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 March 31, 2004
OR
[ ] 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 000-23877
Heritage Commerce Corp
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150 Almaden Boulevard
San Jose, California 95113
(408) 947-6900
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 preceding 12 months (or for such shorter period that the registrant was required to file 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 Rule 12b-2 of the Exchange Act). YES [X] NO [ ]
APPLICABLE ONLY TO CORPORATE ISSUERS:
The Registrant had 11,586,779 shares of Common Stock outstanding on May 7, 2004.
Heritage Commerce Corp and Subsidiaries
Part I -- FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS
HERITAGE COMMERCE CORP AND SUBSIDIARIES
See notes to condensed consolidated financial statements
HERITAGE COMMERCE CORP AND SUBSIDIARIES
See notes to condensed consolidated financial statements
HERITAGE COMMERCE CORP AND SUBSIDIARIES
See notes to condensed consolidated financial statements
HERITAGE COMMERCE CORP AND SUBSIDIARIES
1) The unaudited condensed consolidated financial statements
of Heritage Commerce Corp (the "Company") and its wholly owned subsidiary:
Heritage Bank of Commerce (HBC) have been prepared pursuant to the rules and
regulations for reporting on Form 10-Q. Accordingly, certain information and
notes required by accounting principles generally accepted in the United States
of America ("GAAP") for annual financial statements are not included herein. The
interim statements should be read in conjunction with the consolidated financial
statements and notes thereto included in the Company's Form 10-K for the year
ended December 31, 2003. The Company has also established the following
unconsolidated subsidiary grantor trusts: Heritage Capital Trust I; Heritage
Statutory Trust I; Heritage Statutory Trust II; and Heritage Commerce Corp
Statutory Trust III which are Delaware Statutory business trusts formed for the
exclusive purpose of issuing and selling trust preferred securities. HBC is a commercial bank serving customers located in Santa
Clara, Alameda, and Contra Costa counties of California. No customer accounts
for more than 10 percent of revenue for HBC or the Company. Management evaluates
the Company's performance as a whole and does not allocate resources based on
the performance of different lending or transaction activities. Accordingly, the
Company and its subsidiary operate as one business segment. In the Company's opinion, all adjustments necessary for a
fair presentation of these condensed consolidated financial statements have been
included and are of a normal and recurring nature. Certain reclassifications
have been made to prior year amounts to conform to current year
presentation. The results for the three months ended March 31, 2004 are not
necessarily indicative of the results expected for any subsequent period or for
the entire year ending December 31, 2004. 2)
Quarterly Report on Form 10-Q
Table of Contents
PART I. FINANCIAL INFORMATION
Page No.
Item 1. Financial Statements
(unaudited):
Condensed Consolidated Balance Sheets
Condensed Consolidated Income Statements
Condensed Consolidated Statements of Cash Flows
Condensed Consolidated Notes to Financial Statements
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II. OTHER INFORMATION
Item 4. Submission of Matters to A Vote of Security Holders
Item 6. Exhibits and Reports on Form 8-K
Signatures
Exhibit Index
CONDENSED CONSOLIDATED BLANCE SHEETS (UNAUDITED)
March 31, December 31,
(Dollars in thousands) 2004 2003
- ---------------------------------------------------------------- ------------ ------------
ASSETS
Cash and due from banks......................................... $ 49,684 $ 39,978
Interest bearing deposits in other financial institutions....... 2,041 2,039
Federal funds sold.............................................. 67,700 72,200
------------ ------------
Total cash and cash equivalents.................. 119,425 114,217
Securities available-for-sale, at fair value.................... 204,705 153,473
Loans held for sale, at lower of cost or market................. 25,512 30,638
Loans, net of deferred costs.................................... 670,739 666,088
Allowance for probable loan losses.............................. (12,151) (13,451)
------------ ------------
Loans, net....................................... 658,588 652,637
Premises and equipment, net..................................... 3,711 4,034
Accrued interest receivable and other assets.................... 20,673 20,425
Corporate owned life insurance.................................. 25,602 25,273
Other investments............................................... 2,507 2,504
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TOTAL............................................ $ 1,060,723 $ 1,003,201
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LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits
Demand, noninterest bearing............................... $ 287,633 $ 238,423
Demand, interest bearing.................................. 108,764 105,260
Savings and money market.................................. 340,212 345,886
Time deposits, under $100................................. 39,724 39,869
Time deposits, $100 and over.............................. 97,634 94,002
Brokered deposits......................................... 11,018 11,970
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Total deposits............................................... 884,985 835,410
Accrued interest payable and other liabilities............... 10,057 10,643
Other borrowings............................................. 48,600 43,600
Notes payable to subsidiary grantor trusts................... 23,702 23,702
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Total liabilities................................ 967,344 913,355
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Commitments and contingencies
Shareholders' equity:
Preferred stock, no par value; 10,000,000 shares authorized;
none outstanding.......................................... -- --
Common stock, no par value; 30,000,000 shares authorized;
shares outstanding: 11,495,008 at March 31, 2004
and 11,381,037 at December 31, 2003....................... 65,776 65,234
Unallocated ESOP shares...................................... (380) (443)
Accumulated other comprehensive income, net of taxes......... 1,000 79
Retained earnings............................................ 26,983 24,976
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Total shareholders' equity....................... 93,379 89,846
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TOTAL............................................ $ 1,060,723 $ 1,003,201
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CONDENSED CONSOLIDATED INCOME STATEMENTS (UNAUDITED)
Three Months Ended
March 31,
------------------------
(Dollars in thousands, except per share data) 2003 2002
- ------------------------------------------------------------- ----------- -----------
Interest income:
Loans, including fees..................................... $ 10,514 $ 11,185
Securities, taxable...................................... 1,284 1,069
Securities, non-taxable.................................. 115 96
Interest bearing deposits in other financial institutions. 3 16
Federal funds sold........................................ 68 82
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Total interest income 11,984 12,448
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Interest expense:
Deposits.................................................. 1,581 2,280
Subsidiary grantor trusts................................. 482 490
Other..................................................... 126 3
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Total interest expense....................................... 2,189 2,773
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Net interest income before provision for probable
loan losses................................................ 9,795 9,675
Provision for probable loan losses........................... 600 1,300
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Net interest income after provision for probable
loan losses................................................ 9,195 8,375
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Noninterest income:
Gain on sale of loans..................................... 727 557
Servicing income.......................................... 505 425
Service charges and other fees on deposit accounts........ 473 411
Appreciation of company owned life insurance ............. 329 334
Gain on sale of securities available-for-sale............. 212 425
Mortgage brokerage fees................................... 119 363
Other..................................................... 109 449
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Total noninterest income..................................... 2,474 2,964
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Noninterest expenses:
Salaries and employee benefits............................ 4,720 4,704
Occupancy................................................. 1,050 819
Loan origination costs.................................... 357 317
Professional fees......................................... 355 271
Advertising and promotion................................. 247 171
Furniture and equipment................................... 237 391
Client services........................................... 185 250
Telephone................................................. 113 83
Stationery & supplies..................................... 70 106
Other..................................................... 1,378 1,388
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Total noninterest expenses................................... 8,712 8,500
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Income before provision for income taxes..................... 2,957 2,839
Provision for income taxes................................... 950 910
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Net income................................................... $ 2,007 $ 1,929
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Earnings per share:
Basic................................................... $ 0.18 $ 0.17
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Diluted................................................. $ 0.17 $ 0.17
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Three Months Ended
March 31,
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(Dollars in thousands) 2004 2,003
- ------------------------------------------------------------------ ------------ ------------
Cash flows from operating activities:
Net income........................................................ $ 2,007 $ 1,929
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization..................................... 472 429
Provision for probable loan losses................................ 600 1,300
Gain on disposals of property and equipment....................... (10) --
Gain on sale of securities available-for-sale..................... (212) (425)
Amortization /accretion of discounts and premiums on securities... 116 350
Gains on sales of loans........................................... (727) (557)
Proceeds from sales of loans held for sale....................... 13,480 10,855
Originations of loans held for sale............................... (12,450) (18,341)
Maturities of loans held for sale................................. 4,823 9,351
Appreciation of Company Owned Life Insurance...................... (329) (334)
Effect of changes in:
Accrued interest receivable and other assets.................. (227) 956
Accrued interest payable and other liabilities................ (1,124) 171
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Net cash provided by operating activities......................... 6,419 5,684
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Cash flows from investing activities:
Net (increase) decrease in loans.................................. (6,551) 22,101
Purchases of securities available-for-sale........................ (70,162) (4,087)
Maturities/paydowns/calls of securities available-for-sale........ 2,890 9,098
Proceeds from sales of securities available-for-sale............. 17,637 21,370
(Purchases) redemption of other investments....................... (3) 316
Purchases of premises and equipment............................... (139) (115)
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Net cash (used in) provided by investing activities............... (56,328) 48,683
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Cash flows from financing activities:
Net increase (decrease) in deposits............................... 49,575 (17,310)
Net proceeds from issuance of common stock........................ 542 274
Net change in other borrowings.................................... 5,000 --
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Net cash provided by (use in ) financing activities............... 55,117 (17,036)
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Net increase in cash and cash equivalents......................... 5,208 37,331
Cash and cash equivalents, beginning of period.................... 114,217 86,632
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Cash and cash equivalents, end of period.......................... $ 119,425 $ 123,963
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Supplemental disclosures of cash paid during the period for:
Interest....................................................... $ 2,547 $ 3,385
Income taxes................................................... $ -- $ 350
Notes to Condensed Consolidated Financial Statements
March 31, 2004
(Unaudited)
The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. No compensation expense has been recognized in the financial statements for employee stock arrangements, as the Company's stock option plan provides for the issuance of options at a price of no less than the fair market value at the date of the grant.
SFAS No. 123, Accounting for Stock-Based Compensation, requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method at the grant date of all stock options. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which differ significantly from the Company's stock option awards. Those models also require subjective assumptions, which greatly affect the calculated values. The Company's calculations were made using the Black-Scholes option pricing model with the following weighted average assumptions: expected life, 84 months; risk-free interest rate, 3.31% and 3.34% for March 31, 2004 and 2003; stock volatility of 37% and 22% in March 31, 2004 and 2003; and no dividends during the expected term. The Company's calculations are based on a multiple option valuation approach, and forfeitures are recognized as they occur.
Had compensation expense for the Company's stock option plan been determined under the requirements of SFAS No. 123 the Company's pro forma net income and earnings per common share would have been as follows:
Three Months Ended
March 31,
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(Dollars in thousands, except per share data) 2004 2003
- --------------------------------------------------------------- -------- ---------
Net income
As reported................................................ $ 2,007 $ 1,929
Less: Compensation expense for amortization of fair value
of stock awards, net of taxes.......................... (183) (176)
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Pro forma.................................................. $ 1,824 $ 1,753
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Net income per common share - basic
As reported................................................ $ 0.18 $ 0.17
Pro forma.................................................. $ 0.16 $ 0.16
Net income per common share - diluted
As reported................................................ $ 0.17 $ 0.17
Pro forma.................................................. $ 0.15 $ 0.15
3)
Earnings Per ShareBasic earnings per share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method. There were 117,770 and 843,584 stock options at March 31, 2004 and 2003 considered to be antidilutive and excluded from the computation of diluted earnings per share. For each of the periods presented, net income is the same for basic and diluted earnings per share. Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows:
Three Months Ended
March 31,
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2004 2003
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Weighted average common shares outstanding - used
in computing basic earnings per share.................... 11,375,388 11,135,467
Dilutive effect of stock options outstanding,
using the treasury stock method.......................... 422,941 261,432
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Shares used in computing diluted earnings per share.......... 11,798,329 11,396,899
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4)
Comprehensive IncomeComprehensive Income includes net income and other comprehensive income, which represents the change in the Company's net assets during the period from non-owner sources. The Company's sources of other comprehensive income are unrealized gains and losses on securities available-for-sale and I/O strips, which are treated like available-for-sale securities, and are presented net of tax. Reclassification adjustments resulting from gains or losses on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose are excluded from comprehensive income of the current period. The Company's total comprehensive income was as follows:
Three Months Ended
March 31,
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(Dollars in thousands) 2004 2003
- ---------------------------------------------------------------- ----------- -----------
Net income...................................................... $ 2,007 1,929
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Other comprehensive income (loss), net of tax:
Net unrealized holding gains (losses) on available-for-sale
securities and Interest-Only strips during the period...... 1,065 (63)
Less: reclassification adjustment for realized
gains on available-for-sale securities
included in net income during the period.................... (144) (289)
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Other comprehensive income (loss)............................... 921 (352)
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Comprehensive income............................................ $ 2,928 $ 1,577
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5)
Supplemental Retirement PlanThe Company has a supplemental retirement plan covering key executives and directors (Plan). The Plan is a nonqualified defined benefit plan and is unsecured and unfunded and there are no Plan assets. For the current fiscal year ending December 31, 2004, the Company estimates the contributions to be paid to the Plan will be $1,200,000 of which $237,000 was paid in the first quarter of 2004. The following table presents the amount of periodic benefit cost recognized for the quarters ended March 31, 2004 and 2003:
March 31,
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(Dollars in thousands) 2004 2003
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Components of net periodic benefits cost
Service cost.............................. $ 182 $ 114
Interest cost............................. 102 50
Amortization of (gain)/loss............... 40 (6)
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Net periodic benefit cost................. $ 324 $ 158
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6)
Commitments and ContingenciesFinancial Instruments with Off-Balance Sheet Risk
HBC is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its clients. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk, in excess of the amounts recognized in the balance sheets.
HBC's exposure to credit loss in the event of non-performance of the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual notional amount of those instruments. HBC uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Credit risk is the possibility that a loss may occur because a party to a transaction failed to perform according to the terms of the contract. HBC controls the credit risk of these transactions through credit approvals, limits, and monitoring procedures. Management does not anticipate any significant losses as a result of these transactions.
Commitments to extend credit as of March 31, were as follows:
(Dollars in thousands) 2004 2003
- ---------------------------------- ---------- ----------
Commitments to extend credit...... $ 290,827 $ 282,094
Standby letters of credit......... 8,542 2,738
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$ 299,369 $ 284,832
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Commitments to extend credit are agreements to lend to a client as long as there is no violation of conditions established in the contract. Commitments generally have fixed expiration dates or other termination clauses. Since some of the commitments are expected to expire without being drawn upon, the total commitment amount does not necessarily represent future cash requirements. HBC evaluates each client's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by HBC upon the extension of credit, is based on management's credit evaluation of the borrower. Collateral held varies but may include cash, marketable securities, accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, and/or residential properties. Fair value of these instruments is not considered significant.
Standby letters of credit are written with conditional commitments issued by HBC to guaranty the performance of a client to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to clients. The Company has a deferred liability of $22,000 as of March 31, 2004, which represents the premiums received on the outstanding financial standby letters of credit. The Company recognizes these premiums as income as the commitments are used or as they expire.
7)
ReclassificationsCertain amounts in the December 31, 2003 and March 31, 2003 financial statements have been reclassified to conform to the March 31, 2004 financial statements presentation.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Discussions of certain matters in this Report on Form 10-Q may constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as "believe", "expect", "intend", "anticipate", "estimate", "project", or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company's mission and vision. The Company's actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. The factors include, but are not limited to changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the US Government, real estate valuations, competition in the financial services industry, and other risks. All of the Company's operations and most of its customers are located in California. California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
Heritage operates as the bank holding company for its subsidiary bank: Heritage Bank of Commerce (the "Bank"). HBC is California state chartered bank, which offers a full range of commercial and personal banking services to residents and the business/professional community in Santa Clara, Contra Costa and Alameda Counties, California.
CRITICAL ACCOUNTING POLICIES
General
Heritage Commerce Corp's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In certain instances, we use a discount factor and prepayment assumptions to determine the present value of assets and liabilities. A change in the discount factor or prepayment spreads could increase or decrease the values of those assets and liabilities which would result in either a beneficial or adverse impact to our financial results. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. We apply Accounting Principles Board (APB) No. 25, "Accounting for Stock Issued to Employees" and related interpretations to account for our stock option plan awards. Other estimates that we use are related to the expected useful lives of our depreciable assets. In addition GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change.
Allowance for Probable Loan Losses
The allowance for probable loan losses is an estimate of the losses that may be sustained in the Company's loan portfolio. The allowance is based on two basic principles of accounting. (1) Statement of Financial Accounting Standards (SFAS) No. 5 "Accounting for Contingencies", which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.
The Company's allowance for probable loan losses has three basic components: the formula allowance, the specific allowance and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses an historical loss view as an indicator of future losses and, as a result formula losses could differ from the losses incurred in the future. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information, and fair market value of collateral are used to estimate those losses. The use of these values is inherently subjective and our actual losses could differ from the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowances. For further information regarding our allowance for credit losses, see Allowance for Probable Loan Losses on page 18.
Loan Sales and Servicing
The amounts of gains recorded on sales of loans and the initial recording of servicing assets and interest only strips is based on the estimated fair values of the respective components. In recording the initial value of the servicing assets and the fair value of the Interest-Only (I/O) strips receivable, the Company uses estimates which are made based on management's expectations of future prepayment and discount rates. For the quarter ended March 31, 2004, management's estimate of constant prepayment rate ("CPR") was 14% and the weighted average discount rate assumption was 10%. These prepayment and discount rates were based on current market conditions and historical performance of the various pools of loans. If actual prepayments with respect to sold loans occur more quickly than projected the carrying value of the servicing assets may have to be adjusted through a charge to earnings. A corresponding decrease in the value of the I/O strip receivable would also be expected.
Stock Based Awards
Under APB No. 25, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company's stock at the date of the grant over the amount required to be paid to the Company by the optionee upon exercising the option. Because the Company's stock option plans provide for the issuance of options at a price of no less than the fair market value at the date of the grant, no compensation expense is required to be recognized for stock options on the date of grant.
RESULTS OF OPERATIONS
Overview
Net income for the three months ended March 31, 2004 was $2,007,000, up 4% from $1,929,000 for the three months ended March 31, 2003. Earnings per diluted share were $0.17 for the three months ended March 31, 2004 and 2003. Annualized return on average assets and return on average equity for the quarter ended March 31, 2004 were 0.82% and 8.83%, compared with returns of 0.85% and 9.32%, for the same period in the prior year.
For the three months ended March 31, 2004, as compared with the same period in the prior year, net interest income increased slightly from $9,675,000 to $9,795,000, an increase of $120,000, or 1%. The Company's net interest margin was 4.38% for the three months ended March 31, 2004, down 26 basis points from 4.64% for the three months ended March 31, 2003, the change reflects the decrease in the yields on earning assets of 61 basis points offset by a corresponding decrease in the cost of interest bearing liabilities of 47 basis points and the effects of the change in mix of earning assets, primarily the increase in the average level of investment securities, and the mix in interest bearing liabilities.
Total assets as of March 31, 2004 were $1,060,723,000, an increase of $117,608,000, or 12%, from $943,115,000 as of March 31, 2003, and an increase of $57,522,000, or 6%, from total assets of $1,003,201,000 as of December 31, 2003. Total deposits as of March 31, 2004 were $884,985,000, an increase of $60,359,000, or 7%, from $824,626,000 as of March 31, 2003, and an increase of $49,575,000, or 6%, from total deposits of $835,410,000 as of December 31, 2003.
Total loan portfolio as of March 31, 2004 were $670,739,000, an increase of $19,213,000, or 3%, from $651,526,000 as of March 31, 2003 and an increase of $4,651,000, or 1%, from $666,088,000 as of December 31, 2003. The Company's allowance for probable loan losses was $12,151,000, or 1.81%, of total loans at March 31, 2004. This compares with an allowance for probable loan losses of $14,247,000, or 2.19%, and $13,451,000, or 2.02% of total loans at March 31, 2003 and December 31, 2003. The decrease in the overall level of the allowance of loan losses since December 31, 2003 is primarily the result of a $2,000,000 charge-off related to one unsecured commercial loan in the first quarter of 2004 offset by the provisions made during the quarter. The Company's nonperforming assets were $4,801,000, compared to $4,800,000 as of March 31, 2003 and $4,580,000 as of December 31, 2003.
The Company's shareholders' equity at March 31, 2004 was $93,379,000, up from $84,143,000 at March 31, 2003 and $89,846,000 as of December 31, 2003. The increase in shareholders' equity is a result of the income generated during the period, the exercise of common stock options and the increase in other comprehensive income from fair value changes. Book value per share increased to $8.12 at March 31, 2004, from $7.50 at March 31, 2003 and $7.89 at December 31, 2003. The Company's leverage capital ratio was 11.54% at March 31, 2004 compared to 11.25% at March 31, 2003 and 11.17% at December 31, 2003.
Net Interest Income and Net Interest Margin
The following table presents the Company's average balance sheet, net interest income and the resultant yields and rates paid for the period presented:
For the Three Months Ended For the Three Months Ended
March 31, 2004 March 31, 2003
--------------------------------- ---------------------------------
Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/
(Dollars in thousands) Balance Expense Rate Balance Expense Rate
- ----------------------------------------------------------------- ---------- ---------- --------- ---------- ---------- ---------
Assets:
Loans, gross..................................................... $ 691,624 $ 10,514 6.11% $ 693,852 $ 11,185 6.54%
Investment securities............................................ 176,184 1,399 3.19% 116,921 1,165 4.04%
Interest bearing deposits in other financial institutions........ 2,039 3 0.59% 7,312 16 0.89%
Federal funds sold............................................... 29,145 68 0.94% 28,014 82 1.19%
---------- ---------- ---------- ----------
Total interest earning assets................................. 898,992 $ 11,984 5.36% 846,099 $ 12,448 5.97%
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Cash and due from banks.......................................... 45,035 37,211
Premises and equipment, net...................................... 3,983 5,215
Other assets..................................................... 31,777 34,431
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Total assets.................................................. $ 979,787 $ 922,956
========== ==========
Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing......................................... $ 106,143 $ 119 0.45% $ 92,657 $ 146 0.64%
Savings and money market......................................... 336,364 841 1.01% 302,756 976 1.31%
Time deposits, under $100........................................ 39,611 142 1.44% 45,165 243 2.18%
Time deposits, $100 and over..................................... 96,251 349 1.46% 107,853 550 2.07%
Brokered deposits................................................ 11,652 130 4.49% 37,947 365 3.90%
Other borrowings................................................. 52,191 608 4.69% 24,022 493 8.32%
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Total interest bearing liabilities............................ 642,212 $ 2,189 1.37% 610,400 $ 2,773 1.84%
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Demand, noninterest bearing...................................... 234,693 217,630
Other liabilities................................................ 11,502 10,978
---------- ----------
Total liabilities............................................. 888,407 839,008
Shareholders' equity............................................. 91,380 83,948
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Total liabilities and
shareholders' equity....................................... $ 979,787 $ 922,956
========== ==========
Net interest income / margin................................................. $ 9,795 4.38% $ 9,675 4.64%
========== ==========
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Note: |
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Yields and amounts earned on loans include loan fees of $991,000 and $1,101,000 for the three month periods ended March 31, 2004 and 2003, respectively. Interest income is reflected on an actual basis, not a fully taxable equivalent basis, and does not include a fair value adjustment. Nonaccrual loans of $4,171,000 and $4,800,000 for the period ended March 31, 2004 and 2003, respectively, are included in the average balance calculation above. |
The Company's net interest income for the three months ended March 31, 2004 was $9,795,000, an increase of $120,000, or 1%, over the same three month period in the prior year. For the three months ended March 31, 2004 compared to the same periods in the prior year, average interest earning assets increased by $52,893,000, or 6%. For the three months ended March 31, 2004, the average yield on interest earning assets was 5.36%, down 61 basis points from 5.97% for the same period in 2003. Over the same period the rates paid on interest bearing liabilities declined 47 basis points to 1.37% from 1.84%. As a result, the net interest margin decreased 26 basis points to 4.38% for the three months ended March 31, 2004, from 4.64% for the same period in the prior year. The decrease in the first quarter of 2004 compared to the same period in the prior year was primarily attributable to the continuing low interest rate environment and changes in the level and mix of earning assets and interest bearing liabilities. Overall, the changes in volume contributed $373,000 to net interest income while the effect of the changes in rates reduced this contribution by $253,000 resulting in the overall increase in March 31, 2004 from March 31, 2003 of $120,000.
The following table sets forth an analysis of the changes in interest income resulting from changes in the average volume of interest earning assets and liabilities and changes in the average rates earned and paid. The total change is shown in the column designated "Net Change" and is allocated in the columns to the left, to the portions respectively attributable to volume changes and rate changes that occurred during the period indicated. Changes due to both volume and rate have been allocated to the change in volume.
Three Months Ended March 31,
2004 vs. 2003
----------------------------------
Increase (Decrease) Due to Change In:
Average Average Net
(Dollars in thousands) Volume Rate Change
- -------------------------------------------------------------- ---------- ---------- ----------
Interest earning assets
Loans, gross.............................................. $ (27) $ (644) $ (671)
Investments securities.................................... 472 (238) 234
Interest bearing deposits in other financial institutions. (8) (5) (13)
Federal funds sold........................................ 3 (17) (14)
---------- ---------- ----------
Total interest earning assets................................ $ 440 $ (904) $ (464)
---------- ---------- ----------
Interest bearing liabilities
Demand, interest bearing.................................. 15 (42) (27)
Savings and money market.................................. 81 (216) (135)
Time deposits, under $100................................. (20) (81) (101)
Time deposits, $100 and over.............................. (43) (158) (201)
Brokered deposits......................................... (294) 59 (235)
Other borrowings.......................................... 328 (213) 115
---------- ---------- ----------
Total interest bearing liabilities........................... $ 67 $ (651) $ (584)
---------- ---------- ----------
Net interest income.......................................... $ 373 $ (253) $ 120
========== ========== ==========
Provision for Probable Loan Losses
The provision for probable loan losses represents the current period expense associated with maintaining an appropriate allowance for credit losses. The loan loss provision and level of allowance for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's assessment of the quality of the loan portfolio, the valuation of problem loans and the general economic conditions in the Company's market area. Periodic fluctuations in the provision for loan losses result from management's assessment of the adequacy of the allowance for probable loan losses; however, actual loan losses may vary from current estimates. For the three months ended March 31, 2004, the provision for probable loan losses was $600,000, compared to $1,300,000 for the same periods in the prior year. See additional discussion at Allowance for Probable Loan Losses.
Noninterest Income
The following table sets forth the various components of the Company's noninterest income for the periods indicated:
Three Months Ended Increase (decrease)
March 31, 2004 versus 2003
-------------------- --------------------
(Dollars in thousands) 2004 2003 Amount Percent
- ---------------------------------------------------- --------- --------- --------- ---------
Gain on sale of loans............................... $ 727 $ 557 $ 170 31 %
Servicing income.................................... 505 425 80 19 %
Service charges and other fees on deposits accounts. 473 411 62 15 %
Appreciation of company owned life insurance........ 329 334 (5) (1)%
Gain on sale of securities available-for-sale....... 212 425 (213) (50)%
Mortgage brokerage fees............................. 119 363 (244) (67)%
Other............................................... 109 449 (340) (76)%
--------- --------- ---------
Total............................................... $ 2,474 $ 2,964 $ (490) (17)%
========= ========= =========
Noninterest income for the three months ended March 31, 2004 was $2,474,000, down 17% from $2,964,000 for the same period in the prior year. The decrease was primarily due to the amendment of an equipment lease agreement resulting in a change in the classification from equipment under operating leases to a direct financing lease arrangement, which is now included in the loan portfolio. As a result, the payment amounts are now recorded as principal and interest payments rather than noninterest income and expenses. The decrease in gain on sale of securities available-for-sale of $213,000 and mortgage brokerage fees of $244,000, which resulted from the change in the underlying market conditions, for the first quarter of 2004 from the prior year was partially offset by an increase in gains on sales of loans of $170,000 and servicing income of $80,000, which was primarily the result of expansion of the SBA lending operation into additional geographic areas of California and the overall increase in the level of loans serviced. The increases in service charges and other fees on deposit accounts of $62,000 was due to an increase in the activity and level of demand deposit accounts.
Noninterest Expense
The following table sets forth the various components of the Company's noninterest expenses for the periods indicated:
Three Months Ended Increase (decrease)
March 31, 2004 versus 2003
-------------------- --------------------
(Dollars in thousands) 2004 2003 Amount Percent
- ---------------------------------------------------- --------- --------- --------- ---------
Salaries and employee benefits...................... $ 4,720 $ 4,704 $ 16 0 %
Occupancy........................................... 1,050 819 231 28 %
Loan origination costs.............................. 357 317 40 13 %
Professional fees................................... 355 271 84 31 %
Advertising and promotion........................... 247 171 76 44 %
Furniture and equipment............................. 237 391 (154) (39)%
Client services..................................... 185 250 (65) (26)%
Telephone........................................... 113 83 30 36 %
Stationery & supplies............................... 70 106 (36) (34)%
Other............................................... 1,378 1,388 (10) (1)%
--------- --------- ---------
Total............................................... $ 8,712 $ 8,500 $ 212 2 %
========= ========= =========
The following table indicates the percentage of noninterest expense in each category:
For The Three Months Ended March 31,
-------------------------------------------
Percent Percent
(Dollars in thousands) 2004 of Total 2003 of Total
- ---------------------------------------------------- --------- --------- --------- ---------
Salaries and employee benefits...................... $ 4,720 54 % $ 4,704 55 %
Occupancy........................................... 1,050 12 % 819 10 %
Loan origination costs.............................. 357 4 % 317 4 %
Professional fees................................... 355 4 % 271 3 %
Advertising and promotion........................... 247 3 % 171 2 %
Furniture and equipment............................. 237 3 % 391 5 %
Client services..................................... 185 2 % 250 3 %
Telephone........................................... 113 1 % 83 1 %
Stationery & supplies............................... 70 1 % 106 1 %
Other............................................... 1,378 16 % 1,388 16 %
--------- --------- --------- ---------
Total............................................... $ 8,712 100 % $ 8,500 100 %
========= ========= ========= =========
Noninterest expenses for the three months ended March 31, 2004 were $8,712,000, up $212,000, or 2%, from $8,500,000 for the same period in the prior year.
For the three month period ended March 31, 2004 compared to the three month period ended March 31, 2003:
Income Taxes
The provision for income taxes for the three months ended March 31, 2004 was $950,000, as compared to $910,000 for the same periods in the prior year. The following table shows the income tax rate for each period indicated.
Three Months Ended
March 31,
--------------------
2004 2003
- ---------------------------------------------------- --------- ---------
Income tax rate..................................... 32.13 % 32.05 %
The difference in the effective tax rate compared to the statutory tax rate of 42% is primarily the result of the Company's investment in Bank Owned Life Insurance policies whose earnings are not subject to taxes, low income housing tax credits and investments in municipal securities.
FINANCIAL CONDITION
Total assets increased $57,522,000, or 6%, to $1,060,723,000 at March 31, 2004 from $1,003,201,000 at December 31, 2003, and increased $117,608,000, or 12%, from $943,115,000 at March 31, 2003. Securities available-for-sale increased $51,232,000, or 33%, to $204,705,000 at March 31, 2004 from $153,473,000 at December 31, 2003, and increased $105,269,000, or 106%, from $99,436,000 at March 31, 2003. Total loan portfolio increased $4,651,000, or 1%, to $670,739,000 at March 31, 2004 from $666,088,000 at December 31, 2003, and increased $19,213,000, or 3%, from $651,526,000 at March 31, 2003. The increase in the assets was primarily funded by increases in deposits and other borrowings. Total deposits increased $49,575,000 or 6% to $884,985,000 at March 31, 2004 from $835,410,000 at December 31, 2003, and increased $60,359,000, or 7%, from $824,626,000 at March 31, 2003. Other borrowings increased $5,000,000, or 11%, to $48,600,000 at March 31, 2004 from $43,600,000 at December 31, 2003. The Company did not have any other borrowings at March 31, 2003.
Securities Portfolio
The following table sets forth the estimated fair value of investment securities at the dates indicated:
March 31,
---------------------- December 31,
(Dollars in thousands) 2004 2003 2003
- ----------------------------------------------- ---------- ---------- ----------
Securities available-for-sale (at fair value):
U.S. Treasury.................................. $ 6,021 $ 4,631 $ 7,015
U.S. Government Agencies....................... 63,301 33,434 36,115
Mortgage-Backed Securities..................... 105,377 40,335 79,615
Municipals..................................... 14,835 9,115 15,704
CMOs........................................... 15,171 11,921 15,024
---------- ---------- ----------
Total securities available-for-sale............ $ 204,705 $ 99,436 $ 153,473
========== ========== ==========
The following table summarizes the composition of the Company's investment securities and the weighted average yields at March 31, 2004:
March 31, 2004
Maturity
----------------------------------------------------------------------------------------
After One and After Five and
Within One Year Within Five Years Within Ten Years After Ten Years Total
--------------- --------------- --------------- --------------- ----------------
(Dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield
- ------------------------------- -------- ------ -------- ------ -------- ------ -------- ------ --------- ------
Securities available-for-sale:
U.S. Treasury.................. $ -- -- % $ 6,021 1.67 % $ -- -- % $ -- -- % $ 6,021 1.67 %
U.S. Government Agencies....... -- -- % 63,301 2.17 % -- -- % -- -- % 63,301 2.17 %
Mortgage-Backed Securities..... -- -- % 331 5.08 % 7,980 3.54 % 97,066 4.09 % 105,377 4.05 %
Municipals - Nontaxable....... 472 4.91 % 11,998 2.93 % 2,365 3.29 % -- -- % 14,835 3.05 %
CMOs........................... -- -- % -- -- % -- -- % 15,171 3.08 % 15,171 3.08 %
-------- -------- -------- -------- ---------
Total available-for-sale....... $ 472 4.91 % $ 81,651 2.26 % $ 10,345 3.48 % $112,237 3.95 % $ 204,705 3.25 %
======== ======== ======== ======== =========
|
Note: |
|
Yield on non-taxable municipal securities are not presented on a fully tax equivalent basis. |
Loans
Total loan portfolio increased $4,651,000, or 1%, to $670,739,000 at March 31, 2004 from $666,088,000 at December 31, 2003, and increased $19,213,000, or 3%, from $651,526,000 at March 31, 2003.
For the three months ended March 31, 2004, $12,450,000 in loans guaranteed by the U.S. Small Business Administration (SBA) were generated and held for sale, and $12,753,000 of SBA loans held for sale was sold into the secondary market.
At March 31, 2004 and December 31, 2003, the Company serviced SBA loans, which it had sold into the secondary market of approximately $125,117,000 and $117,770,000. At March 31, 2004 and December 31, 2003, the carrying amount of the servicing assets was $1,967,000 and $1,876,000, respectively. There was no valuation allowance as of March 31, 2004 or December 31, 2003. The balance of Interest-Only (I/O) strip receivable at March 31, 2004 and December 31, 2003 was $2,960,000, net of unrealized gain of $945,000, and $2,803,000, net of unrealized gain of $925,000, respectively. These assets represent the servicing spread generated from the sold guaranteed portions of SBA loans. Servicing income from these loans was $505,000 for the quarter ended March 31, 2004, compared to $425,000 for the same period in 2003. Amortization of the related assets was $380,000 for the quarter ended March 31, 2004, compared to $297,000 for the same period in 2003. Heritage Bank of Commerce is a preferred lender with the U.S. Small Business Administration, which allows the Company to grant certain U.S. Small Business Administration loans without the prior approval of the SBA.
The following table summarizes the composition of the Company's loan portfolio at the dates indicated:
March 31, % of December 31, % of
(Dollars in thousands) 2004 Total 2003 Total
- ------------------------------------- ------------ ----------- ----------- -----------
Commercial........................... $ 275,536 41 % $ 281,561 42 %
Real estate - mortgage............... 287,833 43 % 276,908 42 %
Real estate - land and construction.. 101,389 15 % 101,082 15 %
Direct financing lease............... 3,749 1 % 3,931 1 %
Consumer............................. 1,715 0 % 1,743 0 %
------------ ----------- ----------- -----------
Total loans..................... 670,222 100 % 665,225 100 %
=========== ===========
Deferred loan costs.................. 517 863
Allowance for loan losses............ (12,151) (13,451)
------------ -----------
Loans, net........................... $ 658,588 $ 652,637
============ ===========
The loan portfolio is primarily composed of commercial loans to companies principally engaged in manufacturing, wholesale, and service businesses and real estate lending, with the balance in direct equipment finance leases and consumer loans. While no specific industry concentration is considered significant, the Company's lending operations are dependent on the technology and real estate industries and their supporting companies. The Company's borrowers could be adversely impacted by a downturn in these sectors of the economy, which could reduce the demand for loans and adversely impact the borrowers' abilities to repay their loans.
The following table sets forth the maturity distribution of the Company's loan portfolio at March 31, 2004:
Over One
Due in Year But
One Year Less Than Over
(Dollars in thousands) or Less Five Years Five Years Total
- ------------------------------------- ------------ ----------- ----------- -----------
Commercial........................... $ 262,182 $ 12,610 $ 744 $ 275,536
Real estate - mortgage............... 199,890 48,526 39,417 287,833
Real estate - land and construction.. 101,389 -- -- 101,389
Direct financing lease............... 982 2,767 -- 3,749
Consumer............................. 1,470 245 -- 1,715
------------ ----------- ----------- -----------
Total loans..................... $ 565,913 $ 64,148 $ 40,161 $ 670,222
============ =========== =========== ===========
Loans with variable interest rates... $ 549,996 $ 30,829 $ -- $ 580,825
Loans with fixed interest rates...... 15,917 33,319 40,161 89,397
------------ ----------- ----------- -----------
Total loans..................... $ 565,913 $ 64,148 $ 40,161 $ 670,222
============ =========== =========== ===========
The table above also shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. At March 31, 2004, approximately 87% of the Company's loan portfolio consisted of floating interest rate loans.
Nonperforming assets
Nonperforming assets consist of nonaccrual loans, loans past due 90 days and still accruing, troubled debt restructurings and other real estate owned. Management generally places loans on nonaccrual status when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is generally reversed from income. Loans are charged off when management determines that collection has become unlikely. Restructured loans are those where the Company has granted a concession on the interest paid or original repayment terms due to financial difficulties of the borrower. Other real estate owned ("OREO") consists of real property acquired through foreclosure on the related underlying defaulted loans. The following table shows nonperforming assets at the dates indicated:
March 31,
---------------------- December 31,
(Dollars in thousands) 2004 2003 2003
- ------------------------------------------------ ---------- ---------- -----------
Nonaccrual loans................................ $ 4,171 $ 4,800 $ 3,972
Loans 90 days past due and still accruing 630 -- 608
Restructured loans.............................. -- -- --
---------- ---------- -----------
Total nonperforming loans................... 4,801 4,800 4,580
Other real estate owned......................... -- -- --
---------- ---------- -----------
Total nonperforming assets.................. $ 4,801 $ 4,800 $ 4,580
========== ========== ===========
Nonperforming assets as a percentage of
period end loans plus other real estate owned. 0.72 % 0.74 % 0.69 %
As of March 31, 2004, the Company had $4,171,000 loans on nonaccrual status, compared to $3,972,000 as of December 31, 2003, which were considered impaired loans. The impaired loans had a related valuation allowance of $1,287,000 and $464,000 at March 31, 2004 and December 31, 2003, respectively. The Company had $630,000 and $608,000 loans past due 90 days or more and still accruing interest, no restructured loans and no foreclosed assets as of March 31, 2004 and December 31, 2003.
The Company had $4,800,000 in loans on nonaccrual status as of March 31, 2003, which were considered impaired loans. The impaired loans had a related valuation allowance of $634,000 at March 31, 2003. The Company had no loans past due 90 days or more and still accruing interest, no restructured loans and no foreclosed assets as of March 31, 2003.
The Company had $258,000 and $106,000 in foregone interest income on nonaccrual loans for the three months ended March 31, 2004 and 2003, respectively. The Company had $17,000 and zero in interest income for cash payments received on nonaccrual loans for the three months ended March 31, 2004 and 2003, respectively.
The Company assigns a risk grade consistent with the system recommended by regulatory agencies to all of its loans. Grades range from "Pass" to "Loss" depending on credit quality, with "Pass" representing loans that involve an acceptable degree of risk. Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes periodic loan by loan review for certain loans to evaluate the level of impairment as well as detailed reviews of other loans (either individually or in pools) based on an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, collateral value, loan volumes and concentrations, size and complexity of the loans, recent loss experience in particular segments of the portfolio, bank regulatory examination results, and current economic conditions in the Company's marketplace, in particular the state of the technology industry and the real estate market.
This process attempts to assess the risk of loss inherent in the portfolio by segregating loans into four components for purposes of determining an appropriate level of the allowance: "watch," "special mention," "substandard" and "doubtful." Additionally, the Company maintains a program for regularly scheduled reviews of certain new and renewed loans by an outside loan review consultant. Any loans identified during an external review process that expose the Company to increased risk are appropriately downgraded and an increase in the allowance for loan losses is established for such loans. Further, the Company is examined periodically by the FDIC, FRB, and the California Department of Financial Institutions at which time a further review of loan quality is conducted.
Loans that demonstrate a weakness, for which there is a possibility of loss if the weakness is not corrected, are categorized as "classified." Classified loans include all loans graded substandard, doubtful and loss and may result from problems specific to a borrower's business or from economic downturns that affect the borrower's ability to repay or that cause a decline in the value of the underlying collateral (particularly real estate).
Allowance for Loan Losses
It is the policy of management to maintain the allowance for probable loan losses at a level adequate for risks inherent in the loan portfolio. Based on information currently available to analyze loan loss delinquency and a history of actual charge-offs, management believes that the loan loss allowance is adequate. However, the loan portfolio can be adversely affected if California economic conditions and the real estate market in the Company's market area were to continue to weaken. Additionally, any weakness of a prolonged nature in the technology industry would have a negative impact on the local market. The effect of such events, although uncertain at this time, could result in an increase in the level of nonperforming loans and increased loan losses, which could adversely affect the Company's future growth and profitability. No assurance of the ultimate level of credit losses can be given with any certainty. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely.
The following table summarizes the Company's loan loss experience as well as provisions, charge-offs and recoveries to the allowance for loan losses and certain pertinent ratios for the periods indicated:
Three Months Ended For the
March 31, Year Ended
-------------------- December 31,
(Dollars in thousands) 2004 2003 2003
- -------------------------------------- --------- --------- ----------
Balance, beginning of period / year... $ 13,451 $ 13,227 $ 13,227
Net charge-offs....................... (1,900) (280) (2,676)
Provision for probable loan losses.... 600 1,300 2,900
--------- --------- ----------
Balance, end of period / year......... $ 12,151 $ 14,247 $ 13,451
========= ========= ==========
Ratios:
Net charge-offs to
average loans outstanding.......... 1.16 % 0.17 % 0.41 %
Allowance for loan losses to average
loans.............................. 1.84 % 2.15 % 2.07 %
Allowance for loan losses to total
loans.............................. 1.81 % 2.19 % 2.02 %
Allowance for loan losses to
nonperforming assets............... 253 % 297 % 294 %
Charge-offs reflect the realization of losses in the portfolio that were recognized previously though provisions for probable loan losses. The net charge-offs as of March 31, 2004 were $1,900,000, compared to $280,000 as of March 31, 2003. Historical net charge-offs are not necessarily indicative of the amount of net charge-offs that the Company will realize in the future.
The following table summarizes the allocation of the allowance for loan losses (ALL) by loan type and the allocated allowance as a percent of loans outstanding in each loan category at the dates indicated:
March 31, 2004 March 31, 2003 December 31, 2003
-------------------- --------------------- --------------------
Percent Percent Percent
of ALL by of ALL by of ALL by
category category category
to total to total to total
loans by loans by loans by
(Dollars in thousands) Amount category Amount category Amount category
- -------------------------------------- --------- --------- ---------- --------- --------- ---------
Commercial............................ $ 9,013 3.27 % $ 7,910 3.09 % $ 9,628 3.42 %
Real estate - mortgage................ 1,803 0.63 % 3,157 1.26 % 2,003 0.72 %
Real estate - land and construction... 1,199 1.18 % 3,180 2.25 % 1,714 1.70 %
Direct financing lease................ 37 0.99 % -- -- % 39 0.99 %
Consumer.............................. 38 2.22 % 51 1.81 % 37 2.12 %
Unallocated........................... 61 -- % (51) -- % 30 -- %
--------- ---------- ---------
Total ........................... $ 12,151 1.81 % $ 14,247 2.19 % $ 13,451 2.02 %
========= ========== =========
The decrease in the overall level of the allowance and in the allowance as a percentage of total loans since December 31, 2003 is primarily the result of the activity related to one unsecured commercial loan. As reported in the Form 10-K for the fiscal year ended December 31, 2003, during the first quarter of 2004 the Company identified a $4 million unsecured commercial line of credit with risks that created doubt about full repayment under the original terms of the agreement. The loan was placed on nonaccrual and a specific reserve was established. Subsequent to placement on nonaccrual, the Company was advised that the borrower had filed for bankruptcy protection. Although the Company continues to negotiate with the borrower within the framework of the bankruptcy, $2.0 million was charged-off in the first quarter of 2004, and a specific reserve of $1.0 million was established for the remaining balance of $2.0 million. Other than the loans already classified, the Company has not identified any additional potential problem loans at March 31, 2004.
Loans are charged against the allowance when management believes that the collectibility of the principal is doubtful. The Company's methodology for assessing the appropriateness of the allowance consists of several key elements, which include specific allowances, the formula allowance and the unallocated allowance.
Specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate the probability that a loss may be incurred in excess of the amount determined by the application of the formula allowance. As of March 31, 2004, nonperforming loans had a related specific valuation allowance of $1,335,000 compared to a specific valuation allowance of $474,000 at December 31, 2003.
The formula allowance is calculated by applying loss factors to outstanding loans and certain unused commitments. Loss factors are based on management's experience and may be adjusted for significant factors that, in management's judgment, may affect the collectibility of the portfolio as of the evaluation date. Due to the Company's limited historical loss experience, management utilizes their prior industry experience to determine the loss factor for each category of loan. The formula allowance on March 31, 2004 was $10,755,000, compared to $12,947,000 on December 31, 2003. The decrease was primarily attributable to the charge-off related to one commercial unsecured loan and the specific reserve established for that loan.
The unallocated allowance is based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. As of March 31, 2004, the Company's unallocated allowance was $61,000, compared to $30,000 on December 31, 2003. In evaluating the appropriateness of the unallocated allowance, management considered the changes in the trend of the volume and severity of past due and classified loans; and trends in the volume of nonaccrual loans, troubled debt restructurings and other loan modifications, changes in national and local economic and business conditions, trends, and developments, including the condition of various market segments, changes in underwriting standards and collection, charge-off, and recovery practices, and changes in the volume and mix of the loan portfolio and in credit concentrations particularly in commercial and real estate land and construction lending. There can be no assurance that the adverse impact of any of these conditions on the Company will not be in excess of the range set forth above.
In addition, the current business, economic, and real estate markets along with the seasoning of the portfolio and the nature and duration of the current business cycle will affect the amount of unallocated reserve.
In an effort to improve its analysis of risk factors associated with its loan portfolio, the Company continues to monitor and to make appropriate changes to its internal loan policies. These efforts better enable the Company to assess risk factors prior to granting new loans and to assess the sufficiency of the allowance for loan losses.
Management believes that it has adequately provided an allowance for estimated probable losses in the credit portfolio. Significant deterioration in Northern California real property values or economic downturns could impact future operating results, liquidity or capital resources and require additional provisions to the allowance or cause losses in excess of the allowance.
Deposits
Total deposits were $884,985,000 at March 31, 2004, up 6%,
compared to deposits of $835,410,000 at December 31, 2003, and up 7% from $824,626,000 at March 31, 2003. Compared to December 31, 2003, noninterest bearing demand deposits increased $49,210,000, or 21%, primarily due to a short term $30,328,000, or 51%, increase in title and escrow deposits at March 31, 2004; interest bearing demand deposits increased $3,504,000, or 3%; savings and money market deposits decreased $5,674,000, or 2%; time deposits increased $3,487,000, or 3%; and brokered deposits decreased $952,000, or 8%.The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated:
Three Months Ended Year Ended
March 31, 2004 December 31, 2003
-------------------- --------------------
Average Average
Average Rate Average Rate
(Dollars in thousands) Balance Paid Balance Paid
- ------------------------------------- ---------- -------- ---------- --------
Demand, noninterest bearing.......... $ 234,693 -- % $ 238,467 -- %
Demand, interest bearing............. 106,143 0.45 % 96,772 0.51 %
Saving and money market.............. 336,364 1.01 % 318,774 1.16 %
Time deposits, under $100............ 39,611 1.44 % 43,060 1.85 %
Time deposits, $100 and over......... 96,251 1.46 % 101,406 1.79 %
Brokered deposits.................... 11,652 4.49 % 24,559 4.05 %
---------- ----------
Total average deposits.......... $ 824,714 0.77 % $ 823,038 0.95 %
========== ==========
Deposit Concentration and Deposit Volatility
The following table indicates the maturity schedule of the Company's time deposits of $100,000 or more as of March 31, 2004.
% of
(Dollars in thousands) Balance Total
- ----------------------------------------------------------- ---------- --------
Three months or less....................................... $ 48,229 44 %
Over three months through twelve months.................... 50,040 46 %
Over twelve months......................................... 10,383 10 %
---------- --------
Total............................................... $ 108,652 100 %
========== ========
The Company focuses primarily on servicing business accounts that are frequently over $100,000 in average size. Certain types of accounts that the Company makes available are typically in excess of $100,000 in average balance per account, and certain types of business clients whom the Company serves typically carry deposits in excess of $100,000 on average. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals.
Return on Equity and Assets
The following table indicates the ratios on the annualized return on average assets and average equity and average equity to average assets for each indicated period.
Three Months Ended
March 31,
--------------------
2004 2003
---------- ---------
Return on average assets............... 0.82 % 0.85 %
Return on average equity............... 8.83 % 9.32 %
Average equity to average assets ratio. 9.33 % 9.10 %
Annualized return on average assets and return on average equity for the quarter ended March 31, 2004 were 0.82% and 8.83%, respectively, compared with returns of 0.85% and 9.32%, respectively, for the same period in 2003. The equity to asset ratio for the quarter ended March 31, 2003 was 9.33%, compared to 9.10% for the same period in 2003.
Interest Rate Risk
The planning of asset and liability maturities is an integral part of the management of an institution's net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities
The following table sets forth the interest rate sensitivity of the Company's interest-earning assets and interest-bearing liabilities at March 31, 2004, using the rate sensitivity gap ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or when it is scheduled to mature within the specified time frame:
Due in Due After
Within Three to One to Due After Not
Three Twelve Five Five Rate-
(Dollars in thousands) Months Months Years Years Sensitive Total
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Interest earning assets:
Federal funds sold........................................ $ 67,700 $ -- $ -- $ -- $ -- $ 67,700
Interest bearing deposits in other financial Institutions. 2,041 -- -- -- -- 2,041
Securities................................................ 327 145 81,651 122,582 -- 204,705
Total loans............................................... 525,456 66,486 64,148 40,161 -- 696,251
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Total interest earning assets........................... 595,524 66,631 145,799 162,743 -- 970,697
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Cash and due from banks..................................... -- -- -- -- 49,684 49,684
Other assets................................................ -- 25,602 -- -- 14,740 40,342
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Total assets............................................ $ 595,524 $ 92,233 $ 145,799 $ 162,743 $ 64,424 $1,060,723
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Interest bearing liabilities:
Demand, interest bearing.................................. $ 108,764 $ -- $ -- $ -- $ -- $ 108,764
Savings and money market.................................. 340,212 -- -- -- -- 340,212
Time deposits............................................. 64,103 69,438 14,835 -- -- 148,376
Other borrowings............................................ 8,800 -- 39,800 -- -- 48,600
Notes payable to subsidiary grantor trusts................ 9,279 -- -- 14,423 -- 23,702
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Total interest bearing liabilities...................... 531,158 69,438 54,635 14,423 -- 669,654
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Noninterest demand deposits................................. 89,807 -- -- -- 197,826 287,633
Accrual interest payable and other liabilities.............. -- -- -- -- 10,057 10,057
Shareholders' equity........................................ -- -- -- -- 93,379 93,379
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Total liabilities and shareholders' equity.............. $ 620,965 $ 69,438 $ 54,635 $ 14,423 $ 301,262 $1,060,723
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Interest rate sensitivity GAP............................... $ (25,441) $ 22,795 $ 91,164 $ 148,320 $(236,838) $ --
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Cumulative interest rate sensitivity GAP.................... $ (25,441) $ (2,646) $ 88,518 $ 236,838 $ -- $ --
Cumulative interest rate sensitivity GAP ratio.............. (2.40)% (0.25)% 8.35 % 22.33 % -- % -- %
Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates. To supplement traditional GAP analysis, the Company performs simulation modeling to estimate the potential effects of changing interest rate environments. The process allows the Company to explore the complex relationships within the GAP over time and various interest rate environments.
Liquidity risk represents the potential for loss as a result of limitations on the Company's ability to adjust for future cash flows, to meet the needs of depositors and borrowers, and to fund operations on a timely and cost-effective basis. The liquidity policy approved by the board of directors requires annual review of the Company's liquidity by the asset/liability committee, which is composed of senior executives, and the finance and investment committee of the board of directors.
The Company's internal asset/liability committee and the finance and investment committee of the board of directors each meet monthly to monitor the Company's investments, liquidity needs and to oversee its asset/liability management. The Company evaluates the rates offered on its deposit products on a weekly basis.
Liquidity and Liability Management
To meet liquidity needs, the Company maintains a portion of its funds in cash deposits in other banks, in Federal funds sold, and in investment securities. At March 31, 2004, the Company's primary liquidity ratio was 20.75%, comprised of $82,123,000 in investment securities available-for-sale with maturities (or probable calls) of up to five years, less $19,993,000 of securities that were pledged to secure public and certain other deposits as required by law and contract; Federal funds sold of $67,700,000, and $49,684,000 in cash and due from banks, as a percentage of total unsecured deposits of $864,992,000.
Capital Resources
The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:
March 31,
---------------------- December 31,
(Dollars in thousands) 2004 2003 2003
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Capital components:
Tier 1 Capital................ $ 113,412 $ 104,166 $ 110,891
Tier 2 Capital................ 10,725 10,117 10,403
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Total risk-based capital.... $ 124,137 $ 114,283 $ 121,294
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Risk-weighted assets............. $ 857,965 $ 803,951 $ 830,537
Average assets................... $ 982,777 $ 925,821 $ 992,608
Minimum
Regulatory
Requirements
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Capital ratios:
Total risk-based capital....... 14.5 % 14.2 % 14.6 % 8.0 %
Tier 1 risk-based capital...... 13.2 % 13.0 % 13.4 % 4.0 %
Leverage ratio (1)............. 11.5 % 11.3 % 11.2 % 4.0 %
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Tier 1 capital divided by average assets (excluding goodwill). |
At March 31, 2004 and 2003, and December 31, 2003, the Company's capital met all minimum regulatory requirements. As of March 31, 2004, management believes that HBC was considered "Well Capitalized" under the Prompt Corrective Action Provisions.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
No material changes have occurred during the quarter to the Company's market risk profile or information. For further information refer to the Company's Form 10-K.
ITEM 4. CONTROLS AND PROCEDURES
(a)
We carried out an evaluation under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as of the end of the period covered by this report, pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934. Based on their review of our disclosure controls and procedures, the principal executive officer and principal financial officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us that is required to be included in our periodic SEC filings.(b) There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, such controls.
Part II - OTHER INFORMATION
ITEM 4. - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 4, 2004, the Company announced that Brad L. Smith had tendered his resignation as Chief Executive Officer and Director to facilitate the settlement with shareholders who had nominated alternative directors for the upcoming annual meeting. Chairman of the Board William Del Biaggio, Jr. was appointed interim CEO effective immediately, while a search for permanent CEO is completed. The Board appointed Ranson Webster to fill the seat vacated by Smith. Webster is the Company's largest individual shareholder and is one of the founders of HBC. As part of the proposed settlement agreement, the Concerned Shareholders Committee has agreed in principle not to further pursue proxy solicitation measures for two years. The settlement and standstill agreement and the Company's press release of May 5, 2004 announcing execution of the definitive agreement are attached to this report as Exhibits 4.1 and 4.2, respectively, and incorporated herein by reference.
ITEM 6. - EXHIBITS AND REPORTS ON FORM 8-K
The exhibit list required by this item is incorporated by reference to the Exhibit Index filed as part of this report.
The Registrant filed a Current Report on Form 8-K dated March 18, 2004 under item 5 to report Phillip Boyce resigned as a Direct of Heritage Commerce Corp and Heritage Bank of Commerce.
The Registrant furnished a Current Report on Form 8-K dated January 20, 2004 under Item 7 and 12, to report its year end 2003 financial results, containing condensed summarized statements of financial position and results of operations.
The Registrant furnished a Current Report on Form 8-K dated April 23, 2004 under item 7 and item 12 to report its quarter ended March 31, 2004 financial results, containing condensed summarized statements of financial position and results of operations.
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.
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Heritage Commerce Corp |
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May 10, 2004 |
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/s/ William Del Biaggio, Jr. Interim Chief Executive Officer |
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May 10, 2004 |
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/s/ Lawrence D. McGovern Chief Financial Officer |