its investment with the intention of limiting the terms of its
investment, does not manage the company on a day-to-day basis, and the investee
company does not cross-market with any of the financial holding company's
controlled depository institutions. Financial holding companies continue to be
subject to the overall oversight and supervision of the Federal Reserve. While
the Company has not elected to become a financial holding company, and may not
do so at the present time, it may elect to do so in the future.
The supervision and regulation of bank holding companies and their
subsidiaries are intended primarily for the protection of depositors, the
deposit insurance funds of the Federal Deposit Insurance Corporation (the
"FDIC") and the banking system as a whole, not for the protection of bank
holding company stockholders or creditors. The
5
banking agencies have broad enforcement power over bank holding companies and
banks, including the power to impose substantial fines and other penalties for
violation of laws and regulations. The following description summarizes some of
the laws to which we are subject. References herein to applicable statutes and
regulations are brief summaries thereof, do not purport to be complete and are
qualified in their entirety by reference to such statutes and regulations.
The Bank is subject to regulation, supervision and examination by the
Federal Reserve, the Federal Deposit Insurance Corporation ("FDIC") and the
Alabama Banking Department. As a member of the FDIC, the Bank's deposits are
insured to the maximum extent provided by law.
Regulatory Restrictions on Dividends - The payment of dividends to the
Company by the Bank is subject to certain restrictions imposed by state and
federal banking laws, regulations and authorities. The Federal Reserve Board
requires that bank holding companies should pay cash dividends on common stock
only out of income available over the past year and only if prospective earnings
retention is consistent with the bank holding company's expected future needs
and financial condition. This policy provides that bank holding companies should
not maintain a level of cash dividends that undermines the bank holding
company's ability to serve as a source of strength for its banking subsidiaries.
The prior approval of the Federal Reserve is required if the total of all
dividends declared by the state member bank in any calendar year will exceed the
sum of such bank's net profits for the year and its retained net profits for the
preceding two calendar years, less any required transfers to surplus. Federal
law also prohibits any state member bank from paying dividends that would be
greater than such bank's undivided profits after deducting statutory bad debt
reserves in excess of such bank's allowance for loan losses. The Bank is
currently prohibited from paying a cash dividend to the Company without seeking
prior written approval from federal banking authorities.
Under Alabama law, a bank may not pay a dividend in excess of 90% of its
net earnings until the bank's surplus is equal to at least 20% of its capital.
The Bank is also required by Alabama law to obtain the prior approval of the
Superintendent of the State Banking Department of Alabama for its payment of
dividends if the total of all dividends declared by the Bank in any calendar
year will exceed the total of (1) the Bank's net earnings (as defined by
statute) for that year, plus (2) its retained net earnings for the preceding two
years, less any required transfers to surplus. No dividends may be paid from the
Bank's surplus without the prior written approval of the Superintendent. The
Bank is currently prohibited from paying dividends to the Company without the
prior approval of the Superintendent of the State Banking Department.
In addition, federal bank regulatory authorities have authority to prohibit
the payment of dividends by bank holding companies if their actions constitute
unsafe or unsound practices. The Federal Reserve Board has issued a policy
statement on the payment of cash dividends by bank holding companies, which
expresses the Federal Reserve Board's view that a bank holding company
experiencing earnings weaknesses should not pay cash dividends that exceed its
net income or that could only be funded in ways that weaken the bank holding
company's financial health, such as by borrowing. Our ability and the Bank's
ability to pay dividends in the future is currently, and could be further,
influenced by bank regulatory policies and capital guidelines.
Source of Strength - Under Federal Reserve Board policy, a bank holding
company is expected to act as a source of financial strength for its bank
subsidiary and commit resources to its support. This support may be required by
the Federal Reserve Board at times when, absent this policy, additional
investments in a troubled bank may not otherwise be warranted. A bank holding
company, in certain circumstances, could be required to guarantee the capital
plan of an undercapitalized banking subsidiary. In addition, any capital loans
by a bank holding company to any of its depository institution subsidiaries
likely will be unsecured and subordinate in right of payment to deposits and to
certain other indebtedness of the banks.
Under the Federal Deposit Insurance Act ("FDIA"), an FDIC-insured
depository institution can be held liable for any loss incurred by, or
reasonably expected to be incurred by, the FDIC in connection with (1) the
default of a common controlled FDIC-insured depository institution or (2) any
assistance provided by the FDIC to any commonly controlled FDIC-insured
depository institution "in danger of default." "Default" is defined generally as
the appointment of a conservator or receiver, and "in danger of default" is
defined generally as the existence of certain conditions indicating that a
default is likely to occur in the absence of regulatory assistance. The FDIC's
claim for damages is superior to claims of stockholders of the insured
depository institution or its holding company but is subordinate to claims of
depositors, secured creditors and holders of subordinated debt (other than
affiliates) of the commonly controlled FDIC-insured depository institution.
Common controlled FDIC-insured depository
6
institutions are liable to the FDIC for any losses incurred in connection with
the failure of a commonly controlled institution.
Safe and Sound Banking Practices - Bank holding companies are not permitted
to engage in unsafe or unsound banking practices. The Federal Reserve Board has
broad authority to prohibit activities of bank holding companies and their
non-banking subsidiaries which represent unsafe or unsound banking practices or
which constitute violations of laws or regulations, and can assess civil money
penalties for certain activities conducted on a knowing or reckless basis, if
those activities caused a substantial loss to a depository institution. The
penalties can be as high as $1,000,000 for each day the activity continues.
The Federal Reserve adopted the Federal Financial Institutions Examination
Council's ("FFIEC") updated rating system which assigns each financial
institution a confidential composite "CAMELS" rating based on an evaluation and
rating of six essential components of an institution's financial condition and
operations including capital adequacy, asset quality, management, earnings,
liquidity and sensitivity to market risk. For most institutions, the FFIEC has
indicated that market risk is rated based upon, but not limited to, an
assessment of the sensitivity of the financial institution's earnings or the
economic value of its capital to adverse changes in interest rates, foreign
exchange rates, commodity prices, or equity prices; management's ability to
identify, measure, monitor and control exposure to market risk; and the nature
and complexity of interest rate risk exposure arising from nontrading positions.
Capital Adequacy Requirements - We are required to comply with the capital
adequacy standards established by the Federal Reserve Board, and the Bank is
subject to additional requirements of the FDIC and the Alabama Banking
Department. The Federal Reserve Board has adopted two basic measures of capital
adequacy for bank holding companies: a risk-based measure and leverage measure.
All applicable capital standards must be satisfied for a bank holding company to
be in compliance.
The risk-based capital standards are designed to make regulatory
requirements more sensitive to differences in risk profiles among banks and bank
holding companies, to account for off-balance-sheet exposure, and to minimize
disincentives for holding liquid capital assets. Assets and off-balance-sheet
items are assigned to broad risk categories, each with appropriate weights. The
resulting capital ratios represent capital as a percentage of total
risk-weighted assets and off-balance-sheet items.
The minimum guidelines for the ratio ("Total Risk-Based Capital Ratio") of
total capital ("Total Capital") to risked-weighted assets (including certain
off-balance sheet items, such as standby letters of credit) is 8%. At least half
of Total Capital must be comprised of common stock, minority interests in the
equity accounts of consolidated subsidiaries, noncumulative perpetual preferred
stock, and a limited amount of cumulative perpetual preferred stock, less
goodwill and other intangible assets ("Tier 1 Capital"). The remainder may
consist of subordinated debt, other preferred stock, and a limited amount of
loan loss reserves ("Tier 2 Capital").
In addition, the Federal Reserve Board has established minimum leverage
ratio guidelines for bank holding companies and state member banks. These
guidelines provide for a minimum ratio (the "Leverage Ratio") of Tier 1 Capital
to average assets, less goodwill and certain other intangible assets, of 3% for
bank holding companies that meet certain specified criteria, including having
the highest regulatory rating. All other bank holding companies generally are
required to maintain a Leverage Ratio of at least 3%, plus an additional cushion
of 1% - 2%, if the institution has less than the highest regulatory rating. The
guidelines also provide that bank holding companies experiencing internal growth
or making acquisitions will be expected to maintain strong capital positions
substantially above the minimum supervisory levels without significant reliance
on intangible assets. Furthermore, the Federal Reserve Board has indicated that
it will consider a tangible Tier 1 Capital Leverage Ratio (deducting all
intangibles) and other indicia of capital strength in evaluating proposals for
expansion or new activities.
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA"), among other things, requires the federal banking agencies to take
"prompt corrective action" regarding depository institutions that do not meet
minimum capital requirements. FDICIA establishes five capital tiers: "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized," and "critically undercapitalized." A bank's capital tier will
depend upon how its capital levels compare to various relevant capital measures
and certain other factors, as established by regulations.
All of the federal banking agencies have adopted regulations establishing
relevant capital measures and relevant capital levels. The relevant capital
measures are the Total Capital ratio, Tier 1 capital ratio, and the leverage
7
ratio. Under the regulations, a state member bank will be (i) well capitalized
if it has a Total Capital ratio of 10% or greater, a Tier 1 capital ratio of 6%
or greater, a Tier 1 leverage ratio of 5% or greater and is not subject to any
written agreement, order, capital directive or prompt corrective action
directive by a federal bank regulatory agency to meet and maintain a specific
capital level for any capital measure, (ii) adequately capitalized if it has a
Total Capital ratio of 8% or greater, a Tier 1 capital ratio of 4% or greater,
and a leverage ratio of 4% or greater (3% in certain circumstances), (iii)
undercapitalized if it has a Total Capital ratio of less than 8%, a Tier 1
capital ratio of less than 4% (3% in certain circumstances), and a leverage
ratio of less than 4%, (iv) significantly undercapitalized if it has a Total
Capital ratio of less than 6%, a Tier 1 capital ratio of less than 3% and a
leverage ratio of less than 3% or (v) critically undercapitalized if its
tangible equity is equal to or less than 2% of average quarterly tangible
assets.
As of December 31, 2003, the consolidated capital ratios of the Company and
the Bank were as follows:
REGULATORY
MINIMUM COMPANY BANK
----------- -------- ------
Tier 1 leverage ratio 3.0-5.0% 6.31% 8.64%
Tier 1 Risk-based capital ratio 4% 8.63% 10.71%
Total Risk-based capital ratio 8% 10.28% 11.99%
As of December 31, 2003, the Company and the Bank were "well capitalized."
Acquisitions by Bank Holding Companies - The BHCA requires every bank
holding company to obtain prior approval of the Federal Reserve Board before it
(1) may acquire all or substantially all of the assets of any bank; (2) may
acquire direct or indirect ownership or control of any voting shares of any
bank, if after such acquisition it would own or control, directly or indirectly,
more than 5% of the voting shares of such bank; or (3) may merge or consolidate
with any other bank holding company. In approving bank acquisitions by bank
holding companies, the Federal Reserve Board is required to consider the
financial and managerial resources and future prospects of the bank holding
company and the banks concerned, the convenience and needs of the communities to
be served and various other factors.
The BHCA further provides that the Federal Reserve Board may not approve
any transaction that would result in a monopoly or would be in furtherance of
any combination or conspiracy to monopolize or attempt to monopolize the
business of banking in any section of the United States, or the effect of which
may be substantially to lessen competition or to tend to create a monopoly in
any section of the country, or that in any other manner would be in restraint of
trade, unless the anti-competitive effects of the proposed transaction are
clearly outweighed by the public interest in meeting the convenience and needs
of the communities to be served. The Federal Reserve Board is required to
consider the financial and managerial resources and future prospects of the bank
holding companies and banks concerned, including capital adequacy, and the
convenience of the community to be served including the parties' performance
under the Community Reinvestment Act.
Control Acquisitions - The Change in Bank Control Act prohibits a person or
group of persons from acquiring "control" of a bank holding company unless the
Federal Reserve Board has been notified and has not objected to the transaction.
Under a rebuttable presumption established by the Federal Reserve Board, the
acquisition of 10% or more of a class of voting stock of a bank holding company
with a class of securities registered under Section 12 of the Exchange Act,
would, under the circumstances set forth in the presumption, constitute
acquisition of control of that bank holding company.
In addition, under the BHCA, any company is required to obtain the prior
approval of the Federal Reserve Board before acquiring 25% (and bank holding
companies are required to obtain prior approval from the Federal Reserve Board
before acquiring 5%) or more of the outstanding common stock of a bank holding
company, or otherwise obtain control or a "controlling influence" over the bank
holding company.
Branching - The BHCA, as amended by the interstate banking provisions of
the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the
"Interstate Banking Act") repealed prior statutory restrictions on interstate
banking, such that a bank holding company may acquire a bank located in any
other state, and any bank holding company located outside Alabama may lawfully
acquire any Alabama-based bank regardless of state law to
8
the contrary, in either case subject to certain deposit-percentage, aging
requirements and other restrictions. In addition, the Interstate Banking Act
generally provided that after June 1, 1997, national state-chartered banks may
branch interstate through acquisition of banks in other states. The State of
Alabama has laws relating specifically to acquisition of banks, bank holding
companies and other types of financial institutions in each state, by financial
institutions that are based in, and not based in, those states. Alabama law has
set five years as the minimum age of banks which may be acquired.
Restrictions on Transactions With Affiliates and Insiders - The Company is
a legal entity separate and distinct from the Bank. Transactions between the
Bank and its affiliates, including the Company, are subject to Sections 23A and
23B of the Federal Reserve Act. Section 23A defines "covered transactions,"
which include extensions of credit, and limits a bank's covered transactions
with any affiliate to 10% of such bank's capital and surplus. All covered and
exempt transactions between a bank and its affiliates must be on terms and
conditions consistent with safe and sound banking practices, and banks and their
subsidiaries are prohibited from purchasing low-quality assets from the bank's
affiliates. Finally, Section 23A requires that all of a bank's extensions of
credit to an affiliate be appropriately secured by acceptable collateral,
generally United States government or agency securities. Section 23B of the
Federal Reserve Act generally requires that certain transactions between a bank
and its respective affiliates be on terms substantially the same, or at least as
favorable to such bank, as those prevailing at the time for comparable
transactions with or involving other nonaffiliated persons.
The restrictions on loans to directors, executive officers, principal
stockholders and their related interests (collectively referred to herein as
"insiders") contained in the Federal Reserve Act and Regulation O apply to all
insured institutions and their subsidiaries and bank holding companies. These
restrictions include limits on loans to one borrower and conditions that must be
met before such a loan can be made. There is also an aggregate limitation on all
loans to insiders and their related interests. These loans cannot exceed the
institution's total unimpaired capital and surplus, and the FDIC may determine
that a lesser amount is appropriate. Insiders are subject to enforcement actions
for knowingly accepting loans in violation of applicable restrictions. State
banking laws also have similar provisions.
FDIC Insurance Assessments - Each financial institution is assigned to one
of three capital groups - well capitalized, adequately capitalized or
undercapitalized - and further assigned to one of three subgroups within a
capital group, on the basis of supervisory evaluations by the institution's
primary federal and, if applicable, state regulators and other information
relevant to the institution's financial condition and the risk posed to the
applicable insurance fund. The actual assessment rate applicable to a particular
bank will, therefore, depend in part upon the risk assessment classification so
assigned to the bank by the FDIC.
Under the FDIA, insurance of deposits may be terminated by the FDIC upon a
finding that the institution has engaged in unsafe and unsound practices, is in
an unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, rule, order, or condition imposed by the FDIC.
Community Reinvestment Act - The Company and the Bank are subject to the
Community Reinvestment Act ("CRA"). The CRA and the regulations issued
thereunder are intended to encourage banks to help meet the credit needs of
their service area, including low and moderate income neighborhoods, consistent
with the safe and sound operations of the banks. The CRA does not establish
specific lending requirements or programs for financial institutions, nor does
it limit an institution's discretion to develop the types of products and
services that it believes are best suited to its particular community,
consistent with the CRA. The CRA requires a bank's primary federal regulator, in
connection with its examination of the institution, to assess the institution's
record of assessing and meeting the credit needs of the community served by that
institution, including low- and moderate-income neighborhoods. These regulatory
assessments are utilized by the Federal Reserve when considering applications to
establish branches, merger applications and applications to acquire the assets
and assume the liabilities of another bank. The Financial Institutions Reform,
Recovery and Enforcement Act of 1989 ("FIRREA") requires federal banking
agencies to make public a rating of a bank's performance under the CRA. In the
case of a bank holding company, the CRA performance record of the banks involved
in the transaction are reviewed by federal banking agencies in connection with
the filing of an application to acquire ownership or control of shares or assets
of a bank or thrift or to merge with any other bank holding company. An
unsatisfactory record can substantially delay or block the transaction. The Bank
has received a satisfactory CRA rating from federal banking agencies.
Current CRA Regulations rate banks based on their actual performance in
meeting community credit needs. CRA performance is evaluated by the Federal
Reserve, the Bank's primary federal regulator, using a lending test, or
investment test, and a service test. The Federal Reserve also will consider: (i)
demographic data about the
9
community; (ii) the bank's capacity and constraints; (iii) the bank's product
offerings and business strategy; and (iv) data on the prior performance of the
bank and similarly situated lenders. As a result of the GLBA, CRA agreements
with private parties must be disclosed and annual CRA reports must be made to a
bank's primary federal regulator. A bank holding company will not be permitted
to become a financial holding company and no new activities authorized under
GLBA may be commenced by a holding company or by a bank financial subsidiary if
any of its bank subsidiaries received less than a "satisfactory" CRA rating in
its latest CRA examination.
USA Patriot Act - On October 26, 2001, President Bush signed into law the
Uniting and Strengthening America by Providing Appropriate Tools Required to
Intercept and Obstruct Terrorism Act of 2001 (the "USA Patriot Act"), which is
designed to deny terrorists and others the ability to obtain access to the
United States financial system. Title III of the USA Patriot Act is the
International Money Laundering Abatement and Anti-Terrorist Financing Act of
2001. Among its provisions, the USA Patriot Act mandates or will require
financial institutions to implement additional policies and procedures,
including additional due diligence and record keeping with respect to any or all
of the following matters, among others: money laundering; suspicious activities
and currency transaction reporting; and currency crimes. The U.S. Department of
the Treasury in consultation with the Federal Reserve Board and other federal
financial institution regulators has promulgated rules and regulations
implementing the USA Patriot Act which (i) prohibits U.S. correspondent accounts
with foreign banks that have no physical presence in any jurisdiction; (ii)
require financial institutions to maintain certain records for correspondent
accounts of foreign banks; (iii) require financial institutions to produce
certain records relating to anti-money laundering compliance upon request of the
appropriate federal banking agency; (iv) require due diligence with respect to
private banking and correspondent banking accounts; (v) facilitate information
sharing between the government, federal law enforcement and financial
institutions; (vi) require financial institutions to have in place an anti-money
laundering program; and (vii) require financial institutions to have in place a
Customer Identification Program, including risk-based procedures to verify the
identity of each customer. The Company has implemented and will continue to
implement the provisions of the USA Patriot Act as such provisions become
effective. The Company currently maintains and will continue to maintain
policies and procedures to comply with the USA Patriot Act requirements. At this
time, the Company does not expect that the USA Patriot Act will have a
significant impact on the financial position of the Company.
Consumer Laws and Regulations - In addition to the laws and regulations
discussed herein, the Bank is also subject to certain consumer laws and
regulations that are designed to protect consumers in transactions with banks.
While the list set forth herein is not exhaustive, these laws and regulations
include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds
Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity
Act and the Fair Housing Act, among others. These laws and regulations mandate
certain disclosure requirements and regulate the manner in which financial
institutions must deal with customers when taking deposits, making loans to or
engaging in other types of transactions with such customers.
LEGISLATIVE AND REGULATORY CHANGES
Various bills are routinely introduced in the United States Congress and
the Alabama legislature with respect to the regulation of financial
institutions. Certain of these proposals, if adopted, could significantly change
the regulation of banks and the financial services industry. We cannot predict
whether any of these proposals will be adopted or, if adopted, how these
proposals would affect us.
EFFECT ON ECONOMIC ENVIRONMENT
The policies of regulatory authorities, especially the monetary policy of
the Federal Reserve Board, have a significant effect on the operating results of
bank holding companies and their subsidiaries. Among the means available to the
Federal Reserve Board to affect the money supply are open market operations in
U.S. Government securities, changes in the discount rate on member bank
borrowings and changes in reserve requirements against member bank deposits.
These means are used in varying combinations to influence overall growth and
distribution of bank loans, investments and deposits, and their use may affect
interest rates charged on loans or paid for deposits.
Federal Reserve Board monetary policies have materially affected the
operating results of commercial banks in the past and are expected to continue
to do so in the future. The nature of future monetary policies and the effect of
such policies on our business and earnings cannot be predicted.
10
STATISTICAL DISCLOSURE
Statistical and other information regarding the following items are set forth in
"Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operations" in the pages indicated below.
Page(s)
Loan Portfolio 19
Selected Loan Maturity and Interest Rate Sensitivity . . . . . . . . . . . . 19
Securities Portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Securities Portfolio Maturity Schedule . . . . . . . . . . . . . . . . . . . 20
Maturities of Large Time Deposits . . . . . . . . . . . . . . . . . . . . . 21
Return on Equity and Assets . . . . . . . . . . . . . . . . . . . . . . . . 22
Capital Adequacy Ratios . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Interest Rate Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . 25
Average Balances, Interest Income/Expense and Yields/Rates . . . . . . . . . 28
Rate/Volume Variance Analysis . . . . . . . . . . . . . . . . . . . . . . . 29
Summary of Loan Loss Experience . . . . . . . . . . . . . . . . . . . . . . 31
Allocation of Loan Loss Reserve . . . . . . . . . . . . . . . . . . . . . . 32
Nonperforming Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Noninterest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Noninterest Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Interest Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
11
ITEM 2. PROPERTIES
Our headquarters are located at 211 Lee Street NE, Decatur, Morgan County,
Alabama. We operate eight banking offices throughout Northern Alabama, one
mortgage origination office and two operations centers. We own two and lease
nine of these offices. Rental expense on the leased properties totaled
approximately $753,119 in 2003.
ITEM 3. LEGAL PROCEEDINGS
The Bank received demand letters from two former directors, officers and
employees of the Bank. The Bank terminated such officers in November 2002 for
cause, as such term is defined by their respective employment contracts. One
officer has claimed monetary compensation, stock options and attorneys' fees,
while the second officer has claimed monetary compensation, as well as stock
options and payment of country club dues for two years following the date of his
termination. The Bank maintains that it terminated each of these officers for
"cause" and that it is under no obligation to pay them any additional
compensation. On March 14, 2003, one of these officers filed a lawsuit against
the Bank in the Circuit Court for Morgan County, Alabama, alleging breach of
contract and demanding certain payments and benefits allegedly due under his
employment agreement. The Bank subsequently 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. The Bank
successfully removed each of these cases to the United States District Court for
the Northern District of Alabama. On March 9, 2004, the Bank reached agreement
on the settlement of the claims of one of the former officers. The Bank intends
to vigorously defend the remaining action brought against the Bank, and does not
believe that the final outcome will have a material impact on the Bank or the
Company.
While we may from time-to-time be a party to various legal proceedings
arising from the ordinary course of business, we believe that there are
currently no other proceedings threatened or pending against us at this time
that will, individually or in the aggregate, materially or adversely affect our
business, financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of stockholders of the Company during
the fourth quarter of the fiscal year covered by this report.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company is not listed on any exchange and there is no organized trading
market for the shares of its common stock. When shares are traded, they are
traded in privately negotiated transactions. Therefore, no reliable information
is available as to trades of the Company's common stock, or as to the prices at
which such common stock has traded.
Management has reviewed the limited information available to the Company as
to the ranges at which shares of the Company's common stock has been sold. The
following table sets forth, on a per share basis for the periods indicated, the
high and low sale prices of the Company's common stock based solely on such
limited available information.
Fiscal 2003 Fiscal 2002
-------------- ---------------
High Low High Low
------- ----- ------- ------
First Quarter $ 8.00 $7.00 $ 12.50 $ 8.00
Second Quarter $ 6.00 $3.50 $ 12.00 $10.00
Third Quarter $ 4.50 $4.00 $ 10.50 $ 9.50
Fourth Quarter $ 8.00 $4.00 $ 9.50 $ 9.50
As of December 31, 2003 the Company had approximately 1,156 stockholders of
record.
12
Holders of our common stock are entitled to receive dividends when, as and
if declared by our board of directors. We have never paid dividends on our
common stock. We conduct our principal business through our subsidiaries,
primarily the Bank. We derive cash available to pay dividends primarily, if not
entirely, from dividends paid by our subsidiaries. There are certain
restrictions that limit the Bank's ability to pay dividends to us and on our
ability to pay dividends. In addition, the Bank is currently prohibited from
paying dividends to the Company without the prior approval of the Superintendent
of the State Banking Department. Our ability to pay dividends to our
stockholders will depend on our earnings and financial condition, liquidity and
capital requirements, the general economic and regulatory climate, our ability
to service any equity or debt obligations senior to our common stock and other
factors deemed relevant by our board of directors. We currently intend to retain
any future earnings to fund the development and growth of our business.
Therefore, we do not at the present time anticipate paying any cash dividends on
our common stock in the foreseeable future.
SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS
The following table provides information as of December 31, 2003 regarding
compensation plans (including individual compensation arrangements) under which
common stock of the Company is authorized for issuance.
EQUITY COMPENSATION PLAN INFORMATION
Number of securities
remaining available for
Number of Securities to be Weighted-average exercise future issuance under
issued upon exercise of price of outstanding equity compensation plans
outstanding options, options, warrants and (excluding securities
warrants and rights rights reflected in column (a))
Plan Category (a) (b) (c)
- ----------------------------------------------------------------------------------------------------------
Equity Compensation
Plans Approved by 1,876,000 3.36 --
Security Holders
Equity Compensation
Plans not Approved by -- -- --
Security Holders
Total 1,876,000 3.36
See Note 13 to the Consolidated Financial Statements for information regarding
the material features of the above plans. Each of the above plans provides that
the number of shares with respect to which options may be granted, and the
number of shares of Company common stock subject to an outstanding option, shall
be proportionately adjusted in the event of a subdivision or consolidation of
shares or the payment of a stock dividend on Company common stock, and the
purchase price per share of outstanding options shall be proportionately
revised.
13
MANAGEMENT'S STATEMENT ON
RESPONSIBILITY FOR FINANCIAL REPORTING
HERITAGE FINANCIAL HOLDING CORPORATION
The management of Heritage Financial Holding Corporation is responsible for
the content and integrity of the consolidated financial statements and all other
financial information included in this annual report. Management believes that
the financial statements have been prepared in conformity with generally
accepted accounting principles applied on a consistent basis to reflect, in all
material respects, the substance of events and transactions that should be
included, and that the other financial information in the annual report is
consistent with those financial statements. The financial statements necessarily
include amounts that are based on management's best estimates and judgments.
Management maintains and depends upon Heritage Financial Holding
Corporation's accounting systems and related systems of internal controls. The
internal control systems are designed to ensure that transactions are properly
authorized and recorded in the Company's financial record and to safeguard the
Company's assets from material loss or misuse. The Company maintains an internal
audit staff which monitors compliance with the Company's systems of internal
controls and reports to management and to the audit committee of the board of
directors.
The audit committee of the board of directors, composed solely of outside
directors, has responsibility for recommending to the board of directors the
appointment of the independent auditors for Heritage Financial Holding
Corporation. The committee meets periodically with the internal auditors and the
independent auditors to review the scope and findings of their respective
audits. The internal auditors, independent auditors and management each have
full and free access to meet privately as well as together with the committee to
discuss internal controls, accounting, auditing, or other financial reporting
matters.
The consolidated financial statements of Heritage Financial Holding
Corporation have been audited by Porter, Keadle, Moore, LLP, independent
auditors, who were engaged to express an opinion as to the fairness of
presentation of such financial statements.
/s/ William M. Foshee /s/ Larry R. Mathews
- ------------------------------ -------------------------------------
William M. Foshee Larry R. Mathews
Chief Financial Officer President and Chief Executive Officer
14
ITEM 6. SELECTED FINANCIAL DATA
The following table sets forth selected financial data and ratios for the
Company and should be read in conjunction with our consolidated financial
statements including the related notes and "Management's Discussion and Analysis
of Financial Condition and Results of Operations." See "Item 8. Heritage
Financial Holding Corporation and Subsidiaries Financial Statements."
Years ended December 31,
-----------------------------------------------------
2003 2002 2001 2000 1999
--------- --------- --------- --------- ---------
(Dollars in thousands except per share data)
EARNINGS SUMMARY:
Interest income $ 30,343 $ 40,465 $ 42,966 $ 35,660 $ 17,248
Interest expense 15,389 21,742 28,594 22,018 9,874
Net interest income 14,954 18,723 14,371 13,642 7,374
Provision for loan losses (1,646) 29,469 3,602 3,389 1,808
Net interest income (loss) after
provision for loan losses 16,600 (10,746) 10,769 10,253 5,566
Noninterest income 4,987 3,825 2,844 1,039 642
Noninterest expense 19,795 15,380 10,023 8,113 4,952
Income (loss) before income taxes 1,793 (22,300) 3,590 3,179 1,256
Income taxes (benefit) 664 (7,887) 1,224 991 395
Net income (loss) 1,129 (14,413) 2,366 2,188 861
PER COMMON SHARE DATA:
(Retroactively adjusted for effects of stock splits)
Net income (loss) - basic $ 0.11 (1.65) $ 0.28 $ 0.26 $ 0.12
Net income (loss) - diluted $ 0.11 (1.65) 0.23 0.22 0.11
Cash dividends declared per common share $ 0.00 0.00 0.00 0.00 0.00
SELECTED AVERAGE BALANCES:
Total assets $537,065 $617,255 $559,921 $401,615 $213,101
Total loans 455,672 544,079 489,897 333,340 172,418
Securities 51,564 39,961 26,662 23,183 19,405
Earning assets 523,986 605,723 546,517 389,795 204,643
Deposits 461,371 544,598 496,283 348,819 180,072
Stockholders' equity 28,213 35,296 34,178 29,910 19,062
Shares outstanding (thousands) (split adjusted) 10,048 8,717 8,485 8,317 7,226
SELECTED PERIOD-END BALANCES:
Total assets $522,426 $592,942 $568,291 $471,458 $297,952
Total loans 385,887 523,850 505,381 422,135 244,620
Securities 101,935 36,762 25,894 26,846 19,969
Earnings assets 494,565 587,734 550,865 458,478 287,307
Deposits 415,615 525,631 504,310 421,244 249,032
Stockholders' equity 30,106 23,703 36,124 33,499 21,920
Shares outstanding (thousands) (split adjusted) 10,511 8,821 8,515 8,476 7,581
SELECTED RATIOS:
Return on average equity 4.00% (4.08)% 6.92% 7.32% 4.52%
Return on average assets 0.21% (2.34)% 0.42% 0.54% 0.40%
Net interest margin (taxable equivalent) 2.86% 3.11% 2.65% 3.52% 3.63%
Allowance for loan losses to loans 3.77% 5.15% 1.20% 1.20% 1.24%
Net charge-offs to average loans 2.37% 1.57% 0.53% 0.41% 0.10%
Average equity to average assets 5.25% 5.72% 6.10% 7.45% 8.95%
15
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
The following is a narrative discussion and analysis of significant changes
in our results of operations and financial condition. The principal purpose of
this review is to provide the reader of the attached financial statements and
accompanying footnotes with a detailed analysis of our financial results. Among
other things, this discussion provides commentary on our critical accounting
policies, strategy, operating philosophies, the components of net interest
margin and balance sheet strength as measured by the quality of assets, the
composition of the loan portfolio and capital adequacy.
Like most community banks, we derive most of our income from interest we
receive on our loans and investments. Our primary source of funds for making
these loans and investments is our deposits, on which we pay interest.
Consequently, one of the key measures of our success is our amount of net
interest income, or the difference between the income on our interest earning
assets, such as loans and investments, and the expense on our interest-bearing
liabilities such as deposits. Another key measure is the spread between the
yield we earn on these interest-earning assets and the rate we pay on our
interest-bearing liabilities.
We have included a number of tables in the following discussion which we
believe assist our description of our results of operations and financial
condition. However, our financial statements present a complete picture of such
results of operations and financial condition, and you should read this
discussion in conjunction with the consolidated financial statements and
selected financial data included elsewhere in this Annual Report.
Our principal subsidiary is Heritage Bank (the "Bank"), a financial
institution organized and existing under the laws of Alabama and headquartered
in Decatur, Alabama. The Bank operates ten offices throughout Northern Alabama.
The Company also has another wholly owned subsidiary, Heritage Financial
Statutory Trust I ("Heritage Trust"), a Connecticut statutory trust. Heritage
Trust is a consolidated special purpose entity formed solely to issue cumulative
trust preferred securities.
The Company was established in the year 2000 in order to facilitate a
reorganization and merger of the Company and the Bank into a bank holding
company structure. The reorganization was effective on August 31, 2000.
RESTRICTIONS ON OPERATIONS
As previously reported, a targeted, limited scope review of the Bank's loan
portfolio identified certain assets of the Bank that management and regulatory
authorities believed should be classified. 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.
Management has taken certain corrective actions to address concerns about
the Bank's asset quality. The Bank may not declare or pay cash dividends without
seeking the prior approval of the regulatory authorities. During 2002 and 2003,
the Company and the Bank hired certain management personnel who were given
specific written authority by the Board of Directors to implement sound lending,
recordkeeping and accounting practices. Management also developed an educational
program for the Board of Directors and completed a written review of staffing
requirements for the Bank.
Management's focus on addressing asset quality, loan and audit issues has
resulted in a substantial decrease in loan loss reserves during 2003 and in
increase in the Bank's Tier I leverage ratio to 8.58% as of December 31, 2003.
Management continues to be vigilant in its review of the Bank's loan portfolio,
as an increase in classified loans and other loan-related issues could trigger
additional restrictions on the Bank's operations.
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
16
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, if any, are credited 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. Actual losses for these loans can vary significantly from this
estimate. Management continually reviews the methodology and assumptions used to
calculate the allowance for appropriateness given the most recent losses
realized and other factors that influence the estimation process. 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.
EXECUTIVE SUMMARY
The Bank is a $535 million financial institution with community banking
offices, operations and team members located principally in Morgan, Madison,
Marshall and Jefferson County, Alabama. We gather substantially all of our
deposits in these market areas. We use these deposits, as well as other
financing sources, to fund our loan and investment portfolios. We earn interest
income on our loans and investments. In addition, we generate noninterest income
from a number of sources including deposit and loan services, mortgage
originations, and investment securities. Our principal noninterest expenses
include employee compensation and benefits, occupancy and equipment related
costs, data processing and other administrative expenses. Our financial results
are affected by our credit quality, the economic environment, including interest
rates, consumer and business confidence and spending, as well as the competitive
conditions within our industry.
EARNINGS OVERVIEW
The Company recorded net income of $1,129,000 for the year ended 2003, a
107.8% increase over the same period in 2002. The Company experienced a net loss
of ($14,413,000) in 2002, a 709.2% decrease from 2001. The Company also recorded
earnings per share (basic and diluted) for the year ended 2003 of $0.11, a 106.7
% increase over the loss of ($1.65) for 2002, which was a 689.3% decrease from
basic earnings per share for the year ended 2001 of $0.28.
The increase in the Company's net income in 2003 is primarily attributable
to the $31,115,000 decrease in the provision for loan losses. The Company
experienced a 20% decrease in net interest income due to decreases in average
loans of 16.3%, decreases in average earning assets of 13.5% and decreases in
average total assets of 13.0%.
Interest expense decreased by $6,353,000, or 29.2% in 2003. This decrease
is due both to a decrease in interest rates payable on deposits and a decrease
in average total deposits of $83,227,000 in 2003.
Noninterest income increased $1,162,000, or 30.4% for the year ended
December 31, 2003. The increase is due primarily to a large increase in mortgage
banking income and service fees. While mortgage origination growth helped fuel
the Company's return to profitability, rising mortgage interest rates in the
last half of 2003 caused mortgage originations to decrease. Mortgage origination
income may not return to the high level experienced in 2003 during 2004.
Noninterest expense increased by $4,415,000, or 28.7%, in 2003 versus 2002.
Increases in noninterest expense were primarily fueled by an increase in
occupancy and equipment expense, an increase in data processing expense and an
increase in advertising expense. The Company attributed these expense increases
to growth of the Company's infrastructure and its requirements for additional
technology to monitor its loan portfolio.
17
HIGHLIGHTS
During 2003, we worked diligently to resolve issues with the credit quality
of our loan portfolio, revise our lending and loan review policies and address
any substandard loans remaining on our books. As a result, we have significantly
reduced our nonperforming assets, from $29,782,000 at December 31, 2002 to
$17,594,000 at December 31, 2003. We have also worked to return our regulatory
capital ratios to levels in excess of regulatory requirements and, as a result,
the Company and the Bank were considered "well capitalized" at December 31,
2003.
CHALLENGES
While we made great strides during 2003, we faced, and will continue to
face, challenges to our continued growth. We will work to increase net interest
income following the $3.8 million decrease, or 20%, we experienced during 2003.
Additionally, while the increase in noninterest income of $1,162,000 was
helpful, we will continue to search for alternative income sources as we believe
mortgage banking revenues may decrease or remain at 2003 levels during the
coming year. We also experienced a decrease of $110 million in deposits during
2003, although much of this decrease was in brokered and out of area deposits.
We will continue to strive toward a greater share of the deposit market in our
areas.
EARNING ASSETS
Our total assets were $522,426,000 at December 31, 2003, a decrease of
$70,516,000, or 11.9% from December 31, 2002. The decrease primarily resulted
from a decrease in gross loans of $137,963,000. Total assets were $592,942,000
at December 31, 2002, an increase of $24,651,000, or 4.3% from $568,291,000 as
of December 31, 2001. The increase in total assets in 2002 primarily related to
an increase in securities available for sale of $10,868,000 and other assets,
primarily deferred tax assets, of $9,169,000. The increase in total assets was
funded primarily by an increase in deposits.
Our average earning assets were $523,986,000 in 2003, representing a
decrease of $81,737,000 or 13.5% from 2002. The decrease in average earning
assets was mainly due to the decease in average loans outstanding of
$88,407,000. This decrease in average loans was due to an effort by management
to increase the quality of our loan portfolio.
Management considers many criteria in managing assets, including
creditworthiness, diversification and structural characteristics, maturity and
interest rate sensitivity. The following table sets forth the Bank's
interest-earning assets by category at December 31, in each of the last three
years.
Years Ended December 31,
-------------------------------
2003 2002 2001
---------- -------- ---------
(In thousands)
Interest-bearing deposits with banks $ 116 $ 98 $ 326
Securities 101,935 36,762 25,894
Federal funds sold 632 14,681 6,716
Mortgage loans held-for-sale 5,996 12,343 12,548
Loans:
Real estate 257,210 371,714 344,749
Commercial and other 128,676 152,136 160,632
---------- -------- ---------
Total loans 385,886 523,850 505,381
---------- -------- ---------
Interest-earning assets $ 494,565 $587,734 $ 550,865
========== ======== =========
LOAN PORTFOLIO
Loans are the largest category of interest-earning assets, accounting for
87.0% of average interest earning assets at December 31, 2003. Loans typically
provide higher yields than other types of interest-earning assets. Loans involve
inherent risk and liquidity risks which management attempts to control and
mitigate. Our average loans, net of unearned income, totaled $455.7 million at
December 31, 2003, a decrease of $88,407,000, or 16.3% from the December 31,
2002 average loans of $544.1 million. This decrease resulted from lower loan
volume as a result of credit policies and procedures initiated in the first
quarter of 2003 in response to the Bank's previous asset quality
18
issues. Due to these same credit quality issues, net charge-offs of $10.8
million and foreclosures of $13.2 million in 2003 also affected the balances.
Average loans increased $54,182,000 or 11.1% from year-end 2001 to 2002. The
increase in loans was a result of strong loan demand, primarily due to the
increase in refinancing. Loan growth for 2002 was funded primarily through
deposits. The most significant loan increase came from real estate mortgage
loans, which increased approximately $36,832,000 or 13.4% over the 2001 year-end
amount.
The Loan Portfolio table presents the classifications of loans by major
category at December 31, 2003, and for each of the preceding four years.
December 31,
------------------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
-------------------- -------------------- -------------------- -------------------- --------------------
Percent Percent Percent Percent Percent
Amount of Total Amount of Total Amount of Total Amount of Total Amount of Total
--------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
(Dollars in Thousands)
Commercial,
financial and
agricultural $116,202 30.11% $132,237 25.24% $138,344 26.71% $105,393 24.97% $ 66,144 27.04%
Real estate -
construction 26,583 6.89 60,206 11.49 70,073 13.53 90,603 21.46 49,432 20.21
Real estate-mortgage 230,626 59.77 311,508 59.47 274,676 55.46 205,422 48.66 112,643 46.05
Consumer 12,475 3.23 19,899 3.80 22,288 4.30 20,717 4.91 16,410 6.70
--------- --------- --------- --------- --------- --------- --------- --------- --------- ---------
385,886 100.0% 523,850 100.0% 505,381 100.0% 422,135 100.0% 244,629 100.0%
========= ========= ========= ========= =========
Allowance for loan
losses (14,562) (26,991) (6,074) (5,065) (3,036)
Unearned income - - - - (9)
--------- --------- --------- --------- ---------
Net loans $371,324 $496,859 $499,307 $417,070 $241,584
========= ========= ========= ========= =========
The following table sets forth maturities of selected categories of the
loan portfolio and the related sensitivity to interest rate changes.
SELECTED LOAN MATURITY AND INTEREST RATE SENSITIVITY
Rate Structure for Loans
Maturity Maturing Over One Year
--------------------------------------- -----------------------------
Over One
One Year Over Predetermined Floating or
Year or Through Five Interest Adjustable
Less Five Years Years Total Rate Rate
-------- ----------- ------ -------- -------------- -------------
(Amounts in thousands)
Commercial, financial
and agricultural $ 59,440 $ 51,583 $5,179 $116,202 $ 29,432 $ 27,330
Real estate - construction 24,867 1,520 196 26,583 883 833
-------- ----------- ------ -------- -------------- -------------
Total $ 84,307 $ 53,103 $5,375 $142,785 $ 30,315 $ 28,163
======== =========== ====== ======== ============== =============
SECURITIES PORTFOLIO
Our portfolio of securities classified as available for sale increased by
$63,912,000 or 182.0% from the year 2002 to 2003. The increase in the portfolio
in 2003 was the result of market opportunities that allowed us to make purchases
with an acceptable interest rate spread. The securities portfolio increased by
$10,868,000 or 42.0% from the year 2001 to 2002. The balance in the securities
portfolio increased as a result of deposit growth in 2002.
We maintain an investment strategy of seeking portfolio yields within
acceptable risk levels, as well as providing liquidity. The Bank maintains one
classification of securities: "Available-for-Sale." The classification of
securities as Available-for-Sale is consistent with our investment philosophy of
maintaining flexibility to manage the portfolio. The Available-for-Sale
securities are carried at fair market value and represent all of our securities
at year-end 2003 and 2002. At year-end 2003 and 2002, unrealized gains in the
Available-for-Sale portfolio amounted to $342,000 and $95,000, respectively.
At year-end 2003 and 2002, obligations of the United States Government or
its agencies and obligations of states and political subdivisions represented
approximately 32.2% and 63.1%, respectively, of our securities portfolio.
19
The following table presents the carrying amounts of our securities
portfolio at December 31, in each of the last three years.
December 31,
-------------------------
2003 2002 2001
------- ------- -------
(In thousands)
AVAILABLE-FOR-SALE
U.S. government and agencies . . . . . . . . . . . $30,593 $ - $15,697
Mortgage-backed securities . . . . . . . . . . . . 61,640 23,208 617
Asset-backed securities . . . . . . . . . . . . . . - - 4,474
State and municipal . . . . . . . . . . . . . . . . 1,336 1,330 2,590
Corporate debt . . . . . . . . . . . . . . . . . . 5,469 10,588 1,190
------- ------- -------
Total . . . . . . . . . . . . . . . . . . . . . . $99,038 $35,126 $24,568
======= ======= =======
The maturities and weighted average yields of the investments in the 2003
portfolio of securities are presented below. Amounts are presented at amortized
cost.
SECURITY PORTFOLIO MATURITY SCHEDULE
Maturing
-----------------------------------------------------------------------------
Within After One But After Five But After
One Year Within Five Years Within Ten Years Ten Years
-------------- --------------------- --------------------- ---------------
Amount Yield Amount Yield Amount Yield Amount Yield
------- ----- --------- ---------- --------- ---------- ------- ------
(Amounts in thousands)
SECURITIES AVAILABLE-FOR-SALE
U. S. Government and agencies $ - - $ 7,100 2.05% $ 23,388 2.50% - -%
Mortgage-backed securities . . - - 368 4.52% 9,522 4.12% 51,553 4.35%
State and municipal (1) . . . - - - - 185 3.65% 1,109 5.53%
Corporate debt . . . . . . . . - - - - - - 5,470 8.63%
------- ----- --------- ---------- --------- ---------- ------- ------
$ - - $ 7,468 2.17% $ 33,095 2.97% $58,132 4.71%
======= ========= ========= =======
(1) The weighted average yields are calculated on the basis of the cost and
effective yield weighted for the scheduled maturity of each security. The
weighted average yields on tax-exempt obligations have been computed on a
fully taxable equivalent basis using a tax rate of 34%.
We did not hold any securities of which the aggregate value on December 31,
2003, 2002 and 2001 exceeded ten percent of stockholders' equity at that date.
(Securities which are payable from and secured by the same source of revenue or
taxing authority are considered to be securities of a single issuer. Securities
of the U.S. Government and U.S. Government agencies and corporations are not
included.)
DEPOSITS AND BORROWED FUNDS
Our average deposits decreased by $83,226,000 or 15.3% from 2002 to 2003.
The decrease primarily resulted from a decrease of $88.7 million in certificate
of deposits as we decreased our reliance on brokered and out of market funds.
Brokered funds decreased by $19.9 million in 2003 and out of market funds
decreased by $35.3 million in 2003. Our average deposits rose $48,315,000 or
9.7% from the year 2001 to 2002. The largest area of growth in 2002 was in
interest bearing demand accounts, which increased $7,417,000 or 13.8%. From 2001
to 2002, other time deposits of more than $100,000 increased $4,990,000 or 3.5%.
Savings deposits increased $3,582,000 or 7.4%, and time deposits of less than
$100,000 increased $4,616,000 or 1.9%. From year-end 2001 to year-end 2002,
total non-interest bearing deposits increased $716,000 or 3.4%. Deposit growth
has been generated primarily outside of our local markets.
20
The following table sets forth our deposit structure at December 31, of
each of the last three years.
December 31,
----------------------------
2003 2002 2001
-------- -------- --------
(In thousands)
Noninterest-bearing deposits:
Individuals, partnerships and corporations . . . . . . $ 22,992 $ 21,961 $ 21,296
U.S. Government and states and political subdivisions 624 -- --
Certified and official checks . . . . . . . . . . . . 4,526 -- --
-------- -------- --------
Total noninterest-bearing deposits . . . . . . . . . 28,142 21,961 21,296
-------- -------- --------
Interest-bearing deposits:
Interest-bearing demand accounts . . . . . . . . . . . 77,141 61,244 53,776
Saving accounts . . . . . . . . . . . . . . . . . . . 48,558 51,769 48,187
Certificates of deposit, less than $100,000 . . . . . 167,404 244,448 239,831
Certificates of deposit, more than $100,000 . . . . . 94,370 146,209 141,220
-------- -------- --------
Total interest-bearing deposits . . . . . . . . . . 387,473 503,670 483,014
-------- -------- --------
Total deposits . . . . . . . . . . . . . . . . . . . $415,615 $525,631 504,310
======== ======== ========
The following table presents a breakdown by category of the average amount
of deposits and the average rate paid on deposits for the periods indicated:
Years Ended December 31,
---------------------------------------------------
2003 2002 2001
--------------- --------------- -----------------
Amount Rate Amount Rate Amount Rate
-------- ----- -------- ----- -------- -------
(Dollars in thousands)
Noninterest-bearing deposits . . $ 25,897 -% $ 21,832 -% $ 16,975 -%
Interest-bearing demand deposits 63,161 1.22 50,622 1.61 39,299 3.10
Savings deposits . . . . . . . . 54,125 1.16 64,773 1.92 43,079 3.17
Time deposits . . . . . . . . . . 318,188 3.64 407,370 4.33 396,930 6.09
-------- ----- -------- ----- -------- -------
Total deposits . . . . . . . . $461,371 2.98% $544,597 3.62% $496,283 5.39%
======== ======== ========
At December 31, 2003, time deposits greater than $100,000 aggregated
approximately $94,370,000. Maturities of time certificates of deposit and other
time deposits of $100,000 or more outstanding at December 31, 2003, are
summarized as follows (in thousands):
MATURITIES OF LARGE TIME DEPOSITS
(In thousands)
Three months or less . . . . . . . . . . . . . . . . . . . . $ 8,556
Over three through six months . . . . . . . . . . . . . . . . 12,169
Over six through twelve months . . . . . . . . . . . . . . . 36,269
Over twelve months . . . . . . . . . . . . . . . . . . . . . 37,376
-------
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . $94,370
=======
Borrowed funds of $74,308,000 as of December 31, 2003, consist of long-term
Federal Home Loan Bank advances, an advance from a pooled trust preferred
private placement for subordinated debentures, a short-term borrowing from a
commercial bank and federal funds purchased. We have $12,500,000 in lines to
purchase Federal Funds, on an unsecured basis, from commercial banks. At
December 31, 2003, we had $406,000 advanced against these lines. At December 31,
2002 and 2001, we had no funds advanced against these lines. We are also
approved to borrow up to $88,733,000 under various short-term and long-term
programs offered by the Federal Home Loan Bank of Atlanta. These borrowings are
secured under a blanket lien agreement on certain qualifying mortgage
instruments in loan and investment security portfolios. The unused portion of
these available funds amounted to $32,311,000, $42,223,000, and $46,000,000 at
year-end 2003, 2002 and 2001, respectively.
21
CAPITAL RESOURCES
Stockholders' equity increased $6,402,000 or 27.0% to $30,106,000 as of
December 31, 2003 compared to 2002. The increase in stockholders' equity was
attributable to the net income for the year of $1,129,000, $2,300,000 in
proceeds from a private placement in March 2003 and $2,801,000 in proceeds from
the exercise of stock options. Stockholders' equity decreased $12,421,000 or
34.4% to $23,703,000 as of December 31, 2002 compared to 2001. This decease was
primarily attributable to a net loss of $14,413,000 in 2002. Stockholders'
equity increased $2,625,000 or 7.8% to $36,124,000 as of December 31, 2001. This
increase was attributable to net income and the issuance of stock through exempt
offerings, employee stock purchase plan purchases and the exercise of stock
options.
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 our
10.20% subordinated debentures (the "subordinated debentures").
Under the terms of the indenture, we may elect to defer payments of
interest for up to ten semiannual payment periods. For the duration of such
deferral period, we are restricted from paying dividends to shareholders or
paying debt that is junior to the debentures.
We have fully and unconditionally guaranteed all obligations of Heritage
Trust on a subordinated basis with respect to the preferred securities. We
account for the Heritage Trust preferred securities as a minority interest.
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 us. Both the preferred securities of Heritage Trust and our
subordinated debentures 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.
A strong capital position, which is vital to our continued profitability,
also promotes depositor and investor confidence and provides a solid foundation
for the future growth of the organization. The objective of management is to
maintain a level of capitalization that is sufficient to take advantage of
profitable growth opportunities while meeting regulatory requirements. This is
achieved by improving profitability through effectively allocating resources to
more profitable businesses, improving asset quality, strengthening service
quality, and streamlining costs. The primary measures used by management to
monitor the results of these efforts are the ratios of return on average assets,
return on average common equity and average equity to average assets.
The table below summarizes these and other key ratios for us for each of
the last three years.
RETURN ON EQUITY AND ASSETS
2003 2002 2001
----- ------- -----
Return on average assets . . . . . . . . . . . . . 0.21% (2.34)% 0.42%
Return on average common equity . . . . . . . . . . 4.00 (4.08) 6.92
Dividend payout ratio . . . . . . . . . . . . . . . 0.00 0.00 0.00
Average common shareholders' equity to average
assets ratio . . . . . . . . . . . . . . . . . . 5.25 5.72 6.10
In addition, banks and bank holding companies are required to maintain
capital to support, on a risk-adjusted basis, certain off-balance sheet
activities such as loan commitments. The Federal Reserve Board has adopted
capital guidelines governing the activities of bank holding companies. These
guidelines require the maintenance of an amount of capital based on
risk-adjusted assets so that categories of assets with potentially higher credit
risk will require more capital than assets with lower risk.
The capital guidelines classify capital into two tiers, referred to as Tier
1 and Tier 2. Under risk-based capital requirements, Total Capital consists of
Tier 1 capital which is generally common stockholders' equity less
22
goodwill and Tier 2 capital which is primarily a portion of the allowance for
loan losses and certain qualifying debt instruments. In determining risk-based
capital requirements, assets are assigned risk-weights of 0% to 100%, depending
primarily on the regulatory assigned levels of credit risk associated with such
assets. Off-balance sheet items are considered in the calculation of
risk-adjusted assets through conversion factors established by the regulators.
The framework for calculating risk-based capital requires banks and bank holding
companies to meet the regulatory minimums of 4% Tier 1 and 8% total risk-based
capital. In 1990 regulators added a leverage computation to the capital
requirements, comparing Tier 1 capital to total average assets less goodwill.
The table below illustrates our regulatory capital ratios under federal
guidelines at December 31, 2003, 2002 and 2001:
CAPITAL ADEQUACY RATIOS
Years ended December 31,
Statutory ----------------------------------
Minimum 2003 2002 2001
---------- ----------- --------- ----------
(Amounts in thousands)
Tier 1 Capital $ 35,113 30,749 $ 46,180
Tier 2 Capital 6,732 8,687 6,074
----------- --------- ----------
Total Qualifying Capital $ 41,845 39,436 $ 52,254
=========== ========= ==========
Risk Adjusted Total Assets (including
off-balance-sheet exposures) $ 407,053 $505,129 $ 488,824
=========== ========= ==========
Adjusted quarterly average assets $ 556,466 $650,604 $ 587,901
=========== ========= ==========
Tier 1 Capital Ratio 4.00% 8.63% 6.09% 9.45%
Total Capital Ratio 8.00% 10.28% 7.81% 10.69%
Leverage Ratio 4.00% 6.31% 4.94% 7.86%
On December 31, 2003, the Company and the Bank each exceeded the regulatory
minimums and together qualified as a well capitalized institution under the
regulations. On December 31, 2002, the Bank qualified as an adequately
capitalized institution under the regulations. We have worked aggressively to
improve regulatory capital ratios which previously had deteriorated due to
issues with the Bank's credit quality.
LIQUIDITY MANAGEMENT
We focus on maintaining and managing adequate liquidity. Liquidity refers
to the ability of the Company to meet its cash flow requirements in the normal
course of business, including loan commitments, deposit withdrawals, liability
maturities and ensuring that the Company is in a position to take advantage of
investment opportunities in a timely and cost-efficient manner. Management of
liquidity also includes management of funding sources and their utilization
based on current, future and contingency needs. Additionally, management strives
to maximize our earnings by investing our excess funds in securities.
Historically, we have maintained a high loan-to-deposit ratio. Retail
deposit growth is a primary focus of our funding and liquidity strategy. To meet
our short-term liquidity needs, we maintain core deposits and have borrowing
capacity through the FHLB and federal funds lines. Long-term liquidity needs are
met primarily through these sources, time deposits, the repayment of loans,
sales of loans and the maturity or sale of investment securities, including
short-term investments. We have entered into certain contractual obligations and
commercial commitments that arise in the normal course of business and involve
elements of credit risk, interest rate risk and liquidity risk.
The liability portion of the balance sheet provides liquidity through
various interest-bearing and noninterest-bearing deposit accounts. We also
utilize a variety of funding sources to meet the needs of funding loan growth,
securities acquisitions and deposit fluctuations. Fed Funds lines and our line
of credit are sources of short-term borrowings, and we also utilize Fed Funds
lines and our credit facilities with the Federal Home Loan Bank for long-term
borrowings. At December 31, 2003 we had $12,094,000 of federal funds available
and credit of approximately $88,733,000 from The Federal Home Loan Bank of which
approximately $32,311,000 was available
23
and unused. At December 31, 2002, we had $13,500,000 of federal funds available,
$850,000 available under the short-term borrowing and a line of credit of
approximately $65,223,000 from The Federal Home Loan Bank of which approximately
$42,223,000 was available and unused.
The primary source of funds available to the Company is payment of
dividends from the Bank. Banking laws and other regulations limit the amount of
dividends a bank subsidiary may pay without prior regulatory approval. Our Bank
may not pay any dividends to the Company without the prior approval of the
regulatory authorities.
The Company has no off-balance sheet arrangements that are expected to
materially affect liquidity. The Company believes that the level of liquidity is
sufficient to meet current and future liquidity requirements.
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The following table illustrates the Company's contractual obligations as of
December 31, 2003
Payments Due By Period
----------------------
(amounts in thousands)
Less than After
Contractual obligations Total 1 year 1-3 Years 3-5 Years 5 Years
- --------------------------- -------- ---------- ---------- ---------- --------
Note payable $ 7,480 $ 7,480 $ - $ - $ -
Trust preferred securities 10,000 - - - 10,000
Operating lease obligations 6,423 859 1,740 1,393 2,431
FHLB advances 56,422 11,422 12,000 7,000 26,000
Time deposits 261,730 175,069 68,572 18,089 -
-------- ---------- ---------- ---------- --------
Total $342,055 $ 194,830 $ 82,312 $ 26,482 $ 38,431
======== ========== ========== ========== ========
INTEREST RATE SENSITIVITY MANAGEMENT
Interest rate sensitivity is a function of the repricing characteristics of
our portfolio of assets and liabilities. These repricing characteristics are the
time frames within which the interest-bearing assets and liabilities are subject
to change in interest rates either at replacement or maturity during the life of
the instruments. Sensitivity is measured as the difference between the volume of
assets and liabilities in our current portfolio that is subject to repricing in
future time periods. The differences are known as interest sensitivity gaps and
are usually calculated separately for segments of time ranging from zero to
thirty days, thirty-one to ninety days, ninety-one days to one year, one to five
years, over five years and on a cumulative basis.
24
The following table shows interest sensitivity gaps for different intervals
as of December 31, 2003.
INTEREST RATE SENSITIVITY ANALYSIS
(Amounts in thousands)
--------------------
0-30 31-90 91-365 1-5 Over 5
Days Days Days Years Years Total
-------- --------- ---------- --------- ------- --------
Interest-earning assets (1)
Loans $189,245 $ 9,818 $ 29,564 $139,724 $ 5,013 $373,364
Mortgage loans held-for-sale 5,996 - - - - 5,996
Securities available-for-sale 983 920 2,898 30,967 66,167 101,935
Time deposits in other banks 116 -- -- -- -- 116
Federal funds sold 632 -- -- -- -- 632
-------- --------- ---------- --------- ------- --------
196,972 10,738 32,462 170,691 71,180 482,043
Interest-bearing liabilities (2)
Demand deposits (3) 25,714 25,714 25,713 - - 77,141
Savings deposits (3) 16,186 16,186 16,186 - - 48,558
Time deposits 14,790 11,832 148,744 86,408 - 261,774
Federal funds purchased 406 - - - - 406
Federal Home Loan Bank advances 10,422 - 1,000 19,000 26,000 56,422
Trust preferred securities - - - - 10,000 10,000
Other debt 7,480 - - - - 7,480
-------- --------- ---------- --------- ------- --------
74,998 53,732 191,643 105,408 36,000 461,781
-------- --------- ---------- --------- ------- --------
Interest sensitivity gap $121,974 $(42,994) $(159,181) $ 65,283 $35,180 $ 20,262
======== ========= ========== ========= ======= ========
Cumulative interest sensitivity gap $121,974 $ 78,980 $ (80,201) $(14,918) $20,262
======== ========= ========== ========= =======
Ratio of interest-earning assets to
interest-bearing liabilities 2.63 .20 .17 1.62 1.98
Cumulative ratio 2.63 1.61 .75 .96 1.04
Ratio of cumulative gap to total
interest-earning assets .25 .16 (.17) (.03) .04
- ---------------
(1) Excludes nonaccrual loans
(2) Excludes matured certificates which have not been redeemed by the customer
and on which no interest is accruing.
(3) Demand and savings deposits are assumed to be subject to movement into
other deposit instruments in equal amounts during the 0-30 day period, the
31-90 day period, and the 91-365 day period.
The above table indicates that in a rising interest rate environment our
earnings may be positively affected in the short-term because 43.1% of earning
assets reprice within 90 days and only 27.9% of interest-bearing liabilities
reprice during the same period. As seen in the preceding table, for the first
90 days of repricing opportunity there is an excess of interest earning assets
over interest-bearing liabilities of approximately $79.0 million. However, in
the longer-term, the table reflects that our earnings will be negatively
impacted by rising interest rates. For the first 365 days, interest-bearing
liabilities exceed earning assets by $80.2 million. During this one-year time
frame, 69.4% of all interest-bearing liabilities will reprice compared to 49.8%
of all interest-earning assets. Changes in the mix of earning assets or
supporting liabilities can either increase or decrease the net interest margin
without affecting interest rate sensitivity. Due to management's continued
emphasis on profitability, many of the higher-yielding assets presented in the
table above have call or prepayment features, which may result in such assets
having a shorter effective life. This in turn may reduce the interest rate
sensitivity gap presented above. It should be noted, therefore, that a matched
interest-sensitive position by itself would not ensure maximum net interest
income.
Management continually evaluates the condition of the economy, the pattern
of market interest rates, and other economic data to determine the types of
investments that should be made and at what maturities. Using this analysis,
management from time to time assumes calculated interest sensitivity gap
positions to maximize net interest income based upon anticipated movements in
the general level of interest rates.
25
OFF-BALANCE SHEET ARRANGEMENTS
In the normal course of business, the Company engages in a variety of
financial transactions that, under generally accepted accounting principles,
either are not recorded on the balance sheet or are recorded on the balance
sheet in amounts that differ from the full contract or notional amounts. These
transactions involve financial instruments that are initiated by our customers
in order to meet their financing needs or risk management objectives. These
financial instruments include commitments to extend credit, standby letters of
credit and financial guarantees. Standby letters of credit carry the possibility
that the customer will fail to perform under the terms of the contract.
Commitments to extend credit and standby letters of credit also involve an
element of liquidity risk as a result of the uncertainty around the timing and
ultimate amount of funding under these financial instruments. The contract
amounts of these instruments reflect the extent of involvement the Company has
in particular classes of financial instruments.
Commitments to extend credit are agreements to lend to a customer as long
as there is no violation of any condition established in the contract.
Commitments to extend credit generally have fixed expiration dates or other
termination clauses that may require payment of a fee by the customer.
Collateral, if deemed necessary, is based on Management's credit evaluation of
the customer and may include business assets of commercial borrowers as well as
personal property and real estate of individual borrowers and guarantors.
Unfunded commitments under commercial lines of credit, revolving credit lines
and overdraft protection agreements are commitments for possible future
extensions of credit to existing customers. These lines of credit are
uncollateralized and usually do not contain a specified maturity date and may
not be drawn upon to the total extent to which the Company is committed. The
Company's exposure to credit risk in the event of nonperformance by the customer
is the contract amount. Fixed-rate commitments are subject to market risk
resulting from fluctuations in interest rates and the Company's exposure is
limited to the replacement value of those commitments. The Company's subsidiary
bank had outstanding commitments to extend credit of approximately $34.9 million
at December 31, 2003 and $75.6 million at December 31, 2002. Since many of the
commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements.
Standby letters of credit are conditional commitments issued to guarantee
the performance of a customer to a third party. These guarantees are primarily
issued to businesses in the Company's delineated trade area. The majority of
letters of credit issued have expiration dates within one year. The amount of
credit risk involved in issuing letters of credit in the event of nonperformance
by the other party is the contract amount. The Company's subsidiary bank had
standby letters of credit outstanding of approximately $3.3 million at December
31, 2003 and $3.3 million at December 31, 2002. The Company holds real estate,
equipment, automobiles and customer deposits as collateral supporting those
commitments for which collateral is deemed necessary.
RESULTS OF OPERATIONS
SUMMARY
We reported net income of $1.1 million or $0.11 per diluted share for the
year ended December 31, 2003, compared to a net loss of $(14.4) million or
($1.65) per diluted share for the year ended December 31, 2002. Net income in
2001 was $2.4 million or $0.23 per diluted share. Net earnings resulted in a
return on average assets of 0.21%, (2.34)% and 0.42% for the three years ended
December 31, 2003, respectively. The return on average stockholders' equity for
the three years ended December 31, 2003 was 4.00%, (4.08)% and 6.92%,
respectively.
NET INTEREST INCOME
The largest component of our net income is net interest income, which is
the difference between the revenue generated on interest-earning assets and
interest paid on deposits and borrowings. Net interest income is determined by
the rates earned on our interest-earning assets, rates paid on our
interest-bearing liabilities, the relative amounts of interest-earning assets
and interest-bearing liabilities, the degree of mismatch, and the maturity and
repricing characteristics of our interest-earning assets and interest-bearing
liabilities. Net interest income divided by average interest-earning assets
represents our net interest margin. For purposes of discussion, income that is
either exempt from federal income taxes or taxed at a preferential rate has been
adjusted to fully taxable equivalent amounts, using a statutory federal tax rate
of 34%.
Our net interest income decreased $3,829,000 or 20.4% in 2003. This
decrease primarily resulted from a decrease in average loans of $88,407,000.
Net interest income increased $4,356,000 or 30.1% to $18,813,000 from
26
2001 to 2002. This increase in net interest income is due primarily to a
decrease in interest paid on deposits. Interest income was $30,373,000 in 2003,
a decrease of $10,181,000 or 25.1% from 2002. Interest income was $40,554,000 in
2002, which represented a decrease of $2,498,000 or 5.8% over 2001. Interest
and fee income produced by the loan portfolio decreased by $10,039,000, or 26.1%
in 2003. Interest and fee income produced by the loan portfolio decreased
$1,899,000 or 4.7% in 2002 from 2001. Interest income on securities remained
the same in 2003 from 2002. Interest income on securities increased $156,000 or
9.5% in 2002 from 2001. This change is primarily due to an increase in the size
of the investment portfolio. Interest income other than loans and securities
decreased $142,000, or 43.6%, from 2002 to 2003 and decreased $755,000 or 69.8%
from 2001 to 2002.
Total interest expense decreased by $6,352,000 or 29.2% in 2003 from 2002.
This reduction is due to a decrease in the rates paid on deposits along with a
decrease in average interest-bearing deposits of $87,292,000 in 2003 from 2002.
Total interest expense decreased by $6,854,000 or 24.0% in 2002 from 2001. This
reduction is primarily due to a decline in the rates paid on deposits. Interest
expense on deposits decreased $7,035,000 or 26.3% in 2002 from 2001.
The trend in net interest income is commonly evaluated in terms of average
rates using the net interest margin and the interest rate spread. The net
interest margin or the net yield on earning assets is computed by dividing fully
taxable equivalent net interest income by average earning assets. This ratio
represents the difference between the average yield on average earning assets
and the average rate paid for all funds used to support those earning assets.
Our net interest margin decreased by 25 basis points in 2003. Our net interest
margin increased 46 basis points in 2002 from 2.65% at year-end 2001 to 3.11% at
year-end 2002. The yield on earning assets decreased 90 basis points to 5.80%
in 2003 from 2002, and decreased 118 basis points to 6.70% in 2002 from 7.88% in
2001. Our cost of funds decreased 70 basis points to 3.21% at year-end 2003 from
2002 and decreased 177 basis points to 3.91% at year-end 2002 from 5.68% at
year-end 2001.
The interest rate spread measures the difference between the average yield
on earning assets and the average rate paid on interest bearing sources of
funds. The interest rate spread eliminates the impact of noninterest bearing
funds and gives a direct perspective on the effect of market interest rate
movements. During recent years, the net interest margins and interest rate
spreads have been under intense pressure to maintain historical levels, due in
part to tax laws that discouraged investment in tax-exempt securities and
intense competition for funds with non-bank institutions. Our interest rate
spread decreased by 20 basis points in 2003. Our interest rate spread increased
59 basis points to 2.79% from 2001 to 2002.
The economic conditions during 2003 and the prolonged low interest rate
environment presented a challenge to the Company and the Bank. Since the
beginning of 2001, the Federal Reserve has lowered short-term interest rates a
total of 500 basis points. These factors contributed to historically low
interest rates, leading to higher prepayments of mortgage loans and other
fixed-rate interest-earning assets tied to treasury yields. Prepayments from
these assets were being reinvested at lower rates, while liability costs, which
are tied to other indices, were not declining at the same place as asset yields.
These factors help to explain the decreases in net interest margin and interest
rate spread during 2003.
27
The tables that follow show, for the periods indicated, the daily average
balances outstanding for the major categories of interest-bearing assets and
interest-bearing liabilities, and the average interest rate earned or paid by us
thereon. Such yields are calculated by dividing income or expense by the average
balance of the corresponding assets or liabilities. Also shown are the changes
in income attributable to changes in volume and changes in rate.
AVERAGE BALANCES, INTEREST INCOME/EXPENSE AND YIELDS/RATES
Taxable Equivalent Basis
YEARS ENDED DECEMBER 31,
------------------------
2003 2002 2001
------------------------------ ------------------------------ ------------------------------
INTEREST AVERAGE INTEREST AVERAGE INTEREST AVERAGE
AVERAGE INCOME/ YIELDS/ AVERAGE INCOME/ YIELDS/ AVERAGE INCOME/ YIELDS/
BALANCE EXPENSE RATE BALANCE EXPENSE RATE BALANCE EXPENSE RATE
------------------------------ ------------------------------ ------------------------------
ASSETS
Earning assets:
Loans, net of unearned
income (1) $455,672 28,384 6.23% $544,079 38,423 7.06% $489,897 40,322 8.23%
Securities:
Taxable 50,271 1,714 3.41% 37,513 1,603 4.27% 24,308 1,460 6.01%
Tax-exempt 1,293 91 7.04% 2,448 202 8.25% 2,354 189 8.03%
--------- --------- --------- --------- --------- ---------
Total securities 51,564 1,805 3.50% 39,961 1,805 4.52% 26,662 1,649 6.18%
Time deposits in other banks 117 4 3.42% 161 6 3.73% 446 25 5.61%
Federal funds sold 16,633 180 1.08% 21,522 320 1.49% 29,512 1,056 3.58%
--------- --------- --------- --------- --------- ---------
Total interest earning
assets (2) 523,986 30,373 5.80% 605,723 40,554 6.70% 546,517 43,052 7.88%
Noninterest earning assets:
Cash and due from banks 7,256 4,452 5,410
Premises and equipment 7,260 6,753 6,220
Accrued interest and other
assets 20,512 8,915 7,541
Allowance for loan losses (21,949) (8,588) (5,767)
--------- --------- ---------
Total assets $537,065 $617,255 $559,921
========= ========= =========
LIABILITIES AND
STOCKHOLDERS' EQUITY
Interest-bearing liabilities:
Demand deposits $ 63,161 773 1.22% $ 50,622 854 1.69% $ 39,299 1,219 3.10%
Savings deposits 54,125 626 1.16% 64,773 1,245 1.92% 43,079 1,367 3.17%
Time deposits 318,188 11,595 3.64% 407,371 17,618 4.32% 396,930 24,166 6.09%
--------- --------- --------- --------- --------- ---------
Total deposits 435,474 12,994 2.98% 522,766 19,717 3.77% 479,308 26,752 5.58%
Other short term borrowings 95 1 1.05% 928 36 3.88% 53 2 3.77%
Other 44,576 2,394 5.37% 32,520 1,988 6.11% 24,271 1,841 7.59%
--------- --------- --------- --------- --------- ---------
Total interest-bearing
liabilities 480,145 15,389 3.21% 556,214 21,741 3.91% 503,632 28,595 5.68%
--------- --------- ---------
Non-interest bearing liabilities:
Demand deposits 25,897 21,832 16,975
Accrued interest and
other liabilities 2,810 3,913 5,136
Stockholders' equity 28,213 35,296 34,178
--------- --------- ---------
Total liabilities and
stockholders' equity $537,065 $617,255 $559,921
========= ========= =========
Net interest income/
net interest spread 14,984 2.59% 18,813 2.79% 14,457 2.20%
======== ======== ========
Net yield on earning
assets 2.86% 3.11% 2.65%
======== ======== ========
Taxable equivalent
adjustment:
Loans 7 21 22
Investment securities 23 69 64
--------- --------- ---------
Total taxable equivalent
adjustment 30 90 86
--------- --------- ---------
Net interest income $ 14,954 $ 18,723 $ 14,371
========= ========= =========
(1) Average loans include nonaccrual loans. All loans and deposits are
domestic.
(2) Tax equivalent adjustments have been based on an assumed tax rate of 34
percent, and do not give effect to the disallowance for federal income tax
purposes of net interest expense related to certain tax-exempt earning
assets.
28
RATE/VOLUME VARIANCE ANALYSIS
Taxable Equivalent Basis
The following table shows the change in net interest income from 2003 to
2002 and from 2002 to 2001 due to changes in volumes and rates. (Dollars in
thousands)
Years Ended December 31,
-----------------------
2003 Compared to 2002 2002 Compared to 2001
--------------------- ---------------------
Rate/ Net Rate/ Net
Volume Yield Change Volume Yield Change
-------- ------- -------- ------- ------- -------
Earning assets:
Loans, net of unearned income $(3,557) (6,482) (10,039) 4,182 (6,081) (1,899)
Securities:
Taxable 476 (365) 111 644 (501) 143
Tax exempt (75) (36) (111) 8 5 13
Time deposits in other banks (1) (1) (2) (5) (14) (19)
Federal funds sold (173) 33 (140) (430) (306) (736)
-------- ------- -------- ------- ------- -------
Total interest earning assets (3,330) (6,851) (10,181) 4,399 (6,897) (2,498)
-------- ------- -------- ------- ------- -------
Interest-bearing liabilities:
Demand deposits 184 (265) (81) 289 (654) (365)
Savings deposits (262) (357) (619) 536 (658) (122)
Time deposits (1,697) (4,326) (6,023) 620 (7,168) (6,548)
Other short term borrowings 93 (128) (35) 34 - 34
Other 670 (264) 406 548 (401) 147
-------- ------- -------- ------- ------- -------
Total interest-bearing liabilities (1,012) (5,340) (6,352) 2,027 (8,881) (6,854)
-------- ------- -------- ------- ------- -------
Net interest income $(2,318) (1,511) (3,829) 2,372 1,984 4,356
======== ======= ======== ======= ======= =======
ALLOWANCE FOR LOAN LOSSES
The Bank's lending officers are responsible for the ongoing review and
administration of each loan. They make the initial identification of loans which
present some difficulty in collection or where there is an indication that the
probability of loss exists. Lending officers are responsible for the collection
effort on a delinquent loan. Senior management is informed of the status of
delinquent and problem loans on a monthly basis.
Management makes recommendations monthly to the Board of Directors as
to-charge-offs. Management reviews the allowance for loan losses on a monthly
basis. Our policy is to discontinue interest accrual when payment of principal
and interest is 90 days or more in arrears.
The allowance for loan losses represents management's assessment of the
risks associated with extending credit and its evaluation of the quality of the
loan portfolio. Management analyzes the loan portfolio to determine the adequacy
of the allowance for loan losses and the appropriate provisions required to
maintain a level considered adequate to absorb anticipated loan losses. In
assessing the adequacy of the allowance, management reviews the size, quality
and risk of loans in the portfolio. Management also considers such factors as
loan loss experience, the amount of past due and nonperforming loans, specific
known risks, the status and amount of nonperforming assets, underlying
collateral values securing loans, current and anticipated economic conditions
and other factors which affect the allowance for loan losses.
While it is our policy to charge off in the current period the loans in
which a loss is considered probable, there are additional risks of future losses
which cannot be quantified precisely or attributed to particular loans or
classes of loans. Because these risks include the state of the economy,
management's judgment as to the adequacy of the allowance is necessarily
approximate and imprecise.
29
During 2003, the allowance for loan losses was approximately $14.6 million.
This compares to an approximate allowance for loan losses of $27.0 million at
the end of 2002 and $6.1 million at the end of 2001. At December 31, 2003 and
2002, the recorded investment in loans that were considered to be impaired was
approximately $13,047,000 and $24,354,000, respectively, of which approximately
$12,523,000 and $15,794,000, respectively, were on nonaccrual. For the year
ended December 31, 2003, the Company recognized approximately $748,000 of
interest income on nonaccrual loans. If loans on nonaccrual at December 31,
2003 had performed in accordance with their original terms, the Company would
have reported approximately $882,000 in interest income.
As a result of its ongoing evaluation of the adequacy of the allowance for
loan losses, a decline in problem credits and continued recoveries of loans
previously charged off, management decided to reduce the allowance for loan
losses during 2003. Management considers the allowance for loan losses at
December 31, 2003 and December 31, 2002 to be adequate.
During 2003, the Company sold multifamily and commercial mortgage loans,
both performing and non-performing, totaling approximately $13,800,000 to a
third party at a net price of 93.7% of the outstanding balance. Under the terms
of the purchase agreement, the Company was required to repurchase any
non-performing loan for which the first monthly payment was not received by the
purchaser. No loans have been repurchased by the Company. In recording this
transaction, the allowance allocated to the loans sold was reversed from the
allowance for loan losses resulting in a negative provision of approximately
$665,000.
The primary reason for the decrease in the allowance for loan losses during
2003 was the charge-off of approximately $11 million in loans during 2003 as a
result of credit quality issues identified during 2002. These charge-offs,
coupled with management's aggressive efforts to increase credit quality during
2003, led to the $12.4 million reduction in the allowance for loan losses.
Conversely, the large increase in the allowance for loan losses between December
31, 2001 and December 31, 2002 was due to the same credit quality issues
discovered in 2002. The allowance was increased by $2 million during the second
quarter of 2002, and by an additional $20.9 million by the end of 2002 as the
full extent of the asset quality issues were discovered.
The following table sets forth certain information with respect to our
loans, net of unearned income, and the allowance for loan losses for the five
years ended December 31, 2003.
30
SUMMARY OF LOAN LOSS EXPERIENCE
2003 2002 2001 2000 1999
--------- --------- --------- --------- ---------
(Dollars in thousands)
Allowance for loan losses at beginning of year $ 26,991 $ 6,074 $ 5,065 $ 3,036 $ 1,402
Loans charged off:
Commercial, financial and agricultural 4,405 4,274 1,262 1,039 --
Real Estate - mortgage 6,076 3,847 1,046 -- --
Consumer 838 704 387 416 195
--------- --------- --------- --------- ---------
Total loans charged off 11,319 8,825 2,695 1,455 195
--------- --------- --------- --------- ---------
Recoveries on loans previously charged off:
Commercial, financial and agricultural 200 201 33 66 --
Real Estate - mortgage 223 3 28 -- --
Consumer 113 69 41 29 21
--------- --------- --------- --------- ---------
Total recoveries 536 273 102 95 21
--------- --------- --------- --------- ---------
Net loans charged off 10,783 8,552 2,593 1,360 174
Provision for loan losses (1,646) 29,469 3,602 3,389 1,808
--------- --------- --------- --------- ---------
Allowance for loan losses at end of period $ 14,562 $ 26,991 $ 6,074 $ 5,065 $ 3,036
========= ========= ========= ========= =========
Loans, net of unearned income, at end of period $385,887 $523,850 $505,381 $422,135 $244,620
Average loans, net of unearned income,
outstanding for the period 455,672 544,079 489,897 333,340 172,418
Ratio of net charge-offs to net average loans 2.37% 1.57% 0.53% 0.41% 0.10%
In evaluating the allowance, management also considers our historical loan
loss experience, the amount of past due and nonperforming loans, current and
anticipated economic conditions, lender requirements and other appropriate
information. We allocate the allowance for loan losses to specific loan
categories based on an average of the previous two years net losses for each
loan type and management's judgment as to potential losses and significant areas
of risk in the portfolio.
31
Management allocated the allowance for loan losses to specific loan classes
as follows:
ALLOCATION OF LOAN LOSS RESERVE
December 31
--------------------------------------------------------------------------------------------------
2003 2002 2001 2000 1999
------------------ ------------------ ------------------ ------------------ ------------------
Percent Percent Percent Percent Percent
of Loans of Loans of Loans of Loans of Loans
in Each in Each in Each in Each in Each
Category Category Category Category Category
to Total to Total to Total to Total to Total
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
------- --------- ------- --------- ------- --------- ------- --------- ------- ---------
(Dollars in Thousands)
DOMESTIC LOANS
Commercial, financial
and agricultural $ 6,745 46.3% $ 9,593 24.5% $ 1,622 26.7% $ 1,265 25.0% $ 821 27.0%
Real estate 7,661 52.6 16,881 71.8 4,191 69.0 3,552 70.1 2,012 66.3
Consumer 156 1.1 517 3.7 261 4.3 248 4.9 203 6.7
------- --------- ------- --------- ------- --------- ------- --------- ------- ---------
$14,562 100.0% $26,991 100.0% $ 6,074 100.0% $ 5,065 100.0% $ 3,036 100.0%
======= ========= ======= ========= ======= ========= ======= ========= ======= =========
NONPERFORMING ASSETS
Nonperforming assets include nonperforming loans and foreclosed real estate
held for sale. Nonperforming loans include loans classified as nonaccrual or
renegotiated. A delinquent loan is placed on nonaccrual status when it becomes
90 days or more past due and management believes, after considering economic and
business conditions and collection efforts, that the borrower's financial
condition is such that the collection of interest is doubtful. When a loan is
placed on nonaccrual status, all interest which has been accrued on the loan but
remains unpaid is reversed and deducted from earnings as a reduction of reported
interest income. No additional interest income is accrued on the loan balance
until the collection of both principal and interest becomes reasonably certain.
When a problem loan is finally resolved, there may ultimately be an actual
write-down or charge-off of the principal balance of the loan to the allowance
for loan losses. The accrual of interest on loans is discontinued at the time
the loan is 90 days delinquent unless the loan is well collateralized and in
process of collection. Recognition of any interest after a loan has been placed
on nonaccrual is accounted for on a cash basis.
We had nonperforming assets at December 31, 2003, of approximately
$17,594,000, $29,782,000 as of 2002, $12,415,000 as of 2001, $6,188,000 as of
2000, and $1,170,000 as of December 31, 1999.
32
The following table presents information concerning outstanding balances of
nonperforming assets at December 31, 2003, 2002, 2001, 2000 and 1999.
NONPERFORMING ASSETS
December 31,
-----------------------------------------------
2003 2002 2001 2000 1999
-------- -------- -------- ------- --------
(Dollars in thousands)
Nonaccruing loans . . . . . . . . . . . . . . . . . . . $12,523 $15,794 $ 4,062 $ 617 $ 43
Loans past due 90 days or more . . . . . . . . . . . . 524 8,560 4,125 5,358 914
Restructured loans . . . . . . . . . . . . . . . . . . -- -- -- -- --
-------- -------- -------- ------- --------
Total nonperforming loans . . . . . . . . . . . . . 13,047 24,354 8,187 5,975 957
Other real estate . . . . . . . . . . . . . . . . . . . 4,547 5,428 4,228 213 213
-------- -------- -------- ------- --------
Total . . . . . . . . . . . . . . . . . . . . . . . $17,594 $29,782 $12,415 $6,188 $ 1,170
======== ======== ======== ======= ========
Percentages:
Loans loss allowance to total nonperforming assets 82.77% 90.63% 48.92% 81.85% 259.49%
Total nonperforming loans to total loans
(net of unearned interest) . . . . . . . . . . . . . 3.38% 4.65 1.62 1.42 0.39
Total nonperforming assets to total assets . . . . . . . 3.37 5.02 2.18 1.31 0.39
The above nonperforming loans represent all material credits for which
management has serious doubts as to the ability of the borrowers to comply with
the loan repayment terms.
NONINTEREST INCOME
Noninterest income consists of revenues generated from a broad range of
financial services and activities including fee-based services and profits and
commissions earned through credit life insurance sales and other activities. In
addition, gains or losses realized from the sale of investment portfolio
securities are included in noninterest income. One of the Bank's strategies has
been to increase non-interest income. The Bank continues to emphasize growth in
mortgage origination income and service fees in order to provide additional
revenue generation capabilities, however, continued growth in the mortgage
origination area may not be possible. Total noninterest income increased by
$1,162,000 or 30.4% for the year ended December 31, 2003, as compared to the
year 2002. This increase was primarily due to increased mortgage origination
fees, as refinancing and home purchases continued at a record pace. Total
noninterest income increased by $981,000 or 34.5% for the year ended December
31, 2002, as compared to the year 2001.
The table below sets forth the components of our noninterest income for the
periods indicated.
NONINTEREST INCOME
Years Ended December 31, Percent Change
------------------------------- ----------------------
2003 2002 2001 2003/2002 2002/2001
--------- --------- --------- ---------- ----------
(Dollars in thousands)
Service charges on deposits $ 1,137 1,018 867 11.69% 17.42%
Mortgage banking income 3,342 2,455 1,918 36.13 28.00
Securities gains 206 233 24 (11.59) 870.83
Other 303 119 35 154.62 240.0
--------- --------- --------- ---------- ----------
Total $ 4,988 $ 3,825 $ 2,844 30.41% 34.49%
========= ========= ========= ========== ==========
NONINTEREST EXPENSES
Noninterest expense to average assets was 3.69% in 2003, 2.49% in 2002 and
1.79% in 2001.
Noninterest expense increased $4,415,000 or 28.7% from the year 2002 to
2003. Losses on foreclosed real estate increased $953,000 or 1,254% from year
2002 to 2003. Salaries and employee benefits increased $668,000 or
33
7.96% from year 2002 to 2003. Noninterest expense increased $5,356,000 or 53.4%
from the year 2001 to 2002. Salaries and employee benefits increased $2,928,000
or 53.6%. These increases are attributed to the overall growth and expansion of
the Company. Due to its growth, the Company recognized the need for increased
depth and experience in management and operational control. The Company also
needed assistance in responding to the asset and credit quality issues
discovered during 2002. During each of 2003 and 2002, the Company hired members
of a new management team to assist the Company's growth and to address previous
credit quality issues. Also included in salary increases for 2003 and 2002 are
normal salary increases and increased health benefit costs.
Occupancy and equipment expense increased $877,000 or 54.0% from year 2002
to 2003, and $392,000 or 31.9% from the year 2001 to 2002. The increase in 2003
was mainly due to relocating the Company's operations to a new leased facility
in Birmingham, Alabama, as well as improvements to existing facilities. Data
processing increased due to additions in Company infrastructure to monitor loans
and credit quality.
The table below sets forth our noninterest expenses for the periods
indicated.
NONINTEREST EXPENSES
Years Ended December 31,
------------------------------- 2003/2002 2002/2001
Percent Percent
2003 2002 2001 Change Change
--------- --------- --------- ---------- ----------
(Dollars in thousands)
Salaries and employee benefits $ 9,056 $ 8,388 $ 5,460 7.96% 53.63%
Occupancy and equipment expense 2,502 1,625 1,233 53.97 31.79
Loss on foreclosed real estate 1,028 76 - 1,252.63 -
Professional fees 1,734 1,275 583 36.00 118.70
Charge off and collection expense 55 533 139 -89.68 283.45
Loan fees and services 612 453 303 35.10 49.51
Data processing 607 421 190 44.18 121.58
Advertising 592 401 336 47.63 19.35
Supplies 382 399 262 -4.26 52.29
Other 3,227 1,809 1,517 78.39 19.25
--------- --------- --------- ---------- ----------
Total $ 19,795 $ 15,380 $ 10,023 28.71% 53.45%
========= ========= ========= ========== ==========
INCOME TAXES
Income tax expense increased $8,551,000 or 108.4% in 2003. Income tax
expense increased due to the Company recording income in 2003, as opposed to the
loss recorded in 2002. Income tax expense decreased $9,111,000 or 744.4% to
($7,887,000) for the year-end December 31, 2002. The decrease is the result of
the net loss from operations. The effective tax rate as a percentage of pretax
income was 37.0% in 2003, 35.4% in 2002 and 34.1% in 2001. There is no current
or pending tax legislation of which management is aware that if passed would
have any material effect on the consolidated financial statements. For further
information concerning the provision for income taxes, refer to Note 9, Income
Taxes, of the "Notes to Financial Statements."
IMPACT OF INFLATION AND CHANGING PRICES
A bank's asset and liability structure is substantially different from that
of an industrial company in that virtually all assets and liabilities of a bank
are monetary in nature. Management believes the impact of inflation on financial
results depends upon our ability to react to changes in interest rates and by
such reaction to reduce the inflationary impact on performance. Interest rates
do not necessarily move in the same direction, or at the same magnitude, as the
prices of other goods and services. As discussed previously, management seeks to
manage the relationship between interest-sensitive assets and liabilities in
order to protect against wide interest rate fluctuations, including those
resulting from inflation.
34
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 our Asset/Liability Management 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 interest-earning assets and interest-bearing liabilities over the
entire life of the instruments, but places particular emphasis on the first
year. An Asset/Liability Management policy requires risk assessment relative to
interest pricing and related terms.
We use 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
our 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 December 31, 2003, our simulation analysis reflected that our
earnings are at greatest risk in a declining interest rate environment.
35
The following table below depicts the results of the simulation assuming
one and two percent decreases and increases in the prime interest rates in a
one-year time horizon.
INTEREST RATE RISK
One Year Time Horizon
Estimated Repricing Amounts
------------------------------------------------
Down Up Down Up
1 Percent 1 percent 2 Percent 2 Percent
---------- ----------- ---------- -----------
RATE SENSITIVE ASSETS:
Loans $ 324,667 $ 300,923 $ 338,413 $ 299,665
Deposits in banks 116 116 116 116
Federal funds sold 632 632 632 632
Securities 35,704 16,765 44,784 15,797
---------- ----------- ---------- -----------
TOTAL RATE SENSITIVE ASSETS 361,119 318,436 383,945 316,210
---------- ----------- ---------- -----------
RATE SENSITIVE LIABILITIES
Deposits - Demand 125,822 125,822 125,822 125,822
Deposits - Time 175,367 175,367 175,367 175,367
Other Borrowed Money 19,308 31,308 19,308 39,308
---------- ----------- ---------- -----------
TOTAL RATE SENSITIVE LIABILITIES 320,497 332,497 320,497 340,497
---------- ----------- ---------- -----------
RATE SENSITIVITY GAP $ 40,622 $ (14,061) $ 63,448 $ (24,287)
========== =========== ========== ===========
RECENT ACCOUNTING PRONOUNCEMENTS
In January 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 46 "Consolidation of Variable Interest Entities - An
Interpretation of ARB No. 51" ("FIN 46") which provides guidance on how to
identify a variable interest entity (VIE) and determine when the assets,
liabilities, noncontrolling interests, and results of operations of a VIE are to
be included in an entity's consolidated financial statements. A VIE exists when
either the total equity investment at risk is not sufficient to permit the
entity to finance its activities by itself, or the equity investors lack one of
three characteristics associated with owning a controlling financial interest.
Those characteristics include the direct or indirect ability to make decisions
about an entity's activities through voting rights or similar rights, the
obligation to absorb the expected losses of an entity if they occur, or the
right to receive the expected residual returns of the entity if they occur. FIN
46 will be effective for the Company for financial statements in periods after
December 31, 2003.
Beginning January 1, 2004, the Company will apply the provisions of FIN 46
to its wholly owned subsidiary trust that issued capital securities to
third-party investors. The application of FIN 46 will result in the
deconsolidation of the wholly owned subsidiary trust. Deconsolidation will not
have a significant impact on the operations of the Company, but will result in
increases in other assets and trust preferred securities of $310,000 each
beginning in the first quarter of 2004.
Other accounting standards that have been issued or proposed by the
Financial Accounting Standards Board and other standard setting entities that do
not require adoption until a future date are not expected to have a material
impact on the Company's consolidated financial statements upon adoption.
36
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Please refer to "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Market Risk," which is incorporated
herein by reference.
ITEM 8. FINANCIAL STATEMENTS
The financial statements and supplemental data required by Regulation S-X
and by Item 302 of Regulation S-K are set forth in the pages listed below.
[The remainder of this page intentionally left blank]
37
HERITAGE FINANCIAL HOLDING CORPORATION AND SUBSIDIARIES
FINANCIAL STATEMENTS
Page(s)
Report of Independent Certified Public Accountants 39
Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . . 40
Consolidated Balance Sheets
as of December 31, 2003 and 2002 . . . . . . . . . . . . . . . . . . . 41
Consolidated Statements of Operations
for the Years Ended December 31, 2003, 2002 and 2001 . . . . . . . . . 42
Consolidated Statements of Changes in Stockholders' Equity
for the Years Ended December 31, 2003, 2002 and 2001 . . . . . . . . . 43
Consolidated Statements of Comprehensive Income
for the Years Ended December 31, 2003, 2002 and 2001 . . . . . . . . . 44
Consolidated Statements of Cash Flows
for the Years Ended December 31, 2003, 2002 and 2001 . . . . . . . . . 45
Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . 47
38
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
To the Board of Directors and Shareholders
Heritage Financial Holding Corporation and Subsidiaries
Decatur, Alabama
We have audited the accompanying consolidated balance sheet of Heritage
Financial Holding Corporation and subsidiaries as of December 31, 2003, and the
related consolidated statements of operations, changes in shareholders' equity,
comprehensive income and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit. The consolidated financial statements for the years ended December
31, 2002 and 2001 were audited by other auditors whose report, dated February
25, 2003, expressed an unqualified opinion on those statements.
We conducted our audit in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the 2003 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Heritage
Financial Holding Corporation and subsidiaries as of December 31, 2003, and the
results of their operations and their cash flows for the year then ended, in
conformity with accounting principles generally accepted in the United States of
America.
/s/ PORTER KEADLE MOORE, LLP
Atlanta, Georgia
February 6, 2004, except for note 12 as to which the date is March 9, 2004
39
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders
Heritage Financial Holding Corporation
Decatur, Alabama
We have audited the accompanying consolidated balance sheet of Heritage
Financial Holding Corporation (a Delaware corporation) and subsidiaries as of
December 31, 2002, and the related consolidated statements of operations,
changes in shareholders' equity, comprehensive income and cash flows for each of
the two years in the period ended December 31, 2002. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the consolidated
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Heritage Financial
Holding Corporation and subsidiaries as of December 31, 2002, and the results of
their operations and their cash flows for each of the two years in the period
ended December 31,2002, in conformity with accounting principles generally
accepted in the United States of America.
/S/ Schauer Taylor Cox Vise Morgan & Fowler, P.C.
Birmingham, Alabama
February 25, 2003
40
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2003 AND 2002
Assets
------
2003 2002
------------- ------------
Cash and due from banks, including reserve requirements
of $7,267,000 and $3,467,000 $ 8,663,330 4,759,310
Interest-bearing deposits with other banks 115,551 97,707
Federal funds sold 632,000 14,681,498
------------- ------------
Cash and cash equivalents 9,410,881 19,538,515
Investment securities available-for-sale 99,037,992 35,125,841
Other investments 2,897,061 1,635,961
Mortgage loans held-for-sale 5,995,929 12,343,440
Loans, net 371,324,621 496,858,908
Premises and equipment, net 7,223,966 7,105,706
Accrued interest receivable 2,391,861 3,404,344
Cash surrender value of life insurance 11,015,000 -
Foreclosed real estate 4,546,740 5,428,047
Other assets 8,581,753 11,501,035
------------- ------------
$522,425,804 592,941,797
============= ============
Liabilities and Shareholders' Equity
------------------------------------
Deposits:
Noninterest-bearing $ 28,141,627 21,961,197
Interest-bearing 387,473,302 503,669,662
------------- ------------
Total deposits 415,614,929 525,630,859
Federal funds purchased 406,073 -
Note payable 7,480,000 6,650,000
Federal Home Loan Bank advances 56,422,156 23,000,000
Trust preferred securities 10,000,000 10,000,000
Accrued interest payable 1,899,628 3,288,749
Other liabilities 497,626 669,143
------------- ------------
Total liabilities 492,320,412 569,238,751
------------- ------------
Commitments and contingencies
Shareholders' equity:
Preferred stock, par value $0.01; authorized 10,000,000 shares;
no shares issued and outstanding - -
Common stock, par value $0.01; authorized 40,000,000 shares;
10,510,791 and 8,821,144 shares issued and outstanding 105,108 88,211
Additional paid-in capital 37,322,707 32,234,654
Accumulated deficit (7,548,144) (8,676,524)
Accumulated other comprehensive income 225,721 56,705
------------- ------------
Total shareholders' equity 30,105,392 23,703,046
------------- ------------
$522,425,804 592,941,797
============= ============
See accompanying notes to consolidated financial statements.
41
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
2003 2002 2001
----------------- ------------ -----------
Interest income:
Interest and fees on loans $ 28,377,963 38,402,218 40,300,281
Interest and dividends on securities:
Taxable 1,651,624 1,603,251 1,460,386
Tax-exempt 68,242 133,119 124,585
Interest on federal funds sold 180,301 320,016 1,055,690
Other 65,041 6,264 24,905
----------------- ------------ -----------
Total interest income 30,343,171 40,464,868 42,965,847
----------------- ------------ -----------
Interest expense:
Deposits 12,993,846 19,716,658 26,751,607
Federal Home Loan Bank advances 1,088,025 977,348 962,690
Other 1,306,916 1,047,729 880,222
----------------- ------------ -----------
Total interest expense 15,388,787 21,741,735 28,594,519
----------------- ------------ -----------
Net interest income 14,954,384 18,723,133 14,371,328
Provision for loan losses (1,645,878) 29,468,734 3,602,047
----------------- ------------ -----------
Net interest income (loss) after provision for loan losses 16,600,262 (10,745,601) 10,769,281
----------------- ------------ -----------
Other income:
Service charges 1,137,434 1,018,421 867,323
Gain on sales of securities, net 205,801 233,372 23,926
Mortgage banking income 3,341,481 2,454,626 1,917,456
Miscellaneous 302,734 118,864 35,197
----------------- ------------ -----------
Total other income 4,987,450 3,825,283 2,843,902
----------------- ------------ -----------
Other expenses:
Salaries and employee benefits 9,056,110 8,388,132 5,460,426
Occupancy 2,501,840 1,625,162 1,232,525
Losses on foreclosed real estate 1,028,550 76,035 -
Other operating 7,208,602 5,290,357 3,330,345
----------------- ------------ -----------
Total other expenses 19,795,102 15,379,686 10,023,296
----------------- ------------ -----------
Earnings (loss) before income taxes 1,792,610 (22,300,004) 3,589,887
Income tax (expense) benefit (664,230) 7,887,221 (1,223,966)
----------------- ------------ -----------
Net earnings (loss) $ 1,128,380 (14,412,783) 2,365,921
================= ============ ===========
Basic earnings (loss) per share $ 0.11 (1.65) 0.28
================= ============ ===========
Diluted earnings (loss) per share $ 0.11 (1.65) 0.23
================= ============ ===========
See accompanying notes to consolidated financial statements.
42
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
Retained Accumulated
Additional Earnings Other
Common Stock Paid-in (Accumulated Comprehensive
Shares Amount Capital Deficit) Income (Loss) Total
----------- --------- ----------- ------------- -------------- ------------
Balance, December 31, 2000 8,475,822 $ 84,758 30,203,113 3,370,338 (158,907) 33,499,302
Exercise of stock options 36,000 360 86,850 - - 87,210
Issuance of shares under employee
stock purchase plan 3,325 33 31,412 - - 31,445
Issuance of compensatory options - - 37,843 - - 37,843
Change in accumulated other
comprehensive income (loss),
net of tax - - - - 102,159 102,159
Net earnings - - - 2,365,921 - 2,365,921
----------- --------- ----------- ------------- -------------- ------------
Balance, December 31, 2001 8,515,147 85,151 30,359,218 5,736,259 (56,748) 36,123,880
Exercise of stock options 303,700 3,037 20,534 - - 23,571
Issuance of shares under employee
stock purchase plan 2,297 23 25,171 - - 25,194
Tax benefit of nonqualified
stock options - - 702,817 - - 702,817
Issuance of compensatory options - - 1,126,914 - - 1,126,914
Change in accumulated other
comprehensive income (loss),
net of tax - - - - 113,453 113,453
Net loss - - - (14,412,783) - (14,412,783)
----------- --------- ----------- ------------- -------------- ------------
Balance, December 31, 2002 8,821,144 88,211 32,234,654 (8,676,524) 56,705 23,703,046
Issuance of common stock 693,035 6,930 2,287,678 - - 2,294,608
Exercise of stock options 1,140,430 11,404 3,762,691 - - 3,774,095
Retirement of common stock
related to exercise of options (146,968) (1,469) (971,227) - - (972,696)
Issuance of common stock under
employee stock purchase plan 3,150 32 8,911 - - 8,943
Change in accumulated other
comprehensive income (loss),
net of tax - - - - 169,016 169,016
Net earnings - - - 1,128,380 - 1,128,380
----------- --------- ----------- ------------- -------------- ------------
Balance, December 31, 2003 10,510,791 $105,108 37,322,707 (7,548,144) 225,721 30,105,392
=========== ========= =========== ============= ============== ============
See accompanying notes to consolidated financial statements.
43
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
2003 2002 2001
-------------- ------------ ----------
Net earnings (loss) $ 1,128,380 (14,412,783) 2,365,921
-------------- ------------ ----------
Other comprehensive income:
Unrealized holding gains on securities available-for-sale 453,294 422,461 194,189
Reclassification adjustment for gains on sales
of securities available-for-sale (205,801) (233,372) (23,926)
-------------- ------------ ----------
Total other comprehensive income, before income taxes 247,493 189,089 170,263
-------------- ------------ ----------
Income tax expense related to other comprehensive income:
Unrealized holding gains on securities available-for-sale 148,449 168,984 77,676
Reclassification adjustment for gains on sales of
securities available-for-sale (69,972) (93,348) (9,572)
-------------- ------------ ----------
Total income tax expense related to other
comprehensive income 78,477 75,636 68,104
-------------- ------------ ----------
Total other comprehensive income, net of tax 169,016 113,453 102,159
-------------- ------------ ----------
Comprehensive income (loss) $ 1,297,396 (14,299,330) 2,468,080
============== ============ ==========
See accompanying notes to consolidated financial statements.
44
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
2003 2002 2001
--------------- ------------- ------------
Cash flows from operating activities:
Net earnings (loss) $ 1,128,380 (14,412,783) 2,365,921
Adjustments to reconcile net earnings (loss) to net
cash provided (used) by operating activities:
Depreciation, amortization and accretion 1,636,918 790,839 437,999
Provision for loan losses (1,645,878) 29,468,734 3,602,047
Deferred income tax expense (benefit) 2,194,873 (6,700,257) (264,948)
Gains on sale of securities, net (205,801) (261,671) (23,926)
(Gain) loss on sale of premises and equipment (9,440) 2,250 1,786
Compensatory options - 1,126,914 37,843
Losses on foreclosed real estate 1,028,550 249,491 23,926
Change in:
Accrued interest receivable and other assets 1,643,415 (1,363,330) 334,876
Accrued interest payable and other liabilities (1,560,638) (915,766) 52,267
Mortgage loans held-for-sale 6,347,511 204,882 (12,548,322)
Other, net - 7,381 (154,965)
--------------- ------------- ------------
Net cash provided (used) by operating activities 10,557,890 8,196,684 (6,135,496)
--------------- ------------- ------------
Cash flows from investing activities:
Purchases of investment securities available-for-sale (162,950,031) (101,267,892) (18,774,196)
Proceeds from calls and maturities of investment securities
available-for-sale 82,579,687 55,317,503 19,399,714
Proceeds from sales of investment securities available-for-sale 16,508,898 35,340,361 520,493
Purchases of other investments (1,261,100) - -
Net change in loans 116,221,233 (31,020,203) (89,959,157)
Purchases of premises and equipment (1,421,475) (1,343,238) (1,287,676)
Proceeds from sale of premises and equipment 78,326 44,315 7,665
Purchase of bank owned life insurance (11,000,000) - -
Proceeds from sales of other real estate 10,811,689 2,549,330 106,250
--------------- ------------- ------------
Net cash provided (used) by investing activities 49,567,227 (40,379,824) (89,986,907)
--------------- ------------- ------------
Cash flows from financing activities:
Net change in deposits (110,015,930) 21,321,121 83,065,500
Net change in Federal funds purchased 406,073 - -
Proceeds from note payable 830,000 6,650,000 -
Proceeds from FHLB borrowings 33,422,156 10,000,000 1,000,000
Proceeds from issuance of stock 2,303,551 25,195 31,445
Issuance of trust preferred securities - - 10,000,000
Proceeds from exercise of stock options 2,801,399 23,571 87,210
--------------- ------------- ------------
Net cash provided (used) by financing activities (70,252,751) 38,019,887 94,184,155
--------------- ------------- ------------
Net change in cash and cash equivalents (10,127,634) 5,836,747 (1,938,248)
Cash and cash equivalents at beginning of year 19,538,515 13,701,768 15,640,016
--------------- ------------- ------------
Cash and cash equivalents at end of year $ 9,410,881 19,538,515 13,701,768
=============== ============= ============
45
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
2003 2002 2001
------------ ---------- ----------
Supplemental disclosures of cash flow information:
Cash paid (refunded) during the year for:
Interest $16,777,908 22,657,501 28,542,252
Income taxes $ (682,526) 645,436 1,670,781
Noncash investing and financing activities:
Change in other comprehensive income, net of tax $ 169,016 113,453 102,159
Transfer of loans to other real estate and repossessions $13,266,567 5,029,426 4,920,288
See accompanying notes to consolidated financial statements.
46
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Basis of Presentation
------------------------------------------
Heritage Financial Holding Corporation (the "Company") is a bank holding
company whose business is conducted by its wholly-owned Subsidiaries:
Heritage Bank (the "Bank") and Heritage Financial Statutory Trust I
("Heritage Trust"), created by the Company for the purpose of issuing trust
preferred securities. The consolidated financial statements include the
accounts of the Company, the Bank and Heritage Trust. All significant
intercompany balances and transactions have been eliminated in
consolidation.
As a bank holding company, the Company is subject to regulation by the
Federal Reserve Bank. The Bank is primarily regulated by the State of
Alabama State Banking Department and the Federal Deposit Insurance
Corporation and undergoes periodic examinations by these regulatory
agencies. The Bank, whose main offices are in Birmingham and Decatur,
Alabama, provides a full range of commercial and consumer banking services
primarily in Morgan, Madison and Jefferson counties in north and central
Alabama.
During 2002, management of the Company identified significant operational
and asset quality deficiencies at the Bank as the result of its own
investigation and examinations performed by certain bank regulatory
agencies. The results of the examinations by regulatory authorities are
confidential. The asset quality deficiencies resulted in material increases
to the Bank's allowance for loan losses, and correspondingly material
reductions in the capital levels of the Company and the Bank. In concert
with the regulators, the Board of Directors and management of the Company
and the Bank have identified specific corrective steps and actions to
address capital deficiencies, improve asset quality, and enhance
operational controls and procedures. The Bank, without the prior written
approval of its regulators, may not declare or pay any cash dividends. In
addition, the Bank has determined to hire and retain certain personnel who
have been given specific written authority by the Board of Directors to
implement sound lending, recordkeeping and accounting practices. The Bank
also has taken steps to develop an educational program for board members
and to create a written review of the Bank's staffing requirements. The
Board of Directors of the Company intends to cause management of the
Company and the Bank to take steps to attain and maintain a Tier 1 leverage
ratio of 8 percent and maintain other capital ratios so as to be
"well-capitalized" as defined by the FDIC. Should the Tier 1 leverage ratio
fail to meet the specified Tier 1 leverage ratio of 8 percent or
subsequently fall below such level, the Bank must notify the regulatory
authorities and take steps to increase capital sufficient to meet the
required ratios within 30 days. Management believes that the Bank is
generally in compliance with the corrective steps identified above. Failure
to accomplish these objectives could subject the Company and the Bank to
onerous regulatory actions.
The accounting principles followed by the Company, and the methods of
applying these principles, conform with accounting principles generally
accepted in the United States of America ("GAAP") and with general
practices in the banking industry. In preparing the financial statements in
conformity with GAAP, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities as
of the dates of the balance sheet and revenue and expenses for the years
then ended. Actual results could differ significantly from those estimates.
Material estimates common to the banking industry that are particularly
susceptible to significant change in the near term include, but are not
limited to, the determination of the allowance for loan losses and the
valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans.
Cash and Cash Equivalents
----------------------------
Cash and due from banks and federal funds sold are considered cash and cash
equivalents for cash flow reporting purposes. Generally, federal funds are
sold for one-day periods.
Investment Securities
----------------------
The Company classifies its securities in one of three categories: trading,
available-for-sale, or held-to-maturity. Trading securities are bought and
held principally for sale in the near term. Held-to-maturity securities are
those securities for which the Company has the ability and intent to hold
until maturity. All other securities not included in trading or
held-to-maturity are classified as available-for-sale. At December 31, 2003
and 2002, the Company had classified all of its investment securities as
available-for-sale.
47
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
Available-for-sale securities are recorded at fair value. Unrealized
holding gains and losses, net of the related tax effect, are excluded from
earnings and are reported as a separate component of shareholders' equity
until realized.
Investment Securities, continued
----------------------------------
A decline in the market value of any available-for-sale investment below
cost that is deemed other than temporary is charged to earnings and
establishes a new cost basis for the security.
Premiums and discounts are amortized or accreted over the life of the
related security as an adjustment to the yield. Realized gains and losses
for securities classified as available-for-sale are included in earnings
and are derived using the specific identification method for determining
the cost of securities sold.
Other Investments
------------------
Other investments include equity securities with no readily determinable
fair value. These investments are carried at cost and include Federal Home
Loan Bank ("FHLB") stock and Community Financial Services stock.
Mortgage Loans Held-for-sale
------------------------------
Mortgage loans held-for-sale are carried at the lower of aggregate cost or
market value. At December 31, 2003 and 2002, the cost of mortgage loans
held-for-sale approximates the market value.
Loans and Allowance for Loan Losses
----------------------------------------
Loans are stated at the principal amount outstanding, net of the allowance
for loan losses. Interest on loans is calculated by using the simple
interest method on daily balances of the principal amount outstanding.
The accrual of interest is discontinued on a loan when a loan becomes 90
days past due and is not both well collateralized and in the process of
collection, or when management believes, after considering economic and
business conditions and collection efforts, that the principal or interest
will not be collectible in the normal course of business. When a loan is
placed on nonaccrual status, previously accrued and uncollected interest is
charged against interest income on loans. Generally, payments received on
nonaccrual loans are applied to principal.
A loan is impaired when, based on current information and events, it is
probable that all amounts due according to the contractual terms of the
loan will not be collected. Impaired loans are measured based on the
present value of expected future cash flows, discounted at the loan's
effective interest rate, or at the loan's observable market price, or the
fair value of the collateral if the loan is collateral dependent.
The allowance for loan losses is established through a provision for loan
losses charged to earnings. Loans are charged against the allowance for
loan losses when management believes that the collectibility of the
principal is unlikely. The allowance represents an amount, which, in
management's judgment, will be adequate to absorb probable losses on
existing loans that may become uncollectible.
Management's judgment in determining the adequacy of the allowance is based
on evaluations of the collectibility of loans. These evaluations take into
consideration such factors as changes in the nature and volume of the loan
portfolio, current economic conditions that may affect the borrower's
ability to pay, overall portfolio quality, and review of specific problem
loans. In determining the adequacy of the allowance for loan losses,
management uses a loan grading system that rates individual loans into risk
classifications. These risk categories are assigned allocations of loss
based on management's estimate of potential loss which is generally based
on an analysis of historical loss experience, current economic conditions,
performance trends, and discounted collateral deficiencies. The combination
of these results is compared monthly to the recorded allowance for loan
losses and material differences are adjusted by increasing or decreasing
the provision for loan losses. Management has an internal loan review
department that is independent of the lending function to challenge and
corroborate the loan grading system and provide additional analysis in
determining the adequacy of the allowance for loan losses.
48
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
Management believes the allowance for loan losses is adequate at December
31, 2003 and 2002. While management uses available information to recognize
losses on loans, future additions to the allowance may be necessary based
on changes in economic conditions. 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 based on judgments different
than those of management.
Mortgage Banking Activities
-----------------------------
Mortgage banking income represents net gains from the sale of mortgage
loans and fees received from borrowers and loan investors related to the
Company's origination of single-family residential mortgage loans.
Premises and Equipment
------------------------
Premises and equipment are stated at cost less accumulated depreciation.
Depreciation is computed primarily using the straight-line method over the
estimated useful lives of the assets. When assets are retired or otherwise
disposed, the cost and related accumulated depreciation are removed from
the accounts, and any gain or loss is reflected in earnings for the period.
The cost of maintenance and repairs which do not improve or extend the
useful life of the respective asset is charged to earnings as incurred,
whereas significant renewals and improvements are capitalized. The range of
estimated useful lives for buildings and improvements is 10 to 40 years,
and for furniture and equipment, 3 to 10 years. Leasehold improvements are
depreciated over the remaining lease term, or the estimated useful life of
the improvement, whichever is shorter (ranging from 5 to 15 years).
Foreclosed Real Estate
------------------------
Foreclosed real estate includes real estate received in full or partial
satisfaction of a loan. Foreclosed assets are reported at the lower of
carrying amount of the related loan or net realizable value.
Income Taxes
-------------
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective
tax bases. Additionally, the recognition of future tax benefits, such as
net operating loss carryforwards, is required to the extent that
realization of such benefits is more likely than not. Deferred tax assets
and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which the assets and liabilities are
expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income tax expense in
the period that includes the enactment date.
In the event the future tax consequences of differences between the
financial reporting bases and the tax bases of the Company's assets and
liabilities results in deferred tax assets, an evaluation of the
probability of being able to realize the future benefits indicated by such
asset is required. A valuation allowance is provided for the portion of the
deferred tax asset when it is more likely than not that some portion or all
of the deferred tax asset will not be realized. In assessing the
realizability of the deferred tax assets, management considers the
scheduled reversals of deferred tax liabilities, projected future taxable
income, and tax planning strategies.
Advertising Costs
------------------
The Company's policy is to expense advertising costs as incurred.
Advertising expense for the years ended December 31, 2003, 2002 and 2001
amounted to approximately $542,000, $401,000 and $336,000, respectively.
Accumulated Other Comprehensive Income
-----------------------------------------
At December 31, 2003 and 2002, accumulated other comprehensive income
consisted of the net of tax effects of net unrealized gains on securities
available-for-sale of $225,721 and $56,705, respectively.
49
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
Stock-Based Compensation
-------------------------
The Company's stock-based compensation plans described in note 13 are
accounted for based on the intrinsic value method set forth in Accounting
Principles Board (APB) Opinion 25, Accounting for Stock Issued to
Employees, and related interpretations. Compensation expense for employee
stock options is not recognized if the exercise price of the option equals
or exceeds the fair value of the stock on the date of grant. Compensation
expense for restricted share awards is ratably recognized over the period
of service, usually the restricted period, based on the fair value of the
stock on the date of grant. Had compensation costs been determined based
upon the fair value of the options at the grant dates consistent with the
method of Statement of Financial Accounting Standards No. 123, the
Company's net earnings (loss) and earnings (loss) per common share would
have reflected the pro forma amounts below. For disclosure purposes, the
Company immediately recognized the expense associated with the option
grants assuming that all awards vest upon grant.
December 31,
------------------------------------
2003 2002 2001
----------- ------------ ----------
Net earnings (loss) as reported $1,128,380 (14,412,783) 2,365,921
Deduct: Total stock-based employee compensation
expense determined under fair-value based method
for all awards (270,907) (116,621) (563,962)
----------- ------------ ----------
Pro forma net earnings (loss) $ 857,473 (14,529,404) 1,801,959
=========== ============ ==========
Basic earnings (loss) per share:
As reported $ 0.11 (1.65) 0.28
=========== ============ ==========
Pro forma $ 0.09 (1.67) 0.21
=========== ============ ==========
Diluted earnings (loss) per share:
As reported $ 0.11 (1.65) 0.23
=========== ============ ==========
Pro forma $ 0.08 (1.67) 0.17
=========== ============ ==========
Stock-Based Compensation
-------------------------
The weighted average grant-date fair value of options granted in 2003, 2002
and 2001 was $0.89, $1.52, and $3.43, respectively. The fair value of
options granted in 2003 is estimated on the date of grant using the Minimum
Value options-pricing model with a risk-free interest rate of 4%, a
dividend yield of 0% and an expected life of eight years. The fair value of
each option granted in 2002 and 2001 is estimated on the date of grant
using the Black-Scholes options-pricing model with the following weighted
average assumptions used for grants in 2002 and 2001, respectively -
dividend yield of 0% and 0%, respectively; risk free interest rate of 4%
and 5%, respectively; expected volatility of .26 and .217, respectively;
and an expected life of one year and five years, respectively.
Net Earnings Per Share
-------------------------
Net earnings per 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. The average market price during the year is used to compute
equivalent shares. For 2002, basic earnings per share is calculated based
on weighted average shares outstanding of 8,717,303 and the potential
effect of outstanding options would be antidilutive and therefore is not
presented. The reconciliations of the amounts used in the computation of
both "basic earnings per share" and "diluted earnings per share" for the
years ended December 31, 2003 and 2001 are as follows:
50
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED
Net Earnings Per Share, continued
---------------------------------
Net Common Per Share
Earnings Shares Amount
---------- ---------- -----------
FOR THE YEAR ENDED DECEMBER 31, 2003
Basic earnings per share $1,128,380 10,048,167 $ 0.11
Effect of dilutive securities:
Stock options - 110,257 -
---------- ---------- -----------
Diluted earnings per share $1,128,380 10,158,424 $ 0.11
========== ========== ===========
FOR THE YEAR ENDED DECEMBER 31, 2001
Basic earnings per share $2,365,921 8,484,624 $ 0.28
Effect of dilutive securities:
Stock options - 2,002,342 (0.05)
---------- ---------- -----------
Diluted earnings per share $2,365,921 10,486,966 $ 0.23
========== ========== ===========
At December 31, 2003 and 2002, a total of 3,000 and 3,239,016,
respectively, potential common shares related to stock options were not
included in the computation of diluted earnings per share because they
would have been antidilutive.
Recent Accounting Pronouncements
----------------------------------
In January 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation No. 46 "Consolidation of Variable Interest Entities -
An Interpretation of ARB No. 51" ("FIN 46") which provides guidance on how
to identify a variable interest entity (VIE) and determine when the assets,
liabilities, noncontrolling interests, and results of operations of a VIE
are to be included in an entity's consolidated financial statements. A VIE
exists when either the total equity investment at risk is not sufficient to
permit the entity to finance its activities by itself, or the equity
investors lack one of three characteristics associated with owning a
controlling financial interest. Those characteristics include the direct or
indirect ability to make decisions about an entity's activities through
voting rights or similar rights, the obligation to absorb the expected
losses of an entity if they occur, or the right to receive the expected
residual returns of the entity if they occur. FIN 46 will be effective for
the Company for financial statements in periods after December 31, 2003.
Beginning January 1, 2004, the Company will apply the provisions of FIN 46
to its wholly owned subsidiary trust that issued capital securities to
third-party investors. The application of FIN 46 will result in the
deconsolidation of the wholly owned subsidiary trust. Deconsolidation will
not have a significant impact on the operations of the Company, but will
result in increases in other assets and trust preferred securities of
$310,000 each beginning in the first quarter of 2004.
Reclassifications
-----------------
Reclassifications of certain amounts in the 2002 and 2001 financial
statements have been made to conform with the financial statement
presentation for 2003. The reclassifications had no effect on net earnings
or shareholders' equity as previously reported.
51
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(2) INVESTMENT SECURITIES
Investment securities available-for-sale at December 31, 2003 and 2002 are
as follows:
December 31, 2003
-----------------------------------------------
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
----------- ---------- ---------- ----------
U. S. government agencies $30,489,233 130,797 26,740 30,593,290
Mortgage-backed securities 61,443,132 237,116 40,382 61,639,866
State and political subdivisions 1,294,011 41,928 - 1,335,939
Corporate debt 5,469,615 - 718 5,468,897
----------- ---------- ---------- ----------
$98,695,991 409,841 67,840 99,037,992
=========== ========== ========== ==========
December 31, 2002
-----------------------------------------------
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
----------- ---------- ---------- ----------
Mortgage-backed securities $22,832,366 375,515 - 23,207,881
State and political subdivisions 1,294,471 39,543 4,433 1,329,581
Corporate debt 10,904,495 - 316,116 10,588,379
----------- ---------- ---------- ----------
$35,031,332 415,058 320,549 35,125,841
=========== ========== ========== ==========
52
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(2) INVESTMENT SECURITIES, CONTINUED
Unrealized losses and fair value, aggregated by investment category and
length of time that individual securities have been in a continuous
unrealized loss position, as of December 31, 2003 are summarized as
follows:
Less than 12 Months 12 Months or More Total
----------------------- --------------------- ----------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Losses Value Losses Value Losses
----------- ---------- --------- ---------- ---------- ----------
U. S. government agencies $ 7,257,190 26,740 - - 7,257,190 26,740
Mortgage-backed securities 6,477,646 40,382 6,477,646 40,382
Corporate debt 5,468,897 718 - - 5,468,897 718
----------- ---------- --------- ---------- ---------- ----------
$19,203,733 67,840 - - 19,203,733 67,840
=========== ========== ========= ========== ========== ==========
At December 31, 2003, unrealized losses in the investment securities
portfolio related to debt securities totaled $67,840. The unrealized losses
on these debt securities arose due to changing interest rates and are
considered to be temporary. These unrealized losses are considered
temporary because of acceptable investment grades on each security and the
repayment sources of principal and interest are largely government backed.
The amortized cost and estimated fair value of investment securities
available-for-sale at December 31, 2003, by contractual maturity, are shown
below. Expected maturities will differ from contractual maturities because
borrowers have the right to call or prepay obligations with or without call
or prepayment penalties.
Amortized Estimated
Cost Fair Value
----------- ----------
Due from one to five years $30,489,233 30,593,290
Due from five to ten years 185,000 185,844
Due after ten years 6,578,626 6,618,992
Mortgage-backed securities 61,443,132 61,639,866
----------- ----------
$98,695,991 99,037,992
=========== ==========
Proceeds from sales of securities available-for-sale during 2003, 2002 and
2001 were $16,508,898, $35,340,361 and $520,493, respectively. Gross gains
of $229,551, $350,233 and $23,926 for 2003, 2002 and 2001, respectively,
along with gross losses of $23,750 and $116,861 for 2003 and 2002,
respectively, were realized on those sales. There were no losses on sales
of securities available-for-sale in 2001.
Securities with a carrying value of approximately $26,976,000 and
$20,873,000 at December 31, 2003 and 2002, respectively, were pledged to
secure public deposits and for other purposes as required by law.
53
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(3) LOANS
Major classifications of loans at December 31, 2003 and 2002 are summarized
as follows:
2003 2002
------------ -----------
Commercial $116,202,517 132,236,338
Real estate - mortgage 230,626,217 311,508,055
Real estate - construction 26,583,296 60,205,855
Consumer 12,474,874 19,899,254
------------ -----------
Total loans 385,886,904 523,849,502
Less: allowance for loan losses 14,562,283 26,990,594
------------ -----------
$371,324,621 496,858,908
============ ===========
The Company grants loans and extensions of credit primarily within the
northern and central region of Alabama, which encompasses Morgan, Madison,
and Jefferson counties. Although the Bank has a diversified loan portfolio,
a substantial portion of the portfolio is collateralized by improved and
unimproved real estate which is dependent upon the real estate market.
At December 31, 2003 and 2002, the recorded investment in loans that were
considered to be impaired was approximately $13,047,000 and $24,354,000,
respectively, of which approximately $12,523,000 and $15,794,000,
respectively, were on non-accural status. The Company had approximately
$524,000 and $8,560,000 in loans past due more than ninety days and still
accruing interest at December 31, 2003 and 2002, respectively. The related
allowance for loan losses on impaired loans was approximately $4,229,000
and $2,991,000 at December 31, 2003 and 2002, respectively. The average
recorded investment in impaired loans for the years ended December 31, 2003
and 2002 was approximately $13,309,000 and $10,324,000, respectively. For
the years ended December 31, 2003, 2002 and 2001, the Company recognized
approximately $748,000, $561,000 and $519,000, respectively, of interest
income on impaired loans for cash payments received in excess of principal
amounts due.
Changes in the allowance for loan losses were as follows:
2003 2002 2001
------------- ----------- -----------
Balance at beginning of year $ 26,990,594 6,074,230 5,064,889
Amounts charged off (11,318,747) (8,825,046) (2,695,237)
Recoveries on amounts previously charged off 536,314 272,676 102,531
Provision for loan losses (1,645,878) 29,468,734 3,602,047
------------- ----------- -----------
Balance at end of year $ 14,562,283 26,990,594 6,074,230
============= =========== ===========
As a result of its ongoing evaluation of the adequacy of the allowance for
loan losses, a decline in problem credits and continued recoveries of loans
previously charged off, management decided to reduce the allowance for loan
losses during 2003.
During 2003, the Company sold multifamily and commercial mortgage loans,
both performing and non-performing, totaling approximately $13,800,000 to a
third party at a net price of 93.7% of the outstanding balance. Under the
terms of the purchase agreement, the Company was required to repurchase any
non-performing loan for which the first monthly payment was not received by
the purchaser. No loans have been repurchased by the Company. In recording
this transaction, the allowance allocated to the loans sold was reversed
from the allowance for loan losses resulting in a negative provision of
approximately $665,000.
54
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(4) PREMISES AND EQUIPMENT
Major classifications of premises and equipment are summarized as follows:
2003 2002
------------ ---------
Land $ 1,147,055 1,152,443
Leasehold improvements 2,376,156 1,761,777
Buildings and improvements 1,621,299 1,565,225
Furniture and equipment 5,067,916 4,116,105
------------ ---------
10,212,426 8,595,550
Less accumulated depreciation 2,988,460 1,804,581
------------ ---------
7,223,966 6,790,969
Construction in progress - 314,737
------------ ---------
$ 7,223,966 7,105,706
============ =========
Depreciation expense was approximately $1,241,000, $598,000 and $437,000,
for the years ended December 31, 2003, 2002 and 2001, respectively.
(5) TIME DEPOSITS
The aggregate amount of time deposit accounts with a minimum denomination
of $100,000 was $94,370,000 and $146,208,880 at December 31, 2003 and 2002,
respectively.
At December 31, 2003, the scheduled maturities of time deposits are as
follows:
2004 $175,069,441
2005 52,935,099
2006 15,636,631
2007 8,745,778
2008 9,343,240
------------
$261,730,189
============
At December 31, 2003 and 2002, the Company had approximately $5,168,000 and
$25,100,000, respectively, in time deposits purchased through third party
brokers. The weighted average cost of these deposits during 2003 and 2002
was 4.03% and 3.62%, respectively. These deposits have various maturity
dates and are included in the schedule above.
(6) NOTE PAYABLE
On October 30, 2002, the Company entered into a line of credit agreement
with a commercial bank, whereby the Company can borrow up to $7,500,000
bearing interest at LIBOR plus 2.5%. The note matures on March 1, 2004 and
is secured by the stock of the Bank and guaranteed by the Board of
Directors of the Company. The loan agreement contains certain restrictive
covenants that the Company is either in compliance with or has requested
waivers for violations. At December 31, 2003 and 2002, the Company had
$7,480,000 and $6,650,000, respectively, outstanding under this line of
credit agreement.
55
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(7) FEDERAL HOME LOAN BANK ADVANCES
The Bank has advances from the FHLB with monthly interest payments at
various maturity dates and interest rates ranging from 1.15% to 4.97% at
December 31, 2003. The FHLB advances are collateralized by a blanket
assignment on all residential first mortgage loans and selected investment
securities.
Advances from the FHLB outstanding at December 31, 2003 and 2002 consist of
the following:
OUTSTANDING DECEMBER 31,
--------------------------
Maturity Date Conversion Date Rate Rate Type 2003 2002
----------------- ---------------------------- ----- --------- ------------ ------------
March 29, 2004 N/A 1.15% Variable $ 10,422,156 -
February 9, 2011 February 9, 2004 and every
three months thereafter 4.97% Fixed 5,000,000 5,000,000
February 23, 2011 May 23, 2001 and every three
months thereafter 4.16% Fixed 8,000,000 8,000,000
January 17, 2012 January 17,2005 and every
three months thereafter 3.85% Fixed 10,000,000 10,000,000
October 20, 2004 N/A 1.72% Fixed 1,000,000 -
October 20, 2005 N/A 2.42% Fixed 1,500,000 -
October 20, 2006 N/A 2.99% Fixed 2,000,000 -
October 22, 2007 N/A 3.62% Fixed 2,000,000 -
April 20, 2005 N/A 2.07% Fixed 1,500,000 -
November 22, 2010 November 22, 2004 and every -
three months thereafter 3.45% Fixed 3,000,000 -
November 24, 2008 November 22, 2004 and every -
three months thereafter 3.12% Fixed 5,000,000 -
May 24, 2005 N/A 2.06% Fixed 2,000,000 -
November 24, 2006 N/A 2.99% Fixed 3,000,000 -
November 25, 2005 N/A 2.37% Fixed 2,000,000 -
------------ ------------
$ 56,422,156 23,000,000
============ ============
The FHLB has the option to convert $31,000,000 of the total advances
outstanding into three month LIBOR-based floating rate advances. If the
FHLB elects to convert the advances, the Bank may terminate the transaction
without payment of a prepayment fee.
The Bank is required to purchase and hold certain amounts of FHLB stock in
order to obtain FHLB borrowings. No ready market exists for the FHLB stock,
and it has no quoted market value. The stock is redeemable at $100 per
share subject to certain limitations set by the FHLB. At December 31, 2003
and 2002 the Bank owned FHLB stock amounting to $ 2,821,200 and $1,560,100,
respectively, which is pledged as collateral for outstanding advances.
(8) TRUST PREFERRED SECURITIES
In February 2001 the Company formed a wholly-owned Connecticut statutory
trust, Heritage Trust, which issued $10 million of trust preferred
securities that qualify as Tier I capital under Federal Reserve Board
guidelines. The Company owns all of the common securities of Heritage
Trust. The proceeds from the issuance of the common securities and the
trust preferred securities were used by Heritage Trust to purchase $10.3
million of junior subordinated debentures of the Company, which pay
interest at 10.20%. The proceeds received by the Company from the sale of
the junior subordinated debentures were used for general purposes,
primarily to provide capital to the Bank.
56
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(8) TRUST PREFERRED SECURITIES, CONTINUED
Under the terms of the indenture, the Company may elect to defer payments
of interest on the junior subordinated debentures for up to ten semiannual
payment periods. For the duration of such deferral period, the Company is
restricted from paying dividends to shareholders and from paying debt that
is junior to the debentures. The Company anticipates that certain interest
payments may need to be deferred during 2004.
The trust preferred securities are mandatorily redeemable upon maturity of
the debentures on December 31, 2031, or upon earlier redemption as provided
in the indenture. The Company has the right to redeem the debentures
purchased by Heritage Trust, in whole or in part, on or after December 31,
2011. As specified in the indenture, if the debentures are redeemed prior
to maturity, the redemption price will be the principal amount and any
accrued but unpaid interest.
(9) INCOME TAXES
The provision for income taxes is summarized as follows:
2003 2002 2001
------------ ----------- ----------
Current $(1,530,643) (1,186,964) 1,488,914
Deferred 2,283,721 (7,019,729) (264,948)
Change in valuation allowance (88,848) 319,472 -
------------ ----------- ----------
$ 664,230 (7,877,221) 1,223,966
============ =========== ==========
The differences between the provision for income taxes and the amount
computed by applying the statutory federal income tax rate to earnings
(loss) before income taxes are as follows:
2003 2002 2001
--------- ----------- ----------
Pre-tax income (loss) at statutory rates (34%) $609,487 (7,582,001) 1,220,562
Differences:
State taxes, net of federal benefit 55,583 (713,600) 43,079
Tax exempt interest income (29,726) (66,900) (57,438)
Change in valuation allowance (88,848) 319,472 -
Compensation expense related to stock options exercised 189,888 - -
Other, net (72,154) 155,808 17,763
--------- ----------- ----------
$664,230 (7,887,221) 1,223,966
========= =========== ==========
57
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(9) INCOME TAXES, CONTINUED
The following summarizes the tax effects of temporary differences that give
rise to significant portions of the deferred tax assets and deferred tax
liabilities. The net deferred tax asset is included as a component of other
assets at December 31, 2003 and 2002.
2003 2002
----------- ----------
Deferred tax assets:
Allowance for loan losses $3,875,795 8,437,534
Deferred compensation on stock options 85,729 297,373
Foreclosed real estate 303,118 -
Net operating loss carryforward 2,842,378 778,114
Other 180,687 47,869
----------- ----------
Total gross deferred tax assets 7,287,707 9,560,890
Valuation allowance (230,624) (319,472)
----------- ----------
Total net deferred tax assets 7,057,083 9,241,418
----------- ----------
Deferred tax liabilities:
Unrealized gains on available-for-sale securities 116,281 37,803
Premises and equipment 484,742 474,204
----------- ----------
Total gross deferred tax liabilities 601,023 512,007
----------- ----------
Net deferred tax asset $6,456,060 8,729,411
=========== ==========
The future tax consequences of the differences between the financial
reporting and tax basis of the Company's assets and liabilities resulted in
a net deferred tax asset. A valuation allowance was established for a
portion of the net deferred tax asset associated with the parent company
state net operating loss carryforwards, as the realization of this portion
of the deferred tax asset is dependent on future state taxable income of
the parent company only. As of December 31, 2003, the Company has net
operating loss carryforwards totaling approximately $7,405,000 for federal
income tax purposes and approximately $10,143,000 for state income tax
purposes that will begin to expire in 2023 unless previously utilized.
(10) RELATED PARTY TRANSACTIONS
The Company conducts transactions with its directors and executive
officers, including companies in which they have beneficial interests, in
the normal course of business. It is the policy of the Company that loan
transactions with directors and officers be made on substantially the same
terms as those prevailing at the time made for comparable loans to other
persons. The following is a summary of activity for related party loans for
2003:
Beginning balance $15,812,000
New loans 9,237,000
Repayments (9,019,000)
Charged-off (8,000)
------------
Ending balance $16,022,000
============
At December 31, 2003 and 2002, the Company had deposit relationships with
related parties of approximately $1,552,000 and $3,512,000, respectively.
58
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(11) COMMITMENTS
The Company leases various office space for banking and operational
facilities under operating lease arrangements. Future minimum lease
payments required for all operating leases having a remaining term in
excess of one year at December 31, 2003 are as follows:
Year Ending December 31, Amount
------------------------ ----------
2004 $ 859,142
2005 868,381
2006 871,881
2007 742,988
2008 649,751
Thereafter 2,430,782
----------
Total minimum obligation $6,422,925
==========
Total rent expense was approximately $780,000, $636,000 and $458,000, for
2003, 2002 and 2001, respectively.
The Company is a party to financial instruments with off-balance-sheet risk
in the normal course of business to meet the financing needs of its
customers. These financial instruments include commitments to extend
credit, standby letters of credit and financial guarantees. Those
instruments involve, to varying degrees, elements of credit risk in excess
of the amount recognized in the balance sheet. The contract amounts of
those instruments reflect the extent of involvement the Company has in
particular classes of financial instruments.
The exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit and
standby letters of credit and financial guarantees written is represented
by the contractual amount of those instruments. The Company uses the same
credit policies in making commitments and conditional obligations as it
does for on-balance-sheet instruments.
In most cases, the Company requires collateral or other security to support
financial instruments with credit risk.
Contractual Amount
-----------------------
2003 2002
----------- ----------
Financial instruments whose contract amounts represent credit risk:
Commitments to extend credit $34,936,000 75,574,000
Standby letters of credit and financial guarantees written $ 3,303,000 3,259,000
Commitments to extend credit are agreements to lend to a customer as long
as there is no violation of any condition established in the contract.
Commitments generally have fixed expiration dates or other termination
clauses and may require payment of a fee. Since many of the commitments may
expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements. The Company evaluates each
customer's creditworthiness on a case-by-case basis. The amount of
collateral obtained, if deemed necessary by the Company, upon extension of
credit is based on management's credit evaluation. Collateral held varies
but may include unimproved and improved real estate, certificates of
deposit, or personal property.
Standby letters of credit and financial guarantees written are conditional
commitments issued by the Company to guarantee the performance of a
customer to a third party. Those guarantees are primarily issued to
businesses in the Company's delineated trade area. The credit risk involved
in issuing letters of credit is essentially the same as that involved in
extending loan facilities to customers. The Company holds real estate,
equipment,
59
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(11) COMMITMENTS, CONTINUED
automobiles and customer deposits as collateral supporting those
commitments for which collateral is deemed necessary.
The Company has employment agreements with certain key employees. The
agreements, among other things, include salary, bonus, incentive stock
option, and change in control provisions.
The Company has $12,094,000 available for the purchase of overnight federal
funds from three correspondent financial institutions.
(12) CONTINGENCIES
The Bank received demand letters from two former directors, officers, and
employees of the Bank. The Bank terminated such officers in November 2002
for cause, as such term is defined by their respective employment
contracts. One officer has claimed monetary compensation, stock options and
attorneys' fees, while the second officer has claimed monetary
compensation, as well as stock options and payment of country club dues for
two years following the date of his termination. The Bank maintains that it
terminated each of these officers for "cause" and that it is under no
obligation to pay them any additional compensation. On March 14, 2003, one
of these officers filed a lawsuit against the Bank in the Circuit Court for
Morgan County, Alabama, alleging breach of contract and demanding the
benefits due under his employment agreement. The Bank subsequently 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. The Bank successfully removed each of these
cases to the United States District Court for the Northern District of
Alabama. On March 9, 2004, the Bank reached agreement on the settlement of
the claims of one of the former officers. The Bank intends to vigorously
defend the remaining action brought against the Bank, and does not believe
that the final outcome will have a material impact on the Bank or the
Company.
(13) EMPLOYEE AND DIRECTOR BENEFIT PROGRAMS
The Company has a profit sharing and 401(k) plan for the benefit of
substantially all employees subject to certain minimum age and service
requirements. Under this plan, the employees may defer up to fifteen
percent of their compensation with a fifty percent matching employer
contribution of up to six percent of compensation. The Company's
contribution pursuant to this formula was approximately $275,000, $92,000
and $66,000 for the years of 2003, 2002 and 2001, respectively. The vesting
schedule for the plan begins at 20% after three years of employment and
graduates to 50% in year 4 and reaches 100% after five years of employment.
The Bank also adopted an Employee Stock Purchase Plan (the "ESPP") on June
20,1995. The Company assumed the ESPP in its holding company reorganization
that was finalized in August 2000. The ESPP covers substantially all
employees, subject to eligibility requirements. Under the ESPP, employees
are given the opportunity to subscribe to purchase shares of the Company's
common stock at a purchase price equivalent to 85% of the stated fair value
of the common stock, as determined by the board of directors of the
Company. Employee contributions to the ESPP are made through payroll
deduction. The maximum number of shares available-for-sale under the ESPP
is 100,000. The Board approved and ratified modification of the ESPP on May
8, 2001.
60
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(13) EMPLOYEE AND DIRECTOR BENEFIT PROGRAMS, CONTINUED
The Company has an Incentive Stock Compensation Plan (the "Compensation
Plan") whereby the Company may grant stock options to eligible directors
and key employees. Under the Compensation Plan, the Company has entered
into incentive stock option agreements and nonqualified option agreements
(together the "Agreements") which provide for these directors and key
employees to purchase shares of Company's $0.01 par value common stock at
the fair market value at the dates of grant. The following summary sets
forth activity under the Agreements for years ended December 31, 2003,
2002, and 2001:
2003 2002 2001
-------------------------- ------------------------- -------------------------
Weighted Weighted Weighted
Average Average Average
Option Price Option Price Option Price
Shares Per Share Shares Per Share Shares Per Share
----------- ------------- ---------- ------------- ---------- -------------
Outstanding, beginning of year 3,239,016 $ 3.75 3,957,032 $ 3.77 3,970,032 $ 3.72
Granted during the year 462,000 $ 3.41 120,000 $ 3.34 23,000 $ 11.50
Forfeited during the year (684,586) $ 4.47 (387,000) $ 3.70 - $ -
Exercised during the year (1,140,430) $ 3.31 (451,016) $ 3.89 (36,000) $ 2.42
----------- ------------- ---------- ------------- ---------- -------------
Outstanding, end of year 1,876,000 $ 3.67 3,239,016 $ 3.75 3,957,032 $ 3.77
=========== ============= ========== ============= ========== =============
Number of shares exercisable 960,367 $ 3.35 1,559,816 $ 3.92 1,630,232 $ 4.03
=========== ============= ========== ============= ========== =============
Options outstanding at December 31, 2003 are exercisable at option prices
ranging from $3.34 to $11.50, as presented in the table below. Such options
have a weighted average remaining contractual life of approximately eight
years.
Options Exercise Price Expiration Date Exercisable
--------- --------------- ----------------- -----------
1,410,000 $ 3.34 August, 2008 846,000
275,000 $ 3.34 December, 2012 107,000
35,000 $ 3.34 January, 2013 -
25,000 $ 3.34 May, 2013 4,167
49,500 $ 3.34 June, 2013 -
1,000 $ 3.75 March, 2006 600
15,000 $ 3.75 July, 2013 -
23,000 $ 3.75 August, 2013 -
15,000 $ 3.75 September, 2013 -
10,000 $ 3.75 October, 2013 -
4,000 $ 3.75 November, 2013 -
7,500 $ 3.75 November, 2013 -
3,000 $ 3.75 November, 2013 -
2,000 $ 6.50 July, 2004 2,000
1,000 $ 11.50 March, 2006 600
--------- --------------- -----------
1,876,000 $ 3.67 960,367
========= =============== ===========
At December 31, 2003, the shares under option include 1,410,000
nonqualified options issued primarily to Company directors and 466,000
incentive stock options issued to certain key employees of the Company.
61
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(14) REGULATORY MATTERS
The Company is subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum
capital requirements can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken, could have a
direct material effect on the Company's financial statements. Under capital
adequacy guidelines and the regulatory framework for prompt corrective
action, the Company must meet specific capital guidelines that involve
quantitative measures of the assets, liabilities and certain
off-balance-sheet items as calculated under regulatory accounting
practices. The capital amounts and classification are also subject to
qualitative judgments by the regulators about components, risk weightings,
and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company to maintain minimum amounts and ratios (set forth in
the table below) of total and Tier 1 capital (as defined in the
regulations) to risk-weighted assets (as defined), and of Tier 1 capital to
average assets (as defined). Management believes, as of December 31, 2003,
that the Company and the Bank meet all capital adequacy requirements to
which they are subject.
As of December 31, 2003, the most recent notification from the FDIC
categorized the Bank as well capitalized under the regulatory framework for
prompt corrective action. As of December 31, 2002, the most recent
notification from the FDIC categorized the Bank as adequately capitalized
under the regulatory framework for prompt corrective action. To be
categorized as well capitalized and adequately capitalized the Bank must
maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage
ratios as set forth in the table. There are no conditions or events since
that notification that management believes have changed the Bank's
category.
The Company's and the Bank's actual capital amounts and ratios are
presented below.
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
--------------- -------------------- -----------------------
Amount Ratio Amount Ratio Amount Ratio
------- ------ --------- --------- ---------- -----------
(dollars in thousands)
AS OF DECEMBER 31, 2003:
Total Capital (to Risk-Weighted Assets)
Consolidated $41,845 10.28% $ 32,561 8.00% N/A N/A
Bank $49,246 11.99% $ 32,866 8.00% $ 41,082 10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated $35,113 8.63% $ 16,280 4.00% N/A N/A
Bank $43,994 10.71% $ 16,433 4.00% $ 24,649 6.00%
Tier 1 Capital (to Average Assets)
Consolidated $35,113 6.31% $ 22,257 4.00% N/A N/A
Bank $43,994 8.64% $ 20,372 4.00% $ 25,465 5.00%
AS OF DECEMBER 31, 2002:
Total Capital (to Risk-Weighted Assets)
Consolidated $39,436 7.81% $ 40,410 8.00% N/A N/A
Bank $45,182 8.98% $ 40,233 8.00% $ 50,292 10.00%
Tier 1 Capital (to Risk-Weighted Assets)
Consolidated $30,479 6.09% $ 20,205 4.00% N/A N/A
Bank $38,640 7.68% $ 20,117 4.00% $ 30,175 6.00%
Tier 1 Capital (to Average Assets)
Consolidated $30,749 4.94% $ 24,923 4.00% N/A N/A
Bank $38,640 5.99% $ 25,794 4.00% $ 32,243 5.00%
62
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(15) SHAREHOLDERS' EQUITY
Dividends paid by the Bank are the primary source of funds available to the
Company. Banking regulations limit the amount of dividends that may be paid
without prior approval of the regulatory authorities. These restrictions
for the Bank are based on the level of regulatory classified assets, prior
year's earnings, and the ratio of equity capital to total assets. Pursuant
to the regulatory restrictions discussed in note 1, the Bank cannot pay any
cash dividends without prior approval of the regulatory authorities.
During 2003, the Company sold 693,035 shares of common stock through a
private placement at a price of $3.34 per share. The private placement was
completed on April 14, 2003 and resulted in total net proceeds of
$2,294,608. As shares were offered and sold pursuant to an exemption for
the registration requirements of the applicable Federal and state
securities laws, none of the offered and sold shares will be registered
with the United States Securities and Exchange Commission or any state
securities commission. The proceeds of this offering were used to increase
the Bank's regulatory capital ratios and for general corporate purposes.
The Board of Directors, at its discretion, can issue shares of preferred
stock up to a maximum of 10,000,000 shares. The Board is authorized to
determine the number of shares, voting powers, designations, preferences,
limitations and relative rights.
(16) OTHER OPERATING EXPENSES
Other operating expenses for the years ended December 31 2003, 2002 and
2001 included the following items that exceeded one percent of total
revenues:
2003 2002 2001
---------- --------- -------
Professional fees $1,733,948 1,275,308 582,783
Charge off and collection expense 54,873 532,782 139,469
FDIC insurance 426,532 102,000 86,000
Data processing 675,592 420,998 190,300
Advertising 541,803 401,505 336,017
Supplies 357,914 398,449 262,024
(17) FAIR VALUE OF FINANCIAL INSTRUMENTS
The Company is required to disclose fair value information about financial
instruments, whether or not recognized on the face of the balance sheet,
for which it is practicable to estimate that value. The assumptions used in
the estimation of the fair value of the Company's financial instruments are
detailed below. Where quoted prices are not available, fair values are
based on estimates using discounted cash flows and other valuation
techniques. The use of discounted cash flows can be significantly affected
by the assumptions used, including the discount rate and estimates of
future cash flows. The following disclosures should not be considered a
surrogate of the liquidation value of the Company, but rather a good faith
estimate of the increase or decrease in value of financial instruments held
by the Company since purchase, origination, or issuance.
Cash and Cash Equivalents
----------------------------
For cash, due from banks, interest-bearing deposits with other banks,
and federal funds sold, the carrying amount is a reasonable estimate
of fair value.
Investment Securities Available-for-sale
------------------------------------------
Fair values for investment securities are based on quoted market
prices.
Other Investments
------------------
The carrying amount of other investments approximates fair value.
63
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(17) FAIR VALUE OF FINANCIAL INSTRUMENTS, CONTINUED
Loans and Mortgage Loans Held-for-sale
------------------------------------------
The fair value of fixed rate loans is estimated by discounting the
future cash flows using the current rates at which similar loans would
be made to borrowers with similar credit ratings. For variable rate
loans, the carrying amount is a reasonable estimate of fair value.
Mortgage loans held-for-sale are valued based on the current price at
which these loans could be sold into the secondary market.
Cash Surrender Value of Life Insurance
-------------------------------------------
For cash surrender value of life insurance, the carrying value is a
reasonable estimate of fair value.
Deposits
--------
The fair value of demand deposits, interest-bearing demand deposits,
and savings, is the amount payable on demand at the reporting date.
The fair value of fixed maturity certificates of deposit is estimated
by discounting the future cash flows using the rates currently offered
for deposits of similar remaining maturities.
Federal Funds Purchased
-------------------------
Because federal funds purchased are acquired at variable rates that
reset frequently and are generally short-term in nature, the carrying
value is a reasonable estimate of fair value.
Note Payable
-------------
Because the Company's note payable bears interest at a floating rate
that resets frequently, the carrying amount is a reasonable estimate
of fair value.
FHLB Advances
--------------
The fair value of FHLB advances is estimated based upon discounted
future cash flows using a discount rate comparable to the current
market rate for such borrowings.
Trust Preferred Securities
----------------------------
The fair value of the trust preferred securities is estimated based
upon discounted future cash flows using a discount rate comparable to
the current market rate for such borrowings.
Commitments to Extend Credit and Standby Letters of Credit
------------------------------------------------------------------
Commitments to extend credit and standby letters of credit are
generally short-term and at variable interest rates. Therefore, both
the carrying value and estimated fair value associated with these
instruments are immaterial.
Limitations
-----------
Fair value estimates are made at a specific point in time, based on
relevant market information and information about the financial
instrument. These estimates do not reflect any premium or discount
that could result from offering for sale at one time the Company's
entire holdings of a particular financial instrument. Because no
market exists for a significant portion of the Company's financial
instruments, fair value estimates are based on many judgments. These
estimates are subjective in nature and involve uncertainties and
matters of significant judgment and therefore cannot be determined
with precision. Changes in assumptions could significantly affect the
estimates.
Fair value estimates are based on existing on and off-balance sheet
financial instruments without attempting to estimate the value of
anticipated future business and the value of assets and liabilities
that are not considered financial instruments. Significant assets and
liabilities that are not considered financial instruments include the
deferred income taxes and premises and equipment. In addition, the tax
ramifications related to the realization of the unrealized gains and
losses can have a significant effect on fair value estimates and have
not been considered in the estimates.
64
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(17) FAIR VALUE OF FINANCIAL INSTRUMENTS, CONTINUED
The carrying amount and estimated fair values of the Company's financial
instruments at December 31, 2003 and 2002 are as follows:
2003 2002
--------------------- --------------------
Carrying Estimated Carrying Estimated
Amount Fair Value Amount Fair Value
--------- ---------- -------- ----------
(In thousands)
Assets:
Cash and cash equivalents $ 9,411 9,411 19,539 19,539
Investment securities $ 99,038 99,038 35,126 35,126
Other investments $ 2,897 2,897 1,636 1,636
Mortgage loans held-for-sale $ 5,996 5,996 12,343 12,343
Loans, net $ 371,325 366,334 496,859 527,056
Cash surrender value life insurance $ 11,015 11,015 - -
Liabilities:
Deposits $ 415,615 419,981 525,631 527,869
Federal funds purchased $ 406 406 - -
Note payable $ 7,480 7,480 6,650 6,650
Trust Preferred Securities $ 10,000 13,639 10,000 10,000
FHLB advances $ 56,422 54,990 23,000 30,829
65
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(18) HERITAGE FINANCIAL HOLDING COMPANY (PARENT COMPANY ONLY) CONDENSED
FINANCIAL STATEMENTS
BALANCE SHEETS
DECEMBER 31, 2003 AND 2002
2003 2002
----------- ----------
Assets
------
Cash $ 928,966 15,853
Investment in subsidiaries 46,279,649 39,017,232
Other assets 1,091,079 2,530,043
----------- ----------
$48,299,694 41,563,128
=========== ==========
Liabilities and Shareholders' Equity
------------------------------------
Note payable $ 7,480,000 6,650,000
Junior subordinated debentures 10,310,000 10,310,000
Other liabilities 404,302 900,082
Shareholders' equity 30,105,392 23,703,046
----------- ----------
$48,299,694 41,563,128
=========== ==========
STATEMENTS OF EARNINGS
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
2003 2002 2001
------------ ------------ ---------
Dividends from subsidiaries $ 31,620 720,000 2,115,710
Interest income - 31,357 27,228
Management fees - - 218,000
------------ ------------ ---------
Total income 31,620 751,357 2,360,938
------------ ------------ ---------
Expenses:
Interest 1,305,928 1,099,886 905,562
Salaries and benefits - 2,119,946 394,734
Other operating expenses 334,019 538,525 471,462
------------ ------------ ---------
Total expenses 1,639,947 3,758,357 1,771,758
------------ ------------ ---------
Earnings (loss) before income tax benefit and equity in
undistributed earnings (loss) of subsidiaries (1,608,327) (3,007,000) 589,180
Income tax benefit 609,252 1,279,879 583,857
------------ ------------ ---------
Earnings (loss) before equity in undistributed
earnings (loss) of subsidiaries (999,075) (1,727,121) 1,173,037
Equity in undistributed earnings (loss) of subsidiaries 2,127,455 (12,685,662) 1,192,884
------------ ------------ ---------
Net earnings (loss) $ 1,128,380 (14,412,783) 2,365,921
============ ============ =========
66
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(18) HERITAGE FINANCIAL HOLDING COMPANY (PARENT COMPANY ONLY) CONDENSED
FINANCIAL STATEMENTS CONTINUED
STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
2003 2002 2001
------------ ------------ ------------
Cash flows from operating activities:
Net earnings (loss) $ 1,128,380 (14,412,783) 2,365,921
Adjustments to reconcile net earnings (loss) to net
cash provided (used) by operating activities:
Equity in undistributed (earnings) loss of subsidiaries (2,127,455) 12,685,662 (1,192,884)
Compensatory options - 1,126,914 37,843
Change in:
Other assets 1,438,964 (112,244) (792,886)
Other liabilities (495,780) - -
------------ ------------ ------------
Net cash provided (used) by operating activities (55,891) (712,451) 417,994
------------ ------------ ------------
Cash flows from investing activities consisting of
capital contributions to subsidiaries (4,965,946) (6,500,000) (10,320,200)
------------ ------------ ------------
Cash flows from financing activities:
Proceeds from note payable 830,000 6,650,000 -
Issuance of junior subordinated debentures - - 10,310,000
Proceeds from exercise of stock options 2,801,399 23,571 87,210
Proceeds from issuance of stock 2,303,551 25,195 31,445
------------ ------------ ------------
Net cash provided by financing activities 5,934,950 6,698,766 10,428,655
------------ ------------ ------------
Net change in cash 913,113 (513,685) 526,449
Cash at beginning of year 15,853 529,538 3,089
------------ ------------ ------------
Cash at end of year $ 928,966 15,853 529,538
============ ============ ============
67
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
On July 18, 2003, the Company filed a Form 8-K regarding the dismissal of
Schauer Taylor Cox Vise Morgan & Fowler, P.C. ("Schauer Taylor"), as its
independent accountants. The Company dismissed Schauer Taylor on July 9, 2003
and appointed Porter Keadle Moore, LLP ("PKM") as its new independent
accountants on the same date, effective immediately. This determination followed
the Company's decision to seek proposals from independent accountants to audit
the Company's financial statements for the fiscal year ending December 31, 2003.
The decision to dismiss Schauer Taylor and to retain PKM was approved by the
Company's Audit Committee on July 9, 2003. Schauer Taylor's report on the
Company's 2002 financial statements was issued earlier in February, 2003, in
conjunction with the filing of the Company's Annual Report on Form 10-K for the
year ended December 31, 2002.
During the Company's two most recent fiscal years ended December 31, 2002,
and the subsequent interim period through July 8, 2003, there were no
disagreements between the Company and Schauer Taylor on any matter of accounting
principles or practices, financial statement disclosure, or auditing scope or
procedure, which disagreements, if not resolved to Schauer Taylor's
satisfaction, would have caused Schauer Taylor to make reference to the subject
matter of the disagreement in connection with its reports.
The audit reports of Schauer Taylor on the consolidated financial
statements of the Company and subsidiaries as of and for the fiscal years ended
December 31, 2002 and 2001 did not contain any adverse opinion or disclaimer of
opinion, nor were they qualified or modified as to uncertainty, audit scope, or
accounting principles.
As required by Securities and Exchange Commission regulations, the Company
provided Schauer Taylor with a copy of these disclosures and required that
Schauer Taylor furnish the Company with a letter addressed to the Commission
stating whether it agrees with the statements by the Company and, if not,
stating the respects in which it does not agree. A letter from Schauer Taylor is
attached as Exhibit 16.
None of the reportable events described under Item 304(a)(1)(v) of
Regulation S-K occurred within the Company's two most recent fiscal years and
the subsequent interim period through July 8, 2003.
During the Company's most recent fiscal years ended December 31, 2002, and
the subsequent interim period through July 8, 2003, the Company did not consult
with PKM regarding any of the matters or events set forth in Item 304(a)(2)(i)
and (ii) of Regulation S-K.
ITEM 9A. 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
Annual 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
control over financial reporting to remediate those weaknesses, there have been
no significant changes in either the Company's or the Bank's internal control
over financial reporting during the fourth quarter of 2003 that have materially
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
68
PART III
ITEM 10, 11, 12, 13 AND 14. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT;
EXECUTIVE COMPENSATION; SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS; CERTAIN
RELATIONSHIPS AND RELATED TRANSACTIONS; AND PRINCIPAL ACCOUNTANT FEES
AND SERVICES.
The information set forth under the captions "Directors and Executive
Officers," "Executive Compensation," "Security Ownership of Certain Beneficial
Owners and Management and Related Stockholder Matters," "Certain Relationships
and Related Transactions" and "Principal Accounting Fees and Services" included
in the Company's definitive proxy statement to be filed no later than April 30,
2004, in connection with the Company's 2004 Annual Meeting of Stockholders is
incorporated herein by reference.
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PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) Financial Statements, Financial Schedules and Exhibits.
(1) The consolidated financial statements of Heritage Financial Holding
Corporation and its subsidiaries filed as a part of this Annual Report
on Form 10-K are listed in Item 8 of this Annual Report on Form 10-K,
which is hereby incorporated by reference herein.
(2) All schedules to the consolidated financial statements of Heritage
Financial Holding Corporation and its subsidiaries have been omitted
because they are not required under the related instructions or are
inapplicable, or because the required information has been provided in
the consolidated financial statements or the notes thereto.
(3) The exhibits required by Regulation S-K are set forth in the following
list and are filed either by incorporation by reference from previous
filings with the Securities and Exchange Commission or by attachment
to this Annual Report on Form 10-K as indicated below.
EXHIBIT
NO. EXHIBIT
(3)-1 Certificate of Incorporation of Heritage Financial Holding Corporation, filed as Exhibit 1 to
the Company's Registration Statement on Form 8-A, is hereby incorporated herein by
reference.
(3)-2 Bylaws of Heritage Financial Holding Corporation, filed as Exhibit 2 to the Company's
Registration Statement on Form 8-A, is hereby incorporated herein by reference.
(4)-1 Indenture, dated as of February 22, 2001, between Heritage Financial Holding Corporation
and State Street Bank and Trust Company, filed as Exhibit 4-1 to the Company's annual
report on Form 10-KSB filed March 31, 2001, is hereby incorporated by reference.
(4)-2 Guarantee Agreement, dated as of February 22, 2001, between Heritage Financial Holding
Corporation and State Street Bank and Trust Company, filed as Exhibit 4-2 to the
Company's annual report on Form 10-KSB filed March 31, 2001, is hereby incorporated by
reference.
(4)-3 Placement Agreement, dated as of February 9, 2001, by and among First Tennessee Capital
Markets, Keefe, Bruyette & Woods, Inc., Heritage Financial Holding Corporation and
Heritage Financial Statutory Trust I, filed as Exhibit 4-3 to the Company's annual report on
Form 10-KSB filed March 31, 2001, is hereby incorporated by reference.
(10)-1 Heritage Financial Holding Corporation Employee Stock Purchase Plan, filed as Exhibit (4)-
2 to the Company's Registration Statement on Form S-8 (Registration No. 333-55942), is
hereby incorporated herein by reference.
(10)-2 Heritage Financial Holding Corporation Incentive Stock Compensation Plan, filed as
Exhibit (4)-3 to the Company's Registration Statement on Form S-8 (Registration No. 333-
55942), is hereby incorporated herein by reference.
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EXHIBIT
NO. EXHIBIT
(10)-3 Employment Agreement dated as of January 23, 2003, effective as of October 23, 2002, by
and between Heritage Bank and Larry R. Mathews filed as Exhibit (10) - 5 to the
Company's Annual Report on Form 10-K for the year ended December 31, 2002, is hereby
incorporated by reference.
Employment Agreement dated as of February, 2003, effective as of October 25, 2002, by
(10)-4 and between Heritage Bank and Don H. Pruett filed as Exhibit (10) - 1 to the Company's
Quarterly Report on Form 10-Q for the quarter ended March 31, 2004, is hereby
incorporated by reference.
(10)-5 Employment Agreement dated as of January, 2003, by and between Heritage Bank and
Robert F. Harwell Jr. filed as Exhibit (10) - 2 to the Company's Quarterly Report on Form
10-Q for the quarter ended March 31, 2004, is hereby incorporated by reference.
(10)-6 Employment Agreement dated as of June 10, 2003, effective as of May 23, 2003, by and
between Heritage Bank and William M. Foshee filed as Exhibit (10) - 1 to the Company's
Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 is hereby
incorporated by reference.
(10)-7 Loan Agreement dated as of October 30, 2002, by and between Heritage Financial Holding
Corporation and First Tennessee Bank National Association, filed as Exhibit 99.2 to the
Company's Current Report on Form 8-K on November 5, 2002.
16 Letter from Schauer Taylor Cox Vice Morgan & Fowler, P.C.
21 Subsidiaries of the Registrant
23.1 Consent of Independent Certified Public Accountants
23.2 Consent of Independent Auditors
24 Powers of Attorney.
31.1 Certification of principal executive officer pursuant to Exchange Act Rule 13a - 14(a) or
15d -14(a)
31.2 Certification of principal financial officer pursuant to Exchange Act Rule 13a - 14(a) or
15d -14(a)
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
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
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(b) Reports on Form 8-K
Form 8-K furnished November 7, 2003 to disclose under Item 12 the Company's
earnings for the quarter ended September 30, 2003
(c) Exhibits
The exhibits required to be filed with this Annual Report on Form 10-K pursuant
to Item 601 of Regulation S-K are listed under "Exhibits" in Part IV, Item 15(a)
(3) of this Annual Report on Form 10-K, and are incorporated herein by
reference.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
HERITAGE FINANCIAL HOLDING CORPORATION
Date: March 29, 2004 By /s/ Larry R. Matthews
--------------------------------
Larry R. Matthews
Interim Chief Executive Officer
Date: March 29, 2004 By /s/ William M. Foshee
--------------------------------
William M. Foshee
Chief Financial Officer
73