UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
[ ] 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: 000-31823
HERITAGE FINANCIAL HOLDING CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
Delaware 63 - 1259533
---------------------- -------------------------------
(State of Incorporation) (IRS Employer Identification No.)
211 Lee Street , N.E.
Decatur, Alabama 35601
(Address of principal executive office)
(256) 355-9500
(Issuer's telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last
report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the past 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes X No
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes No X
----- -----
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Common Stock, $0.01 par value Outstanding at August 12, 2004:
10,536,260 Shares
FORM 10-Q
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2004
TABLE OF CONTENTS
PAGE NO.
--------
Part I - FINANCIAL INFORMATION
Item 1 - Financial Statements (Unaudited)
Consolidated Statements of Financial Condition as of
June 30, 2004 and December 31, 2003. . . . . . . . . . . . . . . . 3
Consolidated Statements of Income for the three months
ended June 30, 2004 and 2003 . . . . . . . . . . . . . . . . . . . 4
Consolidated Statements of Comprehensive Income for the
three months ended June 30, 2004 and 2003. . . . . . . . . . . . . 5
Consolidated Statements of Income for the six months
ended June 30, 2004 and 2003 . . . . . . . . . . . . . . . . . . . 6
Consolidated Statements of Comprehensive Income for the
six months ended June 30, 2004 and 2003. . . . . . . . . . . . . . 7
Consolidated Statements of Cash Flow for the
six months ended June 30, 2004 and 2003. . . . . . . . . . . . . . 8
Notes to Consolidated Financial Statements . . . . . . . . . . . . 10
Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations. . . . . . . . . . . 15
Item 3 - Quantitative and Qualitative Disclosures about Market Risk . . . . 26
Item 4 - Controls and Procedures. . . . . . . . . . . . . . . . . . . . . . 27
PART II - Other Information
Item 1 - Legal Proceedings. . . . . . . . . . . . . . . . . . . . . . . . . 27
Item 4 - Submission of Matters to a Vote of Security Holders. . . . . . . . 27
Item 5 - Other Information. . . . . . . . . . . . . . . . . . . . . . . . . 28
Item 6 - Exhibits and Reports on Form 8-K . . . . . . . . . . . . . . . . . 28
SIGNATURES
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
JUNE 30, 2004 (UNAUDITED) AND DECEMBER 31, 2003
JUNE 30,
2004 December 31,
(UNAUDITED) 2003
------------- --------------
ASSETS
Cash and due from banks . . . . . . . . . . . . . . . . . . . $ 12,578,012 $ 8,663,330
Interest bearing deposits with other banks. . . . . . . . . . 818,151 115,551
Federal funds sold. . . . . . . . . . . . . . . . . . . . . . - 632,000
------------- --------------
CASH AND CASH EQUIVALENTS . . . . . . . . . . . . . . . . . 13,396,163 9,410,881
Securities available-for-sale . . . . . . . . . . . . . . . . 95,332,898 99,037,992
Other Investments . . . . . . . . . . . . . . . . . . . . . . 3,987,061 2,897,061
Mortgage loans held-for-sale. . . . . . . . . . . . . . . . . 19,293,341 5,995,929
Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394,538,127 385,886,904
Allowance for loan losses . . . . . . . . . . . . . . . . . . (11,441,341) (14,562,283)
------------- --------------
LOANS, NET. . . . . . . . . . . . . . . . . . . . . . . . . 383,096,787 371,324,621
Premises and equipment, net . . . . . . . . . . . . . . . . . 7,064,416 7,223,966
Accrued interest. . . . . . . . . . . . . . . . . . . . . . . 2,236,399 2,391,861
Cash surrender value of life insurance. . . . . . . . . . . . 11,239,320 11,015,000
Foreclosed real estate. . . . . . . . . . . . . . . . . . . . 1,146,281 4,546,740
Other assets. . . . . . . . . . . . . . . . . . . . . . . . . 8,954,549 8,891,753
------------- --------------
TOTAL ASSETS. . . . . . . . . . . . . . . . . . . . . . . $545,747,216 $ 522,735,804
------------- --------------
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
DEPOSITS
Noninterest bearing . . . . . . . . . . . . . . . . . . . . $ 30,328,038 $ 28,141,627
Interest-bearing. . . . . . . . . . . . . . . . . . . . . . 369,031,982 387,473,302
------------- --------------
TOTAL DEPOSITS. . . . . . . . . . . . . . . . . . . . . . 399,360,020 415,614,929
Short-term borrowings . . . . . . . . . . . . . . . . . . . . 7,480,000 7,480,000
Federal funds purchased . . . . . . . . . . . . . . . . . . . 17,336,761 406,073
Accrued interest. . . . . . . . . . . . . . . . . . . . . . . 1,432,984 1,899,628
FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . 78,222,156 56,422,156
Junior subordinated debentures. . . . . . . . . . . . . . . . 10,310,000 10,310,000
Other liabilities . . . . . . . . . . . . . . . . . . . . . . 1,103,355 497,626
------------- --------------
TOTAL LIABILITIES . . . . . . . . . . . . . . . . . . . . 515,245,276 492,630,412
------------- --------------
STOCKHOLDERS' EQUITY
Preferred stock - par value $0.01 per share; 10,000,000
authorized. . . . . . . . . . . . . . . . . . . . . . . . . - -
Common stock ($.01 par value; 40,000,000 shares authorized,
10,536,260 and 10,510,791 shares issued and outstanding at
June 30, 2004 and December 31, 2003). . . . . . . . . . . . 105,363 105,108
Additional paid-in capital. . . . . . . . . . . . . . . . . . 37,413,445 37,322,707
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . (5,970,083) (7,548,144)
Accumulated other comprehensive income (loss) . . . . . . . . (1,046,785) 225,721
------------- --------------
TOTAL STOCKHOLDERS' EQUITY. . . . . . . . . . . . . . . . 30,501,990 30,105,392
------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY. . . . . . . . $545,747,216 $ 522,735,804
------------- --------------
See notes to consolidated financial statements
3
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30,
-----------------------
2004 2003
---------- -----------
INTEREST INCOME
Interest and fees on loans. . . . . . . . . . . . . . . . . . . $6,058,885 $6,939,758
Interest and dividends on securities:
Taxable securities. . . . . . . . . . . . . . . . . . . . . . 919,761 330,519
Nontaxable securities . . . . . . . . . . . . . . . . . . . . 29,682 17,058
Interest on deposits with other banks . . . . . . . . . . . . . 736 1,262
Interest earned on federal funds sold and securities purchased. 7 38,117
---------- -----------
TOTAL INTEREST INCOME . . . . . . . . . . . . . . . . . . . . 7,009,071 7,326,714
---------- -----------
INTEREST EXPENSE
Interest on deposits. . . . . . . . . . . . . . . . . . . . . . 2,317,887 3,438,018
Interest on FHLB borrowings . . . . . . . . . . . . . . . . . . 496,703 244,500
Interest on fed funds purchased . . . . . . . . . . . . . . . . 35,688 -
Interest on short-term borrowings . . . . . . . . . . . . . . . 68,440 59,560
Interest on junior subordinated debentures. . . . . . . . . . . 262,905 270,810
---------- -----------
TOTAL INTEREST EXPENSE. . . . . . . . . . . . . . . . . . . . 3,181,623 4,012,888
---------- -----------
NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . . 3,827,448 3,313,826
Provision for loan losses . . . . . . . . . . . . . . . . . . . 18,141 (616,200)
---------- -----------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES . . . . . . . 3,809,307 3,930,026
NONINTEREST INCOME
Customer service fees . . . . . . . . . . . . . . . . . . . . . 326,083 286,090
Mortgage banking fee income . . . . . . . . . . . . . . . . . . 755,592 1,233,142
Investment security gains (losses). . . . . . . . . . . . . . . 593,813 (37,580)
Gains (losses) on sale of foreclosed real estate. . . . . . . . 31,323 (93,950)
Other operating income. . . . . . . . . . . . . . . . . . . . . 386,526 250,144
---------- -----------
TOTAL NONINTEREST INCOME. . . . . . . . . . . . . . . . . . . 2,093,337 1,637,846
---------- -----------
NONINTEREST EXPENSES
Salaries and employee benefits. . . . . . . . . . . . . . . . . 2,408,072 2,358,290
Occupancy and equipment expense . . . . . . . . . . . . . . . . 604,316 562,175
Other operating expenses. . . . . . . . . . . . . . . . . . . . 1,440,597 1,873,581
---------- -----------
TOTAL NONINTEREST EXPENSES. . . . . . . . . . . . . . . . . . 4,452,985 4,794,046
---------- -----------
Income before income taxes. . . . . . . . . . . . . . . . . . . . 1,449,659 773,826
Provision for income tax expense. . . . . . . . . . . . . . . . . 487,812 289,238
---------- -----------
NET INCOME. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 961,847 $ 484,588
========== ===========
BASIC EARNINGS PER COMMON SHARE . . . . . . . . . . . . . . . . . $ .09 .05
========== ===========
DILUTED EARNINGS PER COMMON SHARE . . . . . . . . . . . . . . . . $ .09 $ .04
========== ===========
See notes to consolidated financial statements
4
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
THREE MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
THREE MONTHS ENDED
JUNE 30,
-------------------------
2004 2003
------------ -----------
NET INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 961,847 $ 484,588
Other comprehensive income (loss) , net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during the period,
net of tax of $(808,285) and $(20,589) . . . . . . . . . . . . . . . . (1,569,024) (39,967)
Reclassification adjustments for (gains) losses included in net income,
net of tax of $(201,896) and $12,777. . . . . . . . . . . . . . . . . (391,917) 24,803
------------ -----------
Other comprehensive income (loss) . . . . . . . . . . . . . . . . . . (1,960,941) (15,164)
------------ -----------
COMPREHENSIVE INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (999,095) $ 469,424
------------ -----------
5
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
--------------------------
2004 2003
------------ ------------
INTEREST INCOME
Interest and fees on loans. . . . . . . . . . . . . . . . . . . $11,907,643 $15,547,344
Interest and dividends on securities:
Taxable securities. . . . . . . . . . . . . . . . . . . . . . 1,895,216 700,005
Nontaxable securities . . . . . . . . . . . . . . . . . . . . 48,366 34,127
Interest on deposits with other banks . . . . . . . . . . . . . 1,392 2,762
Interest earned on federal funds sold and securities purchased. 566 80,859
------------ ------------
TOTAL INTEREST INCOME . . . . . . . . . . . . . . . . . . . . 13,853,183 16,365,097
------------ ------------
INTEREST EXPENSE
Interest on deposits. . . . . . . . . . . . . . . . . . . . . . 4,706,774 7,382,068
Interest on FHLB borrowings . . . . . . . . . . . . . . . . . . 962,533 489,000
Interest on fed funds purchased . . . . . . . . . . . . . . . . 46,247 -
Interest on short-term borrowings . . . . . . . . . . . . . . . 137,625 116,148
Interest on junior subordinated debentures. . . . . . . . . . . 525,810 525,810
------------ ------------
TOTAL INTEREST EXPENSE. . . . . . . . . . . . . . . . . . . . 6,378,989 8,513,026
------------ ------------
NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . . 7,474,194 7,852,071
Provision for loan losses . . . . . . . . . . . . . . . . . . . (760,412) (516,200)
------------ ------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES . . . . . . . 8,234,606 8,368,271
NONINTEREST INCOME
Customer service fees . . . . . . . . . . . . . . . . . . . . . 625,804 515,375
Mortgage banking fee income . . . . . . . . . . . . . . . . . . 1,079,657 1,437,763
Investment security gains (losses). . . . . . . . . . . . . . . 593,813 184,765
Gains (losses) on sale of foreclosed real estate. . . . . . . . 73,540 (221,600)
Other operating income. . . . . . . . . . . . . . . . . . . . . 738,345 320,276
------------ ------------
TOTAL NONINTEREST INCOME. . . . . . . . . . . . . . . . . . . 3,111,159 2,236,579
------------ ------------
NONINTEREST EXPENSES
Salaries and employee benefits. . . . . . . . . . . . . . . . . 4,615,804 4,352,926
Occupancy and equipment expense . . . . . . . . . . . . . . . . 1,234,886 1,119,751
Other operating expenses. . . . . . . . . . . . . . . . . . . . 3,121,892 3,478,321
------------ ------------
TOTAL NONINTEREST EXPENSES. . . . . . . . . . . . . . . . . . 8,972,582 8,950,998
------------ ------------
Income before income taxes. . . . . . . . . . . . . . . . . . . . 2,373,183 1,653,852
Provision for income tax expense. . . . . . . . . . . . . . . . . 795,122 619,205
------------ ------------
NET INCOME. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,578,061 $ 1,034,647
============ ============
BASIC EARNINGS PER COMMON SHARE . . . . . . . . . . . . . . . . . $ .15 .11
============ ============
DILUTED EARNINGS PER COMMON SHARE . . . . . . . . . . . . . . . . $ .14 $ .11
============ ============
6
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
-------------------------
2004 2003
------------ -----------
NET INCOME. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,578,061 $1,034,647
Other comprehensive income (loss) , net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during the period,
net of tax of $(453,637) and $63,092. . . . . . . . . . . . . (880,589) 122,472
Reclassification adjustments for gains included in net income,
net of tax of $201,896 and $62,820. . . . . . . . . . . . . . (391,917) (121,945)
------------ -----------
Other comprehensive income (loss) . . . . . . . . . . . . . . (1,272,506) 527
------------ -----------
COMPREHENSIVE INCOME. . . . . . . . . . . . . . . . . . . . . . . . $ 305,555 $1,035,174
------------ -----------
7
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
Six Months Ended
June 30,
----------------------------
2004 2003
------------- -------------
OPERATING ACTIVITIES
Net Income . . . . . . . . . . . . . . . . . . . . . . . . $ 1,578,061 $ 1,034,647
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Provision for loan losses. . . . . . . . . . . . . . . . (760,412) (516,200)
Depreciation, amortization, and accretion. . . . . . . . 921,658 550,602
Loss (gain) on sale of other real estate . . . . . . . . (73,540) 221,600
Loss on sale of premises and equipment 6,300 ---
Realized investment security gains . . . . . . . . . . . (593,813) (184,765)
Compensatory options (tax benefit forfeited) --- (5,803)
Changes in:
Accrued interest receivable. . . . . . . . . . . . . . 155,462 988,442
Accrued interest payable . . . . . . . . . . . . . . . (466,644) (1,265,731)
Cash surrender value of life insurance (224,320) ---
Mortgage loans held-for-sale . . . . . . . . . . . . . (13,297,412) (7,153,638)
Other assets . . . . . . . . . . . . . . . . . . . . . 592,743 1,080,348
Other liabilities. . . . . . . . . . . . . . . . . . . 605,728 595,211
------------- -------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES. (11,556,195) (4,655,287)
------------- -------------
INVESTING ACTIVITIES
Purchases of securities available-for-sale . . . . . . . . (27,318,615) (77,197,843)
Proceeds from sales of securities available for sale . . . 20,404,102 14,487,862
Proceeds from calls, paydowns and maturities of
securities available-for-sale. . . . . . . . . . . . . . 8,940,870 58,416,492
Proceeds from sale of other investments 250,000 ---
Purchases of other investments (1,340,000) ---
Net (increase) decrease in loans to customers. . . . . . . (11,523,449) 65,809,094
Purchases of premises and equipment. . . . . . . . . . . . (444,197) (321,299)
Proceeds from disposition of premises and equipment. . . . 20,297 8,474
Proceeds from disposition of foreclosed real estate. . . . 3,985,696 2,498,729
Writedowns of other real estate --- 765,042
------------- -------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES. . . (7,025,292) 64,466,551
------------- -------------
8
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
SIX MONTHS ENDED JUNE 30, 2004 AND 2003
(UNAUDITED)
Six Months Ended
June 30,
----------------------------
2004 2003
------------- -------------
FINANCING ACTIVITIES
Net decrease in deposits. . . . . . . . . . . . . . . . (16,254,909) (63,547,116)
Proceeds from issuance of stock . . . . . . . . . . . . 80,974 2,200,209
Proceeds from federal funds purchased . . . . . . . . . 16,930,688 ---
Proceeds from FHLB advances . . . . . . . . . . . . . . 21,800,000 ---
Proceeds from short-term debt . . . . . . . . . . . . . --- 830,000
Proceeds from exercise of stock options . . . . . . . . 10,020 2,601,300
------------- -------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 22,556,773 (57,915,607)
------------- -------------
NET INCREASE IN CASH AND CASH EQUIVALENTS . . . . . . . . 3,985,282 1,895,657
Cash and Cash Equivalents at Beginning of Period. . . . . 9,410,881 19,538,515
------------- -------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD. . . . . . . . $ 13,396,165 21,434,172
------------- -------------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest. . . . . . . . . . . . . . . . . . . . . . . $ 6,845,633 $ 9,778,757
Taxes --- ---
Noncash investing and financing activities:
Change in other comprehensive, net. . . . . . . . . . $ (1,272,506) $ 527
Transfer of loans to other real estate. . . . . . . . $ 511,696 $ 2,375,999
9
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
JUNE 30, 2004
NOTE A - BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Heritage Financial
Holding Corporation and its subsidiary Heritage Bank (the "Bank") collectively,
the Company. The accompanying unaudited consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by accounting principles generally accepted in the United
States of America for complete financial statements. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included. Operating results for the
three and six-month periods ended June 30, 2004 and 2003 are not necessarily
indicative of the results that may be expected for the year ending December 31,
2004.
The consolidated statement of financial condition at December 31, 2003 has been
derived from the audited consolidated financial statements at that date, but
does not include all of the information and footnotes required by accounting
principles generally accepted in the United States of America for complete
financial statements.
CRITICAL ACCOUNTING POLICIES
The accounting and financial reporting policies of the Company conform to
accounting principles generally accepted in the United States of America and to
general practices within the banking industry. Following is a description of the
accounting policies applied by the Company which are deemed critical by Company
management. In determining which accounting policies are critical in nature, the
Company has identified the policies that require significant judgment or involve
complex estimates. The application of these policies has a significant impact on
the Company's financial statements. Financial results could differ significantly
if different judgments or estimates are applied.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established through provisions for loan losses
charged to operations. Loans are charged against the allowance for loan losses
when management believes that the collection of principal is unlikely.
Subsequent recoveries are added to the allowance. Management's evaluation of the
adequacy of the allowance for loan losses is based on a formal analysis which
assesses the risk within the loan portfolio. This analysis includes
consideration of historical performance, current economic conditions, and levels
of nonperforming loans, loan concentrations and review of certain individual
loans. Management believes that the allowance for loan losses is adequate. While
management uses available information to recognize losses on loans, future
additions to the allowance for loan losses may be necessary based on changes in
economic conditions and the results of management's ongoing review of the loan
portfolio. In addition, various regulatory agencies, as an integral part of
their examination
10
process, periodically review the Bank's allowance for loan losses. Such agencies
may require the Bank to recognize additions to the allowance for loan losses
based on their judgment.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these estimates.
For further information, refer to the consolidated financial statements and
footnotes thereto for Heritage Financial Holding Corporation and subsidiaries
for the year ended December 31, 2003, included in the Company's Annual Report on
Form 10-K.
NOTE B - INCOME TAXES
The effective tax rates of approximately 33.50 % and 37.40 % for the six months
ended June 30, 2004 and 2003, respectively, differ from the statutory rate
principally because of the effect of state income taxes.
NOTE C - SECURITIES
The Company applies the accounting and reporting requirements of Statement of
Financial Accounting Standards No. 115, Accounting for Certain Investments in
Debt and Equity Securities ("SFAS 115"). This pronouncement requires that all
investments in debt securities be classified as either "held-to-maturity"
securities, which are reported at amortized cost; "trading" securities, which
are reported at fair value, with unrealized gains and losses included in
earnings; or "available-for-sale" securities, which are reported at fair value,
with unrealized gains and losses excluded from earnings and reported in a
separate component of stockholders' equity (net of deferred tax effect).
At June 30, 2004, the Company had net unrealized losses of approximately
$1,586,000 in available-for-sale securities which are reflected in the presented
assets and resulted in a decrease in stockholders' equity of $1,047,000, net of
deferred taxes. There were no held-to-maturity or trading securities at June 30,
2004 or December 31, 2003.
NOTE D - TRUST PREFERRED SECURITIES
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
11
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 became effective for the Company for financial statements in
periods after December 31, 2003.
The Company now applies the provisions of FIN 46 to its wholly-owned subsidiary
trust that issued capital securities to third-party investors. The application
of FIN 46 resulted in the deconsolidation of the wholly-owned subsidiary trust.
Deconsolidation resulted in increases in other assets and trust preferred
securities of $310,000 as of June 30, 2004 and December 31, 2003.
NOTE E - RECENT DEVELOPMENTS
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 2004
and an increase in the Bank's Tier I leverage ratio to 8.53% as of June 30,
2004. 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.
On July 15, 2004, the Company and The Peoples Holding Company ("Peoples")
entered into a definitive merger agreement. According to the agreement, the
Company will merge with and into Peoples, and each Company shareholder may elect
to receive one of the three following options: (1) 0.200 shares of Peoples
common stock for each share of Company common stock, (2) $6.25 in cash for each
share of Company common stock, or (3) a combination of 40% cash and 60% common
stock at the same exchange ratio listed above, subject to the overall limitation
that the aggregate stock consideration will equal approximately 60% of the total
consideration received by Company shareholders. The merger is expected to close
in the first quarter of 2005 and is subject to certain closing conditions and
regulatory approval.
NOTE F - STOCK-BASED COMPENSATION
The Company has long-term incentive stock option plans and an employee stock
purchase plan. The Company accounts for those plans under the recognition and
measurement principles of APB Opinion 25, Accounting for Stock Issued to
Employees, and related interpretations using the intrinsic value based method,
as permitted by Statement of Financial Accounting Standards (SFAS) No. 123,
Accounting for Stock-based Compensation and SFAS No. 148, Accounting for
Stock-Based Compensation - Transition and Disclosure. No stock-based employee
compensation cost has been reflected in net income for these plans. Net income
and earnings per share would not be materially different during the three and
six month periods ended June 30, 2004 and 2003 if the Company had applied the
fair value based method of SFAS No. 123. The fair value for these options was
estimated at the dates of grant using the Black-Scholes option pricing model.
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options that have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the
12
expected stock price volatility. Because the Company's employee stock options
have characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
NOTE G - COMMITMENTS
In the normal course of business, the Company enters into commitments to extend
credit which are agreements to lend to customers as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and generally require a
payment of fees. Since many of the commitments are expected to expire without
being drawn upon, the total amounts do not necessarily represent expected future
cash flows.
Standby letters of credit are commitments issued by the Company to guarantee the
performance of a customer to a third party. These guarantees are primarily
issued to support public and private borrowing arrangements, including
commercial paper, bond financing and similar transactions, and expire in
decreasing amounts with terms ranging from one to four years. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to customers.
The following represents the Company's commitments to extend credit and standby
letters of credit as of June 30, 2004 and December 31, 2003:
June 30, December 31,
2004 2003
----------- -------------
Commitments to extend credit . . . . . . . . $29,268,000 $ 34,936,000
Standby and commercial letters of credit . . 2,517,000 3,303,000
----------- -------------
Total commitments. . . . . . . . . . . . . . $31,785,000 $ 38,239,000
----------- -------------
13
NOTE H - EARNINGS PER SHARE
Basic earnings per share are based on the weighted average number of common
shares outstanding during the period while the effects of potential shares
outstanding during the period are included in diluted earnings per share. The
reconciliation of the amounts used in the computation of both "basic earnings
per share" and "diluted earnings per share" for the three and six months ended
June 30, 2004 and 2003 presented in the financial statements were calculated as
follows:
2004 2003
----------- ----------
Common Per Share Net Common Per Share
Net Income Share Amount Income Share Amount
For the quarters ended June
30, 2004 and 2003
Basic earnings per share $ 961,847 10,519,270 $ .09 $ 484,588 10,408,868 $ .05
Effect of stock options - 531,035 0.00 - 654,441 (.01)
----------- ---------- ----------- ---------- ---------- -----------
Diluted earnings per share $ 961,847 11,050,305 $ .09 $ 484,588 11,063,309 $ .04
=========== ========== =========== ========== ========== ===========
2004 2003
----------- ----------
Common Per Share Net Common Per Share
Net Income Share Amount Income Share Amount
For the six months ended June
30, 2004 and 2003
Basic earnings per share $ 1,578,061 10,516,194 $ .15 $1,034,647 9,677,464 $ .11
Effect of stock options - 532,181 (0.01) - 1,106,259 .00
----------- ---------- ----------- ---------- ---------- -----------
Diluted earnings per share $ 1,578,067 11,048,375 $ .14 $1,034,647 10,783,723 $ .11
=========== ========== =========== ========== ========== ===========
14
ITEM 2. - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Heritage Financial Holding Corporation (the "Company") is primarily engaged in
the business of directing and planning the activities of its wholly owned
subsidiary, Heritage Bank (the "Bank"). The Company's primary asset is its
investment in the Bank.
The consolidated operating results of the Company include those of the Company
and the Bank. All significant intercompany transactions and balances have been
eliminated in consolidation. The operating results of the Company depend
primarily on net interest income, which is the difference between interest
income on interest-earning assets, primarily loans and investment securities,
and interest expense on interest-bearing liabilities, primarily deposits and
advances from the Federal Home Loan Bank ("FHLB") and other sources. Net
earnings are also affected by non-interest income and non-interest expenses,
such as fees, compensation and benefits, building and occupancy expense, and
other expenses.
The discussion and analysis included herein covers material changes in financial
condition, liquidity and capital resources that have occurred since December 31,
2003, as well as certain material changes in results of operations during the
three and six months ended June 30, 2004 as compared to the same periods in
2003.
This discussion is intended to assist in an understanding of the Company and its
subsidiary's financial condition and results of operations. Unless the context
otherwise indicates, "the Company" shall include the Company and its subsidiary.
This analysis should be read in conjunction with the consolidated financial
statements and related notes appearing in Item 1 of the Company's Quarterly
Report on Form 10-Q for the period ended June 30, 2004, and "Management's
Discussion and Analysis of Financial Condition and Results of Operations,"
appearing in the Company's Annual Report on Form 10-K for the year ended
December 31, 2003.
OVERVIEW
The Bank is a $544 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 are salaries and
benefits, occupancy, 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.
We reported net income of $1,578,000 for the first six months of 2004. Net
income increased 53% over the $1,035,000 reported in the first six months of
2003. Diluted earnings per share for the first six months of 2004 were $.14 per
share versus $.11 per share in the prior year period.
During the first half of 2004, we experienced an increase in assets, as total
assets increased $23,011,000 (4.4%) to $545,747,000 from the 2003 year-end
balance. On a year-over-year basis, total assets increased $10,052,000 (1.9%)
from the $535,695,000 balance at June 30, 2003. At the end of the first half of
2004, total net loans were $383,097,000, an increase of $11,772,000 (3.2%) from
year-end, but a decrease of
15
approximately $45.1 million (10.5%) on a year-over-year basis. Deposits
decreased $16,255,000 (3.9%) in the first half of 2004 to $399,360,000 from the
2003 year-end balance. Deposits decreased $62,724,000 (13.6%) on a
year-over-year basis from June 30, 2003 to June 30, 2004.
At June 30, 2004, non-performing assets totaled $11,639,000, a decrease of
$5,955,000 from the December 31, 2003 balance of $17,594,000. The ratio of
non-performing assets to total assets decreased from 3.37% at December 31, 2003
to 2.10% at June 30, 2004. The ratio of non-performing loans to total loans
decreased from 3.51% to 2.74% during the first half of 2004.
The Bank ended the first half of 2004 with a Tier 1 risk-based capital ratio of
10.78% and a total risk-based capital ratio of 12.04% compared to 9.23% and
10.53% at the end of the first half of 2003.
The following table provides a summary of the major elements of income and
expense for the periods indicated.
CONDENSED COMPARATIVE INCOME STATEMENT
Percentage
Three months ended Change
June 30, Increase
In Thousands (except percentages) 2004 2003 (Decrease)
----------- ----------- -----------
Interest Income $ 7,009 $ 7,327 (4.3%)
Interest Expense 3,182 4,013 (20.7%)
-----------
Net interest income 3,827 3,314 15.5%
Provision for loan losses 18 (616) (102.9%)
----------- -----------
Net interest income after
provision for loan losses 3,809 3,930 (3.1%)
Noninterest income 2,093 1,638 27.8%
Noninterest expense 4,453 4,794 (7.1%)
----------- -----------
Income before income taxes 1,450 774 87.3%
Income taxes 488 289 68.7%
----------- -----------
Net income $ 962 $ 485 98.4%
=========== ===========
Percentage
Six months ended Change
June 30, Increase
In Thousands (except percentages) 2004 2003 (Decrease)
----------- ----------- -----------
Interest Income $ 13,853 $ 16,365 (15.4%)
Interest Expense 6,379 8,513 (25.1%)
----------- -----------
Net interest income 7,474 7,852 (4.8%)
Provision for loan losses (760) (516) 47.3%
----------- -----------
Net interest income after
provision for loan losses 8,235 8,368 (1.6%)
Noninterest income 3,111 2,237 39.1%
Noninterest expense 8,973 8,951 .2%
----------- -----------
Income before income taxes 2,373 1,654 43.5%
Income taxes 795 619 28.4%
----------- -----------
Net income $ 1,578 $ 1,035 52.5%
=========== ===========
16
HIGHLIGHTS
During the first half of 2004, we continued to work 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 continued to reduce our nonperforming assets to $11,639,000 at
June 30, 2004, from $17,594,000 at December 31, 2003. We also continued our
efforts to originate new loans consistent with the Bank's strengthened credit
standards, and had net originations totaling $11.5 million during the first half
of 2004.
CHALLENGES
While we continued our progress in the reduction of nonperforming assets, we
faced, and will continue to face, challenges to our continued growth. We
experienced a decrease of $16 million in deposits during the first half of 2004,
although much of this decrease was in brokered and out of area deposits.
Deposits are the primary source of funds for supporting our earning assets, and
we continue to strive toward a greater share of the deposit market in our area.
FINANCIAL CONDITION
JUNE 30, 2004 COMPARED TO DECEMBER 31, 2003
LOANS
Loans comprised the largest category of the Company's earning assets on June 30,
2004. Loans, net of allowance for loan losses, were 70.2% of total assets at
June 30, 2004, and 71.0% of total assets at December 31, 2003. Total net loans
were $383,097,000 at June 30, 2004, representing a 3.2% increase from the
December 31, 2003 total of $371,325,000. During 2004, the Company transferred
$512,000 of loans to foreclosed real estate, $2.4 million in net loans were
charged off, a negative provision of $760,000 was recorded and net originations
totaled $11.5 million. Management intends to continue efforts to originate new
loans consistent with the Bank's strengthened credit standards. Mortgage loans
held for sale increased from $6 million at December 31, 2003, to $19.3 million
at June 30, 2004. This increase primarily resulted from the creation of the
wholesale mortgage division in the first quarter of 2004.
ALLOWANCE FOR LOAN LOSSES
When determining the adequacy of the allowance for loan losses, management
considers changes in the size and character of the loan portfolio, changes in
non-performing and past due loans, regulatory classification of assets,
historical loan loss experience, the existing risk of individual loans,
concentrations of loans to specific borrowers or industries, existing and
prospective economic conditions, and other factors. The allowance for loan
losses decreased $3,121,000 during the six months ended June 30, 2004 to
$11,441,000 at June 30, 2004 from $14,562,000 at December 31, 2003. Net charge
offs in an aggregate amount of $2.4 million and the negative provision of
$760,000 accounted for the decrease in the allowance for loan losses. The
allowance for loan losses represented 2.90% and 3.77% of loans
17
receivable at June 30, 2004 and December 31, 2003, respectively. (See further
discussion in "Provision for Loan Losses" below.)
In the opinion of management, the allowance for loan losses was adequate at June
30, 2004 to provide for potential loan losses in the loan portfolio at that
date. While management believes it has established its existing allowance for
loan losses in accordance with accounting principles generally accepted in the
United States of America, there can be no assurance that the Bank will not be
required to increase the allowance in the future. Such increases could have a
material adverse effect on the Bank's financial condition and results of
operations. Losses ultimately confirmed will vary from original estimates as
adjustments are made in the period in which these factors and other
considerations become known.
Changes in the allowance for loan losses for the six months ended June 30, 2004
and 2003 were as follows:
2004 2003
------------ ------------
Balance at beginning of the year $14,562,000 $26,991,000
Charge-offs (2,578,000) (4,467,000)
Recoveries 217,000 181,000
--------------------------
Net charge-offs (2,360,000) (4,286,000)
Provision for loan losses (760,000) (516,000)
--------------------------
Balance as of June 30 $11,441,000 $22,189,000
============ ============
INVESTMENT SECURITIES AND OTHER EARNING ASSETS
The investment securities portfolio is used to make various term investments, to
provide a source of liquidity and to serve as collateral to secure certain
government deposits. Federal funds sold are a tool in managing the daily cash
position of the Company. Investment securities decreased $3,705,000 from
December 31, 2003 to $95,333,000 at June 30, 2004. Federal funds sold decreased
$632,000 from December 31, 2003.
ASSET QUALITY
Between December 31, 2003 and June 30, 2004, the Company experienced a decrease
in nonperforming assets (defined as nonaccrual loans, loans past due 90 days or
greater, restructured loans, nonaccruing securities and other real estate).
Total nonperforming assets decreased from $17,594,000 to $11,639,000 during this
period. The ratio of nonperforming assets to total assets decreased from 3.37%
to 2.13% and the ratio of nonperforming loans to total loans decreased from
3.51% to 2.74% during the first six months of 2004. The reduction in this ratio
is the result of management's aggressive efforts to increase credit quality. The
ratio of loan loss allowance to total nonperforming assets increased from 82.77%
to 98.30%
18
during this same period. The Company competes for loans, and has made certain
loans to businesses, along the Birmingham-Huntsville-Decatur, Alabama high-tech
corridor. During the past year, the high tech industry segment has experienced
and continues to experience a more significant downturn compared with other
sectors of the economy. The Company and the Bank have taken steps to intensively
monitor its overall loan portfolio; including the hiring of additional personnel
to monitor credit quality and adherence to credit policies and procedures.
Management believes that these additions, as well as additional recently
retained personnel, will provide the Bank with the necessary resources to
improve controls over the lending functions, identify any potential areas of
concern in a timelier manner, and ensure that future loans comply with the
Bank's lending policies and procedures.
Accrual of interest is discontinued on a loan when management believes, after
considering economic conditions and collection efforts, that the borrower's
financial condition is such that collection of interest is doubtful. Interest
previously accrued but not collected is reversed against current period earnings
and interest is recognized on a cash basis when such loans are placed on
nonaccrual status. 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.
The following table sets forth nonaccrual loans, loans past due 90 days or more
and foreclosed real estate at June 30, 2004 and December 31,2003:
NONPERFORMING ASSETS
6/30/2004 12/31/2003
----------- -----------
Nonaccruing loans $ 9,679,000 $12,523,000
Loans past due 90 days or more 814,000 524,000
Foreclosed real estate 1,146,000 4,547,000
----------- -----------
Totals $11,639,000 $17,594,000
=========== ===========
DEPOSITS
Total deposits of $399,360,000 at June 30, 2004 decreased $16,255,000, or 3.9%,
from total deposits of $415,615,000 at year-end 2003 primarily due to a
reduction in brokered deposits and out of market deposits. The brokered deposits
decreased $1,695,000 from year-end 2003 and out of market deposits decreased
$9,009,000 from year-end 2003. We have also experienced decreases in other
interest bearing accounts during 2004 as we continue to build our core customer
deposit base. Deposits are the Company's primary source of funds with which to
support its earning assets. Noninterest-bearing deposits increased $2,186,000,
or 7.8%, from year-end 2003 to June 30, 2004, and interest-bearing deposits
decreased $18,441,000, or 4.8%, from year-end 2003.
19
STOCKHOLDERS' EQUITY
Equity has increased by $397,000 from December 31, 2003 to June 30, 2004. The
major components of this increase were: (1) six months ended June 30, 2004, net
income of $1,578,061, and (2) stock issuance of $90,993. Offsetting this was an
increase in the net unrealized loss on available for sale securities of $
1,272,506.
LIQUIDITY MANAGEMENT
Liquidity is defined as the ability of a company to convert assets into cash or
cash equivalents without significant loss. Liquidity management involves
maintaining the Company's ability to meet the day-to-day cash flow requirements
of its customers, whether they are depositors wishing to withdraw funds or
borrowers requiring funds to meet their credit needs. Without proper liquidity
management, the Company would not be able to perform the primary function of a
financial intermediary and would not, therefore, be able to meet the production
and growth needs of the communities it serves.
The primary function of asset and liability management is not only to assure
adequate liquidity in order for the Company to meet the needs of its customer
base, but to maintain an appropriate balance between interest-sensitive assets
and interest-sensitive liabilities so that the Company can also meet the
investment requirements of its stockholders. Daily monitoring of the sources and
uses of funds is necessary to maintain an acceptable cash position that meets
both requirements. In the banking environment, both assets and liabilities are
considered sources of liquidity funding and both are, therefore, monitored on a
daily basis.
The asset portion of the balance sheet provides liquidity primarily through loan
principal repayments and sales, and maturities and sales of investment
securities. Loans that mature in one year or less equaled approximately
$125,268,000 or 31.8% of the total loan portfolio at June 30, 2004.
The liability portion of the balance sheet provides liquidity through various
customers' interest-bearing and noninterest-bearing deposit accounts. At June
30, 2004, funds were also available through the purchase of federal funds from
correspondent commercial banks from available lines of up to an aggregate of
$23,500,000. The Bank is also a member of the Federal Home Loan Bank of Atlanta.
Such membership provides the Bank with additional lines of credit for liquidity
needs. This line of credit with the Federal Home Loan Bank of Atlanta is
collateralized by a blanket lien on the Bank's single-family mortgage portfolio,
as well as certain commercial real estate mortgages. As of June 30, 2004, the
Federal Home Loan Bank line of credit permitted borrowings of up to
approximately $81 million and as of June 30, 2004, the Bank had borrowed $78
million.
CAPITAL RESOURCES
A strong capital position is vital to the profitability of the Company and the
Bank because it promotes depositor and investor confidence and provides a solid
foundation for future growth of the organization.
On February 22, 2001, Heritage Financial Statutory Trust I ("Heritage Trust"), a
Connecticut statutory trust established by the Company, received $10,000,000 in
proceeds in exchange for $10,000,000 principal amount of Heritage Trust's 10.20%
cumulative trust preferred securities (the "preferred securities") in a pooled
trust preferred private placement. The proceeds of that transaction were then
used by Heritage Trust to purchase an equal amount of 10.20% subordinated
debentures (the "subordinated debentures") of the Company. The Company has fully
and unconditionally guaranteed all obligations of Heritage Trust on a
subordinated basis with respect to the preferred securities. Subject to certain
20
limitations, the preferred securities qualify as Tier 1 capital and are
presented in the Consolidated Statements of Financial Condition as "Guaranteed
preferred beneficial interests in the Company's subordinated debentures." The
sole asset of Heritage Trust is the subordinated debentures issued by the
Company. Both the preferred securities of Heritage Trust and the subordinated
debentures of the Company each have 30-year lives. However, both the Company and
Heritage Trust have a call option of ten years, subject to regulatory approval,
or earlier, depending upon certain changes in tax or investment company laws, or
regulatory capital requirements. Beginning January 1, 2004, the Company no
longer includes Heritage Trust in its consolidated financial statements due to a
recent accounting pronouncement fully described in Note D to the financial
statements included elsewhere in this Form 10-Q.
Regulatory authorities are placing increased emphasis on the maintenance of
adequate capital. Capital strength is measured in two tiers that are used in
conjunction with risk-adjusted assets to determine the risk-based capital
ratios. The Company's Tier 1 capital, which consists of common equity less
goodwill and the guaranteed preferred beneficial interest in the Company's
subordinated debentures, subject to limitations, amounted to approximately
$38,018,000 at June 30, 2004. The Company's Tier 2 capital components are
comprised solely of the allowance for loan losses subject to certain
limitations. Tier 1 capital plus the Tier 2 capital components is referred to as
Total Risk-Based capital and was approximately $43,336,000 at June 30, 2004.
The Company has taken steps to maintain a Tier 1 capital ratio at the Bank of
8%. As of June 30, 2004, the Bank's Tier 1 capital ratio was 8.53%. Although the
Company cannot assure that it will be successful in maintaining this capital
ratio, management believes that the steps it is taking to access additional
capital, implement management changes and enhance internal controls and
procedures will enable the Company to achieve these objectives. The Board of
Directors and management of the Company and the Bank are actively engaged in the
preparation and implementation of strategic business plans for the Company and
the Bank, to address, among other things, the immediate and anticipated future
capital requirements of the Company and the Bank, taking into account the mix of
loans in the Bank's loan portfolio, earnings, and alternative sources of
capital.
As of June 30, 2004 and December 31, 2003, the capital ratios of the Bank were
as follows:
Regulatory June 30, December 31,
Minimum 2004 2003
----------- --------- -------------
Tier 1 leverage ratio 4% 8.53% 8.64%
Tier 1 Risk-based capital ratio 6% 10.78% 10.71%
Total Risk-based capital ratio. 8% 12.04% 11.99%
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2004 AND 2003
SUMMARY
Net income of the Company for the quarter ended June 30, 2004 was $962,000,
compared to net income of $485,000 for the same period in 2003, representing a
$477,000 increase from prior period income.
21
NET INTEREST INCOME
Net interest income, the difference between interest earned on assets and the
cost of interest-bearing liabilities, is the largest component of the Company's
net income. Revenue from earning assets of the Company during the three months
ended June 30, 2004 decreased $317,000, or 4.3%, from the same period in 2003. A
decrease in the average balances of earning assets accounted for $457,000 of
this decrease. An increase in the average rate earned on these assets offset
this decrease by $140,000. Interest expense for the three months ended June 30,
2004 decreased $831,000, or 20.7%, over the corresponding period of 2003 due to
decreases in interest expense paid on interest-bearing deposits. A decrease in
the average balances of interest bearing liabilities accounted for $ 36,000 of
this decrease and the decrease in the average rate paid on these liabilities
accounted for $ 795,000 of this decrease. As a result of these factors, net
interest income increased $514,000, or 15.5%, for the three months ended June
30, 2004, compared to the same period of 2003. The Bank's net interest margin
was 3.05% for the quarter ended June 30, 2004 compared to 2.55% for the quarter
ended June 30, 2003.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents the charge against current earnings
necessary to maintain the allowance for loan losses at a level which management
considers appropriate. This level is determined based upon the Bank's historical
charge-offs, management's assessment of current economic conditions, the
composition of the loan portfolio and the levels of nonaccruing and past due
loans. The Bank recorded a provision for loan losses of $18,000 for the three
months ended June 30, 2004, compared to a negative provision of $616,000 for the
same period of 2003. The 2004 provision primarily resulted from the credit
rating changes for the 2004 period. The allowance for loan losses as a percent
of outstanding loans, net of unearned income, was 2.90 % at June 30, 2004
compared to 4.72 % at June 30, 2003.
NONINTEREST INCOME
Noninterest income for the three months ended June 30, 2004 was $2,093,000
compared to $1,638,000 for the same period of 2003. This increase primarily was
due to the following: (1) annuity sale income of $58,000 in 2004 (2) increase in
the cash surrender value of life insurance of $113,000, and (3) an increase in
the gain on sale of investments of $631,000 and (4) a gain on the sale of
foreclosed real estate of $31,000 in 2004 versus a loss of $94,000 for the same
period in 2003. Partially offsetting this increase was a decrease in mortgage
banking income of $477,000 This decrease was the result of the decreased volume
of refinancing in 2004.
NONINTEREST EXPENSES
Noninterest expenses for the three months ended June 30, 2004 were $4,453,000,
reflecting a 7.1% increase over the same period of 2003. The primary component
of noninterest expenses is salaries and employee benefits, which increased
$50,000, or 2.1%, during the three months ended June 30, 2004, compared to the
same period in 2003. Occupancy costs increased $42,000, or 7.5%, and other
operating expenses decreased $433,000, or 23.1%, from the same period in 2003.
The increase in occupancy expense resulted from two operation centers that were
leased in the second and third quarter of 2003. The decrease in other operating
expenses primarily resulted from the following: (1) decreased advertising
22
expense of $60,000, (2) decrease in other real estate and collection expenses of
$62,000, (3) decrease in FDIC insurance expense of $105,000 and (4) a decease in
other professional services of $49,000.
INCOME TAXES
The Company attempts to maximize its net income through active tax planning. The
provision for income taxes of $488,000 for the three months ended June 30, 2004
decreased $199,000 compared to the same period of 2003. Taxes as a percent of
earnings before income taxes were 33.7% for the quarter ended June 30, 2003, and
37.4% for the quarter ended June 30, 2004.
SIX MONTHS ENDED JUNE 30, 2004 AND 2003
SUMMARY
Net income of the Company for the six months ended June 30, 2004 was $1,578,000,
compared to net income of $1,035,000 for the same period in 2003, representing a
$543,000 increase from prior period income.
NET INTEREST INCOME
Net interest income, the difference between interest earned on assets and the
cost of interest-bearing liabilities, is the largest component of the Company's
net income. Revenue from earning assets of the Company during the six months
ended June 30, 2004 decreased $2,512,000, or 15.4%, from the same period in
2003. A decrease in the average balances of earning assets accounted for
$1,854,000 of this decrease and the decrease in the average rate earned on these
assets accounted for $658,000 of the decrease. Interest expense for the six
months ended June 30, 2004 decreased $2,134,000, or 25.1%, over the
corresponding period of 2003 due to decreases in interest expense paid on
interest-bearing deposits. A decrease in the average balances of interest
bearing liabilities accounted for $ 1,002,000 of this decrease and the decrease
in the average rate paid on these liabilities accounted for $ 1,132,000 of this
decrease. As a result of these factors, net interest income decreased $378,000,
or 4.8%, for the six months ended June 30, 2004, compared to the same period of
2003. The Bank's net interest margin was 3.27% for the six months ended June 30,
2004 compared to 3.13% for the same period in 2003.
PROVISION FOR LOAN LOSSES
The provision for loan losses represents the charge against current earnings
necessary to maintain the allowance for loan losses at a level which management
considers appropriate. This level is determined based upon the Bank's historical
charge-offs, management's assessment of current economic conditions, the
composition of the loan portfolio and the levels of nonaccruing and past due
loans. The Bank recorded a negative provision for loan losses of $760,000 for
the six months ended June 30, 2004, compared to a negative provision of $516,000
for the same period of 2003. The negative provision primarily resulted from the
reduction in classified loans of $16,188,000 from December 31, 2003, to June 30,
2004. The allowance for loan losses as a percent of outstanding loans, net of
unearned income, was 2.90 % at June 30, 2004 compared to 4.93 % at June 30,
2003.
23
NONINTEREST INCOME
Noninterest income for the six months ended June 30, 2004 was $3,111,000
compared to $2,237,000 for the same period of 2003. This increase primarily was
due to the following: (1) annuity sale income of $140,000 in 2004 and (2)
increase in the cash surrender value of life insurance of $224,000, (3) an
increase in the gain on sale of investments of $409,000 and (4) a gain on the
sale of foreclosed real estate of $74,000 in 2004 versus a loss of $222,000 for
the same period in 2003. Partially offsetting this was a decrease in mortgage
banking income of $358,000. This decrease was the result of the decreased volume
of refinancing in 2004.
NONINTEREST EXPENSES
Noninterest expenses for the six months ended June 30, 2004 were $8,973,000,
reflecting a .24% increase over the same period of 2003. The primary component
of noninterest expenses is salaries and employee benefits, which increased
$263,000, or 6.0%, during the six months ended June 30, 2004, compared to the
same period in 2003. Occupancy costs increased $115,000, or 10.3%, and other
operating expenses decreased $356,000, or 10.3%, from the same period in 2003.
The increase in occupancy expense resulted from two operation centers that were
leased in the second and third quarter of 2003. The decrease in other operating
expenses primarily resulted from the following: (1) decrease in advertising of
$106,000, (2) decrease in other real estate and collection expenses of $84,000,
(3) decrease in FDIC insurance of $225,000, (4) decrease in accounting fees of
$151,000, and (5) decrease in other professional fees of $122,000. Partially
offsetting this were increases of $60,000 as a result of outsourcing of the
internal audit function in 2003 and $100,000 increase for expenses related to
lawsuits.
INCOME TAXES
The Company attempts to maximize its net income through active tax planning. The
provision for income taxes of $795,000 for the six months ended June 30, 2004
increased $176,000 compared to the same period of 2003. Taxes as a percent of
earnings before income taxes were 33.5% for the six months ended June 30, 2004,
and 37.4% for the same period in 2003.
RECENTLY ISSUED ACCOUNTING STANDARDS
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.
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
24
the policies that require significant judgment or involve complex estimates. The
application of these policies has a significant impact on the Company's
financial statements. Financial results could differ significantly if different
judgments or estimates are applied.
ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is established through provisions for loan losses
charged to operations. Loans are charged against the allowance for loan losses
when management believes that the collection of principal is unlikely.
Subsequent recoveries are added to the allowance. Management's evaluation of the
adequacy of the allowance for loan losses is based on a formal analysis which
assesses the risk within the loan portfolio. This analysis includes
consideration of historical performance, current economic conditions, level of
nonperforming loans, loan concentrations, and review of certain individual
loans. Management believes that the allowance for loan losses is adequate. While
management uses available information to recognize losses on loans, future
additions to the allowance for loan losses may be necessary based on changes in
economic conditions and the results of management's ongoing review of the loan
portfolio. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the bank's allowances for loan
losses. Such agencies may require the Bank to recognize additions to the
allowance for loan losses based on their judgments.
FORWARD-LOOKING INFORMATION
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for
forward-looking statements made by us or on our behalf. Some of the disclosures
in this Quarterly Report on Form 10-Q, including any statements preceded by,
followed by or which include the words "may," "could," "should," "will,"
"would," "hope," "might," "believe," "expect," "anticipate," "estimate,"
"intend," "plan," "assume" or similar expressions constitute forward-looking
statements. These forward-looking statements, implicitly and explicitly, include
the assumptions underlying the statements and other information with respect to
our beliefs, plans, objectives, goals, expectations, anticipations, estimates,
intentions, financial condition, results of operations, future performance and
business, including our expectations and estimates with respect to our revenues,
expenses, earnings, return on equity, return on assets, efficiency ratio, asset
quality and other financial data and capital and performance ratios. Any
forward-looking statements are subject to numerous assumptions, risks and
uncertainties because of the possibility of changes in underlying factors and
assumptions. Actual results could differ materially from those contained in or
implied by such forward-looking statements for a variety of factors including:
inability to obtain required shareholder or regulatory approval for the proposed
merger with Peoples; ecommendations made by or actions taken by banking
regulatory authorities; significant changes in the economic scenario from the
current anticipated scenario which could materially change anticipated credit
quality trends; the value of investment securities and the ability to generate
loans; significant delay in or inability to execute strategic initiatives
designed to increase capital, reduce non-performing loans and classified assets,
grow revenues and control expenses; ability to maintain sufficient liquidity and
cash flow and significant changes in accounting, tax or regulatory practices or
requirements; changes in interest rates; financial, legal, regulatory or other
changes affecting the banking and financial services industries in general;
continued intense competition from numerous providers of products and services
which compete with the Company's businesses, and other factors listed from time
to time in the Company's SEC reports, including, but not limited to, the Annual
Report on Form 10-K for the year ended December 31, 2003.
Whenever possible, the Company has identified these forward-looking statements
(as defined in Section 21E of the Securities Exchange Act of 1934) by words such
as "anticipates," "may," "believes," "estimates," "projects," "expects,"
"intends," and words of similar import. In addition to the statements
25
included in this Quarterly Report on Form 10-Q, the Company and its
representatives may from time to time make other oral or written statements that
are also forward-looking statements.
The Company expressly disclaims any obligation to update publicly any
forward-looking statements, whether as a result of new information, future
events or otherwise.
If one or more of the factors affecting our forward-looking information and
statements proves incorrect, then our actual results, performance or
achievements could differ materially from those expressed in, or implied by,
forward-looking information and statements contained in this Quarterly Report.
Therefore, we caution you not to place undue reliance on our forward-looking
information and statements. We do not intend to update our forward-looking
information and statements, whether written or oral, to reflect change. All
forward-looking statements attributable to us are expressly qualified by these
cautionary statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk arising from adverse changes in the fair value of
financial instruments due to a change in interest rates, exchange rates and
equity prices. The Company's primary market risk is interest rate variations in
the short-term time horizons also known as interest rate risk.
The primary objective of Asset/Liability Management at the Company is to manage
interest rate risk and achieve reasonable stability in net interest income
throughout interest rate cycles. This is achieved by maintaining the proper
balance of rate sensitive earning assets and rate sensitive liabilities. The
relationship of rate sensitive earning assets to rate sensitive liabilities are
the principal factor in projecting the effect that fluctuating interest rates
will have on future net interest income. Rate sensitive earning assets and
interest-bearing liabilities are those that can be repriced to current market
rates within a relatively short time period. Management monitors the rate
sensitivity of securities over the entire life of these instruments, but places
particular emphasis on the first year. The Company's Asset/Liability Management
policy requires risk assessment relative to interest pricing and related terms.
The Company uses additional tools to monitor and manage interest rate
sensitivity. One of the primary tools is simulation analysis. Simulation
analysis is the primary method of estimating earnings at risk and capital at
risk under varying interest rate conditions. Simulation analysis is used to test
the sensitivity of the Company's net interest income and stockholders' equity to
both the level of interest rates and the slope of the yield curve. Simulation
analysis accounts for the expected timing and magnitude of assets and liability
cash flows, as well as the expected timing and magnitude of deposits that do not
reprice on a contractual basis. In addition, simulation analysis includes
adjustments for the lag between movements in market interest rates on loans and
interest-bearing deposits. These adjustments are made to reflect more accurately
possible future cash flows, repricing behavior and ultimately net interest
income.
As of June 30, 2004, there were no substantial changes in the composition of the
Company's market-sensitive assets and liabilities or their related market values
from that reported as of December 31, 2003. The foregoing disclosures related to
the market risk of the Company should be read in conjunction with the Company's
audited consolidated financial statements, related notes and management's
discussion and analysis of financial condition and results of operations for the
year ended December 31, 2003 included in the Company's Annual Report on Form
10-K.
26
ITEM 4. CONTROLS AND PROCEDURES
(a) The Company carried out an evaluation, under the supervision and
participation of its management, including the Chief Executive Officer and the
Chief Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures (as defined in pursuant to Exchange
Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this
Quarterly report on Form 10-Q. Based on that evaluation, the Chief Executive
Officer and the Chief Financial Officer concluded that the Company's disclosure
controls and procedures are effective in timely alerting them to material
information relating to the Company (including its consolidated subsidiaries)
required to be included in the Company's periodic SEC filings. However, the
Company recently has experienced several changes in top management, and the
effectiveness of such disclosure controls and procedures is dependent on the
Company's personnel to report any issues or matters required to be disclosed in
the Company's SEC filings to the appropriate management personnel on a timely
basis.
(b) Management has previously conducted a comprehensive review of the Company's
internal control over financial reporting which identified significant
weaknesses in the Company's and the Bank's internal control over financial
reporting. While management continues to review and modify the Bank's internal
controls over financial reporting to remediate those weaknesses there have been
no significant changes in either the Company's or the Bank's internal control
over financial reporting during the second quarter of 2004 that have materially
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1 - LEGAL PROCEEDINGS
Reference is made to the legal proceedings previously reported in the Company's
Annual Report on Form 10-K for the fiscal year ended December 31, 2003, under
the heading "Item 3 - Legal Proceedings."
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Shareholders of Heritage Financial Holding Corporation was
held on May 25, 2004, and the stockholders elected five (5) directors. The
following is a tabulation of the voting on this matter.
NAMES VOTES FOR VOTES WITHHELD
- -----------------------------------------------
John T. Moss 6,247,722 49,634
T. Gerald New, M. D. 5,638,277 659,079
Betty B. Sims 6,271,322 26,034
R. Jeron Witt 6,248,322 49,034
Larry R. Mathews 6,247,622 49,734
27
The following directors continued in office following the annual meeting:
Bingham D. Edwards, Timothy A. Smalley, Lenny L. Hayes, Neal A. Holland, Harold
B. Jeffreys, Larry E. Landman and Vernon A. Lane.
The stockholders also ratified the appointment of Porter Keadle Moore, LLP as
independent auditors of the Company for the year ending December 31, 2004. The
following is a tabulation of the voting:
FOR AGAINST ABSTAIN
- ---------------------------------
5,625,077 670,645 1,634
ITEM 5 - OTHER INFORMATION
On July 15, 2004, the Company and The Peoples Holding Company ("Peoples")
entered into a definitive merger agreement. According to the agreement, the
Company will merge with and into Peoples, and each Company shareholder may elect
to receive one of the three following options: (1) 0.200 shares of Peoples
common stock for each share of Company common stock, (2) $6.25 in cash for each
share of Company common stock, or (3) a combination of 40% cash and 60% common
stock at the same exchange ratio listed above, subject to the overall limitation
that the aggregate stock consideration will equal approximately 60% of the total
consideration received by Company shareholders. The merger is expected to close
in the first quarter of 2005 and is subject to certain closing conditions and
regulatory approval.
ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit No. Exhibit Page
- ------------ ----------------------------------------------------------------------------------------- ----
31.1 Certification of principal executive officer pursuant to Exchange Act Rule 13a
- 14(a) or 15d - 14(a) 25
31.2 Certification of principal financial officer pursuant to Exchange Act Rule 13a
- 14(a) or 15d - 14(a) 26
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 27
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 28
28
(b) REPORTS ON FORM 8-K
During the quarter ended June 30, 2004, the Company filed the following
Current Reports on Form 8-K:
On May 4, 2004, the Company filed a Current Report on Form 8-K with
respect to a press release announcing its financial results for the quarter
ended March 31, 2004.
On July 15, 2004, the Company filed a Current Report on Form 8-K with respect to a press
release announcing a definitive merger agreement with The Peoples Holding Company dated
July 15, 2004.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HERITAGE FINANCIAL HOLDING CORPORATION
By: /s/ Larry R. Mathews 8/12/2004
---------------------------------- ---------
Larry R. Mathews Date
President and
Chief Executive Officer
By: /s/ William M. Foshee 8/12/2004
---------------------------------- ---------
William M. Foshee Date
Chief Financial Officer
30