Back to GetFilings.com

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

for the quarterly period ended March 31, 2004

for the transition period from              to             .

Commission File No. 000 – 26505

COMMUNITY BANCORP INC.

(Name of issuer in its charter)

Issuer’s telephone number: (760) 432-1100

(Former Address)

(Former name, former address and former fiscal year, if changed since last report)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Check whether or not the Company is an accelerated filer as defined in Exchange Rule Act 12b-2.    Yes  ¨    No  x

Number of shares of common stock outstanding as of March 31, 2004: 4,374,864

PART 1: FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

COMMUNITY BANCORP INC.

CONSOLIDATED BALANCE SHEET

(March 31, 2004 unaudited)(dollars in thousands, except per share data)

See accompanying notes to unaudited consolidated financial statements.

2

COMMUNITY BANCORP INC.

CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(unaudited)(dollars in thousands, except per share data)

See accompanying notes to unaudited consolidated financial statements.

3

COMMUNITY BANCORP INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

(unaudited)

4

COMMUNITY BANCORP INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

(unaudited)

See accompanying notes to unaudited consolidated financial statements.

5

COMMUNITY BANCORP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2004

(unaudited)

Note 1 Basis of Presentation:

The interim financial statements included herein have been prepared by Community Bancorp Inc. without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). The interim financial statements include the accounts of Community Bancorp Inc. and its wholly owned subsidiary Community National Bank (the “Bank”), (collectively, the “Company”) as consolidated with the elimination of all intercompany transactions. We also have two unconsolidated subsidiaries, Community (CA) Capital Trust I (“Trust I”) and Community (CA) Capital Statutory Trust II (“Trust II”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such SEC rules and regulations. Nevertheless, the Company believes that the disclosures are adequate to make the information presented not misleading. These financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s latest Annual Report as found on Form 10-K. In the opinion of management, all adjustments, including normal recurring adjustments necessary to present fairly the financial position of the Company with respect to the interim financial statements and the results of its operations for the interim period ended March 31, 2004, have been included. Certain reclassifications may have been made to prior year amounts to conform to the 2004 presentation. The results of operations for interim periods are not necessarily indicative of results for the full year.

The preparation of these consolidated financial statements in conformity with accounting principles generally accepted in the Unites States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the valuation of loan servicing rights, interest only strips and the allowance for estimated loan losses

Note 2 Private Placement of Common Stock

On August 7, 2003 the Company completed a private placement of 725,000 shares of common stock at a price of $15.00 per share to certain “accredited investors” including certain directors and officers of the Company and the Bank and their related interests. The directors, officers and their related interests purchased less than 5% of the total offering.

Gross proceeds from the offering were $10,875,000, and offering expenses totaled $807,000, including placement agent fees. Of the $10,068,000 net proceeds of the offering, the Company used $1.8 million to repay debt, and $7.5 million of the proceeds were invested as equity capital in the Bank. The remaining net proceeds were retained by the Company as working capital.

The sale of the common stock is exempt from the registration provisions of the Securities Act of 1933 by virtues of Section 4(2) of such Act and Regulation D promulgated pursuant thereto inasmuch as the sale was limited to 25 investors of which all were “accredited investors” within the meaning of Regulation D. The Company has filed a S-3 registration statement with the SEC for purposes of registering the shares from the private placement.

Note 3 Issuance of Trust Preferred Securities

On September 17, 2003, the Company’s wholly owned subsidiary, Community (CA) Statutory Capital Trust II (“Trust II”), a Connecticut business trust, issued $5 million of Floating Rate Capital Trust Pass-through Securities, with a liquidation value of $1,000 per share. The securities, which mature in 2033, are callable at par after five years and pay cash distributions at a per annum rate and reset quarterly at the three month LIBOR plus 2.95%. The Trust used the proceeds from the sale of the trust preferred securities to purchase junior subordinated debentures of the Company. The Company received $4.9 million from the Trust upon issuance of the junior subordinated debentures, of which $4.75 million was contributed to the Bank to increase its capital. The $5 million is included in long term debt on the books of the Company, while the net $4.9 million is in cash and cash equivalents.

6

Note 4 Significant Accounting Policies

Stock Option Plans

At March 31, 2004, the Company had three stock option plans, which are described more fully in Note 12 in the Company’s 2003 Annual Report on Form 10-K. The Company accounts for stock options using the intrinsic value method under the provisions of Accounting Principles Board (“APB”) Opinion No. 25 and provides proforma net income and proforma earnings per share disclosures for employee stock option grants as if the fair-value-based method, defined in Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, had been applied. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company’s net income would have been reduced to the pro forma amounts indicated below for the three months ended March 31:

The per share weighted average fair value of stock options granted under the plans during the three months ended March 31, 2004 were $2.52 compared to $3.23 for the three months ended March 31, 2003. The fair value of the options were estimated at grant date using a Black-Scholes single option pricing model with the following weighted average assumptions: Three months ended March 31, 2004 - expected dividend yield of 1.14%, a weighted average risk free interest rate of 2.30%, an expected life of 5.0 years and a volatility of 48.25%; Three months ended March 31, 2003 - no expected dividend yield, a risk free interest rate of 1.52%, an expected life of 5.0 years and a volatility of 40.77%.

7

Note 5 Loans and Related Allowance for Loan Losses:

A summary of loans is as follows:

The Company’s lending activities are concentrated primarily in Riverside and San Diego Counties of Southern California. Although the Company seeks to avoid undue concentrations of loans to a single industry based upon a single class of collateral, real estate and real estate associated business areas are among the principal industries in the Company’s market area. As a result, the Company’s loan and collateral portfolios are, to a significant degree, concentrated in those industries. The Company evaluates each credit on an individual basis and determines collateral requirements accordingly. When real estate is taken as collateral, advances are generally limited to a certain percentage of the appraised value of the collateral at the time the loan is made, depending on the type of loan, the underlying property and other factors.

Note 6 Sales and Servicing of SBA Loans:

The Company originates loans to customers under a SBA program that generally provides for SBA guarantees of 70% to 85% of each loan. The Company sells a portion of the SBA 7a loans originated. On loans sold, the Company allocates the carrying value of such loans between the portion sold and the portion retained, based upon estimates of their relative fair value at the time of sale. The difference between the adjusted carrying value and the face amount of the portion retained is amortized to interest income over the life of the related loans using the interest method.

In accordance with FAS 140, the Company recognizes a servicing asset or liability at the time a loan is sold and the Company retains the servicing, based on the present value of the estimated future cash flows. The servicing asset is amortized proportionately over the period based on the ratio of net servicing income received in the current period to total net servicing income projected to be realized from the servicing rights. Projected net servicing income is determined on the basis of the estimated future balance of the underlying loan portfolio, which decreases over time from scheduled loan amortization and prepayments. The Company estimates future prepayment rates based on relevant characteristics of the servicing portfolio, such as loan types, original terms to maturity and recent prepayment speeds, as well as current interest rate levels, market forecasts and other economic conditions.

If the fair value of the servicing assets is less than the amortized carrying value, the asset is considered impaired. A valuation allowance must be established for the impaired asset by a charge against income for the difference between the amortized carrying value and the fair value. As of March 31, 2004 and December 31, 2003, the valuation allowance for the servicing assets was $30,000 and $35,000, respectively. In estimating fair values at

8

March 31, 2004, the Company utilized a weighted average prepayment assumption of approximately 6.92% and a discount rate of 10.00%. In estimating fair values at December 31, 2003, the Company utilized a weighted average prepayment assumption of approximately 7.37% and a discount rate of 10.00%.

Rights to future servicing income from serviced loans that exceed contractually specified servicing fees are classified as interest-only strips. The interest-only strips are recorded at fair value with any unrealized gains or losses recorded in earnings in the period of change of fair value. Unrealized gains or losses on interest-only strips were not material during the three months ended March 31, 2004 and 2003. At March 31, 2004, the fair value of interest-only strips was estimated using a weighted average prepayment assumption of approximately 6.92% and a discount rate of 10.00%. At December 31, 2003, the fair value of interest-only strips was estimated using a weighted average prepayment assumption of approximately 7.37% and a discount rate of 10.00%.

Note 7 Commitments and Contingencies:

In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheets. The contract or notional amounts of these instruments reflect the extent of involvement the Company has in particular classes of financial instruments. The Company uses the same credit policies in making commitments and conditional obligations.

Commitments to extend credit amounting to $15,378,000 and $37,470,000 were outstanding at March 31, 2004 and December 31, 2003, respectively. 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 many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

The Company has undisbursed portions of construction loans totaling $97,656,000 and $100,014,000 as of March 31, 2004 and December 31, 2003, respectively. These commitments are agreements to lend to a customer, subject to meeting certain construction progress requirements. The underlying construction loans have fixed expiration dates.

Standby letters of credit and financial guarantees amounting to $2,783,000 and $1,512,000 were outstanding at March 31, 2004 and December 31, 2003, respectively. Standby letters of credit and financial guarantees are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements. Most guarantees carry a one year term or less.

Undisbursed lines of credit amounting to $30,944,000 and $25,845,000 were outstanding at March 31, 2004 and December 31, 2003, respectively. Undisbursed lines of credit are revolving lines of credit whereby customers can repay principal and advance principal during the term of the loan in their discretion and may expire between one and eighteen months.

The Company generally requires collateral or other security to support financial instruments with credit risk. Management does not anticipate any material loss will result from the outstanding commitments to extend credit, standby letters of credit and financial guarantees. The Company has a reserve for losses on commitments to extend credit totaling $201,000 and $203,000 as of March 31, 2004 and December 31, 2003, respectively.

As of March 31, 2004 and December 31, 2003, the Company had no non-mandatory commitments to sell loans.

In December 2002, the Company entered into an interest rate swap agreement with a third party. The terms of the agreement include, amongst other things, a collateral requirement which would offset any credit risk between the Company and the third party. The collateral requirement is the greater of the mark-to-market value of the interest rate swap agreement or $945,000. As of March 31, 2004, the collateral requirement was $945,000. Should interest

9

rates increase, it is probable that the mark-to-market value of the interest rate swap will exceed the minimum requirement of $945,000, which would require additional securities or other collateral to be pledged. As of March 31, 2004 and December 31, 2003, the Company pledged one agency mortgage backed security classified as available for sale as collateral with a market value of $1.4 million and $1.5 million, respectively. The unrealized gain (loss) on the interest rate swap was $63,000 and ($303,000) as of March 31, 2004 and December 31, 2003, respectively. The unrealized gains or losses on the interest rate swap are recorded as other assets or liabilities with the corresponding change in the amount of liability for the Trust Preferred Security. The change in unrealized gains or losses on the interest rate swap is offset by the corresponding changes in the unrealized gains or losses on the Trust Preferred Securities in the accompanying consolidated income statements.

Because of the nature of its activities, the Company is from time to time subject to pending and threatened legal actions which arise out of the normal course of its business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s financial position, results of operations or liquidity.

During the normal course of business, the Company has made certain indemnities and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include certain agreements with the Company’s officers and directors under which the Company may be required to indemnify such persons for liabilities arising out of their relationships. The duration of these indemnities and guarantees varies, and in certain cases, is indefinite. The majority of these indemnities and guarantees do not provide for any limitation of the maximum potential future payments the Company could be obligated to make.

In connection with the $15.1 million in outstanding debt securities reflecting the issuance of trust preferred securities, the Company issued the full and unconditional payment guarantee of certain accrued distributions.

Historically, the Company has not been obligated to make significant payments for these obligations and no liabilities have been recorded for these indemnities and guarantees in the accompanying balance sheets.

Note 8 Earnings per share

The following tables are a reconciliation of the numerators and denominators of the basic and diluted EPS computations for the net earnings for the Company (dollars in thousands, except share data):

10

Note 9 Segment Information

The following disclosure about segments of the Company is made in accordance with the requirements of SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. The Company segregates its operations into two primary segments: Banking Division and Small Business Administration (“SBA”) Division. The Company determines operating results of each segment based on an internal management system that allocates certain expenses to each.

Note 10 Recent Accounting Developments:

In July 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (“EITF”) 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF 94-3, a liability for an exit cost as defined in EITF 94-3 was recognized at the date of an entity’s commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. The adoption of SFAS No. 146 by the Company on January 1, 2003 did not have a material impact on the Company’s financial condition, results of operations or cash flows.

In December 2002, SFAS No. 148, Accounting for Stock-based Compensation—Transition and Disclosure, an amendment of FASB Statement No. 123, was issued and amends SFAS No. 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for annual financial statements for fiscal years ending after December 15, 2002, and for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. The Company has not adopted the fair value based method of accounting for stock-based employee compensation.

In November 2002, the FASB issued Interpretation (“FIN”) No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees and Indebtedness of Others, an interpretation of SFAS Nos. 5, 57 and 107, and rescission of FIN No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others. FIN No. 45 elaborates on the disclosures to be made by the guarantor in its interim and annual financial statements about its obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial

11

recognition and measurement provisions of the interpretation are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, while the provisions of the disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The adoption of FIN No. 45 did not have a material impact on the Company’s financial condition, results of operations or cash flows.

In December 2003, the FASB issued FIN No. 46R, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. FIN No. 46R requires that variable interest entities be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. FIN No. 46R also requires disclosures about variable interest entities that companies are not required to consolidate but in which a company has a significant variable interest. The consolidation requirements must be adopted no later than the beginning of the first fiscal year or interim period beginning after March 15, 2004. The Company adopted the provision of FIN No. 46R as of December 31, 2003. The adoption of FIN No. 46R did not have a material impact on the Company’s financial condition, results of operations or cash flows.

On April 30, 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities and is effective for hedging relationships entered into or modified after June 30, 2003. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. The adoption of SFAS No. 149 did not have a material impact on the Company’s financial condition, results of operations or cash flows.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity, which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope, which may have previously been reported as equity, as a liability (or an asset in some circumstances). This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of nonpublic companies. The adoption of SFAS No. 150 did not have a material impact on the Company’s financial condition, results of operations or cash flows.

ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following is management’s discussion and analysis of the major factors that influenced our financial performance for the three months ended March 31, 2004. This analysis should be read in conjunction with our 2003 Annual Report as filed on Form 10-K and with the unaudited financial statements and notes as set forth in this report. Unless the context requires otherwise, the terms “Company,” “us,” “we,” and “our” refers to Community Bancorp Inc. on a consolidated basis.

Certain statements contained in this Quarterly Report on Form 10-Q (“Report”), including, without limitation, statements containing the words “believes”, “anticipates”, “intends”, “expects”, and words of similar import, constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such forward looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions in those areas in which we operate, demographic changes, competition, fluctuations in interest rates, changes in business strategy or development plans, changes in governmental regulation, credit quality, the availability of capital to fund the expansion of our business, economic, political and global changes arising from the war on terrorism, the conflict with Iraq and its aftermath, and other factors referenced in our 2003 Annual Report as filed on form 10-K, including in “Item 1. Business - Factors That May Affect Future Results of Operations.” When relying on forward-looking statements to make decisions with respect to our Company, investors and others are cautioned to consider these and other risks and uncertainties. We disclaim any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

12

This discussion should be read in conjunction with our financial statements, including the notes thereto, appearing elsewhere in this report.

Community Bancorp

We are a Southern California-based bank holding company for Community National Bank. We provide traditional commercial banking services to small and medium-sized businesses and individuals in the communities along the I-15 corridor in northern San Diego County and southwest Riverside County. San Diego and Riverside Counties, according to U.S. census data, were among the top ten fastest growing counties in the United States measured by numerical population growth from April 1, 2000 to July 1, 2003.

At March 31, 2004, we had total assets of $502 million, total deposits of $429 million and stockholders’ equity of $39 million. We have five full service branches serving the communities of Bonsall, Escondido, Fallbrook, Temecula and Vista and additional SBA loan production offices that originate loans in California, Arizona, Nevada and Oregon. According to the June 30, 2003 FDIC data, our five branches have an 8.1% combined deposit market share within the five cities we serve, which would rank us first among community banks and fourth among all banks and thrifts in these cities.

Community National Bank

The Bank commenced operations in September 1985 as a national banking association. As a national banking association, the Bank is subject to primary supervision, examination and regulation by the Comptroller of the Currency. The Bank’s deposits are insured by the Federal Deposit Insurance Corporation up to the applicable limits thereof, and like all national banks, the Bank is a member of the Federal Reserve System.

The Bank is comprised of two divisions, Banking and SBA. The Banking Division serves its customers out of the branch offices and is focused on more “traditional” aspects of commercial banking, including building long term relationships and servicing the entire banking relationship. The SBA Division focuses on the origination and servicing of SBA loans that we may retain in the Bank’s loan portfolio or sell to third party investors.

Key Factors in Evaluating Financial Condition and Operating Performance

As a publicly traded community bank holding company, we focus on several key factors including:

Return to Our Stockholders. Our return to our stockholders is measured in the form of return on average equity (“ROE”), and the potential valuation of the stock price relative to our returns and earnings per share (“EPS”). Our net income for the quarter ended March 31, 2004 increased 66% to $1.9 million compared to $1.1 million for the quarter ended March 31, 2003. Net income increased due to an increase in net interest income and non-interest income, partially offset by an increase in operating expenses. Basic EPS increased to $0.43 for the quarter ended

13

March 31, 2004 compared to $0.32 for the quarter ended March 31, 2003. Diluted EPS increased to $0.40 for the quarter ended March 31, 2004 compared to $0.30 for the quarter ended March 31, 2003. Our ROE was 19.43% for the quarter ended March 31, 2004 compared to 21.06% for the quarter ended March 31, 2003. The increase in EPS was due to the increase in net income, partially offset by the increase in average shares outstanding as a result of the common equity offering during the third quarter of 2003. The decrease in ROE is due to the increase in average equity outstanding as a result of the common equity offering, partially offset by the increase in net income.

Return on Average Assets. Our return on average assets (“ROA”) is a measure we use to compare our performance with other banks and bank holding companies. Our ROA for the quarter ended March 31, 2004 increased to 1.55% compared to 1.08% for the quarter ended March 31, 2003. The increase in ROA is due to the increase in net income relative to our increase in average assets.

Development of Core Revenue Streams. Over the past several years, we have focused on not only improving net income, but improving the consistency of our revenue streams in order to create more predictable future earnings and reduce the effect of changes in our operating environment on our net income. Specifically, we have focused on net interest income through a variety of processes, including increases in average interest earning assets as a result of loan generation and retention and improved net interest margin by focusing on core deposit growth and the use of interest rate floors on new loans being originated, combined with improved borrowing costs through the use of an interest rate swap. As a result, our net interest income before provision for loan losses increased 26% to $5.9 million for the quarter ended March 31, 2004 compared to $4.6 million for the quarter ended March 31, 2003. Our net interest margin has also improved to 5.27% for the quarter ended March 31, 2004 compared to 4.79% for the quarter ended March 31, 2003.

We have also improved our non-interest income. Non-interest income for the quarter ended March 31, 2004 was $1.9 million compared to $1.8 million for the quarter ended March 31, 2003. Gain on sale of loans remained stable at $1.1 million for the quarters ended March 31, 2004 and 2003, consistent with the Company’s goal of having gain on sale of loans between $1.0 million and $1.5 million per quarter. Loan servicing fees increased 30% to $198,000 for the first quarter of 2004 compared to $152,000 for the first quarter of 2003. The increase in loan servicing fees is the result of the increase in loans serviced for others.

While we consider gain on sale of loans a part of our core revenue stream, it is subject to changes in the environment in which we operate, including the effects of government regulation. Specifically, changes in the funding of the SBA 7a program on an annual basis can lead to temporary halts in the program itself and fundamental changes in the structure of the program. For example, the SBA 7a program was halted briefly in January 2004, and when the program returned to operation, the maximum loan size had been decreased from $1.3 million to $750,000 per loan. Furthermore, the loans could no longer be secured by a second trust deed as previously allowed under the rules. However, with increased funding from new legislation in April, the SBA rescinded the $750,000 loan cap and piggyback loans were once again allowed.

Asset Quality. For all banks and bank holding companies, asset quality has a significant impact on the overall financial condition and results of operations. Asset quality is measured in terms of percentage of total loans and total assets, and is a key element in estimating the future earnings of a company. Non-performing loans totaled $973,000 as of March 31, 2004 compared to $961,000 as of December 31, 2003. Non-performing loans as a percentage of gross loans decreased to 0.23% as of March 31, 2004 compared to 0.24% as of December 31, 2003. Net of government guarantees, non-performing loans totaled $397,000, or 0.09% as of March 31, 2004 compared to $271,000, or 0.07%, as of December 31, 2003. Non-performing assets were $1.4 million as of March 31, 2004 and December 31, 2003. Net of government guarantees, non-performing assets as a percent of total assets were 0.17% as of March 31, 2004 compared to 0.15% as of December 31, 2003.

Asset Growth. As revenues from both net interest income and non-interest income are a function of asset size, the continued growth in assets has a direct impact in increasing net income and therefore ROE and ROA. The majority of our assets are loans, and the majority of our liabilities are deposits, and therefore the ability to generate loans and deposits are fundamental to our asset growth. Total assets increased 22% (annualized) during the first quarter 2004 from $476.7 million as of December 31, 2003 to $502.4 million as of March 31, 2004. Total gross

14

loans increased 22% (annualized) to $424.4 million as of March 31, 2004 compared to $402.0 million as of December 31, 2003. Total deposits increased 37% (annualized) to $429.1 million as of March 31, 2004 compared to $393.1 million as of December 31, 2003.

Operating Efficiency. Operating efficiency is the measure of how efficiently earnings before taxes are generated as a percentage of revenue. Our efficiency ratio (operating expenses divided by net interest income plus non-interest income) improved to 58.41% for the quarter ended March 31, 2004 compared to 64.31% for the quarter ended March 31, 2003. The improvement in the efficiency ratio is due to the increase in revenues exceeding the increase in operating expenses. Net interest income before provision plus non-interest income increased 20% to $7.7 million for the three months ended March 31, 2004, while operating expenses increased 9% to $4.5 million for the same period.

Critical Accounting Policies and Estimates

The “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” as well as disclosures found elsewhere in this Form 10-Q, are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of the servicing assets and interest-only strips and the valuation of repossessed assets. Actual results could differ from those estimates.

In determining the appropriate level of the allowance for loan losses, our management and Directors’ Loan Committee initially identify all classified, restructured or non-performing loans and assesses each loan for impairment, as well as any government guarantees on these loans, which in general do not require an allowance for loan loss. Loans are considered impaired when it is probable that a creditor will be unable to collect all amounts due according to the original contractual terms of the loan agreement. If the measure of the impaired loan is less than the recorded investment in the loan, a valuation allowance is established with a corresponding charge to the provision for loan losses. We measure an impaired loan by using the fair value of the collateral if the loan is collateral-dependent and the present value of the expected future cash flows discounted at the loan’s effective interest rate if the loan is not collateral-dependent.

After the specific allowances for loans are allocated, the remaining loans are pooled based on collateral type. A range of potential losses is determined using an eight quarter historical analysis by pool based on the relative carrying value at the time of charge off. In addition, our management and Directors’ Loan Committee establish reserve levels for each pool based upon loan type as well as market condition for the underlying collateral, considering such factors as trends in the real estate market, economic uncertainties and other risks that exist as of each reporting period. In general there are no reserves established for the government guaranteed portion of loans outstanding. All non-specific reserves are allocated to each of these pools.

The reserve for losses on commitments to extend credit is determined based on the historical losses on the underlying collateral of the commitment. The majority of these commitments are on construction loans. Our management and Directors’ Loan Committee also establish a reserve for each pool based upon loan type as well as market conditions for the underlying real estate or other collateral, considering such factors

15

as trends in the real estate market, economic uncertainties and other risks that exist as of each reporting period. In general there are no reserves established for the government guaranteed portion of commitments to extend credit.

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

We periodically evaluate servicing assets for impairment. For purposes of measuring impairment, the rights are stratified based on original term to maturity. The amount of impairment recognized is the amount by which the servicing asset for a stratum exceeds its fair value. In estimating fair values at March 31, 2004, we utilized a weighted average prepayment assumption of approximately 6.92% and a discount rate of 10.00%. In estimating fair values at December 31, 2003, we utilized a weighted average prepayment assumption of approximately 7.37% and a discount rate of 10.00%.

Rights to future servicing income from serviced loans that exceed contractually specified servicing fees are classified as interest-only strips. The interest-only strips are recorded at fair value with any unrealized gains or losses recorded in earnings in the period of change of fair value. Unrealized gains or losses on interest-only strips were not material during the three months ended March 31, 2004 and 2003. At March 31, 2004, the fair value of interest-only strips was estimated using a weighted average prepayment assumption of approximately 6.92% and a discount rate of 10.00%. At December 31, 2003, the fair value of interest-only strips was estimated using a weighted average prepayment assumption of approximately 7.37% and a discount rate of 10.00%.

Changes in these assumptions and economic factors may result in increases or decreases in the valuation of our servicing assets and interest-only strips.

RESULTS OF OPERATIONS

Banking Division - Net Income

Net income for the Banking division increased to $1.0 million for the three months ended March 31, 2004 compared to $519,000 for the three months ended March 31, 2003. The increase in net income for the Banking division was primarily driven by increases in net interest income and a decline in the provision for loan losses, and was partially offset by an increase in non-interest expense and a decrease in other income. Net interest income for the Banking division increased from $3.8 million for the three months ended March 31, 2003 to $4.2 million for the three months ended March 31, 2004. This increase is primarily due to the 29% decrease in interest expense from

16

$1.0 million for the three months ended March 31, 2003 to $741,000 for the three months ended March 31, 2004. The reduction in interest expense is the result of changes in the market rates for time deposits combined with an increase in the average balance of transaction accounts (demand deposits plus interest bearing checking, savings and money market accounts) for the three months ended March 31, 2004 when compared to the same period in 2003. Average transaction accounts increased 33% to $186.3 million for the three months ended March 31, 2004 compared to $140.2 million for the three months ended March 31, 2003.

SBA Division - Net Income

Net income for the SBA division increased to $831,000 for the three months ended March 31, 2004 compared to $605,000 for the three months ended March 31, 2003. The increase in net income for the SBA division was primarily driven by increases in net interest income and non-interest income, and was partially offset by increases in provisions for loan losses and non-interest expense. Net interest income for the SBA division increased from $853,000 for the three months ended March 31, 2003 to $1.6 million for the three months ended March 31, 2004. The increase in net interest income is primarily due to the increase in interest earning assets for the SBA division combined with the reduced cost of deposits as a result of the current interest rate environment. See “Interest Income and Expense” of this section for further discussion of net interest income. Non-interest income increased from $1.3 million for the three months ended March 31, 2003 to $1.5 million for the three months ended March 31, 2004, as a result of other fee income generated through the brokering of SBA related loans.

Net gain on sale of loans remained stable at $1.1 million for the quarter ended March 31, 2004 and 2003. During the three months ended March 31, 2004 we originated $36.6 million in SBA loans compared to $14.0 million during the three months ended March 31, 2003. We sold $15.0 million in SBA loans, or 41% of originations, during the three months ended March 31, 2004 compared to $15.8 million in SBA loans, or 113% of originations, during the three month period ended March 31, 2003. Although the dollar amount of sales decreased 5%, the gain on sale of loans remained stable at $1.1 million due to an increase in the premiums received from the secondary market in 2004 when compared with 2003. Other fee income from the brokering of SBA related loans totaled $140,000 for the three months ended March 31, 2004 compared to $63,000 for the three months ended March 31, 2003.

Non-interest expense for the three months ended March 31, 2004 increased to $1.5 million compared to $1.1 million for the three months ended March 31, 2003. The increase in non-interest expense for the three month period ended March 31, 2004 when compared with the same period in 2003 is the result of incentive based compensation from increased SBA loan originations noted above.

Net Income - Consolidated

Net income increased to $1.9 million for the three months ended March 31, 2004 compared to $1.1 million for the three months ended March 31, 2003. Basic earnings per share were $0.43 and $0.32 for the three months ended March 31, 2004 and 2003, respectively. Diluted earnings per share were $0.40 and $0.30 for the three months ended March 31, 2004 and 2003, respectively. ROE was 19.43% for the three months ended March 31, 2004 compared to 21.06% for the three months ended March 31, 2003. The ROA for the three months ended March 31, 2004 was 1.55% compared to 1.08% for the three months ended March 31, 2003.

The increase in net income and profitability for the three months ended March 31, 2004 was mainly due to the increases in net interest income and non-interest income combined with a decrease in the provision for loan losses, partially offset by an increase in non-interest expense. Net interest income increased due to an increase in average interest earning assets and an expanding net interest margin. Non-interest income increased primarily due to an increase in loan servicing fees and fees from the brokerage of SBA related loans. Operating expenses increased as a result of the Company’s expansion and increased loan production, combined with an increase in professional expenses as a result of the Sarbanes-Oxley Act of 2002 and other internal projects.

Interest Income and Expense

Net interest income is the most significant component of our income from operations. Net interest income is the difference (the “interest rate spread”) between the gross interest and fees earned on the loan and investment

17

portfolios and the interest paid on deposits and other borrowings. Net interest income depends on the volume of and interest rate earned on interest earning assets and the volume of and interest rate paid on interest bearing liabilities.

The following table sets forth a summary of average balances with corresponding interest income and interest expense as well as average yield and cost information for the periods presented. Average balances are derived from daily balances, and non-accrual loans are included as interest earning assets for purposes of this table.