UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2004
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 11,666,341 shares of Common Stock outstanding on July 29, 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 consolidated financial statements.
HERITAGE COMMERCE CORP AND SUBSIDIARIES
See notes to condensed consolidated financial statements
HERITAGE COMMERCE CORP AND SUBSIDIARIES
1) Basis of Presentation The unaudited condensed consolidated financial statements
of Heritage Commerce Corp (the "Company") and its wholly owned subsidiary:
Heritage Bank of Commerce ("HBC" or the "Bank") 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 and six months ended June
30, 2004 are not necessarily indicative of the results expected for any
subsequent period or for the entire year ending December 31, 2004. 2) New Accounting Standard At the March 17-18, 2004 Emerging Issues Task Force
(EITF) meeting, the Task Force reached a consensus on Issue No. 03-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments." Issue 03-1 provides guidance for the determination of when an
investment is other-than-temporarily impaired. The guidance for evaluating whether
an investment is other-than-temporarily impaired should be applied in
other-than-temporary impairment evaluations made in reporting periods beginning after
June 15, 2004. Other-than-temporary impairment that may need to be recognized
upon adoption of Issue 03-1 will be dependant on market conditions and
management's intent and ability at the time of the impairment evaluation to hold
investments with market values below amortized cost until a forecasted recovery
in fair value up to (or beyond) amortized cost. Management is in the process of
evaluating the impacts of EITF 03-1 guidance. As of June 30, 2004, the Company held 99 securities, of which
78 had market values below amortized cost. No securities have been carried with
an unrealized loss for over 12 months. The lower market values are due to either
current interest rates or new preferred issue rates being greater at June 30,
2004 than when the securities were purchased. No security has sustained other than temporary loss of value due to a
downgrade in credit ratings. All principal amounts are expected to be paid when
securities mature, or are called by the issuer. The lower market values are
considered temporary and not a permanent impairment. 3) Stock-Based Compensation 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, 4.35% and 2.84%
for June 30, 2004 and 2003; stock volatility of 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: 4) Earnings Per Share Basic 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 16,830 and 324,389, respectively, stock
options for three months ended June 30, 2004 and 2003, 118,816 and 310,386,
respectively, for six months ended June 30, 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: 5) Comprehensive Income (Loss) Comprehensive income (loss) includes net income and other
comprehensive income (loss), 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 (loss) 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 (loss) as unrealized holding gains or losses in the period
in which they arose are excluded from comprehensive income (loss) of the current
period. The Company's total comprehensive income (loss) was as follows: 6) Employee Termination Benefits In the second quarter of 2004, the Company had $972,000
of charges related to the elimination of 11 full-time positions and the
resignation of the former CEO which was recorded as severance in salaries and employee
benefits. At June 30, 2004, $861,000 accrued severance has been recorded under
other liabilities. In addition, $707,000 of retirement plan expense has been
recorded in other noninterest expense in the second quarter of 2004 related to
the resignation of the former CEO and 3 executive employees out of the 11
full-time positions. 7) Supplemental Retirement Plan The Company has a supplemental retirement plan (Plan)
covering key executives and directors. 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 $1,800,000 of which $981,000 and
$1,218,000 were paid for the three and six months ended June 30, 2004. The
following table presents the amount of periodic benefit cost recognized for
three and six months ended June 30, 2004 and 2003: 8) Commitments and Contingencies Financial 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 June 30, were as follows:
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 $28,000 as of June 30, 2004, which represents the fees
received on the outstanding financial standby letters of credit. The Company
recognizes these fees as income as the commitments are used or as they
expire. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
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 Changes in Shareholders' Equity
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 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
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)
June 30, December 31,
(Dollars in thousands) 2004 2003
- ---------------------------------------------------------------- ------------ ------------
ASSETS
Cash and due from banks......................................... $ 55,469 $ 39,978
Interest bearing deposits in other financial institutions....... 935 2,039
Federal funds sold.............................................. 13,800 72,200
------------ ------------
Total cash and cash equivalents.................. 70,204 114,217
Securities available-for-sale, at fair value.................... 230,435 153,473
Loans held for sale, at lower of cost or market................. 31,916 30,638
Loans, net of deferred costs.................................... 706,857 666,088
Allowance for probable loan losses.............................. (12,688) (13,451)
------------ ------------
Loans, net....................................... 694,169 652,637
Premises and equipment, net..................................... 3,641 4,034
Accrued interest receivable and other assets.................... 22,564 20,425
Company owned life insurance.................................... 25,836 25,273
Other investments............................................... 4,622 2,504
------------ ------------
TOTAL............................................ $ 1,083,387 $ 1,003,201
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits
Demand, noninterest bearing............................... $ 301,329 $ 238,423
Demand, interest bearing.................................. 111,282 105,260
Savings and money market.................................. 364,124 345,886
Time deposits, under $100................................. 38,293 39,869
Time deposits, $100 and over.............................. 96,096 94,002
Brokered deposits......................................... 8,045 11,970
------------ -----------
Total deposits............................................... 919,169 835,410
Accrued interest payable and other liabilities............... 9,897 10,643
Other borrowings............................................. 39,800 43,600
Notes payable to subsidiary grantor trusts................... 23,702 23,702
------------ ------------
Total liabilities................................ 992,568 913,355
------------ ------------
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 issued and outstanding: 11,596,491 at
June 30, 2004 and 11,381,037 at December 31, 2003......... 65,974 65,234
Unallocated ESOP shares...................................... (318) (443)
Accumulated other comprehensive income (loss), net of taxes.. (2,620) 79
Retained earnings............................................ 27,783 24,976
------------ ------------
Total shareholders' equity....................... 90,819 89,846
------------ ------------
TOTAL............................................ $ 1,083,387 $ 1,003,201
============ ============
CONDENSED CONSOLIDATED INCOME STATEMENTS (UNAUDITED)
Three Months Ended Six Months Ended
June 30, June 30,
------------------------ ------------------------
(Dollars in thousands, except per share data) 2004 2003 2004 2003
- ------------------------------------------------------------- ----------- ----------- ----------- -----------
Interest income:
Loans, including fees..................................... $ 10,912 $ 10,799 $ 21,427 $ 21,983
Securities, taxable...................................... 1,615 814 2,898 1,882
Securities, non-taxable.................................. 70 83 185 180
Interest bearing deposits in other financial institutions. 1 18 4 35
Federal funds sold........................................ 92 159 161 241
----------- ----------- ----------- -----------
Total interest income 12,690 11,873 24,675 24,321
----------- ----------- ----------- -----------
Interest expense:
Deposits.................................................. 1,579 2,052 3,160 4,332
Subsidiary grantor trusts................................. 481 489 963 979
Other..................................................... 238 11 364 14
----------- ----------- ----------- -----------
Total interest expense....................................... 2,298 2,552 4,487 5,325
----------- ----------- ----------- -----------
Net interest income before provision for probable
loan losses................................................ 10,392 9,321 20,188 18,996
Provision for probable loan losses........................... 600 600 1,200 1,900
----------- ----------- ----------- -----------
Net interest income after provision for probable
loan losses................................................ 9,792 8,721 18,988 17,096
----------- ----------- ----------- -----------
Noninterest income:
Gain on sale of loans..................................... 639 587 1,366 1,144
Servicing income.......................................... 561 451 1,066 876
Service charges and other fees on deposit accounts........ 497 441 970 852
Appreciation of company owned life insurance ............. 234 303 562 637
Gain on sale of securities available-for-sale............. 264 33 476 458
Mortgage brokerage fees .................................. 30 277 149 640
Other..................................................... 79 424 189 873
----------- ----------- ----------- -----------
Total noninterest income..................................... 2,304 2,516 4,778 5,480
----------- ----------- ----------- -----------
Noninterest expenses:
Salaries and employee benefits............................ 5,456 4,521 10,176 9,224
Occupancy................................................. 880 835 1,930 1,654
Professional fees......................................... 961 419 1,316 690
Loan origination costs.................................... 411 360 768 677
Advertising and promotion................................. 252 228 499 399
Furniture and equipment................................... 255 367 492 758
Client services........................................... 231 225 416 475
Telephone................................................. 86 67 199 150
Stationery & supplies..................................... 82 57 152 163
Other..................................................... 2,302 1,407 3,681 2,796
----------- ----------- ----------- -----------
Total noninterest expenses................................... 10,916 8,486 19,629 16,986
----------- ----------- ----------- -----------
Income before provision for income taxes..................... 1,180 2,751 4,137 5,590
Provision for income taxes................................... 380 880 1,330 1,790
----------- ----------- ----------- -----------
Net income................................................... $ 800 $ 1,871 $ 2,807 $ 3,800
=========== =========== =========== ===========
Earnings per share:
Basic................................................... $ 0.07 $ 0.17 $ 0.24 $ 0.34
=========== =========== =========== ===========
Diluted................................................. $ 0.07 $ 0.16 $ 0.24 $ 0.33
=========== =========== =========== ===========
CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (UNAUDITED)
Accumulated
Other
Common Stock Comprehensive Total
------------------------ Unallocated Income (Loss) Retained Shareholders' Comprehensive
(Dollars in thousands) Shares Amount ESOP Shares Net of Taxes Earnings Equity Income
- ----------------------------- ------------ --------- ---------- ------------ --------- ----------- -------------
BALANCES, DECEMBER 31, 2002....... 11,214,414 $ 64,002 $ (693) $ 1,714 $ 17,194 $ 82,217
Net income........................ -- -- -- -- 3,800 3,800 $ 3,800
Net change in unrealized
loss on securities
available-for-sale, net of
reclassification adjustment
and taxes......................... -- -- -- (209) -- (209) (209)
-------------
Total comprehensive income..... $ 3,591
=============
Amortization of stock compensation -- -- 125 -- -- 125
Additional paid-in-capital in ESOP -- 43 -- -- -- 43
Stock options exercised........... 82,454 753 -- -- -- 753
------------ --------- ---------- ------------ --------- -----------
BALANCES, JUNE 30, 2003........... 11,296,868 $ 64,798 $ (568) $ 1,505 $ 20,994 $ 86,729
============ ========= ========== ============ ========= ===========
BALANCES, DECEMBER 31, 2003....... 11,381,037 $ 65,234 $ (443) $ 79 $ 24,976 $ 89,846
Net income........................ -- -- -- -- 2,807 2,807 $ 2,807
Net change in unrealized
loss on securities
available-for-sale, net of
reclassification adjustment
and taxes......................... -- -- -- (2,699) -- (2,699) (2,699)
-------------
Total comprehensive income..... $ 108
=============
Amortization of stock compensation -- -- 125 -- -- 125
Additional paid-in-capital in ESOP -- 103 -- -- -- 103
Common stock repurchased.......... (132,789) (1,934) -- -- -- (1,934)
Stock options exercised........... 348,243 2,571 -- -- -- 2,571
------------ --------- ---------- ------------ --------- -----------
BALANCES, JUNE 30, 2004........... 11,596,491 $ 65,974 $ (318) $ (2,620) $ 27,783 $ 90,819
============ ========= ========== ============ ========= ===========
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Six Months Ended
June 30,
--------------------------
(Dollars in thousands) 2004 2003
- ------------------------------------------------------------------ ------------ ------------
Cash flows from operating activities:
Net income........................................................$ 2,807 $ 3,800
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization..................................... 783 844
Provision for probable loan losses................................ 1,200 1,900
Non-cash compensation expense related to ESOP plan................ 228 168
Gain on sale of securities available-for-sale..................... (476) (458)
Net amortization of premiums / accretion of discounts............. 455 686
Gains on sales of loans held for sale............................. (1,366) (1,144)
Proceeds from sales of loans held for sale....................... 27,392 23,751
Originations of loans held for sale............................... (33,747) (36,721)
Maturities of loans held for sale................................. 6,443 14,327
Appreciation of company owned life insurance...................... (562) (637)
Effect of changes in:
Accrued interest receivable and other assets.................. (1,968) (119)
Accrued interest payable and other liabilities................ 1,167 (1,242)
------------ ------------
Net cash provided by operating activities......................... 2,356 5,155
------------ ------------
Cash flows from investing activities:
Net (increase) decrease in loans.................................. (42,733) 35,910
Purchases of securities available-for-sale........................ (117,735) (82,904)
Maturities/paydowns/calls of securities available-for-sale........ 13,371 28,847
Proceeds from sales of securities available-for-sale............. 22,641 23,562
(Purchases) Redemption of other investments....................... (2,118) 1,234
Purchases of premises and equipment............................... (391) (293)
------------ ------------
Net cash (used in) provided by investing activities............... (126,965) 6,356
------------ ------------
Cash flows from financing activities:
Net increase in deposits.......................................... 83,759 5,969
Net proceeds from issuance of common stock........................ 2,571 753
Common stock repurchased.......................................... (1,934) --
Net change in other borrowings.................................... (3,800) 28,600
------------ ------------
Net cash provided by financing activities......................... 80,596 35,322
------------ ------------
Net (decrease) increase in cash and cash equivalents.............. (44,013) 46,833
Cash and cash equivalents, beginning of period.................... 114,217 86,632
------------ ------------
Cash and cash equivalents, end of period.......................... $ 70,204 $ 133,465
============ ============
Supplemental disclosures of cash paid during the period for:
Interest....................................................... $ 4,555 $ 5,919
Income taxes................................................... $ -- $ 1,570
Supplemental schedule on non-cash investing and financing activity:
Transfer of loans to other real estate owned................... $ -- $ 832
Notes to Condensed Consolidated Financial Statements
June 30, 2004
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- -----------------------
(Dollars in thousands, except per share data) 2004 2003 2004 2003
- --------------------------------------------------------------------- --------- --------- ---------- ----------
Net income
As reported...................................................... $ 800 $ 1,871 $ 2,807 $ 3,800
Less: Compensation expense for amortization of fair value of
stock awards, net of taxes................................. (202) (177) (403) (353)
--------- --------- ---------- ----------
Pro forma........................................................ $ 598 $ 1,694 $ 2,404 $ 3,447
========= ========= ========== ==========
Net income per common share - basic
As reported...................................................... $ 0.07 $ 0.17 $ 0.24 $ 0.34
Pro forma........................................................ $ 0.05 $ 0.15 $ 0.21 $ 0.31
Net income per common share - diluted
As reported...................................................... $ 0.07 $ 0.16 $ 0.24 $ 0.33
Pro forma........................................................ $ 0.05 $ 0.15 $ 0.20 $ 0.30
Three Months Ended Six Months Ended
June 30, June 30,
------------------------ ------------------------
2004 2003 2004 2003
----------- ----------- ----------- -----------
Weighted average common shares outstanding - used
in computing basic earnings per share.................... 11,543,552 11,172,143 11,463,679 11,158,015
Dilutive effect of stock options outstanding,
using the treasury stock method.......................... 411,020 385,108 445,384 329,615
----------- ----------- ----------- -----------
Shares used in computing diluted earnings per share.......... 11,954,572 11,557,251 11,909,063 11,487,630
=========== =========== =========== ===========
Three Months Ended Six Months Ended
June 30, June 30,
------------------------ ------------------------
(Dollars in thousands) 2004 2003 2004 2003
- ------------------------------------------------------------- ----------- ----------- ----------- -----------
Net income................................................... $ 800 $ 1,871 $ 2,807 $ 3,800
Other comprehensive income (loss), net of tax:
Net unrealized holding gain (loss) on available-for-sale
securities and I/O strips during the period............. (3,362) 165 (2,376) 102
Less: reclassification adjustment for realized
gains on available-for-sale securities
included in net income during the period................. (179) (22) (323) (311)
----------- ----------- ----------- -----------
Other comprehensive income (loss)............................ (3,541) 143 (2,699) (209)
----------- ----------- ----------- -----------
Comprehensive income (loss).................................. $ (2,741) $ 2,014 $ 108 $ 3,591
=========== =========== =========== ===========
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- --------------------
(Dollars in thousands) 2004 2003 2004 2003
- ---------------------------------------- --------- --------- --------- ---------
Components of net periodic benefits cost
Service cost......................... $ 160 $ 114 $ 342 $ 228
Interest cost........................ 109 49 211 99
Amortization of (gain)/loss.......... 41 (6) 81 (12)
--------- --------- --------- ---------
Net periodic benefit cost............ $ 310 $ 157 $ 634 $ 315
========= ========= ========= =========
(Dollars in thousands) 2004 2003
- ------------------------------ ------------ ------------
Commitments to extend credit.. $ 279,044 $ 277,936
Standby letters of credit..... 4,588 2,339
------------ ------------
$ 283,632 $ 280,275
============ ============
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 Exchange 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. For additional information relating to the risks of the Company's business see "Risk Factors" in the Company's Annual Report on Form 10-K. All of the Company's operations and most of its customers are located in California. California economic outlook 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. HBC is a 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.
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 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, the Company uses the 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 the Company's financial results. The Company used historical loss experience as one factor in determining the inherent loss that may be present in the Company's loan portfolio. Actual losses could differ significantly from the historical factors that we use. Other estimates that the Company used are related to the expected useful lives of the Company's depreciable assets. In addition GAAP itself may change from one previously acceptable method to another method. Although the economics of the Company's transactions would be the same, the timing of events that would impact the Company's 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 probable future losses and as a result 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 be greater or less than 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 22.
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 June 30, 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. Variations in prevailing interest rates on borrowed funds, changes in general economic conditions, among other factors, could cause changes in the prepayment experience. A corresponding decrease in the value of the I/O strip receivable would also be expected.
Stock Based Awards
The Company accounts for its stock based awards using the intrinsic value method in accordance with Accounting Principles Board ("APB") Opinion No. 25 and related interpretations. Since 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 has been recognized in the financial statements at the date of grant.
RESULTS OF OPERATIONS
Overview
Net income for the three and six months ended June 30, 2004 was $800,000 and $2,807,000, down $1,071,000 and $993,000, or 57% and 26%, respectively, as compared to the three and six months ended June 30, 2003. Earnings per diluted share for the three and six months ended June 30, 2004 were $0.07 and $0.24, respectively, down 56% and 27% from $0.16 and $0.33 per diluted share for the three and six months ended June 30, 2003, respectively. Annualized return on average assets and return on average equity for the three months ended June 30, 2004 were 0.30% and 3.47%,respectively, down from 0.81% and 8.75%,respectively, for the same period in the prior year. Annualized return on average assets and return on average equity for the six months ended June 30, 2004 were 0.55% and 6.14%, respectively, down from 0.83% and 9.03%, respectively, for the same period in the prior year. The significant decrease in net income and earnings per share for the comparable 2003 and 2004 periods is primarily attributable to non-recurring expenses related to the elimination of 11 full time positions to reduce operating costs and the resignation of the former CEO. The non-recurring expenses were partially offset by increases in net interest income.
For the three and six months ended June 30, 2004, as compared with the same period in the prior year, net interest income before provision for probable loan losses increased to $10,392,000 and $20,188,000 from $9,321,000 and $18,996,000, an increase of $1,071,000, or 11% and $1,192,000, or 6%, respectively. The Company's net interest margin was 4.27% and 4.32% for the three and six months ended June 30, 2004, compared with 4.38% and 4.51% for the three and six months ended June 30, 2003, respectively.
Total assets as of June 30, 2004 were $1,083,387,000, an increase of $86,936,000, or 9%, from $996,451,000 as of June 30, 2003, and an increase of $80,186,000, or 8%, from total assets of $1,003,201,000 as of December 31, 2003. Total deposits as of June 30, 2004 were $919,169,000, an increase of $71,264,000, or 8%, from $847,905,000 as of June 30, 2003, and an increase of $83,759,000, or 10%, from total deposits of $835,410,000 as of December 31, 2003.
The total loan portfolio as of June 30, 2004 was $706,857,000, an increase of $69,294,000, or 11%, from $637,563,000 as of June 30, 2003 and an increase of $40,769,000, or 6%, from $666,088,000 as of December 31, 2003. The Company's allowance for probable loan losses was $12,688,000, or 1.79%, of total loans at June 30, 2004. This compares to an allowance for probable loan losses of $14,692,000, or 2.30%, and $13,451,000, or 2.02% of total loans at June 30, 2003 and December 31, 2003, respectively. 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 which was provided for in 2003 offset by the provisions made during the period. The Company's nonperforming assets were $2,632,000, compared to $2,631,000 as of June 30, 2003 and $4,580,000 as of December 31, 2003.
The Company's shareholders' equity at June 30, 2004 was $90,819,000, up from $86,729,000 at June 30, 2003 and $89,846,000 as of December 31, 2003. The increase in shareholders' equity is a result of the income generated over the period and the exercise of common stock options offset by repurchase of common stock and a decline in other comprehensive income from fair value changes. Book value per share increased to $7.83 at June 30, 2004, from $7.68 at June 30, 2003. Book value per share was $7.89 at December 31, 2003. The Company's leverage capital ratio was 10.67% at June 30, 2004 compared to 11.46% at June 30, 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
June 30, 2004 June 30, 2003
--------------------------------- ---------------------------------
Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/
(Dollars in thousands) Balance Expense Rate Balance Expense Rate
- ----------------------------------------------------------------- ---------- ---------- --------- ---------- ---------- ---------
Assets:
Loans, gross..................................................... $ 718,700 $ 10,912 6.11% $ 672,717 $ 10,799 6.44%
Investment securities............................................ 220,990 1,685 3.07% 119,062 897 3.02%
Interest bearing deposits in other financial institutions........ 607 1 0.66% 8,151 18 0.89%
Federal funds sold............................................... 38,742 92 0.96% 54,025 159 1.18%
---------- ---------- ---------- ----------
Total interest earning assets................................. 979,039 $ 12,690 5.21% 853,955 $ 11,873 5.58%
---------- ----------
Cash and due from banks.......................................... 50,239 39,016
Premises and equipment, net...................................... 3,812 4,944
Other assets..................................................... 32,916 33,156
---------- ----------
Total assets.................................................. $1,066,006 $ 931,071
========== ==========
Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing......................................... $ 110,531 $ 115 0.41% $ 96,564 $ 136 0.56%
Savings and money market......................................... 350,445 866 0.99% 303,219 933 1.23%
Time deposits, under $100........................................ 39,211 137 1.41% 44,530 220 1.98%
Time deposits, $100 and over..................................... 98,457 348 1.42% 103,542 491 1.90%
Brokered deposits................................................ 10,102 113 4.50% 26,592 272 4.10%
Other borrowings................................................. 71,520 719 4.05% 26,235 500 7.64%
---------- ---------- ---------- ----------
Total interest bearing liabilities............................ 680,266 $ 2,298 1.36% 600,682 $ 2,552 1.70%
---------- ----------
Demand, noninterest bearing...................................... 283,460 235,557
Other liabilities................................................ 9,639 9,043
---------- ----------
Total liabilities............................................. 973,365 845,282
Shareholders' equity............................................. 92,641 85,789
---------- ----------
Total liabilities and
shareholders' equity....................................... $1,066,006 $ 931,071
========== ==========
Net interest income / margin................................................. $ 10,392 4.27% $ 9,321 4.38%
========== ==========
|
Note: |
|
Yields and amounts earned on loans include loan fees of $1,049,000 and $954,000 for the three month periods ended June 30, 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 $2,102,000 and $767,000 for the period ended June 30, 2004 and 2003, respectively, are included in the average balance calculation above. |
For the Six Months Ended For the Six Months Ended
June 30, 2004 June 30, 2003
--------------------------------- ---------------------------------
Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/
(Dollars in thousands) Balance Expense Rate Balance Expense Rate
- ----------------------------------------------------------------- ---------- ---------- --------- ---------- ---------- ---------
Assets:
Loans, gross..................................................... $ 705,161 $ 21,427 6.11% $ 683,284 $ 21,983 6.49%
Investment securities............................................ 198,587 3,083 3.12% 117,991 2,062 3.52%
Interest bearing deposits in other financial institutions........ 1,322 4 0.61% 7,736 35 0.91%
Federal funds sold............................................... 33,943 161 0.95% 41,020 241 1.18%
---------- ---------- ---------- ----------
Total interest earning assets................................. 939,013 $ 24,675 5.28% 850,031 $ 24,321 5.77%
---------- ----------
Cash and due from banks.......................................... 47,638 38,110
Premises and equipment, net...................................... 3,898 5,079
Other assets..................................................... 32,347 33,449
---------- ----------
Total assets.................................................. $1,022,896 $ 926,669
========== ==========
Liabilities and shareholders' equity:
Deposits:
Demand, interest bearing......................................... $ 108,337 $ 234 0.43% $ 94,610 $ 283 0.60%
Savings and money market......................................... 343,404 1,707 1.00% 302,988 1,908 1.27%
Time deposits, under $100........................................ 39,411 279 1.42% 44,847 463 2.08%
Time deposits, $100 and over..................................... 97,354 697 1.44% 105,698 1,040 1.98%
Brokered deposits................................................ 10,877 243 4.49% 32,269 638 3.99%
Other borrowings................................................. 62,207 1,327 4.29% 25,475 993 7.86%
---------- ---------- ---------- ----------
Total interest bearing liabilities............................ 661,590 $ 4,487 1.36% 605,887 $ 5,325 1.77%
---------- ----------
Demand, noninterest bearing ..................................... 259,076 226,595
Other liabilities................................................ 10,220 9,319
---------- ----------
Total liabilities............................................. 930,886 841,801
Shareholders' equity............................................. 92,010 84,868
---------- ----------
Total liabilities and
shareholders' equity....................................... $1,022,896 $ 926,669
========== ==========
Net interest income / margin................................................. $ 20,188 4.32% $ 18,996 4.51%
========== ==========
|
Note: |
|
Yields and amounts earned on loans include loan fees of $2,040,000 and $2,055,000 for the six month periods ended June 30, 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 $2,102,000 and $767,000 for the period ended June 30, 2004 and 2003, respectively, are included in the average balance calculation above. |
The Company's net interest income before provision for probable loan losses for the three and six months ended June 30, 2004 was $10,392,000 and $20,188,000, an increase of $1,071,000 or 11% and $1,192,000 or 6% over the same periods in the prior year. For the three and six months ended June 30, 2004 compared to the same periods in the prior year, average interest earning assets increased by $125,084,000, or 15% and $88,982,000, or 10%, respecetively. For the three months ended June 30, 2004, the average yield on interest earning assets was 5.21%, down 37 basis points from 5.58% for the same period in 2003. Over the same period the rates paid on interest bearing liabilities declined 34 basis points to 1.36% from 1.70%. For the six months ended June 30, 2004, the average yield on interest earning assets was 5.28%, down 49 basis points from 5.77% for the same period in 2003. Over the same period the rates paid on interest bearing liabilities declined 41 basis points to 1.36% from 1.77%. As a result, the net interest margin decreased 11 basis points to 4.27% for the three months ended June 30, 2004 from 4.38% for the same period in the prior year and decreased 19 basis points to 4.32% for the six months ended June 30, 2004 from 4.51% for the same period in the prior year. The slight decrease in net interest margin in the second quarter and for the six month period was primarily attributable to a decrease in market rates of interest and a change in mix of earning assets with loans, the highest yielding assets, decreasing as a percentage of total earning assets. The increase in average interest bearing liabilities was primarily attributable to growth in demand interest bearing, savings and money market deposits, offset by a decrease of time and brokered deposits and an increase in other borrowins, primarily fixed rate repurchase agreements with maturities of one to five years. The changes in volume contributed $1,049,000 to net interest income while the effect of the changes in rates produced an increase of $22,000 resulting in the overall increase of $1,071,000 for the three months ended June 30, 2004 from 2003. The changes in volume contributed $1,426,000 to net interest income while the effect of the changes in rates reduced the contribution by $234,000 resulting in the overall increase of $1,192,000 for the six months ended June 30, 2004 from 2003.
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 June 30,
2004 vs. 2003
----------------------------------
Increase (Decrease) Due to Change In:
Average Average Net
(Dollars in thousands) Volume Rate Change
- -------------------------------------------------------------- ---------- ---------- ----------
Interest earning assets
Loans, gross.............................................. $ 692 $ (579) $ 113
Investments securities.................................... 776 12 788
Interest bearing deposits in other financial institutions. (12) (5) (17)
Federal funds sold........................................ (37) (30) (67)
---------- ---------- ----------
Total interest earning assets................................ $ 1,419 $ (602) $ 817
---------- ---------- ----------
Interest bearing liabilities
Demand, interest bearing.................................. 16 (38) (22)
Savings and money market.................................. 120 (187) (67)
Time deposits, under $100................................. (19) (64) (83)
Time deposits, $100 and over.............................. (18) (125) (143)
Brokered Deposits......................................... (185) 26 (159)
Other borrowings.......................................... 456 (236) 220
---------- ---------- ----------
Total interest bearing liabilities........................... $ 370 $ (624) $ (254)
---------- ---------- ----------
Net interest income.......................................... $ 1,049 $ 22 $ 1,071
========== ========== ==========
Six Months Ended June 30,
2004 vs. 2003
----------------------------------
Increase (Decrease) Due to Change In:
Average Average Net
(Dollars in thousands) Volume Rate Change
- -------------------------------------------------------------- ---------- ---------- ----------
Interest earning assets
Loans, gross.............................................. $ 667 $ (1,223) $ (556)
Investments securities.................................... 1,252 (231) 1,021
Interest bearing deposits in other financial institutions. (19) (12) (31)
Federal funds sold........................................ (33) (47) (80)
---------- ---------- ----------
Total interest earning assets................................ $ 1,867 $ (1,513) $ 354
---------- ---------- ----------
Interest bearing liabilities
Demand, interest bearing.................................. $ 32 $ (81) $ (49)
Savings and money market.................................. 200 (401) (201)
Time deposits, under $100................................. (38) (146) (184)
Time deposits, $100 and over.............................. (60) (283) (343)
Brokered Deposits......................................... (477) 82 (395)
Other borrowings.......................................... 784 (450) 334
---------- ---------- ----------
Total interest bearing liabilities........................... $ 441 $ (1,279) $ (838)
---------- ---------- ----------
Net interest income.......................................... $ 1,426 $ (234) $ 1,192
========== ========== ==========
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 and six months ended June 30, 2004, the provision for probable loan losses was $600,000 and $1,200,000, compared to $600,00 and $1,900,000 for the same periods in the prior year. See additional discussion at Allowance for Probable Loan Losses on page 22.
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)
June 30, 2004 versus 2003
-------------------- --------------------
(Dollars in thousands) 2004 2003 Amount Percent
- ---------------------------------------------------- --------- --------- --------- ---------
Gain on sale of loans............................... $ 639 $ 587 $ 52 9 %
Servicing income.................................... 561 451 110 24 %
Service charges and other fees on deposit accounts.. 497 441 56 13 %
Appreciation of company owned life insurance........ 234 303 (69) (23)%
Gain on sale of securities available-for-sale....... 264 33 231 700 %
Mortgage brokerage fees............................. 30 277 (247) (89)%
Other............................................... 79 424 (345) (81)%
--------- --------- ---------
Total............................................... $ 2,304 $ 2,516 $ (212) (8)%
========= ========= =========
Six Months Ended Increase (decrease)
June 30, 2004 versus 2003
-------------------- --------------------
(Dollars in thousands) 2004 2003 Amount Percent
- ---------------------------------------------------- --------- --------- --------- ---------
Gain on sale of loans............................... $ 1,366 $ 1,144 $ 222 19 %
Servicing income.................................... 1,066 876 190 22 %
Service charges and other fees on deposit accounts.. 970 852 118 14 %
Appreciation of company owned life insurance........ 562 637 (75) (12)%
Gain on sale of securities available-for-sale....... 476 458 18 4 %
Mortgage brokerage fees............................. 149 640 (491) (77)%
Other............................................... 189 873 (684) (78)%
--------- --------- ---------
Total............................................... $ 4,778 $ 5,480 $ (702) (13)%
========= ========= =========
Noninterest income for the three and six months ended June 30, 2004 was $2,304,000 and $4,778,000, down 8% and 13% from $2,516,000 and $5,480,000 for the same periods 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 as other noninterest income and expense. The mortgage brokerage fees decreased $247,000 and $491,000 for the three and six months ended June 30, 2004 from the prior year as a result of a lower demand for mortgages. The Company discontinued its residential mortgage operation in June 2004 due to market conditions. An increase in gain on sales of loans of $52,000 and $222,000 and servicing income of $110,000 and $190,000 for the three and six months ended June 30, 2004 from the prior year, 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 increase in service charges and other fees on deposit accounts of $56,000 and $118,000 was due to an increase in the activity and level of demand deposit accounts. An increase in gain on sale of securities available-for-sale of $231,000 for three months ended June 30, 2004 from 2003 was due to market conditions.
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)
June 30, 2004 versus 2003
-------------------- --------------------
(Dollars in thousands) 2004 2003 Amount Percent
- ---------------------------------------------------- --------- --------- --------- ---------
Salaries and employee benefits...................... $ 5,456 $ 4,521 $ 935 21 %
Occupancy........................................... 880 835 45 5 %
Professional fees................................... 961 419 542 129 %
Loan origination costs.............................. 411 360 51 14 %
Advertising and promotion........................... 252 228 24 11 %
Furniture and equipment............................. 255 367 (112) (31)%
Client services..................................... 231 225 6 3 %
Telephone........................................... 86 67 19 28 %
Stationery & supplies............................... 82 57 25 44 %
Other............................................... 2,302 1,407 895 64 %
--------- --------- ---------
Total............................................... $ 10,916 $ 8,486 $ 2,430 29 %
========= ========= =========
Six Months Ended Increase (decrease)
June 30, 2004 versus 2003
-------------------- --------------------
(Dollars in thousands) 2004 2003 Amount Percent
- ---------------------------------------------------- --------- --------- --------- ---------
Salaries and employee benefits...................... $ 10,176 $ 9,224 $ 952 10 %
Occupancy........................................... 1,930 1,654 276 17 %
Professional fees................................... 1,316 690 626 91 %
Loan origination costs.............................. 768 677 91 13 %
Advertising and promotion........................... 499 399 100 25 %
Furniture and equipment............................. 492 758 (266) (35)%
Client services..................................... 416 475 (59) (12)%
Telephone........................................... 199 150 49 33 %
Stationery & supplies............................... 152 163 (11) (7)%
Other............................................... 3,681 2,796 885 32 %
--------- --------- ---------
Total............................................... $ 19,629 $ 16,986 $ 2,643 16 %
========= ========= =========
The following table indicates the percentage of noninterest expense in each category:
For The Three Months Ended June 30,
-------------------------------------------
Percent Percent
(Dollars in thousands) 2004 of Total 2003 of Total
- ---------------------------------------------------- --------- --------- --------- ---------
Salaries and employee benefits...................... $ 5,456 50 % $ 4,521 53 %
Occupancy........................................... 880 8 % 835 10 %
Professional fees................................... 961 9 % 419 5 %
Loan origination costs.............................. 411 4 % 360 4 %
Advertising and promotion........................... 252 2 % 228 3 %
Furniture and equipment............................. 255 2 % 367 4 %
Client services..................................... 231 2 % 225 3 %
Telephone........................................... 86 1 % 67 1 %
Stationery & supplies............................... 82 1 % 57 1 %
Other............................................... 2,302 21 % 1,407 16 %
--------- --------- --------- ---------
Total............................................... $ 10,916 100 % $ 8,486 100 %
========= ========= ========= =========
For The Six Months Ended June 30,
-------------------------------------------
Percent Percent
(Dollars in thousands) 2004 of Total 2003 of Total
- ---------------------------------------------------- --------- --------- --------- ---------
Salaries and employee benefits...................... $ 10,176 52 % $ 9,224 54 %
Occupancy........................................... 1,930 10 % 1,654 10 %
Professional fees................................... 1,316 7 % 690 4 %
Loan origination costs.............................. 768 4 % 677 4 %
Advertising and promotion........................... 499 2 % 399 2 %
Furniture and equipment............................. 492 2 % 758 5 %
Client services..................................... 416 2 % 475 3 %
Telephone........................................... 199 1 % 150 1 %
Stationery & supplies............................... 152 1 % 163 1 %
Other............................................... 3,681 19 % 2,796 16 %
--------- --------- --------- ---------
Total............................................... $ 19,629 100 % $ 16,986 100 %
========= ========= ========= =========
Noninterest expenses for the three and six months ended June 30, 2004 were $10,916,000 and $19,629,000, up $2,430,000 and $2,643,000, or 29% and 16%, from $8,486,000 and $16,986,000 for the same period in the prior year.
For the three months ended June 30, 2004, salaries and employee benefits increased $935,000, or 21%, to $5,456,000, as compared to the same period in the prior year. The increase was primarily related to severance of $461,000 for the elimination of 11 full time positions and $511,000 associated with the resignation of the former CEO partially offset by a decrease of $186,000 in loan officer commissions. Salaries and employee benefits increased $952,000, or 10%, to $10,176,000 for the six months of 2004, as compared to the same period in the prior year. Salaries and employee benefits, as a percentage of total noninterest expenses decreased to 50% and 52% from 53% and 54%, respectively, over the comparative three and six months period. The Company believes that the elimination of 11 full time positions will result in a savings in salary and employee benefits of approximately $300,000 pre-tax per quarter beginning in the third quarter of 2004.
For the comparative three month periods, occupancy increased by $45,000, or 5%, to $880,000, and for the six month periods the increase was $276,000, or 17%, to $1,930,000 primarily as a result of increased rental costs related to the opening of a new branch office in Los Gatos in December 2003, depreciation on leasehold improvements and write-offs associated with the outsourcing of the data processing function. Occupancy costs, as a percentage of total noninterest expenses decreased to 8% from 10% over the comparative three months periods and remained fairly constant over the comparative six month periods.
For the comparative three month periods, professional fees increased $542,000, or 129%, to $961,000, and for the six month periods the increase was $626,000, or 91%, to $1,316,000 primarily due to increased legal expenses related to the proxy solicitation for the 2004 annual meetings and other corporate severance matters. Professional fees, as a percentage of total noninterest expenses increased to 9% and 7% from 5% and 4% over the comparative three and six month periods.
For the comparative three month periods, loan origination costs increased by $51,000, or 14%, to $411,000, and for the six month periods the increase was $91,000, or 13%, to $768,000 primarily due to continued growth in the loan portfolio. Loan origination costs, as a percentage of total noninterest expenses remained fairly constant over the comparative three and six month periods.
For the comparative three month periods, advertising and promotion increased $24,000, or 11%, to $252,000, and for the six month periods the increase was $100,000, or 25%, to $499,000 primarily due to several new promotions and sponsorships in 2004. Advertising and promotion, as a percentage of total noninterest expenses decreased to 2% from 3% over the comparative three month periods but remained fairly constant over the comparative six month periods.
For the comparative three month periods, furniture and equipment decreased by $112,000, or 31%, to $255,000, and for the six month periods the decrease was $266,000, or 35%, to $492,000 primarily due to the decrease in the level of purchase of small equipment, fewer equipment repairs, and lower depreciation on furniture and equipment in 2004. Furniture and equipment, as a percentage of total noninterest expenses decreased to 2% from 4% and 5%, respectively, over the comparative three and six month periods.
For the comparative three month periods, client services increased by $6,000, or 3%, to $231,000 but for the six month periods decreased by $59,000, or 12%, to $416,000 primarily due to a reduction in the level and pricing for certain of these services, such as imprinted check charges, courier and armored car, in 2004 compared to the same period in 2003. Client services, as a percentage of total noninterest expenses decreased to 2% from 3% over the comparative three and six month periods.
For the comparative three month periods, telephone expense increased by $19,000, or 28%, to $86,000, and for the six month periods the increase was $49,000, or 33%, to $199,000. Telephone, as a percentage of total noninterest expenses remained fairly constant over the comparative three and six month periods.
For the comparative three month periods, stationery and supplies increased by $25,000, or 44%, to $82,000, and for the six month periods the decrease was $11,000, or 7%, to $152,000. Stationery and supplies, as a percentage of total noninterest expenses remained fairly constant over the comparative three and six month periods.
For the comparative three month period, other noninterest expenses increased $895,000, or 64%, to $2,302,000, and for the six month periods the increase was $885,000, or 32%, to $3,681,000, primarily due to an increase of $707,000 in retirement plan expense associated with the resignation of the former CEO and the elimination of 3 executive employees out of the 11 full time positions in the second quarter of 2004.
In June 2004, the Company announced a plan to streamline its operations and integrate the Bank's four divisions into a single unified business-focused bank, under the Heritage Bank of Commerce name. With the outsourcing of core data processing operations in the first quarter of 2004 and the reduction in staff completed in the second quarter of 2004, the Company anticipate annual savings of approximately $1.4 million pre-tax beginning in the third quarter of 2004.
Income Taxes
The provision for income taxes for the three and six months ended June 30, 2004 was $380,000 and $1,330,000, as compared to $880,000 and $1,790,000 for the same periods in the prior year. The following table shows the effective income tax rate for each period indicated.
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- --------------------
2004 2003 2004 2003
- ---------------------------------------------------- --------- --------- --------- ---------
Effective income tax rate........................... 32.20 % 31.99 % 32.15 % 32.02 %
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 $80,186,000, or 8%, to $1,083,387,000 at June 30, 2004 from $1,003,201,000 at December 31, 2003, and increased $86,936,000, or 9%, from $996,451,000 at June 30, 2003. Total securities available-for-sale increased $76,962,000, or 50%, to $230,435,000 at June 30, 2004 from $153,473,000 at December 31, 2003, and increased $74,075,000, or 47%, from $156,360,000 at June 30, 2003. Total loan portfolio increased $40,769,000, or 6%, to $706,857,000 at June 30, 2004 from $666,088,000 at December 31, 2003, and increased $69,294,000, or 11%, from $637,563,000 at June 30, 2003. Total deposits increased $83,759,000, or 10%, to $919,169,000 at June 30, 2004 from $835,410,000 at December 31, 2003, and increased $71,264,000, or 8%, from $847,905,000 at June 30, 2003. Other borrowings decreased $3,800,000, or 9%, to $39,800,000 at June 30, 2004 from $43,600,000 at December 31, 2003, and increased $11,200,000, or 39%, from $28,600,000 at June 30, 2003.
Securities Portfolio
The following table sets forth the estimated fair value of investment securities at the dates indicated:
June 30,
---------------------- December 31,
(Dollars in thousands) 2004 2003 2003
- ----------------------------------------------- ---------- ---------- -----------
Securities available-for-sale (at fair value)
U.S. Treasury.................................. $ 5,934 $ 4,617 $ 7,015
U.S. Government Agencies....................... 90,439 38,265 36,115
Mortgage-Backed Securities..................... 105,531 81,628 79,615
Municipals..................................... 9,084 11,350 15,704
CMOs........................................... 19,447 20,500 15,024
---------- ---------- -----------
Total securities available-for-sale............ $ 230,435 $ 156,360 $ 153,473
========== ========== ===========
The following table summarizes the composition of the Company's investment securities and the weighted average yields at June 30, 2004:
June 30, 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.................. $ -- -- % $ 5,934 1.67 % $ -- -- % $ -- -- % $ 5,934 1.67 %
U.S. Government Agencies....... -- -- % 90,439 2.31 % -- -- % -- -- % 90,439 2.31 %
Mortgage-Backed Securities..... -- -- % 266 5.08 % 12,186 3.81 % 93,079 3.86 % 105,531 3.86 %
Municipals - Nontaxable....... 461 4.71 % 8,301 2.27 % 322 3.00 % -- -- % 9,084 2.42 %
CMOs........................... -- -- % -- -- % -- -- % 19,447 2.71 % 19,447 2.71 %
-------- -------- -------- -------- ---------
Total available-for-sale....... $ 461 4.71 % $104,940 2.28 % $ 12,508 3.79 % $112,526 3.66 % $ 230,435 3.04 %
======== ======== ======== ======== =========
|
Note: |
Yield on non-taxable municipal securities are not presented on a fully tax equivalent basis. |
Loans
Total loans increased $40,769,000, or 6%, to $706,857,000 as of June 30, 2004 from $666,088,000 as of December 31, 2003, and increased $69,294,000, or 11%, from $637,563,000 as of June 30, 2003.
For the three and six months ended June 30, 2004, $21,296,000 and $33,747,000 in loans guaranteed by the U.S. Small Business Administration (SBA) were generated and held for sale, and $13,273,000 and $26,026,000 of SBA loans held for sale were sold into the secondary market. Gains on sale of SBA loans were $639,000 and $1,366,000, respectively, for the three and six months ended June 30, 2004, compared to $587,000 and $1,144,000, respectively for the three and six months ended June 30, 2003.
At June 30, 2004 and December 31, 2003, the Company serviced SBA loans that it had sold into the secondary market of approximately $132,361,000 and $117,770,000, respectively. At June 30, 2004 and December 31, 2003, the carrying amounts of the servicing asset were $2,054,000 and $1,876,000, respectively. There was no valuation allowance as of June 30, 2004 or December 31, 2003. The carrying amounts of interest-only (I/O) strip receivable at June 30, 2004 and December 31, 2003 were $3,364,000, net of unrealized gain of $1,183,000, 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 $561,000 and $1,066,000 for the quarter and six months ended June 30, 2004, compared to $451,000 and $876,000 for the same periods in 2003. Amortization of the related assets was $366,000 and $745,000 for the quarter and six months ended June 30, 2004, compared to $349,000 and $646,000 for the same periods in 2003. HBC is an SBA Preferred Lender, which allows the Company to grant certain SBA loans without the prior approval of the SBA.
The following table summarizes the composition of the Company's loan portfolio at the dates indicated:
June 30, % of December 31, % of
(Dollars in thousands) 2004 Total 2003 Total
- ----------------------------------- ------------ ----------- ----------- -----------
Commercial......................... $ 298,828 42 % $ 281,561 42 %
Real estate - mortgage............. 290,956 41 % 276,908 42 %
Real estate - land and construction 111,161 16 % 101,082 15 %
Direct financing lease............... 3,578 1 % 3,931 1 %
Consumer........................... 1,625 0 % 1,743 0 %
------------ ----------- ----------- -----------
Total loans................... 706,148 100 % 665,225 100 %
=========== ===========
Deferred loan costs................ 709 863
Allowance for loan losses.......... (12,688) (13,451)
------------ -----------
Loans, net......................... $ 694,169 $ 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. As of June 30, 2004, real estate mortgage loans consists of loans secured by commercial property of $235,211,000, loans secured by first mortgages on 1 - 4 family residential properties of $3,446,000, and home equity lines of credit secured by junior deeds of trust on 1 - 4 family residential properties of $52,299,000. Properties securing the real estate mortgage loans are primarily located in the Company's trade area. 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 loans at June 30, 2004:
Over One
Due in Year But
One Year Less Than Over
(Dollars in thousands) or Less Five Years Five Years Total
- ----------------------------------- ------------ ----------- ----------- -----------
Commercial......................... $ 288,178 $ 10,136 $ 514 $ 298,828
Real estate - mortgage............. 200,220 48,834 41,902 290,956
Real estate - land and construction 111,161 -- -- 111,161
Direct financing lease............. 982 2,596 -- 3,578
Consumer........................... 1,389 236 -- 1,625
------------ ----------- ----------- -----------
Total loans................... $ 601,930 $ 61,802 $ 42,416 $ 706,148
============ =========== =========== ===========
Loans with variable interest rates. $ 582,613 $ 23,943 $ -- $ 606,556
Loans with fixed interest rates.... 19,317 37,859 42,416 99,592
------------ ----------- ----------- -----------
Total loans................... $ 601,930 $ 61,802 $ 42,416 $ 706,148
============ =========== =========== ===========
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 June 30, 2004, approximately 86% 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 HBC 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:
June, 30
---------------------- December 31,
(Dollars in thousands) 2004 2003 2003
- ------------------------------------------------ ---------- ---------- -----------
Nonaccrual loans................................ $ 2,102 $ 767 $ 3,972
Loans 90 days past due and still accruing......... 530 1,032 608
Restructured loans................................ -- -- --
---------- ---------- -----------
Total nonperforming loans................... 2,632 1,799 4,580
Other real estate owned......................... -- 832 --
---------- ---------- -----------
Total nonperforming assets.................. $ 2,632 $ 2,631 $ 4,580
========== ========== ===========
Nonperforming assets as a percentage of
period end loans plus other real estate owned. 0.37 % 0.41 % 0.69 %
As of June 30, 2004, the Company had $2,102,000 loans on nonaccrual status, compared to $767,000 in the same period of the prior year, which were considered impaired loans. The impaired loans had a related valuation allowance of $240,000 at June 30, 2004 and $289,000 at June 30, 2003. The Company had $530,000 loans past due 90 days or more and still accruing interest, no restructured loans and no other real estate owned assets as of June 30, 2004, compared to $1,032,000 loans past due 90 days or more and still accruing interest, no restructured loans and $832,000 other real estate owned assets as of June 30, 2003. The Company had $3,972,000 loans on nonaccrual status as of December 31, 2003, which were considered impaired loans. The impaired loans had a related valuation allowance of $464,000 at December 31, 2003. The Company had $608,000 loans past due 90 days or more and still accruing interest, no restructured loans and no other real estate owned assets as of December 31, 2003. For the three and six months ended June 30, 2004, the Company had $251,000 and $509,000 foregone interest income on nonaccrual loans. For the three and six months ended June 30, 2004, the Company recognized $10,000 and $27,000 in interest income for cash payments received on nonaccrual loans. The Company did not recognize any interest income for cash payments received on nonaccrual loans for the three and six months ended June 30, 2003.
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 could 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:
Six Months Ended For the
June 30, Year Ended
-------------------- December 31,
(Dollars in thousands) 2004 2003 2003
- -------------------------------------- --------- --------- -----------
Balance, beginning of period / year... $ 13,451 $ 13,227 $ 13,227
Net charge-offs....................... (1,963) (435) (2,676)
Provision for probable loan losses.... 1,200 1,900 2,900
--------- --------- -----------
Balance, end of period / year......... $ 12,688 $ 14,692 $ 13,451
========= ========= ===========
Ratios:
Net charge-offs to
average loans outstanding.......... 0.58 % 0.13 % 0.41 %
Allowance for loan losses to average
loans.............................. 1.88 % 2.25 % 2.07 %
Allowance for loan losses to total
loans.............................. 1.79 % 2.30 % 2.02 %
Allowance for loan losses to
non-performing assets.............. 482 % 558 % 294 %
Charge-offs reflects the realization of losses in the portfolio that were recognized previously though provisions for probable loan losses. The net charge-offs for the six months ended June 30, 2004 were $1,963,000, compared to $435,000 for the six months ended June 30, 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:
June 30, 2004 June 30, 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............................ $ 9,690 3.24 % $ 8,551 3.25 % $ 9,628 3.42 %
Real estate - mortgage................ 1,625 0.56 % 2,522 1.00 % 2,003 0.72 %
Real estate - land and construction... 1,253 1.13 % 1,722 1.45 % 1,714 1.70 %
Direct financing lease................ 63 1.76 % -- -- % 37 0.99 %
Consumer.............................. 44 2.71 % 60 2.36 % 39 2.12 %
Unallocated........................... 13 -- % 1,837 -- % 30 -- %
--------- ----------- ---------
Total ........................... $ 12,688 1.79 % $ 14,692 2.30 % $ 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 $4.0 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 and $2.0 million was charged-off in the first quarter of 2004. The Company continued to negotiate with the borrower within the framework of the bankruptcy and the remaining $2.0 million of the loan was paid in full during the second quarter of 2004. Other than the loans already classified at June 30, 2004, the Company has not identified any potential problem loans.
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 June 30, 2004, nonperforming loans had a related specific valuation allowance of $240,000 compared to $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 June 30, 2004 was $12,435,000, compared to $12,947,000 on December 31, 2003.
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 June 30, 2004, the Company's unallocated allowance was $13,000, 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 Bank 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
Deposits totaled $919,169,000 at June 30, 2004, up 10%,
compared to deposits of $835,410,000 at December 31, 2003, and up 8%, compared to deposits of $847,905,000 at June 30, 2003. Compared to December 31, 2003, noninterest bearing demand deposits increased $62,906,000, or 26%, interest bearing demand deposits increased $6,022,000, or 6%, savings and money market accounts increased $18,238,000, or 5%, total time deposits increased $518,000, or less than 1%, and brokered deposits decreased $3,925,000, or 33%.The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated:
Six Months Ended Year Ended
June 30, 2004 December 31, 2003
-------------------- --------------------
Average Average
Average Rate Average Rate
(Dollars in thousands) Balance Paid Balance Paid
- ------------------------------------- ---------- -------- ---------- --------
Demand, noninterest bearing.......... $ 259,076 -- % $ 238,467 -- %
Demand, interest bearing............. 108,337 0.43 % 96,772 0.51 %
Saving and money market.............. 343,404 1.00 % 318,774 1.16 %
Time deposits, under $100............ 39,411 1.42 % 43,060 1.85 %
Time deposits, $100 and over......... 97,354 1.44 % 101,406 1.79 %
Brokered deposits.................... 10,877 4.49 % 24,559 4.05 %
---------- ----------
Total average deposits.......... $ 858,459 0.74 % $ 823,038 0.95 %
========== ==========
Deposit Concentration and Deposit Volatility
The following table indicates the maturity schedule of the Company's time deposits (including brokered deposits) of $100,000 or more as of June 30, 2004.
% of
(Dollars in thousands) Balance Total
- ----------------------------------------------------------- ---------- --------
Three months or less....................................... $ 53,640 52 %
Over three months through twelve months.................... 41,021 39 %
Over twelve months......................................... 9,480 9 %
---------- --------
Total............................................... $ 104,141 100 %
========== ========
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 Six Months Ended
June 30, June 30,
-------------------- -------------------
2004 2003 2004 2003
-------- -------- -------- --------
Return on average assets............... 0.30 % 0.81 % 0.55 % 0.83 %
Return on average equity............... 3.47 % 8.75 % 6.14 % 9.03 %
Average equity to average assets ratio. 8.69 % 9.21 % 9.00 % 9.16 %
Annualized return on average assets and return on average equity for the quarter ended June 30, 2004 were 0.30% and 3.47%, respectively, compared with returns of 0.81% and 8.75%, respectively, for the same period in 2003. The equity to asset ratio for the quarter ended June 30, 2004 was 8.69%, compared to 9.21% for the same period in 2003.
Annualized return on average assets and return on average equity for the six months ended June 30, 2004 were 0.55% and 6.14%, respectively, compared with returns of 0.83% and 9.03%, respectively, for the same period in 2003. The equity to asset ratio for the six months ended June 30, 2004 was 9.00%, compared to 9.16% for the same period in 2003.
The decrease in return on average assets and return on average equity for the three and six months ended June 30, 2004 from 2003 was due to non-recurring expenses of $2.05 million pre-tax for severance, annual meeting and other corporate matters in the second quarter of 2004.
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 June 30, 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
- ----------------------------------------------------- --------- --------- --------- --------- --------- ----------
Interest earning assets:
Federal funds sold................................. $ 13,800 $ -- $ -- $ -- $ -- $ 13,800
Interest bearing deposits in other financial Instit 935 -- -- -- -- 935
Securities......................................... -- 461 104,940 125,034 -- 230,435
Total loans........................................ 553,273 81,282 61,802 42,416 -- 738,773
--------- --------- --------- --------- --------- ----------
Total interest earning assets.................... 568,008 81,743 166,742 167,450 -- 983,943
--------- --------- --------- --------- --------- ----------
Cash and due from banks.............................. -- -- -- -- 55,469 55,469
Other assets......................................... -- 25,836 -- -- 18,139 43,975
--------- --------- --------- --------- --------- ----------
Total assets..................................... $ 568,008 $ 107,579 $ 166,742 $ 167,450 $ 73,608 $1,083,387
========= ========= ========= ========= ========= ==========
Interest bearing liabilities:
Demand, interest bearing........................... $ 111,282 $ -- $ -- $ -- $ -- $ 111,282
Savings and money market........................... 364,124 -- -- -- -- 364,124
Time deposits...................................... 68,600 59,671 14,163 -- -- 142,434
Other borrowings................................... -- 7,100 32,700 -- -- 39,800
Notes payable to subsidiary grantor trusts......... 9,279 -- -- 14,423 -- 23,702
--------- --------- --------- --------- --------- ----------
Total interest bearing liabilities............... 553,285 66,771 46,863 14,423 -- 681,342
--------- --------- --------- --------- --------- ----------
Noninterest demand deposits.......................... 86,977 -- -- -- 214,352 301,329
Accrual interest payable and other liabilities....... -- -- -- -- 9,897 9,897
Shareholders' equity................................. -- -- -- -- 90,819 90,819
--------- --------- --------- --------- --------- ----------
Total liabilities and shareholders' equity....... $ 640,262 $ 66,771 $ 46,863 $ 14,423 $ 315,068 $1,083,387
========= ========= ========= ========= ========= ==========
Interest rate sensitivity GAP........................ $ (72,254) $ 40,808 $ 119,879 $ 153,027 $(241,460) $ --
========= ========= ========= ========= ========= ==========
Cumulative interest rate sensitivity GAP............. $ (72,254) $ (31,446) $ 88,433 $ 241,460 $ -- $ --
Cumulative interest rate sensitivity GAP ratio....... (6.67)% (2.90)% 8.16 % 22.29 % -- % -- %
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 June 30, 2004, the Company's primary liquidity ratio was
17.59%. The liquidity ratio is arrived at by calculating the total of assets with immediate liquidity including $105,401,000 of investment securities available- for-sale with maturities (or probable calls) of up to five years, Federal funds sold of $13,800,000, and $55,469,000 in cash and due from banks less $15,735,000 of securities that were pledged to secure public and certain other deposits as required by law and contract, as a percentage of total unsecured deposits of $903,434,000. The Company has lines of credit of approximately $114,000,000 available from the Federal Home Loan Bank and correspondent banks to meet short-term liquidity needs. There were no balances outstanding on these lines of credit at June 30, 2004 and 2003.Capital Resources
The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:
June 30,
----------------------- December 31,
(Dollars in thousands) 2004 2003 2003
- --------------------------------- ---------- ---------- -----------
Capital components:
Tier 1 Capital................ $ 114,385 $ 106,542 $ 110,891
Tier 2 Capital................ 10,994 10,106 10,403
---------- ---------- -----------
Total risk-based capital.... $ 125,379 $ 116,648 $ 121,294
========== ========== ===========
Risk-weighted assets............. $ 879,146 $ 803,900 $ 830,537
Average assets................... $1,071,685 $ 929,905 $ 992,608
Minimum
Regulatory
Requirements
-----------
Capital ratios:
Total risk-based capital....... 14.3 % 14.5 % 14.6 % 8.0 %
Tier 1 risk-based capital...... 13.0 % 13.3 % 13.4 % 4.0 %
Leverage ratio (1)............. 10.7 % 11.5 % 11.2 % 4.0 %
|
(1) |
|
Tier 1 capital divided by average assets (excluding goodwill). |
At June 30, 2004 and 2003, and December 31, 2003, the Company's capital met all minimum regulatory requirements. As of June 30, 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
We maintain disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act)) that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act, is recorded, processed, summarized and reported within the time period specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to our management, including our Chief (principal) Executive Officer and Chief (principal) Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
(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 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
In June 2004, the Company's Board of Director authorized the purchase of up to $10 million of its common stock, which represents approximately 700,000 share, or 6%, of its outstanding shares at current market price. The share repurchase authorization is valid through June 1, 2005.
The Company intends to finance the purchase using its available cash. Shares may be repurchased by the Company in open market purchases or in privately negotiated transactions as permitted under applicable rules and regulations. The repurchase program may be modified, suspended or terminated by the Board of Directors at any time without notice. The extent to which the Company repurchases its shares and the timing of such repurchases will depend upon market conditions and other corporate considerations.
As of June 30, 2004, repurchases of equity securities are presented in the table below.
Total Number of Approximate Dollar
Total Number Shares Purchased Value of Shares That
of Shares Price Paid as Part of Publicly May Yet Be Purchased
Date Purchased Per Shares Announced Plans Under the Plans
- ---------------------- ------------ ----------- ----------------- ------------------
June 7, 2004.......... 5,664 $ 14.29 5,664 $ 9,919,061
June 9, 2004.......... 1,100 $ 14.30 1,100 $ 9,903,331
June 10, 2004......... 40,000 $ 14.62 40,000 $ 9,318,531
June 14, 2004......... 4,325 $ 14.40 4,325 $ 9,256,251
June 15, 2004......... 900 $ 14.40 900 $ 9,243,291
June 16, 2004......... 5,300 $ 14.48 5,300 $ 9,166,547
June 17, 2004......... 23,000 $ 14.90 23,000 $ 8,823,847
June 18, 2004......... 5,300 $ 14.51 5,300 $ 8,746,944
June 21, 2004......... 6,800 $ 14.48 6,800 $ 8,648,480
June 22, 2004......... 20,000 $ 14.40 20,000 $ 8,360,480
June 23, 2004......... 6,800 $ 14.31 6,800 $ 8,263,172
June 24, 2004......... 6,800 $ 14.50 6,800 $ 8,164,572
June 25, 2004......... 6,800 $ 14.51 6,800 $ 8,065,904
------------ -----------------
Total..................... 132,789 132,789
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ITEM 4. SUBMISSIONS 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 the search for a 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 Company held its 2004 Annual Meeting of Shareholders on May 26, 2004. There were 11,222,564 issued and outstanding shares of Company Common Stock on April 1, 2004, the Record Date for the 2004 Annual Meeting. Each of the shares voting at the meeting was entitled to one vote.
At the 2004 Annual Meeting, the following actions were taken:
Election of Directors
The Company's board is divided into three classes. At the 2004 Annual Meeting, four directors of the Company were elected. The following chart indicates the number of shares cast for each elected director:
|
Name of Director |
Votes For |
Votes Withheld |
|
Frank G. Bisceglia |
9,155,676 |
522,033 |
|
Anneke Dury |
9,115,720 |
561,989 |
|
Louis "Lon" O. Normandin |
9,243,872 |
433,837 |
|
HumphreP. Polanen |
9,229,154 |
448,555 |
In addition to the above four individuals, the following previously elected directors' terms continued after the meeting:
|
Name of Director |
Title |
|
James Blair |
Director |
|
Richard L. Conniff |
Director/Chief Operating Officer |
|
William Del Biaggio, Jr. |
Director/Chairman of the Board/Interim Chief Executive Officer |
|
Roy Lave |
Director |
|
Jack Peckham |
Director |
|
Kirk M. Rossmann |
Director |
|
Charles J. Toeniskoetter |
Director |
|
Ranson Webster |
Director |
Approve of Heritage Commerce Corp 2004 Stock Option Plan grants of stock options to officers, employees and directors of the Company.
|
FOR |
5,609,584 |
|
AGAINST |
756,243 |
|
ABSTAIN |
182,540 |
|
BROKER NON-VOTES |
3,129,342 |
Ratification of Deloitte & Touche, LLP as the Company's auditors
The number of shares cast for and against the ratification of the Board of Directors' selection of Deloitte & Touche, LLP to serve as the Company's auditors for the fiscal year ending December 31, 2004 was as follows:
|
FOR |
8,646,909 |
|
AGAINST |
675,248 |
|
ABSTENTIONS |
355,552 |
To consider and transact such other business as may properly be brought before the meeting.
|
FOR |
8,645,483 |
|
AGAINST |
676,674 |
|
ABSTAIN |
355,552 |
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 furnished a Current Report on Form 8-K dated July 20, 2004 under item 7 and item 12 to report its second quarter ended June 30, 2004 financial results, and condensed consolidated financial information.
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 Commerce Corp |
|
|
|
|
|
August 9, 2004 |
|
/s/ William Del Biaggio, Jr. Interim Chief Executive Officer |
|
|
|
|
|
August 9, 2004 |
|
/s/ Lawrence D. McGovern Chief Financial Officer |