UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 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 November 4, 2004: 10,536,660 Shares
FORM 10-Q
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
SEPTEMBER 30, 2004
TABLE OF CONTENTS
PAGE NO.
--------
PART I - FINANCIAL INFORMATION
Item 1 - Financial Statements (Unaudited)
Consolidated Statements of Financial Condition as of
September 30, 2004 and December 31, 2003. . . . . . . . . . . . . . 3
Consolidated Statements of Income for the three months
ended September 30, 2004 and 2003 . . . . . . . . . . . . . . . . . 4
Consolidated Statements of Comprehensive Income for the
three months ended September 30, 2004 and 2003. . . . . . . . . . . 5
Consolidated Statements of Income for the nine months
ended September 30, 2004 and 2003 . . . . . . . . . . . . . . . . . 6
Consolidated Statements of Comprehensive Income for the
nine months ended September 30, 2004 and 2003 . . . . . . . . . . . 7
Consolidated Statements of Cash Flow for the
nine months ended September 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 . . . . . . . . . . . . . . . . . . . . . . . . . 28
Item 5 - Other Information . . . . . . . . . . . . . . . . . . . . . . . . . 28
Item 6 - Exhibits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
SIGNATURES
PART I - FINANCIAL INFORMATION
ITEM 1 - FINANCIAL STATEMENTS
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30, 2004 (UNAUDITED) AND DECEMBER 31, 2003
SEPTEMBER 30,
2004 December 31,
(UNAUDITED) 2003
--------------- --------------
ASSETS
Cash and due from banks. . . . . . . . . . . . . . . . . . $ 8,353,075 $ 8,663,330
Interest bearing deposits with other banks . . . . . . . . 439,791 115,551
Federal funds sold . . . . . . . . . . . . . . . . . . . . - 632,000
--------------- --------------
CASH AND CASH EQUIVALENTS. . . . . . . . . . . . . . . . 8,792,866 9,410,881
Securities available-for-sale. . . . . . . . . . . . . . . 95,855,843 99,037,992
Other Investments. . . . . . . . . . . . . . . . . . . . . 4,707,061 2,897,061
Mortgage loans held-for-sale . . . . . . . . . . . . . . . 27,412,783 5,995,929
Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . 386,774,781 385,886,904
Allowance for loan losses. . . . . . . . . . . . . . . . . (10,077,538) (14,562,283)
--------------- --------------
LOANS, NET . . . . . . . . . . . . . . . . . . . . . . . 376,697,243 371,324,621
Premises and equipment, net. . . . . . . . . . . . . . . . 6,806,208 7,223,966
Accrued interest . . . . . . . . . . . . . . . . . . . . . 2,125,417 2,391,861
Cash surrender value of life insurance . . . . . . . . . . 11,354,628 11,015,000
Foreclosed real estate . . . . . . . . . . . . . . . . . . 1,625,177 4,546,740
Other assets . . . . . . . . . . . . . . . . . . . . . . . 8,260,542 8,891,753
--------------- --------------
TOTAL ASSETS . . . . . . . . . . . . . . . . . . . . . $ 543,637,768 $ 522,735,804
--------------- --------------
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
DEPOSITS
Noninterest bearing. . . . . . . . . . . . . . . . . . . $ 31,825,706 $ 28,141,627
Interest-bearing . . . . . . . . . . . . . . . . . . . . 357,151,515 387,473,302
--------------- --------------
TOTAL DEPOSITS . . . . . . . . . . . . . . . . . . . . 388,977,221 415,614,929
Short-term borrowings. . . . . . . . . . . . . . . . . . . 7,480,000 7,480,000
Federal funds purchased. . . . . . . . . . . . . . . . . . 10,107,530 406,073
Accrued interest . . . . . . . . . . . . . . . . . . . . . 1,436,840 1,899,628
FHLB advances. . . . . . . . . . . . . . . . . . . . . . . 92,622,156 56,422,156
Junior subordinated debentures . . . . . . . . . . . . . . 10,310,000 10,310,000
Other liabilities. . . . . . . . . . . . . . . . . . . . . 803,267 497,626
--------------- --------------
TOTAL LIABILITIES. . . . . . . . . . . . . . . . . . . 511,737,014 492,630,412
--------------- --------------
STOCKHOLDERS' EQUITY
Preferred stock - par value $0.01 per share; 10,000,000
authorized . . . . . . . . . . . . . . . . . . . . . . . - -
Common stock ($.01 par value; 40,000,000 shares authorized,
10,536,660 and 10,510,791 shares issued and outstanding
at September 30, 2004 and December 31, 2003) . . . . . . 105,367 105,108
Additional paid-in capital . . . . . . . . . . . . . . . . 37,413,442 37,322,707
Accumulated deficit. . . . . . . . . . . . . . . . . . . . (5,836,324) (7,548,144)
Accumulated other comprehensive income . . . . . . . . . . 218,269 225,721
--------------- --------------
TOTAL STOCKHOLDERS' EQUITY . . . . . . . . . . . . . . 31,900,754 30,105,392
--------------- --------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY . . . . . . $ 543,637,768 $ 522,735,804
--------------- --------------
See noted to consolidated financial statements
3
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
(UNAUDITED)
THREE MONTHS ENDED
SEPTEMBER 30,
-----------------------
2004 2003
---------- -----------
INTEREST INCOME
Interest and fees on loans. . . . . . . . . . . . . . . . . . $6,212,024 $7,025,574
Interest and dividends on securities:
Taxable securities . . . . . . . . . . . . . . . . . . . . 916,009 270,157
Nontaxable securities. . . . . . . . . . . . . . . . . . . 50,017 17,063
Interest on deposits with other banks . . . . . . . . . . . . 1,656 1,130
Interest earned on federal funds sold and securities purchased 498 48,799
---------- -----------
TOTAL INTEREST INCOME. . . . . . . . . . . . . . . . . . . 7,180,204 7,362,723
---------- -----------
INTEREST EXPENSE
Interest on deposits. . . . . . . . . . . . . . . . . . . . . 2,214,608 2,956,899
Interest on FHLB borrowings . . . . . . . . . . . . . . . . . 573,208 250,038
Interest on fed funds purchased . . . . . . . . . . . . . . . 32,487 -
Interest on short-term borrowings . . . . . . . . . . . . . . 78,062 69,049
Interest on junior subordinated debentures. . . . . . . . . . 262,905 262,905
---------- -----------
TOTAL INTEREST EXPENSE . . . . . . . . . . . . . . . . . . 3,161,270 3,538,891
---------- -----------
NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . 4,018,934 3,823,832
Provision for loan losses . . . . . . . . . . . . . . . . . . 814,733 (48,393)
---------- -----------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES . . . . . . 3,204,201 3,872,225
NONINTEREST INCOME
Customer service fees . . . . . . . . . . . . . . . . . . . . 321,501 306,450
Mortgage banking fee income . . . . . . . . . . . . . . . . . 663,566 1,011,346
Investment security gains . . . . . . . . . . . . . . . . . . 3,306 21,036
Gains (losses) on sale of foreclosed real estate. . . . . . . 35,028 (465,077)
Other operating income. . . . . . . . . . . . . . . . . . . . 529,375 233,866
---------- -----------
TOTAL NONINTEREST INCOME . . . . . . . . . . . . . . . . . 1,552,776 1,107,621
---------- -----------
NONINTEREST EXPENSES
Salaries and employee benefits. . . . . . . . . . . . . . . . 2,394,003 2,542,633
Occupancy and equipment expense . . . . . . . . . . . . . . . 535,675 536,674
Other operating expenses. . . . . . . . . . . . . . . . . . . 1,652,615 1,583,170
---------- -----------
TOTAL NONINTEREST EXPENSES . . . . . . . . . . . . . . . . 4,582,293 4,662,477
---------- -----------
Income before income taxes. . . . . . . . . . . . . . . . . . . 174,684 317,369
Provision for income tax expense. . . . . . . . . . . . . . . . 40,925 117,071
---------- -----------
NET INCOME. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 133,759 $ 200,298
========== ===========
BASIC EARNINGS PER COMMON SHARE . . . . . . . . . . . . . . . . $ .01 $ .02
========== ===========
DILUTED EARNINGS PER COMMON SHARE . . . . . . . . . . . . . . . $ .01 $ .02
========== ===========
See noted to consolidated financial statements
4
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
THREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
(UNAUDITED)
THREE MONTHS ENDED
SEPTEMBER 30,
------------------------
2004 2003
----------- -----------
NET INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 133,759 $ 200,298
Other comprehensive income (loss) , net of tax:
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during the period,
net of tax of $652,998 and $43,541 . . . . . . . . . . . . . 1,267,235 (84,520)
Reclassification adjustments for gains included in net income,
net of tax of $1,124 and $7,152 . . . . . . . . . . . . . . (2,181) (13,884)
----------- -----------
Other comprehensive income (loss) . . . . . . . . . . . . . . 1,265,054 (98,404)
----------- -----------
COMPREHENSIVE INCOME . . . . . . . . . . . . . . . . . . . . . . . $1,398,813 $ 101,894
----------- -----------
5
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2004 2003
----------- ------------
INTEREST INCOME
Interest and fees on loans. . . . . . . . . . . . . . . . . . $18,119,667 $22,572,918
Interest and dividends on securities:
Taxable securities. . . . . . . . . . . . . . . . . . . . . 2,811,226 970,162
Nontaxable securities . . . . . . . . . . . . . . . . . . . 98,383 51,190
Interest on deposits with other banks . . . . . . . . . . . . 3,047 3,892
Interest earned on federal funds sold and securities purchased 1,064 129,658
----------- ------------
TOTAL INTEREST INCOME . . . . . . . . . . . . . . . . . . . 21,033,387 23,727,820
----------- ------------
INTEREST EXPENSE
Interest on deposits. . . . . . . . . . . . . . . . . . . . . 6,921,382 10,338,967
Interest on FHLB borrowings . . . . . . . . . . . . . . . . . 1,535,741 739,038
Interest on fed funds purchased . . . . . . . . . . . . . . . 78,734 -
Interest on short-term borrowings . . . . . . . . . . . . . . 215,687 185,196
Interest on junior subordinated debentures. . . . . . . . . . 788,714 788,715
----------- ------------
TOTAL INTEREST EXPENSE. . . . . . . . . . . . . . . . . . . 9,540,258 12,051,916
----------- ------------
NET INTEREST INCOME . . . . . . . . . . . . . . . . . . . . . . 11,493,129 11,675,904
Provision for loan losses . . . . . . . . . . . . . . . . . . 54,321 (564,593)
----------- ------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES . . . . . . 11,438,808 12,240,497
NONINTEREST INCOME
Customer service fees . . . . . . . . . . . . . . . . . . . . 947,304 821,825
Mortgage banking fee income . . . . . . . . . . . . . . . . . 1,743,223 2,449,109
Investment security gains . . . . . . . . . . . . . . . . . . 597,119 205,801
Gains (losses) on sale of foreclosed real estate. . . . . . . 108,568 (686,677)
Other operating income. . . . . . . . . . . . . . . . . . . . 1,267,720 554,142
----------- ------------
TOTAL NONINTEREST INCOME. . . . . . . . . . . . . . . . . . 4,663,934 3,344,200
----------- ------------
NONINTEREST EXPENSES
Salaries and employee benefits. . . . . . . . . . . . . . . . 7,009,807 6,895,559
Occupancy and equipment expense . . . . . . . . . . . . . . . 1,770,561 1,656,425
Other operating expenses. . . . . . . . . . . . . . . . . . . 4,774,507 5,061,492
----------- ------------
TOTAL NONINTEREST EXPENSES. . . . . . . . . . . . . . . . . 13,554,875 13,613,476
----------- ------------
Income before income taxes. . . . . . . . . . . . . . . . . . . 2,547,867 1,971,221
Provision for income tax expense. . . . . . . . . . . . . . . . 836,047 736,276
----------- ------------
NET INCOME. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,711,820 $ 1,234,945
=========== ============
BASIC EARNINGS PER COMMON SHARE . . . . . . . . . . . . . . . . $ .16 $ .12
=========== ============
DILUTED EARNINGS PER COMMON SHARE . . . . . . . . . . . . . . . $ .15 $ .12
=========== ============
6
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2004 2003
----------- ------------
NET INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,711,820 $ 1,234,945
Other comprehensive income (loss) , net of tax:
Unrealized gains on securities:
Unrealized holding gains arising during the period,
net of tax of $206,852 and $19,551 . . . . . . . . . . . . . 386,653 37,952
Reclassification adjustments for gains included in net income,
net of tax of $203,013 and $69,972 . . . . . . . . . . . . . (394,105) (135,829)
----------- ------------
Other comprehensive income (loss). . . . . . . . . . . . . . (7,452) 97,877)
----------- ------------
COMPREHENSIVE INCOME . . . . . . . . . . . . . . . . . . . . . . . $1,704,368 $ 1,137,068
----------- ------------
7
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
(UNAUDITED)
Nine Months Ended
September 30,
-----------------------------
2004 2003
------------- --------------
OPERATING ACTIVITIES
Net Income. . . . . . . . . . . . . . . . . . . . . . . . $ 1,711,820 $ 1,234,945
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Provision for loan losses . . . . . . . . . . . . . . . 54,321 (564,593)
Depreciation, amortization, and accretion . . . . . . . 1,325,302 830,235
Loss (gain) on sale of other real estate. . . . . . . . (106,392) 365,483
Loss on sale of premises and equipment . . . . . . . . 6,253 ---
Writedowns of other real estate . . . . . . . . . . . . 321,194
Realized investment security gains. . . . . . . . . . . (597,119) (205,801)
Compensatory options (tax benefit forfeited). . . . . . --- (5,803)
Changes in:
Accrued interest receivable . . . . . . . . . . . . . 266,444 1,278,925
Accrued interest payable. . . . . . . . . . . . . . . (462,788) (1,911,905)
Cash surrender value of life insurance. . . . . . . . (339,628) ---
Mortgage loans held-for-sale. . . . . . . . . . . . . (21,416,854) 7,120,885
Other assets. . . . . . . . . . . . . . . . . . . . . 490,050 839,961
Other liabilities . . . . . . . . . . . . . . . . . . 305,642 81,120
------------- --------------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES (18,762,949) 9,384,646
------------- --------------
INVESTING ACTIVITIES
Purchases of securities available-for-sale. . . . . . . . (33,443,242) (115,256,894)
Proceeds from sales of securities available for sale. . . 26,079,167 16,523,898
Proceeds from calls, paydowns and maturities of
securities available-for-sale . . . . . . . . . . . . . 10,679,049 75,775,863
Proceeds from sale of other investments. . . . . . . . . 475,000 ---
Purchases of other investments. . . . . . . . . . . . . . (2,285,000) (350,600)
Net (increase) decrease in loans to customers . . . . . . (6,742,814) 102,621,864
Purchases of premises and equipment . . . . . . . . . . . (481,094) (998,694)
Proceeds from disposition of premises and equipment . . . 20,298 8,741
Proceeds from disposition of foreclosed real estate . . . 4,488,827 8,762,336
------------- --------------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES . (1,209,809) 7,086,514
8
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
(UNAUDITED)
Nine Months Ended
September 30,
----------------------------
2004 2003
------------- -------------
FINANCING ACTIVITIES
Net decrease in deposits . . . . . . . . . . . . . . (26,637,708) (89,618,721)
Proceeds from issuance of stock. . . . . . . . . . . 80,974 2,309,054
Proceeds from federal funds purchased. . . . . . . . 9,701,457 ---
Proceeds from FHLB advances. . . . . . . . . . . . . 36,200,000 ---
Proceeds from short-term debt. . . . . . . . . . . . --- 830,000
Proceeds from exercise of stock options. . . . . . . 10,020 2,801,700
------------- -------------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 19,354,743 (83,677,967)
------------- -------------
NET INCREASE IN CASH AND CASH EQUIVALENTS. . . . . . . (618,015) 12,793,193
Cash and Cash Equivalents at Beginning of Period . . . 9,410,881 19,538,515
------------- -------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD . . . . . . $ 8,792,866 32,331,708
------------- -------------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for:
Interest . . . . . . . . . . . . . . . . . . . . . $ 10,003,047 13,963,821
Taxes. . . . . . . . . . . . . . . . . . . . . . . --- ---
Noncash investing and financing activities:
Change in other comprehensive income, net. . . . . $ (7,452) $ (97,877)
Transfer of loans to other real estate . . . . . . $ 1,315,871 $ 10,308,202
9
HERITAGE FINANCIAL HOLDING CORPORATION
AND SUBSIDIARIES
SEPTEMBER 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 nine-month periods ended September 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
10
the loan portfolio. In addition, various regulatory agencies, as an integral
part of their examination process, periodically review the Bank's allowance for
loan losses. Such agencies may require the Bank to recognize additions to the
allowance for loan losses based on their judgment.
USE OF ESTIMATES
The preparation of financial statements in conformity with 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 32.80 % and 37.40 % for the nine months
ended September 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 September 30, 2004, the Company had net unrealized gains of approximately
$331,000 in available-for-sale securities which are reflected in the presented
assets and resulted in an increase in stockholders' equity of $218,000, net of
deferred taxes. There were no held-to-maturity or trading securities at
September 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
11
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 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 September 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 8.50% as of September 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
nine month periods ended September 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
12
estimating the fair value of traded options that have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, the
existing models do not necessarily provide a reliable single measure of the fair
value of its employee stock options.
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 September 30, 2004 and December 31, 2003:
September 30, December 31,
-------------- -------------
2004 2003
-------------- -------------
Commitments to extend credit . . . . . . $ 40,059,000 $ 34,936,000
Standby and commercial letters of credit 3,985,000 3,303,000
-------------- -------------
Total commitments. . . . . . . . . . . . $ 44,044,000 $ 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 nine months ended
September 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
September 30, 2004 and 2003
Basic earnings per share $ 133,759 10,536,660 $ .01 $ 200,298 10,408,868 $ .02
Effect of stock options - 813,956 0.00 - 654,441 .00
----------- ---------- ----------- ---------- ------------ ----------
Diluted earnings per share $ 133,759 11,350,616 $ .01 $ 200,298 11,063,309 $ .02
=========== ========== =========== ========== ============ ==========
2004 2003
---- ----
Common Per Share Net Common Per Share
Net Income Share Amount Income Share Amount
For the nine months ended
September 30, 2004 and 2003
Basic earnings per share $ 1,711,820 10,523,044 $ .16 $1,234,945 9,677,464 $ .12
Effect of stock options - 644,325 (0.01) - 1,106,259 .00
----------- ---------- ----------- ---------- ------------ ----------
Diluted earnings per share $ 1,711,820 11,167,369 $ .15 $1,234,945 10,783,723 $ .12
=========== ========== =========== ========== ============ ==========
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 nine months ended September 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 September 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 $542 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 $1,712,000 for the first nine months of 2004. Net
income increased 39% over the $1,235,000 reported in the first nine months of
2003. Diluted earnings per share for the first nine months of 2004 were $.15 per
share versus $.12 per share in the prior year period.
During the first nine months of 2004, we experienced an increase in assets, as
Total
15
assets increased $20,902,000 (4.0%) to $543,638,000 from the 2003 year-end
balance. On a year-over-year basis, total assets increased $35,073,000 (6.9%)
from the $508,564,000 balance at September 30, 2003. At the end of the first
nine months of 2004, total net loans were $376,697,000, an increase of
$5,373,000 (1.5%) from year-end, but a decrease of approximately $7.8 million
(2.0%) on a year-over-year basis. Deposits decreased $26,638,000 (6.4%) in the
first nine months of 2004 to $388,977,000 from the 2003 year-end balance.
Deposits decreased $47,035,000 (10.8%) on a year-over-year basis from September
30, 2003 to September 30, 2004.
At September 30, 2004, non-performing assets totaled $8,856,000, a decrease of
$8,738,000 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 1.61% at September 30, 2004. The ratio of non-performing loans to total loans
decreased from 3.51% to 1.92% during the first nine months of 2004.
The Bank ended the first nine months of 2004 with a Tier 1 risk-based capital
ratio of 10.49% and a total risk-based capital ratio of 11.74% compared to
10.77% and 12.06% at the end of the first nine months 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
September 30, Increase
In Thousands (except percentages) 2004 2003 (Decrease)
---------- ----------- -----------
Interest Income $ 7,180 $ 7,363 (2.5%)
Interest Expense 3,161 3,539 (10.7%)
---------- -----------
Net interest income 4,019 3,823 5.1%
Provision for loan losses 815 (48)
---------- -----------
Net interest income after
provision for loan losses 3,204 3,872 (17.3%)
Noninterest income 1,553 1,108 40.2%
Noninterest expense 4,583 4,662 (1.7%)
---------- -----------
Income before income taxes 175 317 (45.0%)
Income taxes 41 117 (65.0%)
---------- -----------
Net income $ 134 $ 200 (33.0%)
========== ===========
Percentage
Nine months ended Change
September 30, Increase
In Thousands (except percentages) 2004 2003 (Decrease)
---------- ----------- -----------
Interest Income $ 21,033 $ 23,728 (11.4%)
Interest Expense 9,540 12,052 (20.8%)
---------- -----------
Net interest income 11,493 11,676 (1.6%)
Provision for loan losses 54 (565)
---------- -----------
Net interest income after
provision for loan losses 11,439 12,241 (6.6%)
Noninterest income 4,664 3,344 39.5%
Noninterest expense 13,555 13,614 (.4%)
---------- -----------
Income before income taxes 2,548 1,971 29.3%
Income taxes 836 736 13.6%
---------- -----------
Net income $ 1,712 $ 1,235 38.6%
========== ===========
16
HIGHLIGHTS
During the first nine months 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 $8,856,000
at September 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 $888,000 during the first
nine months 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 $27 million in deposits during the first nine months
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
SEPTEMBER 30, 2004 COMPARED TO DECEMBER 31, 2003
LOANS
Loans comprised the largest category of the Company's earning assets on
September 30, 2004. Loans, net of allowance for loan losses, were 69.3% of total
assets at September 30, 2004, and 71.0% of total assets at December 31, 2003.
Total net loans were $376,697,000 at September 30, 2004, representing a 1.5%
increase from the December 31, 2003 total of $371,325,000. During 2004, the
Company transferred $1,316,000 of loans to foreclosed real estate, $4.5 million
in net loans were charged off, a provision of $54,000 was recorded and net
originations totaled $6.7 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
$27.4 million at September 30, 2004. This increase primarily resulted from the
creation of the wholesale mortgage division in the first nine months 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 $4,485,000 during the nine months ended September 30,
17
2004 to $10,078,000 at September 30, 2004 from $14,562,000 at December 31, 2003.
Net charge offs in an aggregate amount of $4.5 million accounted for the
decrease in the allowance for loan losses. The allowance for loan losses
represented 2.61% and 3.77% of loans receivable at September 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
September 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 nine months ended September 30,
2004 and 2003 were as follows:
2004 2003
------------ ------------
Balance at beginning of the year $14,562,000 $26,991,000
Charge-offs (4,821,000) (8,519,000)
Recoveries 283,000 347,000
--------------------------
Net charge-offs (4,538,000) (8,172,000)
Provision for loan losses 54,000 (565,000)
--------------------------
Balance as of September 30 $10,078,000 $18,254,000
============ ============
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 $3,182,000 from
December 31, 2003 to $95,856,000 at September 30, 2004. Federal funds sold
decreased $632,000 from December 31, 2003.
ASSET QUALITY
Between December 31, 2003 and September 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 $8,856,000
during this period. The ratio of nonperforming assets to total assets decreased
from 3.37% to
18
1.61% and the ratio of nonperforming loans to total loans decreased from 3.51%
to 1.92% during the first nine 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 113.80% 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 September 30, 2004 and December 31, 2003:
NONPERFORMING ASSETS
9/30/2004 12/31/2003
---------- -----------
Nonaccruing loans $6,428,000 $12,523,000
Loans past due 90 days or more 803,000 524,000
Foreclosed real estate 1,625,000 4,547,000
---------- -----------
Totals $8,856,000 $17,594,000
========== ===========
DEPOSITS
Total deposits of $388,977,000 at September 30, 2004 decreased $26,638,000, or
6.4%, 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 $3,381,000 from year-end 2003 and out of market deposits decreased
$21,582,000 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 $3,684,000,
or 13.1%, from year-end 2003 to September 30, 2004, and interest-bearing
deposits decreased $30,322,000, or 7.8%, from year-end 2003.
OTHER BORROWINGS
Federal funds purchased increased $9.7 million from December 31, 2003, to
September 30, 2004. FHLB advances increased $36.2 million from December 31, 2003
to September 30, 2004. The increase in these borrowings was used to offset the
$26.6 million decrease in total deposits and to fund the $21.4 increase in
mortgage loans held for sale.
19
STOCKHOLDERS' EQUITY
Equity has increased by $1,795,000 from December 31, 2003 to September 30, 2004.
The major components of this increase were: (1) nine months ended September 30,
2004, net income of $1,711,820, and (2) stock issuance of $90,994. Offsetting
this was a decrease in the net unrealized gain on available for sale securities
of $ 7,452, net of income tax.
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 September 30, 2004.
The liability portion of the balance sheet provides liquidity through various
customers' interest-bearing and noninterest-bearing deposit accounts. At
September 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
September 30, 2004, the Federal Home Loan Bank line of credit permitted
borrowings of up to approximately $99.3 million and as of September 30, 2004,
the Bank had borrowed $93 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
20
securities") in a pooled trust preferred private placement. The proceeds of that
transaction were then used by Heritage Trust to purchase an equal amount of
10.20% subordinated debentures (the "subordinated debentures") of the Company.
The Company has fully and unconditionally guaranteed all obligations of Heritage
Trust on a subordinated basis with respect to the preferred securities. Subject
to certain limitations, the preferred securities qualify as Tier 1 capital and
are presented in the Consolidated Statements of Financial Condition as
"Guaranteed preferred beneficial interests in the Company's subordinated
debentures." The sole asset of Heritage Trust is the subordinated debentures
issued by the Company. Both the preferred securities of Heritage Trust and the
subordinated debentures of the Company each have 30-year lives. However, both
the Company and Heritage Trust have a call option of ten years, subject to
regulatory approval, or earlier, depending upon certain changes in tax or
investment company laws, or regulatory capital requirements. 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
$38,148,000 at September 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 $43,536,000 at September 30,
2004.
The Company has taken steps to maintain a Tier 1 capital ratio at the Bank of
8%. As of September 30, 2004, the Bank's Tier 1 capital ratio was 8.50%.
Although the Company cannot assure that it will be successful in maintaining
this capital ratio, management believes that the steps it is taking to access
additional capital, implement management changes and enhance internal controls
and procedures will enable the Company to achieve these objectives. The Board of
Directors and management of the Company and the Bank are actively engaged in the
preparation and implementation of strategic business plans for the Company and
the Bank, to address, among other things, the immediate and anticipated future
capital requirements of the Company and the Bank, taking into account the mix of
loans in the Bank's loan portfolio, earnings, and alternative sources of
capital.
As of September 30, 2004 and December 31, 2003, the capital ratios of the Bank
were as follows:
Regulatory September 30, December 31,
Minimum 2004 2003
----------- -------------- -------------
Tier 1 leverage ratio 4% 8.50% 8.64%
Tier 1 Risk-based capital ratio 6% 10.49% 10.71%
Total Risk-based capital ratio 8% 11.74% 11.99%
21
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
SUMMARY
Net income of the Company for the quarter ended September 30, 2004 was $134,000,
compared to net income of $200,000 for the same period in 2003, representing a
$66,000 decrease 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 three months
ended September 30, 2004 decreased $183,000, or 2.5%, from the same period in
2003. A decrease in the average balances of earning assets accounted for
$144,000 of this decrease while a decrease in the average rate earned on these
assets accounted for $39,000 of this decrease. Interest expense for the three
months ended September 30, 2004 decreased $378,000, or 10.7%, over the
corresponding period of 2003 due to decreases in interest expense paid on
interest-bearing deposits. A decrease in the average rate paid on these
liabilities accounted for $ 505,000 of this decrease. Partially offsetting this
was an increase in the average balances of interest bearing liabilities which
caused an increase of $127,000. As a result of these factors, net interest
income increased $196,000, or 5.1%, for the three months ended September 30,
2004, compared to the same period of 2003. The Bank's net interest margin was
3.27% for the quarter ended September 30, 2004 compared to 3.12% for the quarter
ended September 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 $815,000 for the three
months ended September 30, 2004, compared to a negative provision of $48,000 for
the same period of 2003. The 2004 provision resulted from a pending sale of
loans that is a direct result of the pending merger with Peoples. The allowance
for loan losses as a percent of outstanding loans, net of unearned income, was
2.61 % at September 30, 2004 compared to 4.53 % at September 30, 2003.
NONINTEREST INCOME
Noninterest income for the three months ended September 30, 2004 was $1,553,000
compared to $1,108,000 for the same period of 2003. This increase primarily was
due to the following: (1) annuity sale income of $100,000 in 2004; (2) increase
in the cash surrender value of life insurance of $115,000; and (3) a gain on the
sale of foreclosed real estate of $36,000 in 2004 versus a loss of $465,000 for
the same period in 2003. Partially offsetting this increase was a decrease in
mortgage banking income of $347,000 This decrease was the result of the
decreased volume of refinancing in 2004.
22
NONINTEREST EXPENSES
Noninterest expenses for the three months ended September 30, 2004 were
$4,583,000, reflecting a 1.7% decrease over the same period of 2003. The primary
component of noninterest expenses is salaries and employee benefits, which
decreased $149,000, or 5.9%, during the three months ended September 30, 2004,
compared to the same period in 2003. The decrease in other operating expenses of
$81,000 primarily resulted from the following: (1) decreased advertising expense
of $129,000; (2) decrease in other real estate and collection expenses of
$78,000; and (3) decrease in FDIC insurance expense of $10,000. Partially
offsetting these decreases was an increase in professional fess of $174,000.
INCOME TAXES
The Company attempts to maximize its net income through active tax planning. The
provision for income taxes of $41,000 for the three months ended September 30,
2004 decreased $76,000 compared to the same period of 2003. Taxes as a percent
of earnings before income taxes were 23.4% for the quarter ended September 30,
2003, and 36.9% for the quarter ended September 30, 2004.
NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003
SUMMARY
Net income of the Company for the nine months ended September 30, 2004 was
$1,712,000, compared to net income of $1,235,000 for the same period in 2003,
representing a $477,000 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 nine months
ended September 30, 2004 decreased $2,695,000, or 11.4%, from the same period in
2003. A decrease in the average balances of earning assets accounted for
$1,577,000 of this decrease and the decrease in the average rate earned on these
assets accounted for $1,118,000 of the decrease. Interest expense for the nine
months ended September 30, 2004 decreased $2,512,000, or 20.8%, 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 $ 2,292,000 of this decrease and the decrease
in the average rate paid on these liabilities accounted for $ 220,000 of this
decrease. As a result of these factors, net interest income decreased $183,000,
or 1.6%, for the nine months ended September 30, 2004, compared to the same
period of 2003. The Bank's net interest margin was 3.28% for the nine months
ended September 30, 2004 compared to 3.17% for the same period in 2003.
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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 $54,000 for the nine
months ended September 30, 2004, compared to a negative provision of $565,000
for the same period of 2003. The provision primarily resulted from a pending
sale of loans that is a direct result of the pending merger with Peoples,
partially offset by a the reduction in classified loans of $27,301,000 from
December 31, 2003, to September 30, 2004. The allowance for loan losses as a
percent of outstanding loans, net of unearned income, was 2.61% at September 30,
2004 compared to 4.53 % at September 30, 2003.
NONINTEREST INCOME
Noninterest income for the nine months ended September 30, 2004 was $4,664,000
compared to $3,344,000 for the same period of 2003. This increase primarily was
due to the following: (1) annuity sale income of $240,000 in 2004; (2) increase
in the cash surrender value of life insurance of $340,000; (3) an increase in
the gain on sale of investments of $391,000; and (4) a gain on the sale of
foreclosed real estate of $109,000 in 2004 versus a loss of $687,000 for the
same period in 2003. Partially offsetting this increase was a decrease in
mortgage banking income of $706,000. This decrease was the result of the
decreased volume of refinancing in 2004.
NONINTEREST EXPENSES
Noninterest expenses for the nine months ended September 30, 2004 were
$13,555,000, reflecting a .4% decrease over the same period of 2003. The primary
component of noninterest expenses is salaries and employee benefits, which
increased $114,000, or 1.7%, during the nine months ended September 30, 2004,
compared to the same period in 2003. Occupancy costs increased $115,000, or
6.9%, and other operating expenses decreased $287,000, or 5.7%, 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 $236,000; (2) decrease in other real estate and collection
expenses of $161,000; (3) decrease in FDIC insurance of $235,000; (4) decrease
in contract services of $429,000; and (5) decrease in mortgage expenses of
$122,000. Partially offsetting this were increases of $76,000 in courier
expense, $113,000 in loan closing cost and $151,000 in merger related expenses.
INCOME TAXES
The Company attempts to maximize its net income through active tax planning. The
provision for income taxes of $836,000 for the nine months ended September 30,
2004 increased $100,000 compared to the same period of 2003. Taxes as a percent
of earnings before income taxes were 32.8% for the nine months ended September
30, 2004, and 37.4% for the same period in 2003.
24
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 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
25
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; recommendations made by or actions taken by banking regulatory
authorities; significant changes in the economic scenario from the current
anticipated scenario which could materially change anticipated credit quality
trends; the value of investment securities and the ability to generate loans;
significant delay in or inability to execute strategic initiatives designed to
increase capital, reduce non-performing loans and classified assets, grow
revenues and control expenses; ability to maintain sufficient liquidity and cash
flow and significant changes in accounting, tax or regulatory practices or
requirements; changes in interest rates; financial, legal, regulatory or other
changes affecting the banking and financial services industries in general;
continued intense competition from numerous providers of products and services
which compete with the Company's businesses, and other factors listed from time
to time in the Company's SEC reports, including, but not limited to, the Annual
Report on Form 10-K for the year ended December 31, 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 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.
26
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 September 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.
ITEM 4. CONTROLS AND PROCEDURES
(a) The Company carried out an evaluation, under the supervision and
participation of its management, including the Chief Executive Officer and the
Chief Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures (as defined in Exchange Act Rules
13a-15(e) and 15d-15(e)) as of the end of the period covered by this Quarterly
report on Form 10-Q. Based on that evaluation, the Chief Executive Officer and
the Chief Financial Officer concluded that the Company's disclosure controls and
procedures are effective in timely alerting them to material information
relating to the Company (including its consolidated subsidiaries) required to be
included in the Company's periodic SEC filings. However, the Company recently
has experienced several changes in top management, and the effectiveness of such
disclosure controls and procedures is dependent on the Company's personnel to
report any issues or matters required to be disclosed in the Company's SEC
filings to the appropriate management personnel on a timely basis.
(b) 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 third quarter of 2004 that have materially
affected, or are reasonably likely to materially affect, the Company's internal
control over financial reporting.
27
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 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
EXHIBITS
Exhibit No. Exhibit Page
- ----------- ------- ------
31.1 Certification of principal executive officer pursuant
to Exchange Act Rule 13a - 14(a) or 15d - 14(a) 30
31.2 Certification of principal financial officer pursuant
to Exchange Act Rule 13a - 14(a) or 15d - 14(a) 31
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
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 33
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HERITAGE FINANCIAL HOLDING CORPORATION
By: /s/ Larry R. Mathews 11/4/2004
----------------------- ------------
Larry R. Mathews Date
President and
Chief Executive Officer
By: /s/ William M. Foshee 11/4/2004
------------------------ ------------
William M. Foshee Date
Chief Financial Officer
29