Washington, D.C. 20549

 

Form 10-Q

 

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 UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                             to                             

 

Commission file number 0-21021

 

Enterprise Bancorp, Inc.

(Exact name of registrant as specified in its charter)

 

 

222 Merrimack Street, Lowell, Massachusetts, 01852

 (Address of principal executive offices) (Zip code)

 

(978) 459-9000

(Issuer’s telephone number, including area code)

 

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        o                  No         ý

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: November 5, 2004, Common Stock - Par Value $0.01: 3,679,827 shares outstanding

 

 

ENTERPRISE BANCORP, INC.

 

INDEX

 

	Cover Page
	Index
PART I FINANCIAL INFORMATION
Item 1	Financial Statements
		Consolidated Balance Sheets – September 30, 2004 and December 31, 2003
		Consolidated Statements of Income - Three and nine months ended September 30, 2004 and 2003
		Consolidated Statement of Changes in Stockholders’ Equity - Nine months ended September 30, 2004
		Consolidated Statements 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 Disclosures About Market Risk
Item 4	Controls and Procedures
PART II OTHER INFORMATION
Item 1	Legal Proceedings
Item 2	Unregistered Sales of Securities and Use of Proceeds
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 Reports on Form 8-K
	Signature page

 

2

 

ENTERPRISE BANCORP, INC.

 

Consolidated Balance Sheets

 

September 30, 2004 and December 31, 2003

(unaudited)

 

(Dollars in thousands)		September 30, 2004			December 31, 2003
Assets
Cash and cash equivalents
Cash and due from banks		$	27,902		$	31,102
Short-term investments		39,170			14,000
Total cash and cash equivalents		67,072			45,102
Investment securities - available for sale, at fair value		187,955			196,308
Loans, less allowance for loan losses of $10,744 at September 30, 2004 and $9,986 at December 31, 2003		541,211			478,853
Premises and equipment		11,645			12,429
Accrued interest receivable		3,669			3,178
Deferred income taxes, net		3,668			3,532
Prepaid expenses and other assets		4,007			5,320
Income taxes receivable		369			293
Core deposit intangible, net of amortization		774			874
Goodwill		5,656			5,656
Total assets		$	826,026		$	751,545
Liabilities and Stockholders’ Equity
Liabilities
Deposits		$	740,423		$	660,824
Borrowed funds		9,537			21,424
Junior subordinated debentures		10,825			10,825
Accrued expenses and other liabilities		4,968			3,006
Accrued interest payable		437			716
Total liabilities		766,190			696,795
Commitments and Contingencies
Stockholders’ Equity
Preferred stock, $0.01 par value per share; 1,000,000 shares authorized; no shares issued		—			—
Common stock $0.01 par value per share; 10,000,000 shares authorized; 3,677,727 and 3,602,023 shares issued and outstanding at September 30, 2004 and December 31, 2003, respectively		37			36
Additional paid-in capital		22,329			21,006
Retained earnings		35,404			31,469
Accumulated other comprehensive income		2,066			2,239
Total stockholders’ equity		59,836			54,750
Total liabilities and stockholders’ equity		$	826,026		$	751,545

 

See accompanying notes to the unaudited consolidated financial statements.

 

3

 

ENTERPRISE BANCORP, INC.

 

Consolidated Statements of Income

 

Three and nine months ended September 30, 2004 and 2003

(unaudited)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in thousands, except per share data)		2004			2003			2004			2003
Interest and dividend income:
Loans		$	8,391		$	7,065		$	23,576		$	20,987
Investment securities		1,830			1,428			5,311			5,986
Short-term investments		147			155			232			242
Total interest and dividend income		10,368			8,648			29,119			27,215
Interest expense:
Deposits		1,681			1,597			4,657			5,168
Borrowed funds		24			27			118			79
Junior subordinated debentures		294			294			883			883
Total interest expense		1,999			1,918			5,658			6,130
Net interest income		8,369			6,730			23,461			21,085
Provision for loan losses		300			233			1,350			833
Net interest income after provision for loan losses		8,069			6,497			22,111			20,252
Non-interest income:
Investment management and trust fees		528			484			1,649			1,419
Deposit service fees		507			559			1,584			1,622
Net gains(loss) on sales of investment securities		(2		)	314			638			1,869
Gains on sales of loans		76			277			275			876
Other income		397			346			1,128			1,026
Total non-interest income		1,506			1,980			5,274			6,812
Non-interest expense:
Salaries and employee benefits		3,684			3,413			10,845			10,145
Occupancy expenses		1,310			1,274			3,841			3,815
Audit, legal and other professional fees		342			181			895			690
Advertising and public relations		177			49			603			365
Supplies and postage		203			162			656			530
Trust professional and custodial expenses		151			112			438			438
Other operating expenses		506			452			1,468			1,325
Total non-interest expense		6,373			5,643			18,746			17,308
Income before income taxes		3,202			2,834			8,639			9,756
Income tax expense		1,158			971			3,136			4,691
Net income		$	2,044		$	1,863		$	5,503		$	5,065
Basic earnings per share		$	0.56		$	0.52		$	1.51		$	1.42
Diluted earnings per share		$	0.53		$	0.50		$	1.45		$	1.37
Basic weighted average common shares outstanding		3,676,922			3,591,374			3,636,209			3,556,541
Diluted weighted average common shares outstanding		3,824,270			3,746,889			3,797,848			3,695,686

 

See accompanying notes to the unaudited consolidated financial statements.

 

4

 

ENTERPRISE BANCORP, INC.

 

Consolidated Statement of Changes in Stockholders’ Equity

 

Nine months ended September 30, 2004

 

(unaudited)

 

		Common Stock					Additional Paid-in			Retained			Comprehensive			Accumulated Other Comprehensive			Total Stockholders’
		Shares		Amount			Capital			Earnings			Income			Income			Equity
(Dollars in thousands, except share data)
Balance at December 31, 2003		3,602,023		$	36		$	21,006		$	31,469					$	2,239		$	54,750
Comprehensive income
Net income										5,503			$	5,503					5,503
Other comprehensive loss, net of reclassification													(173		)	(173		)	(173		)
Total comprehensive income													$	5,330
Common stock dividend paid ($0.43 per share)										(1,568		)							(1,568		)
Common stock issued (1)		30,834					968												968
Stock options exercised		44,870		1			355												356
Balance at September 30, 2004		3,677,727		$	37		$	22,329		$	35,404					$	2,066		$	59,836
Disclosure of other comprehensive income:
Net unrealized holding gains on securities during the period													$	345
Income tax expense													(141		)
Net unrealized holding gains, net of tax													204
Less: Reclassification adjustment for gains included in net income:
Net realized gains on sales of securities during the period													638
Income tax expense													(261		)
Reclassification adjustment, net of tax													377
Other comprehensive loss, net of reclassification													$	(173	)

 

(1) Common stock is issued to shareholders under the dividend reinvestment plan and to members of the Board of Directors in lieu of cash compensation for attendance at Board and board committee meetings.

 

See the accompanying notes to the unaudited consolidated financial statements

 

5

 

ENTERPRISE BANCORP, INC.

 

Consolidated Statements of Cash Flows

 

Nine Months Ended September 30, 2004 and 2003

(unaudited)

 

(Dollars in thousands)		September 30, 2004			September 30, 2003
Cash flows from operating activities:
Net income		$	5,503		$	5,065
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		1,350			833
Depreciation and amortization		2,323			3,457
Amortization of intangible assets		100			100
Net gains on sales of investment securities		(638		)	(1,869		)
Gains on sales of loans		(275		)	(876		)
(Increase) decrease in:
Loans held for sale, net of gain		(1,323		)	3,265
Accrued interest receivable		(491		)	464
Income taxes receivable		(76		)	(301		)
Prepaid expenses and other assets		1,313			(2,942		)
Deferred income taxes		(123		)	(689		)
Increase (decrease) in:
Accrued expenses and other liabilities		1,962			5,584
Accrued interest payable		(279		)	(421		)
Net cash provided by operating activities		9,346			11,670
Cash flows from investing activities:
Proceeds from sales of investment securities		16,004			64,439
Proceeds from maturities, calls and pay-downs of investment securities		25,151			69,928
Purchase of investment securities		(32,881		)	(68,923		)
Net increase in loans		(62,110		)	(53,594		)
Additions to premises and equipment, net		(1,008		)	(1,613		)
Net cash provided by (used in) investing activities		(54,844		)	10,237
Cash flows from financing activities:
Net increase in deposits		79,599			40,362
Net decrease in borrowed funds		(11,887		)	(10,827		)
Cash dividends paid		(1,568		)	(1,350		)
Proceeds from issuance of common stock		968			941
Proceeds from exercise of stock options		356			179
Net cash provided by financing activities		67,468			29,305
Net increase in cash and cash equivalents		21,970			51,212
Cash and cash equivalents at beginning of period		45,102			45,778
Cash and cash equivalents at end of period		$	67,072		$	96,990
Supplemental financial data:
Cash Paid For:
Interest		$	5,937		$	6,551
Income taxes		3,325			5,692

 

See accompanying notes to the unaudited consolidated financial statements.

 

6

 

ENTERPRISE BANCORP, INC.

Notes to Consolidated Financial Statements

 

(1)           Organization of Holding Company

 

Enterprise Bancorp, Inc. (the “company”) is a Massachusetts corporation organized on February 29, 1996, at the direction of Enterprise Bank and Trust Company (the “bank”), for the purpose of becoming the holding company for the bank.  The bank, a Massachusetts trust company organized in 1989, has two wholly owned subsidiaries, Enterprise Insurance Services LLC and Enterprise Investment Services LLC, organized for the purpose of engaging in insurance sales activities and offering non-deposit investment products and related securities brokerage services to its customers.

 

(2)           Basis of Presentation

 

The accompanying unaudited consolidated financial statements and these notes should be read in conjunction with the company’s December 31, 2003 audited consolidated financial statements and notes thereto contained in the company’s annual Form 10-K filed with the Securities and Exchange Commission on March 16, 2004.  Interim results are not necessarily indicative of results to be expected for the entire year.  The company has not changed its significant accounting and reporting policies from those disclosed in its 2003 annual report.

 

In the opinion of management, the accompanying consolidated financial statements reflect all necessary adjustments consisting of normal recurring accruals for a fair presentation.  All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements.

 

Certain fiscal 2003 information has been reclassified to conform to the 2004 presentation.

 

(3)           Stock Options

 

The company measures compensation cost for stock-based compensation plans using the intrinsic value method under which no compensation cost is recorded if, at the grant date, the exercise price of the options is equal to or greater than the fair market value of the company’s common stock.

 

Had the company determined compensation expense based on the fair value at the grant date for its stock options under SFAS 123, the company’s net income would have been reduced to the pro forma amounts indicated in the following table:

 

 

		Three months ended September 30,						Nine months ended September 30,
(Dollars in thousands, except per share data)		2004			2003			2004			2003
Net income as reported		$	2,044		$	1,863		$	5,503		$	5,065
SFAS 123 compensation cost, net of tax		(32		)	(22		)	(98		)	(66		)
Pro forma net income		$	2,012		$	1,841		$	5,405		$	4,999
Basic earnings per share as reported		0.56			0.52			1.51			1.42
Pro forma basic earnings per share		0.55			0.51			1.49			1.41
Diluted earnings per share as reported		0.53			0.50			1.45			1.37
Pro forma diluted earnings per share		0.53			0.49			1.43			1.36

 

There were 104,940 options granted in 2004.  There were no options granted in 2003. For options granted in 2004, the per share weighted average fair value of the stock options was determined to be $3.01, or 11% of the average market value of the company’s common stock at the dates of the grants.  The value was determined by using a binomial distribution model.  The average assumptions used in the model for the 2004 grants for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 3.59%, 15.00%, 1.58% and 6, respectively.

 

7

 

(4)           Accounting Rule Changes

 

In May 2004, due to accounting changes by the Financial Accounting Standards Board (“FASB”) related to trust preferred securities, the Board of Governors of the Federal Reserve System published proposed changes to capital rules for bank holding companies in an Advanced Notice of Proposed Rulemaking (ANPR), dated May 6, 2004.    The ANPR would continue to allow the inclusion of trust preferred securities as a component of Tier 1 capital within prescribed limits, while imposing tighter requirements on the calculation of Tier 1 capital.  Until a final rule is issued the Federal Reserve has instructed bank holding companies to continue to include trust preferred securities in their Tier 1 capital, subject to applicable limits, for regulatory capital purposes.  Under the proposed new calculation method, the company’s Tier 1 regulatory capital ratios as of September 30, 2004, would continue to exceed the minimum required regulatory levels to be

 

8

 

considered “Well Capitalized.” For details regarding accounting rule changes related to trust preferred securities and the company’s deconsolidation of it’s subsidiary, Enterprise (MA) Capital Trust 1, as required by FASB Interpretation No. 46R issued in December 2003, refer to the company’s 2003 Annual Report on Form 10-K.

 

In March 2004, the FASB issued a draft of a proposed new Statement of Financial Accounting Standards, “Share-Based Payment,” for public comment.  The proposed new FASB standard, an amendment of FASB Nos. 123 and 95, would eliminate the ability of companies to account for stock-based compensation transactions using the intrinsic value method and generally would require instead that such transactions be accounted for using a fair-value based method.  Under the intrinsic value method, no compensation cost is recorded if, at the grant date, the exercise price of the options is equal to or greater than the fair market value of the company’s common stock; however, pro forma net income and earnings per share information is supplementally disclosed as if the fair-value based method of accounting had been used.  The fair value method requires companies to recognize compensation expense over the service period, equal to the fair value at the grant date for stock options issued in exchange for employee services.  This proposed statement, if issued as supplemented by recent FASB deliberations, would be applied to public companies prospectively for any interim or annual period beginning after June 15, 2005. The proposed statement allows for two transition alternatives, the modified prospective application method or the modified retrospective application method.  A final statement is expected to be issued in the fourth quarter of 2004.  The company currently uses the intrinsic value method to measure compensation cost and is evaluating the impact the proposed new standard would have on future results of operations.  See note 3, “Stock Options”, above for pro forma information regarding compensation expense using the fair value method under SFAS No. 123.

 

In March 2004, the FASB issued Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments,” to determine the meaning of other-than-temporary impairment and its application to debt and equity securities within the scope of Statement 115.  The task force concluded that an investment is impaired if the fair value of the investment is less than cost. If impaired, the investor must make an evidence-based judgment to determine if the impairment is recoverable within a reasonable period of time considering the severity and duration of the impairment in relation to the forecasted recovery of fair value.  The impairment should be considered other than temporary if the investor does not have the ability and intent to hold an investment for a reasonable period of time sufficient for a forecasted recovery of fair value up to (or beyond) the cost of the investment. For those investments for which impairment is considered other than temporary, the company would recognize in earnings an impairment loss equal to the difference between the investment’s cost and its fair value. EITF No. 03-1 other-than-temporary impairment evaluations are effective for reporting periods beginning after June 15, 2004.

 

In September 2004, the FASB issued two proposed Staff Positions (FSP) due to industry responses to EITF No. 03-1.  The first, FSP EITF 03-1-a, provides guidance for the application of EITF No. 03-1 as it relates to debt securities that are impaired because of interest rate and/or sector spread increases.  The second, FSP EITF 03-1-b delays the effective date of EITF No. 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases until the final issuance of FSP EITF 03-1-a, which is expected in December 2004.

 

(5)           Critical Accounting Estimates

 

In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized.  These estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period.  Actual results could differ from those estimates.  Certain of the critical accounting estimates are more dependent on management’s judgment and in some cases may contribute to volatility in the company’s reported financial performance should the assumptions and estimates used change over time due to changes in circumstances. As discussed in the company’s 2003 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and impairment valuation of goodwill.

 

(6)           Earnings Per Share

 

Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding during the year.  Diluted earnings per share reflects the effect on weighted average shares outstanding of the number of additional shares outstanding if dilutive stock options were converted into common stock using the treasury stock method.

 

9

 

The following table presents the increase in average shares outstanding, using the treasury stock method, for the diluted earnings per share calculation for the quarter and year to date periods ended September 30th and the effect of those shares on earnings:

 

		Three months ended September 30,						Nine months ended September 30,
		2004			2003			2004			2003
Basic weighted average Common shares outstanding		3,676,922			3,591,374			3,636,209			3,556,541
Dilutive shares		147,348			155,515			161,639			139,145
Diluted weighted average Common shares outstanding		3,824,270			3,746,889			3,797,848			3,695,686
Basic earnings per share		$	0.56		$	0.52		$	1.51		$	1.42
Effect of dilutive shares		(0.03		)	(0.02		)	(0.06		)	(0.05		)
Diluted earnings per share		$	0.53		$	0.50		$	1.45		$	1.37

 

(7)           Dividends/Dividend Reinvestment Plan

 

On April 20, 2004 the board of directors of the company approved an annual dividend of $0.43 per share, payable on June 25, to shareholders of record as of June 4, 2004.

 

The company maintains a dividend reinvestment plan (the “DRP”).  The DRP enables stockholders, at their discretion, to elect to reinvest dividends paid on their shares of the company’s common stock by purchasing additional shares of common stock from the company at a purchase price equal to fair market value. In 2004, the company’s shareholders utilized the DRP to reinvest $1.0 million of the $1.6 million dividend paid by the company in June 2004 into 30,834 shares of the company’s common stock.

 

(8)           Guarantees and Commitments

 

Standby letters of credit are conditional commitments issued by the company to guarantee the performance by a customer 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 customers.  If the letter of credit is drawn upon, the bank creates a loan for the customer with the same criteria associated with similar loans.  The fair value of these commitments was estimated to be the fees charged to enter into similar agreements.  At September 30, 2004 and 2003 the fair value of these commitments were not material.

 

The company generally originates fixed rate residential mortgage loans with the anticipation to sell such loans. The company generally does not pool mortgage loans for sale but instead sells the loans on an individual basis and generally does not retain the servicing of these loans.  Interest rate lock commitments related to the origination of mortgage loans that will be sold are considered derivative instruments.  The company estimates the fair value of these derivatives using the difference between the guaranteed interest rate in the commitment and the current market interest rate. To reduce the net interest rate exposure arising from its loan sale activity, the company enters into the commitment to sell these loans at essentially the same time that the interest rate lock commitment is quoted on the origination of the loan. The commitments to sell loans are also considered derivative instruments, with estimated fair values based on changes in current market rates.   At September 30, 2004 the estimated fair value of the company’s derivative instruments were considered to be immaterial.

 

(9)           Income Taxes

 

The bank previously organized and controlled a real estate investment trust, Enterprise Realty Trust, Inc. (“ERT”), through which the bank held mortgages and mortgage-related securities.  This ownership structure enabled the company to receive favorable Massachusetts state income tax treatment on the income earned on the assets held by ERT.  This favorable tax treatment was eliminated on a retroactive basis back to 1999 by the Massachusetts legislature in March 2003.

 

10

 

Under the terms of a settlement agreement between the Massachusetts Department of Revenue and the bank, the net income tax charge recorded in 2003, related to the retroactive change in tax legislation, was approximately $1.1 million.

 

On September 29, 2003 the company dissolved ERT and all ERT assets were transferred in liquidation to the bank.  The company will continue to record state income tax liability on the income earned on these additional assets held by the bank.

 

11

 

Item 2 - Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Management’s discussion and analysis should be read in conjunction with the company’s consolidated financial statements and notes thereto contained in this report.

 

Special Note Regarding Forward-Looking Statements

 

This report contains certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, including statements concerning plans, objectives, future events or performance and assumptions and other statements that are other than statements of historical fact.  Forward-looking statements may be identified by reference to a future period or periods or by use of forward-looking terminology such as “anticipates”, “believes”, “expects”, “intends”, “may”, “plans”, “pursue”, “views” and similar terms or expressions. Statements contained in Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 3 – “Quantitative and Qualitative Disclosures About Market Risk,” including, but not limited to, statements related to management’s views on the banking environment and the economy, market expansion and opportunities, the interest rate environment, credit risk and the level of future non-performing assets and charge-offs, potential asset and deposit growth, future non-interest expenditures and non-interest income growth, and borrowing capacity are forward-looking statements.  The company wishes to caution readers that such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties that may adversely affect the company’s future results. The following important factors, among others, could cause the company’s results for subsequent periods to differ materially from those expressed in any forward-looking statement made herein: (i) changes in interest rates could negatively impact net interest income;  (ii) changes in the business cycle and downturns in the local, regional or national economies, including deterioration in the local real estate market, could negatively impact credit and/or asset quality and result in credit losses and increases in the company’s reserve for loan losses; (iii) changes in consumer spending could negatively impact the company’s credit quality and financial results; (iv) increasing competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services could adversely affect the company’s competitive position within its market area and reduce demand for the company’s products and services; (v) deterioration of securities markets could adversely affect the value or credit quality of the company’s assets and the availability of funding sources necessary to meet the company’s liquidity needs; (vii) changes in technology could adversely impact the company’s operations and increase technology-related expenditures;  (viii) increases in employee compensation and benefit expenses could adversely affect the company’s financial results;  (ix) changes in laws and regulations that apply to the company’s business and operations could increase the company’s regulatory compliance costs and adversely affect the company’s business environment, operations and financial results; and (x) changes in accounting standards, policies and practices, as may be adopted or established by the regulatory agencies, the Financial Accounting Standards Board or the Public Company Accounting Oversight Board could negatively impact the company’s financial results.  Therefore, the company cautions readers not to place undue reliance on any such forward-looking information and statements.

 

Accounting Policies/Critical Accounting Estimates

 

The company has not changed its significant accounting and reporting policies from those disclosed in its 2003 Annual Report on Form 10-K.  In applying these accounting policies, management is required to exercise judgement in determining many of the methodologies, assumptions and estimates to be utilized.  As discussed in the company’s 2003 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the valuation of goodwill.  Management’s estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period.  Actual results could differ from those estimates.

 

General Overview

 

Results of Operations

 

The company’s net income amounted to $5.5 million and $5.1 million for the nine months ended September 30, 2004 and 2003, respectively. The increase was primarily due to net interest income growth and lower tax expense, which were partially offset by decreased net gains on sales of investment securities and residential mortgage loans, increased non-interest expense and an increase in the provision for loan losses.  See note 9, “Income Taxes,” above for further explanation on the higher income tax expense in the 2003 period.

 

The company’s earnings are largely dependent on its net interest margin, which is the difference between the yield on interest earning assets (loans, investment securities and short-term investments) and the cost of interest bearing liabilities (deposits, borrowings and junior subordinated debt securities).  Consequently, the company’s earnings are subject to the risk associated with changes in the interest rate environment.  Accordingly, the management of interest rate risk is a significant component of the company’s risk management process.  The company’s earnings are also impacted by the level

 

12

 

of its provision for loan losses, gains on the sales of investment securities and loans, investment management and trust services income, deposit and loan fees, operating expenses, and income taxes.

 

The downward trend in net interest margin appears to have stabilized as interest earning assets and interest bearing liabilities are repricing with less magnitude than had been realized over the past few years. The company’s net interest margin grew 8 basis points, to 4.47%, for the nine months ended September 30, 2004 compared to the same period in 2003.  The year to date results benefited from the recovery of $0.5 million of interest income on commercial loans previously classified as non-accrual.  Excluding these recoveries, net interest margin was 4.38% compared to 4.39% in the prior year.

 

As a result of the stabilized margin and through continued strong commercial loan and deposit growth, the company’s net interest income increased 11%, or $2.4 million, for the nine months ended September 30, 2004 compared to the same period in 2003.

 

The company provided $1.4 million for loan losses for the nine months ended September 30, 2004, compared to $0.8 million for the same period in 2003. The increase over the prior period was mainly due to additional provision made in the first quarter of 2004.  Through ongoing assessments of the allowance and estimates of the credit risk inherent in the portfolio at the time, including the level of net charge-offs, particularly during the first quarter of 2004, management determined it was prudent to make additional provisions as compared to the same period in 2003. The assessment of credit risk is also a significant component of the company’s risk management process and is discussed in more detail under the heading “Assessment of the Allowance for Loan Losses” below.

 

Non-interest income declined by $1.5 million, or 23%, for the nine months ended September 30, 2004 compared to the same period ended September 30, 2003.  The decrease was primarily due to declines in the net gains realized on sales of investment securities and on fixed rate residential loan sales, of $1.2 million and $0.6 million, respectively.

 

From time to time management may choose to sell investment securities in order to take advantage of certain investment opportunities and to effectively manage its exposure to interest rate risk through asset/liability repositioning.  The higher net gains realized during the nine months ended September 30, 2003, as compared to the same period ended September 30, 2004, were due to attractive market opportunities and to the company’s asset-liability repositioning efforts during the 2003 period.

 

The company generally sells long-term fixed rate residential mortgage loan production to minimize interest rate risk and puts variable rate loans into the company’s portfolio in conjunction with the overall asset-liability management program of the company.  The decrease in net gains on loan sales were due to lower volume of fixed rate mortgage loan originations in 2004 compared to the unusually high volume of refinancing activity in 2003, which was driven by the low market rates during that period. This refinancing activity reached a peak in the summer of 2003 and has subsequently declined due to a slight increase in residential mortgage market rates and the significant portion of the consumer market that had already refinanced during the historically low interest rate environment.

 

Non-interest expenses increased by $1.4 million, or 8%, for the nine months ended September 30, 2004, compared to the same period ended September 30, 2003. The increase was primarily attributed to increases in salaries and employee benefits of $0.7 million related to additional staff hired in late 2003 and in 2004 to support the company’s strategic growth initiatives, annual employee raises and increases in health/life insurance premiums due to general increases in premium rates.  Advertising and public relations expenditures grew $0.2 million to support the company’s growth and expansion into new markets. Audit, legal and professional fees increased $0.2 million primarily due to increases in expenditures related to marketing consulting, professional staffing and recruitment, and outsourced technology consulting due to the company’s growth.

 

Financial Position

 

The company’s primary sources of funds are deposits, borrowings from the Federal Home Loan Bank (“FHLB”), securities sold under agreements to repurchase, earnings and proceeds from the sales, maturities and paydowns on loans and investment securities.  The company uses these funds to originate loans, purchase investment securities, conduct operations, expand the company’s branch network, and pay dividends to shareholders.

 

Total assets increased $74.5 million, or 10%, since December 31, 2003, and amounted to $826.0 million at September 30, 2004.  The increase was primarily due to inflows from deposits reinvested into loans and short-term investments.

 

Loans, net of fees, increased by $63.1 million, or 13%, over December 31, 2003. The growth was primarily in the construction and commercial real estate loan portfolios.  The growth of these portfolios reflects the company’s continued

 

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commitment to developing strong commercial lending relationships with growing businesses, corporations, non-profits, professionals and individuals.

 

Short-term investments increased by $25.2 million since December 31, 2003.  This growth was partially offset by a decline in the investment securities portfolio of $8.4 million, or 4%, due to securities sales and principal prepayments in the mortgage backed securities portfolio.

 

Deposits grew by $79.6 million, or 12%, over December 31, 2003.  Growth was principally seen in checking, savings and money market accounts, as the company continued its focus on developing commercial deposit products for businesses, non-profits and professionals.

 

Borrowed funds declined by $11.9 million since December 31, 2003, due to the paydown of overnight FHLB advances taken at the end of 2003, offset by an increase in customer repurchase agreements.

 

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Assessment of the Allowance for Loan Losses

 

Inherent in the lending process is the risk of loss.  While the company endeavors to minimize this risk, management recognizes that loan losses will occur and that the amount of these losses will fluctuate depending on the risk characteristics of the loan portfolio.  The allowance reflects management’s estimate of the level of loan loss reserves necessary to support the level of credit risk inherent in the loan portfolio at the time.

 

The allowance for loan losses amounted to $10.7 million, or 1.95% of total loans, at September 30, 2004 compared to $10.0 million, or 2.04% of total loans, at December 31, 2003.  The provision for loan losses was $1.4 million for the nine months ended September 30, 2004, compared to $0.8 million for the same period ended September 30, 2003.  Net charge-offs amounted to $0.6 million in 2004, primarily related to the $0.5 million in partial charge-offs of two commercial loan relationships in the first quarter.  The ratio of non-performing loans as a percentage of total loans declined to 0.35% at September 30, 2004 from 0.61% at December 31, 2003.

 

In making its assessment on the adequacy of the allowance, management considers several quantitative and qualitative factors that could have an effect on the credit quality of the portfolio, including the level of delinquencies, non-performing loans, net charge-offs, loan growth and portfolio composition, economic trends and comparison to industry peers.  Based on this assessment of the overall risk profile of the loan portfolio, management determined that the reserve was adequate at September 30, 2004.

 

See “Asset Quality” under “Financial Condition” below for further information on the company’s allowance for loan losses.

 

Opportunities and Risks

 

Management views the current banking landscape as an opportunistic period for the company.  Management believes that industry consolidation, branch expansion and continued market penetration have positioned the company well to achieve success in the coming years.

 

Notwithstanding the substantial competition the company faces to attract deposits and to generate loans within its market area, management believes that it has differentiated the company from competitors by providing customers, composed principally of growing and privately held businesses, professionals, and consumers, with prompt and personal service based on management’s familiarity and understanding of such customers’ banking needs.  The company’s past and continuing emphasis is to provide its customers with highly responsive personal and professional service, to target product lines to customer needs, and to seek out and hire top professionals who understand the community and local banking environment.

 

The company’s market position has been enhanced by the ongoing consolidation within the banking industry, particularly in Massachusetts. Additionally, management actively seeks to expand market share in new and existing markets and grow assets by pursuing strategic opportunities in neighboring communities.

 

The company opened its twelfth branch, in Andover, Massachusetts, on March 15, 2004.  The Andover facility is about one half the size of our typical branch facility.  The company opened there to quickly create a presence in the Andover market, in order to take full advantage of opportunities presented by recent bank-acquisition activity. Due to the strong growth experienced, and the potential in the Andover area, the company plans to relocate into a larger, more permanent office in downtown Andover, within the next 9-12 months.  The company has received the required regulatory approvals to open a full-service branch in Salem, New Hampshire, which will mark Enterprise’s first entry into the Southern New Hampshire market. Management anticipates a late 2004 opening for the Salem branch.  The company has also obtained the required regulatory approvals to open an additional branch office in Tewksbury, Massachusetts, and anticipates that this new facility will open for business in early/mid-2005. The company expects that operating expenses, primarily salaries, marketing, and occupancy, will increase before the company achieves the long-term benefits it anticipates from this strategic growth.

 

The effective management of interest rate and credit risk, and establishing profitable growth in a very competitive landscape, are key challenges for the company.

 

Currently, the company’s exposure to interest rate risk is primarily in a declining interest rate environment, as lower interest rates will lead to further margin compression.  As market rates decline, interest earning assets reprice downward and prepayments of loans and mortgage backed investment securities accelerate, forcing the company to reinvest these proceeds at lower market rates.  Such declines in the rates on earning assets cannot be fully offset by reductions in deposit rates, which are at levels that will not allow for corresponding reductions.

 

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As noted above, credit risk, and in particular credit risk associated with the growing construction and commercial loan portfolios, remains a significant risk to the company’s financial results, inasmuch as a significant decrease in credit quality would result in increased loan loss provisions, which are a direct charge to earnings.

 

Management will seek to mitigate credit risk and margin compression through growth of high quality, high yielding assets and low cost checking and savings deposits.  In addition, management will pursue growth of non-interest income in the form of loan and deposit fees, investment management and trust income, and effective management of non-interest expenses, recognizing that strategic expenditures will continue to be made to support the company’s growth and branch expansion goals.  Gains realized on sales of investment securities are dependent on overall market conditions and the company’s management of its asset-liability position.  Gains realized on the sale of  loans are dependent on the volume of fixed rate residential loans originated, which in turn is reliant on market interest rates.  There can be no assurances that market conditions will continue to support the level of gains realized on the sales of loans or securities to the extent realized through September 30, 2004, and prior periods.

 

Financial Condition

 

Short-term investments

 

The balance in short-term investments of $39.2 million at September 30, 2004 consisted of overnight and term investments having an average maturity of less than three months. The increase in the balance of short-term investments at September 30, 2004, was primarily due to cash inflows from deposits during the period.

 

Investments

 

At September 30, 2004, all of the company’s investment securities were classified as available-for-sale and carried at fair value.  At September 30, 2004, the investment portfolio’s fair market value of $188.0 million represented 23% of total assets, compared to 26% of total assets, or $196.3 million, at December 31, 2003.  During the nine months ended September 30, 2004 the company sold $16.0 million of securities, recognizing  $0.6 million in net gains.   Principal paydowns, calls and maturities totaled $25.2 million during the period, and were primarily comprised of $21.1 million in prepayments on the mortgage backed securities portfolio.  The proceeds from these sales and paydowns were partially utilized to purchase $32.9 million of securities, with the remainder used to pay off maturing short-term FHLB borrowings and fund loan growth.

 

The net unrealized gains on the portfolio at September 30, 2004 were $3.3 million compared to net unrealized gains of $3.5 million at December 31, 2003. The decrease was primarily due to higher market rates at September 30, 2004 compared to December 31, 2003, leading to lower market values on fixed income securities.

 

The net unrealized gains/losses of the company’s bond portfolio fluctuates as interest rates rise and fall.  Due to the fixed rate nature of the company’s bond portfolio, as rates rise the value of the portfolio declines and as rates fall the value of the portfolio rises.  The unrealized gains will only be realized if the securities are sold. If an unrealized loss is deemed to be other than temporary, the company would mark the investment down to its carrying value through a charge to earnings.   Because the decline in fair value is due to changes in interest rates and not a deterioration of credit quality, these investments are not considered other than temporarily impaired.  See Note 4, Accounting Rule Changes, for information regarding recent accounting guidance on the meaning of other-than-temporary impairment and its application to certain investments.

 

Loans

 

Total loans, net of fees, before the allowance for loan losses, were $552.0 million, or 67% of total assets, at September 30, 2004, compared to $488.8 million, or 65% of total assets, at December 31, 2003, an increase of $63.2 million, or 13%.

 

The following table sets forth the loan balances by certain loan categories at the dates indicated and the percentage of each category to total loans, excluding deferred fees.

 

		September 30, 2004					December 31, 2003					September 30, 2003
($ in thousands)		Amount			percent		Amount			percent		Amount			percent
Commercial real estate		$	232,666		42.0	%	$	209,113		42.6	%	$	205,711		44.1	%
Commercial & Industrial		135,444			24.5	%	132,313			27.0	%	127,685			27.4	%
Construction		95,888			17.3	%	69,524			14.2	%	58,376			12.5	%
Total Commercial loans		$	463,998		83.8	%	$	410,950		83.8	%	$	391,772		84.0	%
Residential mortgages		40,655			7.4	%	39,465			8.0	%	37,443			8.0	%
Home equity		42,496			7.7	%	35,139			7.2	%	32,850			7.0	%
Other consumer		4,242			0.8	%	4,558			0.9	%	4,303			0.9	%
Loans held for sale		1,860			0.3	%	262			0.1	%	477			0.1	%
Total Consumer loans		$	89,253		16.2	%	$	79,424		16.2	%	$	75,073		16.0	%
Total Gross loans		$	553,251		100.00	%	$	490,374		100.0	%	$	466,845		100.0	%
Deferred fees		(1,296		)			(1,535		)			(1,436		)
Loans, net of fees		551,955					488,839					465,409
Allowance for loan losses		(10,744		)			(9,986		)			(10,285		)
Net loans		$	541,211				$	478,853				$	455,124

 

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Commercial real estate loans are typically secured by apartment buildings, office facilities, shopping malls, or other commercial property.  Commercial real estate loans increased by $23.6 million, or 11%, at September 30, 2004, compared to December 31, 2003.

 

Commercial and industrial loans include working capital loans, equipment financing (including equipment leases), term loans, revolving lines of credit and loans under various U.S. Small Business Administration programs.  Commercial and industrial loans increased slightly by $3.1 million, or 2%, from December 31, 2003 through September 30, 2004.

 

Management views commercial construction lending as a niche market with the potential for continued growth.  Over the past nine months construction lending, including both commercial and residential construction, grew by $26.4 million or 38% and over the last twelve month period by $37.5 million or 64%.  The company attributes this growth to an experienced team of lenders focused on this market segment, coupled with the company’s expansion into new geographic markets.

 

At September 30, 2004 the company had commercial and construction loan balances participated out to various banks amounting to $18.8 million compared to $14.5 million at December 31, 2003.  These portions participated out to other institutions are not carried as assets on the company’s financial statements. Loans originated by other banks in which the company is the participating institution are carried on the balance sheet and amounted to $19.3 million at September 30, 2004, compared to $6.4 million at December 31, 2003.  The company’s participation in these loans range from 5% to 100% of the total loan commitment, with no single participation exceeding $5.0 million.

 

Total consumer loans, consisting of residential mortgages, home equity loans, consumer loans and residential loans held for sale, increased by $9.8 million, or 12%, since December 31, 2003.

 

Asset Quality

 

The following table sets forth non-performing assets at the dates indicated:

 

(Dollars in thousands)		Sept. 30, 2004			Dec. 31, 2003			Sept. 30, 2003
Non-accrual loans		$	1,904		$	2,983		$	2,583
Accruing loans > 90 days past due		2			—			48
Total non-performing loans		1,906			2,983			2,631
Other real estate owned		—			—			—
Total non-performing assets		$	1,906		$	2,983		$	2,631
Non-performing loans: Loans, net of fees		0.35		%	0.61		%	0.57		%
Non-performing assets: Total assets		0.23		%	0.40		%	0.35		%
Delinquent loans 30-89 days past due: Loans, net of fees		0.49		%	0.51		%	1.06		%

 

The non-performing loan to total loan ratio decreased to 0.35% at September 30, 2004, from 0.61% at December 31, 2003.  The decline resulted from a $1.1 million decrease in non-performing loans and a 13% growth in total loans over the period. Delinquent loans 30-89 days past due decreased slightly over the period.

 

The non-performing loan to total loan ratio also decreased from 0.57% at September 30, 2003 compared to the September 30, 2004 ratio of 0.35%.  The decline resulted from a $0.7 million decrease in non-performing loans and a 19% growth in total loans over the period. Delinquent loans 30-89 days also decreased over the period.

 

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The level of non-performing assets is largely a function of economic conditions and the overall banking environment. Despite prudent loan underwriting, adverse changes within the company’s market area, or deterioration in the local, regional or national economic conditions, could negatively impact the company’s level of non-performing assets in the future.

 

Management continues to closely monitor the credit quality of individual non-performing relationships as well as the loan portfolio in general, industry concentrations, composition of the portfolio, the local real estate market and current economic conditions.  Management believes that the current level of non-performing assets and delinquent loans are reasonable given the growth in the loan portfolio and the substantial commercial composition of the portfolio, and are comparable with peer commercial banks.

 

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The following table summarizes the activity in the allowance for loan losses for the periods indicated:

 

		Nine months ended September 30,
(Dollars in thousands)		2004			2003
Balance at beginning of period		$	9,986		$	9,371
Total loans charged off		(792		)	(121		)
Total recoveries		200			202
Net loans (charged off) /recovered		(592		)	81
Provision charged to operations		1,350			833
Balance at September 30		$	10,744		$	10,285
Annualized net loans (charged off)/recovered: Average loans outstanding		(0.15		)%	0.02		%
Allowance for loan losses: Loans, net of fees		1.95		%	2.21		%
Allowance for loan losses: Non-performing loans		563.69		%	390.92		%

 

Year to date charge-offs amounted to $0.8 million for the nine months ended September 30, 2004.  These charge-offs were primarily composed of the partial charge-offs of two individual commercial loan relationships amounting to $0.5 million in the first quarter. Recoveries of $0.2 million during the period were recognized primarily on previously charged-off commercial and industrial loans.  The provision for the nine months ended September 30, 2004, amounted to $1.4 million compared to $0.8 million for the same period in 2003.

 

The increased provision over 2003 primarily resulted from $533,000 in charge-offs during the first quarter that resulted in a $750,000 provision and a loan loss reserve to loan ratio of 2.04%.  Charge-offs subsequently declined to $221,000 and $38,000 in the second and third quarters, respectively, and the allowance to loan ratio declined to 1.96% and 1.95% at the end of those periods.

 

From a historical perspective, following September 11, 2001, the company began providing for loan loss reserves at a higher level due to management’s estimate of a prolonged and significant economic downturn, which was expected to result in deterioration of the loan portfolio’s credit quality.  Consequently, the company’s loan loss reserve to total loan ratio increased and amounted to 2.27% at December 31, 2001 compared to 2.00% at June 30, 2001. The ratio remained at these levels through September 2003.  In the course of subsequent ongoing assessments, management determined that neither the economic results nor the portfolio’s credit quality deteriorated to the extent previously envisioned.  Consequently, management’s assessment of the portfolio’s credit risk through December 31, 2003 concluded that a reserve level of 2.04% was reasonable and adequate at December 31, 2003.

 

Management maintained the reserve at 2.04% for the quarter ended March 31, 2004.  During the quarters ended June 30, and September 30, 2004, charge-offs, non-performing loans and delinquencies improved and the economic recovery appeared stable.  Accordingly, management deemed the allowance to loan loss ratio of 1.96% and 1.95% at June 30, 2004 and September 30, 2004, respectively, to adequately support the credit risk inherent in the portfolio.

 

See “General Overview – Assessment of the Allowance for Loan Losses” above for further details on management’s assessment of the adequacy of the allowance for loan losses.

 

Deposits and Borrowed Funds

 

Total deposits increased $79.6 million, or 12%, during the first nine months of 2004, to $740.4 million and 90% of total assets at September 30, 2004, from $660.8 million and 88% of total assets at December 31, 2003.  The increase consisted of $43.3 million, or 16%, in checking accounts and $42.5 million, or 17%, in savings/money markets accounts, offset by a decline of $6.1 million or 4% in certificates of deposits.

 

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