UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2004
OR
o		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 0-25979

 

WESTERN SIERRA BANCORP

(Exact name of Registrant as specified in its charter)

 

California		68-0390121
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
4080 Plaza Goldorado Circle		95682
Cameron Park, California		(Zip code)
(Address of principal executive offices)

 

Registrant’s telephone number, including area code: (530) 677-5600

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, no par value per share

 

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 such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes ý No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2) Yes ý No o

 

As of October 28, 2004 there were approximately 7,620,866 shares outstanding of the Registrant’s common stock.

 

 

WESTERN SIERRA BANCORP & SUBSIDIARIES

 

Index to Form 10-Q

 

PART I. Financial Information
	Item 1. Consolidated Financial Statements (unaudited)
		Consolidated Balance Sheet September 30, 2004 and December 31, 2003
		Consolidated Statement of Income Three and nine months ended September 30, 2004 and 2003
		Consolidated Statement of Cash Flows Nine months ended September 30, 2004 and 2003
		Notes to Consolidated Financial Statements
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosure about Market Risk
	Item 4. Controls and Procedures
PART II. Other Information
	Item 1. Legal proceedings
	Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Report on Form 8-K
SIGNATURES

 

2

 

PART I. FINANCIAL INFORMATION

 

Western Sierra Bancorp and Subsidiaries

Unaudited Consolidated Balance Sheet

(dollars in thousands, except number of shares)

 

		September 30, 2004			December 31, 2003
ASSETS:
Cash and due from banks		$	37,579		$	38,584
Federal funds sold		52,235			17,380
Cash and cash equivalents		89,814			55,964
Interest-bearing deposits		4,000			4,198
Loans held for sale		811			940
Investment securities:
Trading, at estimated market value		35			28
Available for sale (amortized cost $86,081in 2004 and $78,156 in 2003)		87,599			79,502
Held to maturity (market value of $3,824 in 2004 and $4,219 in 2003)		3,675			4,058
Total investments		91,309			83,588
Portfolio loans and leases:
Real estate mortgage		583,500			495,948
Real estate construction		208,828			195,889
Commercial		113,374			109,685
Agricultural		13,935			12,185
Installment		4,331			5,795
Lease financing		1,828			2,016
Total gross loans and leases		925,795			821,518
Deferred loan and lease fees, net		(2,806		)	(2,729		)
Allowance for loan and lease losses		(13,082		)	(11,529		)
Net portfolio loans and leases		909,907			807,260
Premises and equipment, net		20,054			19,591
Goodwill and other intangible assets		34,093			34,731
Other assets		29,973			29,439
Total assets		$	1,179,961		$	1,035,711
LIABILITIES AND SHAREHOLDERS’ EQUITY:
Non-interest bearing deposits		$	263,582		$	221,898
Interest bearing deposits:
NOW, money market and savings		395,393			340,922
Time, over $100,000		181,230			145,608
Other time		166,406			164,710
Total deposits		1,006,611			873,138
Borrowed funds		21,500			20,650
Subordinated debentures		36,496			36,496
Other liabilities		9,694			11,990
Total liabilities		1,074,301			942,274
Commitments and contingencies (Note 6)
Shareholders’ equity:
Preferred stock- no par value; 15,000,000 shares authorized; none issued		—			—
Common stock- no par value; 15,000,000 shares authorized; 7,620,866 shares issued in 2004 and 7,439,029 shares in 2003		67,586			66,459
Retained earnings		37,092			26,097
Accumulated other comprehensive income		982			881
Total shareholders’ equity		105,660			93,437
Total liabilities and shareholders’ equity		$	1,179,961		$	1,035,711

 

See notes to the unaudited consolidated financial statements.

 

3

 

Western Sierra Bancorp and Subsidiaries

Unaudited Consolidated Statement of Income

(dollars in thousands, except per share data)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Interest income:
Interest and fees on loans		$	14,971		$	11,843		$	43,398		$	31,641
Interest on investment securities:
Taxable		485			276			1,238			1,055
Exempt from federal taxes		391			361			1,167			1,089
Interest on Federal funds sold		203			182			397			353
Total interest income		16,050			12,662			46,200			34,138
Interest expense:
Interest on deposits		2,336			2,178			6,510			6,224
Interest on borrowed funds and subordinated debentures		549			347			1,658			901
Total interest expense		2,885			2,525			8,168			7,125
Net interest income		13,165			10,137			38,032			27,013
Provision for loan and lease losses (LLP)		600			600			1,910			1,655
Net interest income after LLP		12,565			9,537			36,122			25,358
Non-interest income:
Service charges and fees		1,205			1,202			3,620			2,915
Investment service fee income		140			18			517			34
Net gain on sale and packaging of residential mortgage and government-guaranteed commercial loans		986			1,468			3,033			3,803
(Loss) gain on sale of investment securities		(1		)	19			(12		)	19
Other income		216			229			671			480
Total non-interest income		2,546			2,936			7,829			7,251
Other expenses:
Salaries and benefits		4,892			4,291			14,660			11,142
Occupancy and equipment		1,505			1,259			4,292			3,464
Other expenses		2,338			2,018			7,061			5,453
Merger expenses		—			86			—			86
Amortization of core deposit intangibles		180			134			540			257
Total other expenses		8,915			7,788			26,553			20,402
Income before income tax		6,196			4,685			17,398			12,207
Income taxes		2,347			1,729			6,403			4,501
Net income		$	3,849		$	2,956		$	10,995		$	7,706
Basic earnings per share		$	0.51		$	0.43		$	1.46		$	1.19
Fully diluted earnings per share		$	0.49		$	0.41		$	1.40		$	1.14

 

See notes to the unaudited consolidated financial statements.

 

4

 

Western Sierra Bancorp and Subsidiaries

Unaudited Consolidated Statement of Cash Flows

(dollars in thousands)

 

		Nine Months Ended September 30,
		2004			2003
Cash flows from operating activities:
Net income		$	10,995		$	7,706
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan and lease losses		1,910			1,655
Depreciation and amortization		2,311			1,720
Deferred loan and lease origination fees, net		77			469
Amortization of investment security premiums, net of accretion of discount		647			402
Gain on sale and call of available-for-sale investment securities		(12		)	—
Gain on called held-to-maturity investment securities		—			(19		)
Increase in trading securities		(7		)	(8		)
Loss on sale of premises and equipment		3			6
Gain on sale of other real estate		—			(1		)
Increase in cash surrender value of life insurance policies		(479		)	(282		)
Compensation cost associated with the Bank’s ESOP		150			—
Decrease in loans held for sale		129			3,079
Increase in accrued interest receivable and other assets		(7		)	(3,186		)
(Decrease) increase in accrued interest payable and other liabilities		(2,296		)	3,201
Net cash provided by operating activities		13,421			14,742
Cash flows from investing activities:
Cash acquired in acquisitions		—			40,086
Proceeds from sale and call of available-for-sale investment securities		2,550			—
Proceeds from called held-to-maturity investment securities		—			2,670
Proceeds from matured available-for-sale investment securities		45			1,625
Proceeds from matured held-to-maturity investment securities		—			500
Purchases of available-for-sale investment securities		(20,770		)	(28,139		)
Purchases of held-to-maturity investment securities		—			—
Principal repayments received from available-for-sale SBA Pools and mortgage-backed securities		9,621			5,253
Principal repayments received from held-to-maturity mortgaged-backed securities		378			618
Net decrease in interest-bearing deposits in banks		198			2,689
Proceeds from sale of OREO		—			141
Net increase in loans and leases		(104,634		)	(74,591		)
Proceeds from the sale of premises and equipment		—			—
Purchases of premises and equipment		(2,237		)	(1,057		)
Purchase of life insurance policies		—			(7,000		)
Net cash used in investing activities		(114,849		)	(57,205		)
Cash flows from financing activities:
Net increase in demand, interest-bearing and savings deposits		$	96,155		$	71,487
Net increase in time deposits		37,318			30,889
Net increase in short-term borrowings		850			205
Repayment of ESOP borrowings		(150		)	—
Proceeds from ESOP borrowings		150			325
Purchase of unearned ESOP shares		(150		)	(325		)
Issuance of Trust Preferred Securities		—			20,000
Repurchase of common stock		(85		)	—
Redemption of fractional shares		—			(33		)
Proceeds from the exercise of stock options		1,190			201
Net cash provided by financing activities		135,278			122,749
Increase in cash and cash equivalents		33,850			80,286
Cash and cash equivalents at beginning of year		55,964			36,964
Cash and cash equivalents at end of period		$	89,814		$	117,250
Non-cash investing activities:
Net change in unrealized gain on available-for-sale investment securities		$	173		$	240

 

5

 

Supplemental schedules related to acquisitions:
Acquisition of Central Sierra Bank (CSB) (Note 5):
Deposits				$	129,268
Borrowed Funds				7,650
Other Liabilities				1,869
Interest-bearing deposits in banks				(1,698		)
Investment securities available-for-sale				(2,598		)
Investment securities held-to-maturity				(5,312		)
Loans, net				(82,651		)
Premises and equipment				(3,416		)
Intangibles				(14,167		)
Other assets				(1,561		)
Stock issued				12,702
Cash acquired, net of cash paid to CSB shareholders				$	40,086

 

See notes to the unaudited consolidated financial statements.

 

6

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

1. Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements of Western Sierra Bancorp and subsidiaries (the “Company”) have been prepared in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America for annual financial statements are not included herein.  In the opinion of Management, all adjustments (which consist solely of normal recurring accruals) considered necessary for a fair presentation of the results for the interim periods presented have been included. These interim condensed consolidated financial statements should be read in conjunction with the financial statements and related notes contained in the Company’s 2003 Annual Report on Form 10-K.

 

The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Western Sierra National Bank (WSNB) and its subsidiary WSNB Investment Trust (a Real Estate Investment Trust (“REIT”), Lake Community Bank (LCB), Central California Bank (CCB) and Auburn Community Bank (ACB).  All significant inter-company balances and transactions have been eliminated.  Western Sierra Statutory Trusts I, II, III, and IV are unconsolidated subsidiaries formed solely for the purpose of issuing trust preferred securities.  Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. Certain amounts in the consolidated financial statements for the year ended December 31, 2003 and the three and nine-month period ended September 30, 2003 may have been reclassified to conform to the presentation of the consolidated financial statements in 2004.

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires Management to make estimates and assumptions.  These estimates and assumptions affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from these estimates.

 

2.  Stock-based Compensation

 

At September 30, 2004, the Company has five stock-based compensation plans.  The Company accounts for these plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations.  No stock-based compensation cost is reflected in net income, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant.  In accordance with Financial Accounting Standards Board (“FASB”) No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an Amendment of FASB No. 12, the following table illustrates the effect on net income and earnings per share as if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based compensation.

 

Pro forma adjustments to the Company’s consolidated net earnings and earnings per share are disclosed during the years in which the options become vested (dollars in thousands, except per share data).

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Net earnings as reported		$	3,849		$	2,956		$	10,995		$	7,706
Deduct: Total stock-based compensation expense determined under the fair value based method for all awards, net of related tax effects		(214		)	(258		)	(758		)	(648		)
Pro forma net income		$	3,635		$	2,698		$	10,237		$	7,058
Basic earnings per share - as reported		$	0.51		$	0.43		$	1.46		$	1.19
Basic earnings per share - pro forma		$	0.48		$	0.39		$	1.36		$	1.09
Diluted earnings per share - as reported		$	0.49		$	0.41		$	1.40		$	1.14
Diluted earnings per share - pro forma		$	0.46		$	0.38		$	1.31		$	1.05

 

7

 

The fair value of each option is estimated on the date of grant using an option-pricing model with the following assumptions:

 

		Nine Months Ended September 30, 2004			Nine Months Ended September 30, 2003
Dividend yield (not applicable)
Expected volatility		19.14 – 22.90%			19.71 - 23.69%
Risk-free interest rate		3.90 – 4.56%			3.98 - 4.50%
Expected option life		10 years			10 years
Weighted average fair value of options granted during the year		$	13.32		$	8.51

 

3. Earnings per Share

 

Basic earnings per share (EPS), which excludes dilution, is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock, such as stock options, result in the issuance of common stock, which shares in the earnings of the Company.  Earnings per share is retroactively adjusted for stock dividends and splits for all periods presented. A reconciliation of the numerators and denominators of the basic and diluted EPS computations is as follows (dollars in thousands, except for per share data).

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Basic EPS Computation:
Numerator—net income		$	3,849		$	2,956		$	10,995		$	7,706
Denominator— weighted average number of shares outstanding		7,594,692			6,819,992			7,535,254			6,465,837
Basic earnings per share		$	0.51		$	0.43		$	1.46		$	1.19
Diluted EPS Computation:
Numerator—net income		$	3,849		$	2,956		$	10,995		$	7,706
Denominator— weighted average number of shares outstanding		7,594,692			6,819,992			7,535,254			6,465,837
Effect of dilutive stock options		316,121			332,492			338,165			303,798
		7,910,813			7,152,483			7,873,419			6,769,635
Diluted earnings per share		$	0.49		$	0.41		$	1.40		$	1.14

 

4. Shareholders’ Equity

 

On April 22, 2004, the Company announced a three-for-two stock split effective May 7, 2004.  All shares and per share amounts have been retroactively restated to give effect for the stock split as if it had been declared at the beginning of the earliest period presented.

 

On January 16, 2004 the Company announced that the Board of Directors approved a plan to utilize up to $2 million (or approximately 1% of the total outstanding shares) to repurchase the Company’s common stock.  As of September 30, 2004, the Company had purchased 3,000 shares at an average price of approximately $28.27 under this plan.

 

8

 

5. Acquisitions

 

During 2003, the Company acquired Auburn Community Bank (ACB) and Central Sierra Bank (CSB).  ACB became a wholly-owned subsidiary of the Company and CSB was merged into CCB.  These acquisitions were completed because management believes that their combined performance exceeds what each entity could accomplish independently and furthers the Company’s expansion throughout Northern California.  Total consideration paid to each entity acquired was determined through extensive negotiation supported by internal modeling.  The funds required to pay the cash portion of the consideration for these mergers was generally obtained through the issuance of subordinated debentures (see Note 11 of the Company’s 2003 audited financial statements).

 

The following table summarizes the terms of each acquisition (dollars in thousands, except number shares):

 

		ACB			CSB
Date of acquisition		December 13, 2003			July 11, 2003
Common stock issued		349,976			404,173
Value of common stock issued		$	15,900		$	12,700
Cash paid		$	6,500		$	10,700
Total consideration		$	22,400		$	23,400
Goodwill recorded		$	14,500		$	11,600
Core deposit intangible recorded		$	1,800		$	2,900

 

6. Commitments and Contingencies

 

Leases

 

The Company leases certain of its branch offices under non-cancelable operating leases.  These leases expire on various dates through 2019 and have various renewal options ranging from five to ten years.  Rental payments include minimum rentals, plus adjustments for changing price indexes.  The Company has subleased various office spaces to other companies under non-cancelable agreements that expire in 2007 and 2008.  Future minimum lease payments and sublease rental income are as follows (dollars in thousands):

 

						Minimum
			Minimum			Sublease
Year Ending			Lease			Rental
December 31,			Payments			Income
2004			$	1,541		$	96
2005			1,677			96
2006			1,555			96
2007			1,312			95
2008			1,047			64
Thereafter			4,482			—
			$	11,614		$	447

 

Financial Instruments With Off-Balance-Sheet Risk

 

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business in order to meet the financing needs of its customers and to reduce its exposure to fluctuations in interest rates.  These financial instruments include commitments to extend credit, letters of credit and commitments to sell loans.  These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the consolidated balance sheet.

 

The Company’s exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments.  The Company uses the same credit policies in making commitments and letters of credit as they do for loans and leases included on the consolidated balance sheet.

 

9

 

The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):

 

		September 30, 2004			December 31, 2003
Commitments to extend credit:
Revolving lines of credit secured by 1-4 family residences		$	32,693		$	21,691
Commercial real estate, construction and land development commitments secured by real estate		187,237			161,107
Other commercial commitments not secured by real estate		1,766			1,023
Agricultural commitments		2,586			4,237
Other commitments		59,824			49,949
		$	284,106		$	238,007
Letters of credit		$	22,475		$	18,752

 

Real estate commitments are generally secured by property with loan-to-value ratios not to exceed 80%.  In addition, the majority of the Company’s commitments have variable interest rates.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract.  Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee.  Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.  Each customer’s creditworthiness is evaluated on a case-by-case basis.  The amount of collateral obtained, if deemed necessary upon extension of credit, is based on Management’s credit evaluation of the borrower.  Collateral held varies, but may include deposits, accounts receivable, inventory, equipment, income-producing commercial properties and residential real estate.

 

Letters of credit are conditional commitments to guarantee the performance or financial obligation of a customer to a third party.  The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.

 

Commitments to sell loans are agreements to sell to another party loans originated by the Company.  The Company only sells loans to third parties without recourse.  The Company is not exposed to credit loss if the borrower fails to perform according to the promissory note as long as the Company has fulfilled its obligations stated in the sales commitment.  Commitments to sell loans include the Loans Held for Sale on the balance sheet and certain unfunded loans.  The company minimizes its exposure to interest rate risk on mortgage loans originated for sale by entering into non-mandatory delivery commitments to sell such loans at the same time that it enters into commitments to originate such loans.  Accordingly, the fair value of commitments to originate and sell such loans is not material.

 

7. Comprehensive Income

 

Comprehensive income includes net income and other comprehensive income (loss).  The Company’s only source of other comprehensive income (loss) is derived from unrealized gains and losses on investment securities available-for-sale.  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 of the current period.  The Company’s total comprehensive income was as follows (dollars in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2004			2003			2004			2003
Net income		$	3,849		$	2,956		$	10,995		$	7,706
Other comprehensive income (loss):
Holding gains (losses) arising during period, net of tax		896			(342		)	93			168
Re-classification adjustment, net of tax		1			(12		)	8			(12		)
Total other comprehensive income (loss)		897			(354		)	101			156
Total comprehensive income		$	4,746		$	2,602		$	11,096		$	7,862

 

10

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION.

 

Private securities litigation reform act safe harbor statement

 

This quarterly report on Form 10-Q includes forward-looking information, which is subject to the “safe harbor” created by the Securities Act of 1933 and Securities Act of 1934. These forward-looking statements (which involve the Company’s plans, beliefs and goals) involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors:

 

1.               Competitive pressures in the banking industry and changes in the regulatory environment.

 

2.               Non-compliance with banking regulations and the potential for regulatory penalties and mandates.

 

3.               Exposure to changes in the interest rate environment and the resulting impact on the Company’s interest rate sensitive assets and liabilities.

 

4.               Decline in the health of the economy nationally or regionally which could reduce the demand for loans or reduce the value of real estate collateral securing most of the Company’s loans.

 

5.               Credit quality deterioration that could cause an increase in the provision for loan and lease losses.

 

6.               Asset/Liability matching risks and liquidity risks.

 

7.               Volatility and devaluation in the securities markets.

 

8.               Exposure to losses from fraud and processing of customer transactions deposits, loans, checks, wires and deposits.

 

For additional information concerning risks and uncertainties related to the Company and its operations, please refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 under the heading “Forward-Looking Information”.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to revise or publicly release the results of any revision to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

 

The following sections discuss significant changes and trends in financial condition, capital resources and liquidity of the Company from December 31, 2003 to September 30, 2004. Also discussed are significant trends and changes in the Company’s results of operations for the three and nine months ended September 30, 2004 compared to the same periods in 2003. The consolidated financial statements and related notes appearing elsewhere in this report are condensed and unaudited.

 

11

 

General

 

Western Sierra Bancorp (the “Company”) was incorporated under the laws of the State of California on July 11, 1996. The Company was organized pursuant to a plan of reorganization for the purpose of becoming the parent corporation of Western Sierra National Bank, and on December 31, 1996, the reorganization was effected and shares of the Company’s common stock were issued to the shareholders of Western Sierra National Bank for the common shares held by Western Sierra National Bank’s shareholders.

 

In April 1999, the Company acquired Roseville 1st National Bank and Lake Community Bank in a stock for stock exchange. In May of 2000, the Company acquired Sentinel Community Bank in a stock for stock exchange. All of these mergers were accounted for as poolings of interests and, accordingly, all prior period financial information has been restated to reflect the combined operations of the Company, Roseville 1st National Bank, Lake Community Bank and Sentinel Community Bank. Sentinel Community Bank was immediately merged into Western Sierra National Bank. In May of 2000, Roseville 1st National Bank was also merged into Western Sierra National Bank.

 

In April 2002, the Company acquired Central California Bank for $3.7 million in cash and 252,181 shares of the Company’s stock.  This transaction was accounted for under purchase accounting with a purchase price allocation resulting in intangible assets totaling $2.3 million in goodwill and $1.9 million in core deposit intangible. As required under purchase accounting, no prior period financial statements have been restated to reflect the combined operations of Central California Bank.  In July of 2002, certain assets and liabilities of the Sentinel Community Bank branches were transferred from Western Sierra National Bank to Central California Bank.

 

In July 2003, the Company acquired Central Sierra Bank for $10.7 million in cash and 404,173 shares of the Company’s stock.  This transaction was accounted for under purchase accounting with a purchase price allocation resulting in intangible assets totaling $11.6 million in goodwill and $2.9 million in core deposit intangible. As required under purchase accounting, no prior period financial statements have been restated to reflect the combined operations of Central California Bank.

 

In December 2003, the Company acquired Auburn Community Bank for $6.5 million in cash and 349,976 shares of the Company’s stock.  This transaction was accounted for under purchase accounting with a purchase price allocation resulting in intangible assets totaling $14.5 million in goodwill and $1.8 million in core deposit intangible. As required under purchase accounting, no prior period financial statements have been restated to reflect the combined operations of Auburn Community Bank.

 

The Company is a registered bank holding company under the Bank Holding Company Act. The Company conducts its operations at 4080 Plaza Goldorado Circle, Cameron Park, California 95682.

 

Western Sierra National Bank was organized under national banking laws and commenced operations as a national bank on January 4, 1984. Western Sierra National Bank is a member of the Federal Reserve System and the FDIC insures its deposits to the maximum amount permitted by law. Western Sierra National Bank’s head office is located at 4080 Plaza Goldorado Circle, Cameron Park, and its branch offices are located at 4011 Plaza Goldorado Circle, Cameron Park, 2661 Sanders Drive, Pollock Pines, 3970 J Missouri Flat Road, Placerville, 1450 Broadway, Placerville, 3880 El Dorado Hills Blvd., El Dorado Hills, 571 5th Street, Lincoln, 1545 River Park Dr. #101 & #200, Sacramento, 1801 Douglas Blvd., Roseville, 6951 Douglas Blvd., Granite Bay, 9050 Fairway Drive, Roseville, 2779 East Bidwell, Folsom, CA and 9610 Bruceville Rd., Suite 100, Elk Grove, CA.  In March 2002, Western Sierra National Bank formed WSNB Investment Trust, a Real Estate Investment Trust (“REIT”), to potentially generate additional capital at Western Sierra National Bank and reduce the Company’s overall effective tax rate. Western Sierra National Bank does not have any other affiliates other than Sentinel Associates, Inc., an inactive entity formed by Sentinel Bank in 1983 to develop single-family residential real estate.

 

Lake Community Bank was incorporated as a banking corporation under the laws of the State of California on March 9, 1984 and commenced operations as a California state-chartered bank on November 15, 1984. Lake Community Bank is an insured bank under the Federal Deposit Insurance Act and became a member of the Federal Reserve System in June 2003. Lake Community Bank engages in the general commercial banking business in Lake County in the State of California from its headquarters banking office located at 805 Eleventh Street, Lakeport, California, and its branch located at 4280 Main Street, Kelseyville, California. Lake Community Bank does not have any affiliates or subsidiaries.

 

Central California Bank was incorporated under the laws of the State of California on January 13, 1997, and commenced operations on April 24, 1998. Central California Bank is an insured bank under the Federal Deposit Insurance Act and became a member of the Federal Reserve System in January 2003. Central California Bank engages in the general commercial banking business in Tuolumne and Stanislaus counties in the State of California from its headquarters banking office located at 13753-A Mono Way, Sonora, CA, and its branches located at 400 E. Olive Ave, Turlock, CA, 3700 Lone Tree Way, Antioch, CA, 229

 

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South Washington Street, Sonora, CA, 18711 Tiffeni Drive, Twain Harte, CA, 22712 Main Street, Columbia, CA and loan production offices located at 3400 Tully Rd., #B, Modesto, CA, 1111 Dunbar Road, Arnold, CA,  373 West St. Charles Street, San Andreas, CA, 1239 South Main Street, Angels Camp, CA, 18281 Main Street, Jamestown, CA, 89 Lakewood Mall, Lodi, CA, 11 Ridge Road, Sutter Creek, CA, 87 Highway 26, Valley Springs, CA, and 3505 Spangler Lane, Suite 300, Copperopolis, CA.  Central California Bank does not have any affiliates or subsidiaries.  In July 2003, Central Sierra Bank merged into Central California Bank and its branches are located at 373 West St. Charles Street, San Andreas, CA, 1239 South Main Street, Angels Camp, CA, 18281 Main Street, Jamestown, CA, 89 Lakewood Mall, Lodi, CA, 11 Ridge Road, Sutter Creek, CA, 87 Highway 26, Valley Springs, CA, and 3505 Spangler Lane, Suite 300, Copperopolis, CA.

 

The Company will be opening two more de novo branches before year-end 2004 in addition to the de novo branch opened in Elk Grove, CA in the third quarter of 2004.  Western Sierra Bank will add a branch located at 2761 Del Paso Rd, Sacramento, CA and Central California Bank will open a branch located at 2525 McHenry Ave., Modesto, CA.  Both branches are expected to open in October 2004.

 

In July 2001, December 2001 and September 30, 2003, respectively, four trusts, Western Sierra Statutory Trust I, Western Sierra Statutory Trust II and Western Sierra Statutory Trust III/IV, were established as wholly-owned unconsolidated subsidiaries of the Company for the purpose of issuing and holding Trust Preferred Securities.

 

Auburn Community Bank, a state non-member bank, was originally operating under the name of Auburn National Bank which was incorporated under the laws of the State of California on July 28, 1997, and commenced operations on February 2, 1998.  On July 29, 1999, Auburn National Bank converted from national bank to a state non-member bank and was renamed Auburn Community Bank.  Auburn Community Bank is an insured bank under the Federal Deposit Insurance Act and operates its headquarters banking office located at 412 Auburn-Folsom Road, Auburn, CA and its branch located at 11795 Atwood Road, Auburn, CA.  Auburn Community Bank does not have any affiliates or subsidiaries.

 

Banking Services.  The Company is a locally owned and operated bank holding company, and its primary service area is the Northern California communities of Cameron Park, Pollock Pines, Placerville, El Dorado Hills, Folsom, Lincoln, Sacramento, Roseville, Granite Bay, Sonora, Twain Harte, Columbia, Turlock, Lakeport, Antioch, Rocklin, Sand Andreas, Angels Camp, Jamestown, Lodi, Sutter Creek, Valley Springs, Copperopolis, Auburn and the surrounding communities. The Company’s primary business is serving the banking needs of these communities and its marketing strategy stresses its local ownership and commitment to serve the banking needs of individuals living and working in the Company’s primary service areas and local businesses, including retail, professional and real estate-related activities, in those service areas.

 

The Company offers a broad range of services to individuals and businesses in its primary service areas with an emphasis upon efficiency and personalized attention. The Company provides a full line of consumer services and also offers specialized services, such as courier services to small businesses, middle market companies and professional firms. Each of the Company’s subsidiary banks offers personal and business checking and savings accounts (including individual interest-bearing negotiable orders of withdrawal (“NOW”), money market accounts and/or accounts combining checking and savings accounts with automatic transfer), IRA accounts, time certificates of deposit and direct deposit of social security, pension and payroll checks, computer cash management and internet banking including bill payment. The Company’s subsidiary banks also make available commercial, construction, accounts receivable, inventory, automobile, home improvement, real estate, commercial real estate, single family mortgage, agricultural, Small Business Administration, office equipment, leasehold improvement, installment and credit card loans (as well as overdraft protection lines of credit), issue drafts and standby letters of credit, sell travelers’ checks (issued by an independent entity), offer ATMs tied in with major statewide and national networks, extend special considerations to senior citizens and offer other customary commercial banking services.

 

Most of the Company’s deposits are obtained from commercial businesses, professionals and individuals. At September 30, 2004 there was a large title company deposit customer with $10.0 million or 9.0% of total deposits at Lake Community Bank and another large deposit customer with $8.5 million or 10.4% of total deposits at Auburn Community Bank.  There were no other customers with 5% or more of any of the subsidiary banks’ deposits.

 

Other special services and products include both personal and business economy checking products, business cash management products, financial services through Western Sierra Bank’s Financial Services Division and mortgage products and services.

 

Employees.  At September 30, 2004, the Company and its subsidiaries employed 341 persons on a full-time equivalent basis. The Company believes its employee relations are satisfactory.

 

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Application of Critical Accounting Policies

 

The accounting and reporting policies of The Company and its subsidiaries conform to accounting principles generally accepted in the United States and general practices within the financial services industry. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. A summary of the Company’s most significant accounting policies is contained in Note 1 to the consolidated financial statements. The Company considers its most critical accounting policies to consist of the allowance for loan and lease losses and the estimation of fair value, which are separately discussed below.

 

Allowance for Loan and Lease Losses. The allowance for loan and lease losses represents management’s best estimate of inherent losses in the existing loan portfolio. The allowance for loan and lease losses is increased by the provision for losses on loans and leases charged to expense and reduced by loans and leases charged off, net of recoveries. The provision for loan and lease losses is determined based on management’s assessment of several factors: reviews and evaluations of specific loans and leases, changes in the nature and volume of the loan portfolio, current economic conditions and the related impact on specific borrowers and industry groups, historical loan and lease loss experience, the level of classified and nonperforming loans and the results of regulatory examinations.

 

The Company’s Audit Committee engages experienced independent loan portfolio review professionals many of which are former bank examiners.  The Audit Committee determines the scope of such reviews and will provide the report of findings to management and the Board’s Loan Committee after they have accepted it.  Theses reviews are supplemented with periodic reviews by the Company’s’ credit review function, as well as periodic examination of both selected credits and the credit review process by the applicable regulatory agencies. The information from these reviews assists management in the timely identification of problems and potential problems and provides a basis for deciding whether the credit represents a probable loss or risk that should be recognized.

 

Changes in the financial condition of individual borrowers, in economic conditions, in historical loss experience and in the conditions of the various markets in which collateral may be sold may all affect the required level of the allowance for loan and lease losses and the associated provision for loan and lease losses.

 

Estimation of Fair Value. Accounting principles generally accepted in the United States require that certain assets and liabilities be carried on the Consolidated Balance Sheet at fair value or at the lower of cost or fair value. Furthermore, the fair value of financial instruments is required to be disclosed as a part of the notes to the consolidated financial statements for other assets and liabilities. Fair values are volatile and may be influenced by a number of factors, including market interest rates, prepayment speeds, discount rates, the shape of yield curves and the credit worthiness of counterparties.

 

Fair values for the majority of the Company’s available for sale investment securities are based on quoted market prices. In instances where quoted market prices are not available, fair values are based on the quoted prices of similar instruments with adjustment for relevant distinctions. For trading account assets, fair value is estimated giving consideration to the contractual interest rates, weighted-average maturities and anticipated prepayment speeds of the underlying instruments and market interest rates. (The fair values of residual interests in loans securitized or sold are estimated through the use of a model based on prepayment speeds, weighted-average life, expected credit losses and an assumed discount rate.)

 

Goodwill.  Business combinations involving the Company’s acquisition of the equity interests or net assets of another enterprise or the assumption of net liabilities in an acquisition of branches constituting a business may give rise to goodwill. Goodwill represents the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed in transactions accounted for under the purchase method of accounting. The value of goodwill is ultimately derived from the Company’s ability to generate net earnings after the acquisition. A decline in net earnings could be indicative of a decline in the fair value of goodwill and result in impairment. For that reason, goodwill is assessed for impairment at a reporting unit level at least annually.  While the Company believes all assumptions utilized in its assessment of goodwill for impairment are reasonable and appropriate, changes in earnings, the effective tax rate, historical earnings multiples and the cost of capital could all cause different results for the calculation of the present value of future cash flows.

 

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Financial Condition

 

The Company increased total assets from $1.04 billion at December 31, 2003 to $1.18 billion at September 30, 2004, an increase of $144 million or 14%. The two primary components of asset growth were portfolio loans, which grew $104 million, and cash and equivalents, which increased $34 million.  Current excess cash is expected to be deployed into loans and investments over the coming quarters.  Asset growth was primarily funded by growth in deposits of $133 million.

 

During the first nine months of 2004, non-interest bearing deposits increased from $222 million at year-end 2003 to $264 million at September 30, 2004.  Included in non-interest deposits are local title company deposits, which have increased $10 million to $37 million at September 30, 2004 from $27 million at December 31, 2003.  These funds do not receive interest but do result in an assessment of service fees by the title company’s service bureau to the Company.  During the first nine months of 2004, the service fees on title company deposits incurred by the Company were less than 1% of the average title company deposits outstanding.

 

Results of Operations

 

The Central Sierra Bank (“CSB”) acquisition was effective July 11, 2003 and was accounted for under purchase accounting.  The Auburn Community Bank (“ACB”) acquisition was effective December 13, 2003 and was also accounted for under purchase accounting.  Pursuant to purchase accounting rules, the operating results of the Company for the three and nine-month periods ended September 30, 2003 do not include the operational results of ACB and the operational results of CSB prior to July 11, 2003.

 

The Company reported net income of $3.85 million for the three months ended September 30, 2004 (or $0.49 per share, diluted) compared to $2.96 million (or $0.41 per share, diluted) for the same period in 2003. The quarterly earnings represent an increase of $893,000 or a 30% increase in net income and a 20% increase in diluted earnings per share.

 

The Company reported net income of $11.0 million for the nine months ended September 30, 2004 (or $1.40 per share, diluted) compared to $7.71 million (or $1.14 per share, diluted) for the same period in 2003. These earnings represent an increase of $3.29 million or a 43% increase in net income and a 23% increase in diluted earnings per share.

 

The primary factors contributing to the increase in operating results during the three and nine-month period ended September 30, 2004 as compared to the same period in 2003 include:

 

1.          An increase in net interest income of $3.0 million or 30% in the third quarter over the same period in 2003 and $11.0 million or 41% in the first nine months of 2004 as compared to 2003.  The net increase is the result of an overall increase in average earning assets, which is partially due to the acquisition of $133 million in earning assets from the CSB transaction completed in July 2003, and $84 million in earning assets from the ACB transaction completed in December 2003.  These acquisitions accounted for $90 million or 39% and $145 million or 51% of the total average earning asset growth for the third quarter and nine-month period ended September 30, 2004 over the same periods of the prior year.

 

2.          An increase in year-to-date non-interest income, primarily service fees on deposit accounts (3^rd quarter non-interest income decreased and is discussed as an offset below).  Non-interest income for the first nine months of 2004 increased $578,000 or 8% over the previous year.  Approximately $896,000 or 155% of the increase relates to CSB’s and ACB’s non-interest income in the nine months ended September 30, 2004 that was not included in the nine months ended September 30, 2003 results.  This increase from acquisitions was offset by a reduction in mortgage loan origination and packaging fees of $482,000 and $770,000 for the third quarter and nine-month period ended September 30, 2004 as compared to the same periods of 2003.

 

The above factors were offset in part by:

 

1.          An increase in loan and lease loss provisions of $255,000 for the nine months ended September 30, 2004 as compared to the same period in 2003.  Additional provisions were recorded as a result of growth in loans outstanding.  The percentage of loan and lease loss reserves to gross loans and leases increased to 1.41% at September 30, 2004 from 1.40% at December 31, 2003.

 

2.          Total other expenses increased $1.13 million or 15% and $6.15 million or 30% over the third quarter and year-to-date totals in the previous year.  Total other expenses increased significantly as a result of the addition of CSB and ACB’s operating costs, which added approximately $810,000 (72% of the total increase) and $4.49 million (73% of the total increase) to the third quarter and year-to-date totals of 2004, that were not included in the 2003 results as the acquisitions, accounted for under purchase accounting, did not close until July and December of 2003.

 

3.          A decrease of $390,000 or 13% in non-interest income for the third quarter of 2004 compared to the same period of 2003.

 

4.          An effective tax rate of 37.9% for the third quarter of 2004 as compared to 36.9% for the same period of 2003.

 

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Return on Average Assets and Average Equity

 

Return on average assets (“ROA”) was 1.33% for the third quarter of 2004 as compared to 1.31% for the third quarter of 2003.  Return on equity (“ROE”) was 15.03% for the third quarter of 2004 as compared to 17.01% for the third quarter of 2003.  The compression of ROE was largely due to growth in equity which exceeded the Company’s income growth rate.  Equity grew significantly since June 30, 2003, primarily due to the issuance of stock to acquire two bank subsidiaries and the retention of the Company’s earnings.

 

Net Interest Income (Tax Equivalent Yield Basis)

 

Net interest income is the primary source of income for the Company and represents the excess of interest and fees earned on interest-earning assets (loans, investments and Federal funds sold) over the interest paid on deposits and borrowed funds. Net interest margin is net interest income expressed as a percentage of average earning assets.

 

For the three months ended September 30, 2004, interest income on a tax equivalent basis increased by $3.4 million to $16.3 million or 27% over the same period in 2003. Interest expense on deposit accounts and borrowings increased $360,000 or 14% over the same three-month period ended September 30, 2003. Average earning assets yielded (on a fully tax equivalent basis) 6.20% versus 6.27% a year ago, the effect of which was partially offset by a decrease in the cost of funds where the average cost of funds decreased to 1.46% from 1.58% a year ago. Net interest income (on a tax equivalent basis) increased $3.1 million or 30% to $13.4 million. The net interest margin increased 6 basis points to 5.10% from 5.04% for the same three-month period a year ago.

 

For the nine months ended September 30, 2004, interest income on a tax equivalent basis increased by $12.1 million to $46.9 million or 35% over the same period in 2003. Interest expense on deposit accounts and borrowings increased $1.0 million or 15% over the same nine-month period ended September 30, 2003. Average earning assets yielded (on a fully tax equivalent basis) 6.27% versus 6.52% a year ago, the effect of which was partially offset by a decrease in the cost of funds where the average cost of funds decreased to 1.43% from 1.73% a year ago. Net interest income (on a tax equivalent basis) increased $11.1 million or 40% to $38.7 million. The net interest margin decreased 1 basis points to 5.17% from 5.18% for the same nine-month period a year ago.

 

Net interest margin has remained stable, increasing 6 basis points for the three-month period and decreasing 1 basis point for the nine-month period ended September 30, 2004 as compared to the same periods in 2003.  The primary reasons that the Company was able to stabilize its net interest margin during this challenging rate environment are 1) an increase in the average loan to deposit ratio from 85% and 89% for the three and nine-month periods ended September 30, 2003 to 90% and 92% for the same periods in 2004; 2) the benefit of the portion of the loan portfolio that are fixed rate loans or that have reached contractual interest rate floors (for details regarding loan floors and the interest rate sensitivity of the loan portfolio see item 3, “Quantitative and Qualitative Disclosures About Market Risk” beginning on page 27 of this report) and 3) an increase in the percentage of average non-interest deposits to total deposits from 24% for the three and nine-month periods ended September 30, 2003 to 26% and 25% for the same periods in 2004.

 

Overall, yields trended down from the prior year as a result of new instruments added that have a lower yield than the existing portfolio.  The most material decrease was realized in taxable investment securities, which decreased to 3.22% for the third quarter of 2004 as compared to 3.68% in the same period of 2003 as a result of declining interest rates over the last few years in the bond market, accelerated prepayments on mortgage-backed securities and a lower yield on new investments than the effective yield of the existing portfolio.

 

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The following tables present, for the periods indicated, the distribution of consolidated average assets, liabilities and shareholders’ equity, as well as the total dollar amounts of interest income from average earning assets and the resultant yields and the dollar amounts of interest expense and average interest-bearing liabilities, expressed both in dollars and in rates. Non-accrual loans, which are not considered material, are included in the calculation of the average balances of loans.  Savings deposits include NOW and money market accounts. To compare the tax-exempt asset yields to taxable yields, amounts are adjusted to pre-tax equivalents based on the marginal corporate federal tax rate of 35 percent for the three and nine-month periods ending September 30, 2004 and 34 percent for the same periods in 2003 (dollars in thousands).

 

Average Balances, Interest Income/Expense and Yields/Rates Paid

 

		Three Months Ended
		September 30, 2004								September 30, 2003
		Average Balance			Interest			Yield/ Rate		Average Balance			Interest			Yield/ Rate
Earning assets:
Portfolio loans		$	890,047		$	14,983		6.70%		$	664,456		$	11,857		7.08%
Tax exempt investment securities		34,222			602			6.99%		30,971			547			7.01%
Taxable investment securities		56,931			470			3.28%		41,778			257			2.44%
Federal funds sold		59,038			203			1.37%		75,211			182			0.96%
Interest bearing deposits in banks		4,000			16			1.54%		1,469			18			4.91%
Average earning assets		1,044,238			16,273			6.20%		813,886			12,862			6.27%
Other assets		124,152								92,527
Less ALLL		(12,843		)						(9,636		)
Average total assets		$	1,155,547							$	896,777
Interest bearing liabilities:
Savings Deposits		$	376,649		$	687		0.73%		$	265,301		$	491		0.73%
Time deposits		353,440			1,648			1.86%		327,719			1,686			2.04%
Other borrowings (1)		55,354			549			3.95%		40,720			348			3.39%
Average interest bearing liabilities		785,444			2,885			1.46%		633,740			2,525			1.58%
Non-interest bearing liabilities		257,783								187,827
Other liabilities		10,429								6,251
Shareholders’ equity		101,892								68,959
Average total liabilities and shareholders’ equity		$	1,155,547							$	896,777
Net interest income and net interest margin					$	13,388		5.10%					$	10,337		5.04%

 

(1) For the purpose of this schedule the Company’s subordinated debentures are included in other borrowings.

(2) Net interest margin is calculated by dividing net interest income by average earning assets.

 

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