Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

PACIFIC CAPITAL BANCORP

(Exact Name of Registrant as Specified in its Charter)

(805) 564-6405

(Registrant’s telephone number, including area code)

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

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

Title of Class

Common Stock, no par value

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 X     No     

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    [    ]

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

The aggregate market value of the voting stock held by non-affiliates computed June 30, 2004, based on the sales prices on that date of $28.13 per share: Common Stock—$ 1,185,156,451. This amount is based on reported beneficial ownership by all directors and executive officers and the registrant’s Employee Stock Ownership Plan; however, this determination does not constitute an admission of affiliate status for any of these stockholders.

As of February 22, 2005, there were 45,775,723 shares of the issuer’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE: Portions of registrant’s Proxy Statement for the Annual Meeting of Shareholders on May 24, 2005 are incorporated by reference into Part III.

Table of Contents

2

Table of Contents

PART I

(a)  General Development of the Business

Operations commenced as Santa Barbara National Bank (“the Bank”) in 1960. In 1979, the Bank switched from a national charter to a state charter and changed its name to Santa Barbara Bank & Trust (“SBB&T”). Santa Barbara Bancorp (“SBBancorp”) was formed as a holding company in 1982. In 1998, SBBancorp merged with Pacific Capital Bancorp (“PCB”), a bank holding company that was the parent of First National Bank of Central California (“FNB”). SBBancorp was the surviving company, but took the name Pacific Capital Bancorp to recognize the wider market area. In March 2002, the Company consolidated the two subsidiary banks, SBB&T and FNB, into one national bank charter (“the Bank Merger”), Pacific Capital Bank, N.A. (“PCBNA”). Unless otherwise stated, “Company” refers to this consolidated entity and to its subsidiary bank when the context indicates. “Bancorp” refers to the parent company only.

At the time of the Bank Merger, SBB&T had grown to 29 banking offices with loan, trust and escrow subsidiary offices. Through 1988, banking activities were primarily centered in the southern coastal region of Santa Barbara County. Two banking offices were added in the merger with Community Bank of Santa Ynez Valley on March 31, 1989. Five offices in northern Santa Barbara County were added with the acquisition of First Valley Bank on March 31, 1997, and three offices in the Santa Clara River Valley region of Ventura County were added with the acquisition of Citizens State Bank on September 30, 1997. From 1995 through 1998, six new banking offices were opened in western Ventura County and one in northern Santa Barbara County. The Company acquired Los Robles Bank (“LRB”) at the end of June 2000, when the Company purchased all of the outstanding shares of Los Robles Bancorp, parent of LRB. LRB was merged with SBB&T in the second quarter of 2001. LRB had three offices. Two of these became offices of SBB&T and the third was closed because of its close proximity to one of the existing offices of SBB&T.

At the time of the Bank Merger, FNB had 11 banking offices in Monterey, Santa Cruz, Santa Clara, and San Benito counties. The offices in Santa Clara County use the name South Valley National Bank, which was a separate subsidiary of PCB until it was consolidated with FNB shortly before PCB merged with SBBancorp. The offices in San Benito County use the name San Benito Bank (“SBB”). SBB was a separate bank prior to its merger with FNB at the end of July 2000. FNB also provided trust and investment services to its customers.

Subsequent to the Bank Merger, the Company opened an additional banking office in the Simi Valley area of Ventura County. Pacific Crest Capital Inc. (“PCCI”) was acquired in March 2004. Its subsidiary, Pacific Crest Bank with its deposit offices and lending activities was merged into PCBNA. The deposit offices are located in Encino and Beverly Hills in Los Angeles County, and in San Diego in San Diego County. The lending activities of the former Pacific Crest Bank are conducted in a number of western states. Primarily these loans are for income producing properties and loans to small businesses guaranteed by the Small Business Administration. PCCI was merged into the Bancorp.

PCBNA now has 45 banking offices from San Diego in the South to Morgan Hill in the North. The Company continues to use the brand names of Santa Barbara Bank & Trust, First National Bank of Central California, South Valley National Bank, and San Benito Bank in their respective market areas, and Pacific Capital Bank for the three former offices of Pacific Crest Bank.

The Company has several other subsidiaries. PCB Services Corporation was formed in 1988. This subsidiary, which was primarily involved in mortgage brokering services and the servicing of brokered loans, ceased those activities in 2001 and now has only insignificant activities. A second, Pacific Capital Services Corporation, is inactive. There are two additional subsidiaries, SBB&T Automobile Loan Securitization Corporation and SBB&T RAL Funding Corporation, that are or were used in the securitizations mentioned in Note 10 to the Consolidated Financial Statements.

3

Table of Contents

(b)  Financial Information about Industry Segments

Information about industry segments is provided in Note 26 to the Consolidated Financial Statements in Item 8 of this report. In addition, the following information is provided to assist the reader in understanding the Company’s business segments:

In addition to the retail and business deposits managed by the above banking offices, the Company makes use of brokered deposits and deposits received from the State of California which are administered by the Company’s Treasury department.

The Company’s lending businesses are organized broadly by product line, not region. There is one manager for commercial lending, another for consumer lending, and one for Wealth Management, the lending to high net worth customers.

Several of the Company’s businesses are conducted over a wider geographic area. The income tax refund businesses described in Management’s Discussion and Analysis in Item 7 of this report (“MD&A”) on pages 62 through 68 and which comprise a separate reportable segment in Note 26 to the Financial Statements, are conducted in all 50 states. The commercial equipment leasing business is conducted throughout the Western United States. The indirect auto lending business is conducted in several counties in California other than the counties listed above in which the Company conducts deposit activities. Neither the commercial equipment leasing nor the indirect automobile lending businesses comprise an individual segment reportable in Note 26. As described above, the lending businesses acquired with PCCI are conducted in California, Arizona, Texas, and Oregon. They are reported as a separate segment in Note 26.

(c)  Narrative Description of Business

Holding Company:  Bancorp is a bank holding company. As of December 31, 2004, as described above, it had one bank subsidiary. Bancorp provides support services to its subsidiary bank, PCBNA. These services include executive management, legal, accounting and treasury, and investor relations.

Bank Products and Services:  PCBNA offers a full range of commercial banking services to households, professionals, and small- to medium-sized businesses. These include various

4

Table of Contents

commercial, real estate and consumer loan, leasing and deposit products. PCBNA offers other services such as electronic fund transfers and safe deposit boxes to both individuals and businesses. In addition, services such as lockbox payment servicing, foreign currency exchange, letters of credit, and cash management are offered to business customers. PCBNA also offers trust and investment services to individuals and businesses. These include acting as trustee or agent for living and testamentary trusts, charitable remainder trusts, employee benefit trusts, and profit sharing plans, as well as executor or probate agent for estates. Investment management and advisory services are also provided.

PCBNA also offers products related to income tax returns filed electronically. The Company is one of three financial institutions, which together provide over 90% of these products on a national basis. The Company provides these products to taxpayers who file their returns electronically. For both products, the taxpayer instructs the Internal Revenue Service to remit his/her refund to the Company. In the case of a Refund Anticipation Loan (RAL), the Company will have lent the taxpayer some portion of the amount of his/her refund and will apply the refund when received from the IRS to repayment of the loan. In the case of a Refund Transfer (RT), the Company will forward the refund to the taxpayer once it has been received from the IRS. As a loan product, there is credit risk associated with a RAL. There is no credit risk associated with an RT. Because they are associated with income tax returns, there is a high degree of seasonality to the income from these programs. These programs are more fully described in the MD&A on pages 62 through 68.

Additional information about the products by the various business segments of PCBNA is provided in Note 26 of the Financial Statements in Item 8 of this form.

Customer concentration:  There are no customers individually accounting for 10% or more of consolidated revenues.

Competition:  For most of its banking products, the Company faces competition in its market area from branches of most of the major California money center banks, some of the statewide savings and loan associations, and other local community banks, savings and loans, and credit unions. For some of its products, the Company faces competition from other non-bank financial service companies, especially securities firms and asset or investment managers. Some of these competitors emphasize price and others technology. The Company strives to compete primarily on the basis of customer service.

Employees:  The Company currently employs the equivalent of 1,369 full time employees. Additional employees would be added if new opportunities for geographic expansion or other business activities should occur.

(d)  Financial Information about Foreign and Domestic Operations and Export Sales

The Company does not have any foreign business operations or export sales of its own. However, it does provide financial services including wire transfers, foreign currency exchange, letters of credit, and loans to other businesses involved in foreign trade.

(e)   Available Information

The Company maintains an Internet website at http://www.pcbancorp.com. The Company makes available its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934, as amended, and other information related to the Company, free of charge, through this site as soon as reasonably practicable after it electronically files those documents with, or otherwise furnishes them to, the SEC. The Company’s Internet website and the information contained therein or connected thereto are not intended to be incorporated into this annual report on Form 10-K.

5

Table of Contents

The Company maintains its executive offices in leased premises at 1021 Anacapa St., Santa Barbara, California. The Trust & Investment Services Division is also located in this building. The Company leases other premises in the Santa Barbara area for Information Technology, Operations Support and other administrative functions and other premises in Ventura County for its Delinquency Management Unit and for the relationship managers in that county. Of the 45 branch banking offices, all or a portion of 31 are leased. The 45 branch offices are located in the eight California counties mentioned above in Item 1(a). The Company owns the building used by its Residential Real Estate, Business Services, and International Banking units.

The Company has obtained the master lease on the shopping center where one of its branch offices is located. As explained in Note 12 to the Consolidated Financial Statements in Item 8 of this Annual Report, the portion of the lease related to the building is classified as a capital lease.

Premises are utilized based on needed space and the geography of the customer served. There is no necessary correspondence between use of the buildings and business segments. For example, in addition to employees providing deposit related services, portions of the branch offices frequently house Consumer and Commercial Banking segment employees involved in lending activities. Similarly, of the Residential Real Estate, Business Services, and International Banking units housed in the building mentioned above, the first is in the Consumer Banking segment and the second two are in the Commercial Banking segment. Rather than attempt an allocation of ownership of these assets, for segment reporting in Note 26, all buildings are recognized as assets of the “All Other” segment, but rental expenses are generally charged to the business segments when allocation is practicable.

The buildings are of various ages and consequently require varying levels of maintenance. All are suitable and adequate for their intended use.

The Company has been named in several lawsuits filed by customers and others. The significant suits are described in Note 17 to the Consolidated Financial Statements in Item 8 of this report. The Company does not expect that these suits will have any material impact on its financial condition or operating results.

The Company is involved in various other litigation of a routine nature that is being handled and defended in the ordinary course of the Company’s business. In the opinion of Management, based in part on consultation with legal counsel, the resolution of these litigation matters will not have a material impact on the Company’s financial condition or operating results.

There were no matters submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

6

Table of Contents

PART II

(a)  Market Information

The Company’s common stock trades on The Nasdaq Stock Market under the symbol “PCBC”. The following table presents the high and low closing sales prices of the Company’s common stock for each quarterly period for the last two years as reported by The Nasdaq Stock Market:

(b)  Holders

There were approximately 9,400 shareholders as of December 31, 2004. This number includes an estimate of the number of shareholders whose shares are held in the name of brokerage firms or other financial institutions. The Company is not provided with the number or identities of these shareholders, but has estimated the number of such shareholders from the number of shareholder documents requested by these firms for distribution to their customers.

Based on filings with the SEC by institutional investors, approximately 28% of the Company’s shares are owned by these institutions. These institutions may be investing for their own accounts or acting as investment managers for other investors.

(c)  Dividends

The Company declares dividends four times a year. The Company declares cash dividends to its shareholders each quarter. Its policy is to declare and pay dividends of between 35% and 40% of its net income to shareholders. The following table presents cash dividends declared per share for the last two years:

The above per share figures are adjusted for the 4 for 3 stock split that was distributed in June 2004. The pre-split amounts for the first two quarters of 2004 were $0.22 per share. Adjusted for the split, the quarterly figures were $0.165. These amounts have been rounded to $0.17 per share for presentation.

The Company funds the dividends paid to shareholders primarily from dividends received from the subsidiary bank, PCBNA.

(d )  Securities Authorized for Issuance Under Equity Compensation Plans

The required table for this section of Item 5 is included in Note 18 to the Consolidated Financial Statements in Item 8 of this report and is hereby incorporated by reference.

7

Table of Contents

The following table compares selected financial data for 2004 with the same data for the four prior years. The Company’s Consolidated Financial Statements and the accompanying notes presented in Item 8 explain reasons for the year-to-year changes. The following data has been derived from the Consolidated Financial Statements of the Company and should be read in conjunction with those statements, which are included in this report.

*Prior to 2001, the Company followed a practice of declaring dividends in one quarter and paying them in the next. In 2001, the Company switched to a practice of declaring dividends in the same quarter in which they were paid. Consequently, no dividend was declared in the first quarter of 2001, but the dividend that had been declared in the fourth quarter of 2000 was paid in the first quarter of 2001.

**The above results of operations and balances for 2000 have been restated to reflect the Company’s business combination with San Benito Bank in that year that was accounted for as a pooling of interest transaction.

***Includes obligations under capital lease.

8

Table of Contents

ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Pacific Capital Bancorp

and Subsidiaries

INTRODUCTION

Purpose and Definition of Terms

The following provides Management’s comments on the financial condition and results of operations of Pacific Capital Bancorp and its subsidiaries. Unless otherwise stated, “we” or “the Company” refers to this consolidated entity. You should read this discussion in conjunction with the Company’s Consolidated Financial Statements and the notes to the Consolidated Financial Statements. These statements and notes are presented on pages 79 through 135 of this Annual Report on Form 10-K. “Bancorp” will be used when referring to the parent company only. Terms with which you may not be familiar are printed in bold and defined the first time they occur or are defined in a note on pages 68 through 73. These notes are designated by a letter. References to notes designated by a number refer to notes to the Consolidated Financial Statements that are found on pages 84 through 135 of this document. The impact of recent accounting pronouncements is disclosed in Note 1.

Subsidiaries

The Company has one subsidiary bank, Pacific Capital Bank, N.A. (“PCBNA”). This bank is the survivor of a merger of the Company’s two former banking subsidiaries, Santa Barbara Bank & Trust (“SBB&T”) and First National Bank of Central California (“FNB”). The Company merged the two banks on March 29, 2002 to obtain the efficiencies of a single primary bank regulator. Prior to the merger, SBB&T was regulated by the Federal Reserve Bank of San Francisco (“FRBSF”) and the California Department of Financial Institutions while FNB was regulated by the Office of the Comptroller of the Currency (“OCC”). PCBNA continues to use the SBB&T and FNB brands as well as two additional brands, South Valley National Bank (“SVNB”) and San Benito Bank (“SBB”). These had been independent banks that had merged with FNB before FNB and SBB&T merged. The brand Pacific Capital Bank is used for the three banking offices acquired from Pacific Crest Bank when the Company purchased its parent company Pacific Crest Capital Inc. (“PCCI”) in March 2005. PCB Services Corporation is a non-bank subsidiary of Bancorp which was primarily involved in mortgage brokering and the servicing of brokered loans. It ceased this business and became essentially inactive in 2001. The Company pays a small number of out-of-state employees through this company. The Company has a second inactive subsidiary, Pacific Capital Services Corporation. The Company has two subsidiaries that are special purpose entities which are used in the securitizations mentioned in Note 10. One of these, SBB&T Automobile Loan Securitization Corporation, is now inactive, as the securitization it was used for has been closed. The three subsidiaries used for the trust preferred securities described in Note 13 are not consolidated with the Company and the rest of its subsidiaries. The reason they are not consolidated is explained in the “Consolidation of Variable Interest Entities” section of Note 1.

Forward-Looking Statements

This discussion and analysis provides insight into Management’s assessment of the operating trends over the last several years and its expectations for 2005. Such expressions of expectations are not historical in nature and are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties that may cause actual future results to differ materially from those expressed in any forward-looking statement. Such risks and uncertainties with respect to the Company include:

9

Table of Contents

This discussion also provides information on the strategies adopted by the Company to address these risks, and the results of these strategies.

Pooling-of-Interest Restatements

We accounted for the merger of SBB with the Company using the “pooling-of-interests” method of accounting. As a result, we restated all amounts in this discussion and in the Consolidated Financial Statements to reflect the results of operations as if this merger had occurred prior to the earliest period presented. In contrast, the acquisition of PCCI was accounted for as a purchase transaction, and its results of operations are included with those of the Company only from the date of acquisition, which was March 5, 2004.

GAAP AND NON-GAAP MEASURES

In various sections of this discussion and analysis, we have called attention to the significant impacts on the Company’s balance sheet and year to date income statement caused by its tax refund anticipation loans (“RAL”) and refund transfer (“RT”) programs. These programs account for approximately 30% of the Company’s pretax income. We have discussed the results of operations and actions taken by the Company to manage these programs in the section below titled “Refund Anticipation Loan and Refund Transfer Programs.” Included in the discussion is a summary statement of the results of operations for the programs. These programs comprise one of the Company’s operating segments for purposes of segment reporting in Note 26, “Segment Disclosure,” to the Consolidated Financial Statements. As such, Management believes that separately reporting operating results for the programs is consistent with accounting principles generally accepted in the United States (“GAAP”).

Because there are only two other financial institutions with nationwide refund programs of similar size to those of the Company, Management computes a number of amounts and ratios exclusive of the balances and operating results of these programs. We do this so that we may compare the results of the Company’s traditional banking operations with the results of other financial institutions. For the last several years, we have conducted conference calls with analysts and investors in connection with our quarterly earnings releases. During these calls, investors and analysts have expressed through their questions an interest in knowing certain balances and the usual performance ratios for the Company exclusive of the RAL and RT programs. We believe analysts and investors request this information for the same reason that Management uses it internally, namely, to provide more comparability with virtually all of the rest of the Company’s peers that do not operate such programs. For example, Management compares the Company’s net interest margin without RAL interest income or expense to the net interest margin of other banks to determine the efficiency with which it prices loans and deposits. Consequently, we have provided these amounts and ratios both with and without the balances and results of the RAL and RT programs in our press releases and in our periodic quarterly and annual reports on Forms 10-Q and 10-K, respectively. All such amounts and ratios that exclude the balances and results of the RAL and RT programs are clearly labeled as “without” or “excluding RAL/RT.”

While we provide these amounts and ratios both with and without the balances and results of the RAL and RT programs, we would stress that both shareholders and potential investors should pay attention primarily to the GAAP results that include the operating results of the RAL and RT programs.

10

Table of Contents

In the section of this discussion that explains the RAL and RT programs, “Tax Refund Anticipation Loan and Refund Transfer Programs” that begins on page 62, we include several tables that reconcile all numbers and ratios reported in this discussion exclusive of the RAL/RT balances or results to the same numbers and ratios for the Company as a whole reported in the Consolidated Financial Statements. The reconciliations for amounts and ratios related to credit quality are included in Table 9B on page 45. The tables provide the consolidated numbers or ratios, the RAL/RT adjustment, and the numbers or ratios exclusive of the RAL/RT adjustment.

In addition to the non-GAAP measures computed related to the Company’s balances and results exclusive of its RAL and RT programs, we have included other financial information determined by methods other than in accordance with GAAP. We use these non-GAAP measures in our analysis of the business and its performance. In particular, net interest income, net interest margin and operating efficiency are calculated on a fully tax-equivalent basis (“FTE”).

The use of FTE measurement is a common practice in banking and Management finds that calculating these measures on an FTE basis provides a useful picture of net interest income, net interest margin and operating efficiency for comparative purposes. The efficiency ratio also uses net interest income on an FTE basis. The calculation of net interest income on this basis is explained in Note B. Table 2 contains a reconciliation of the amounts and ratios with and without the FTE adjustment. Net interest income as reported on the Company’s Consolidated Income Statement in Item 8 of this Annual Report on Form 10-K is not reported on an FTE basis.

OVERVIEW OF EARNINGS PERFORMANCE

In 2004, the Company earned net income of $87.9 million, or $1.92 per diluted share. This represents a 16% increase over the $75.7 million net income or $1.64 per diluted share reported for 2003.

The significant factors impacting net income for 2004 compared to 2003 were:

Each of these items will be addressed in more detail in various sections of this discussion.

2003 earnings had increased just slightly over 2002 earnings. The major differences between 2003 and 2002 were as follows:

11

Table of Contents

From a longer range perspective, for the five years of 2000 through 2004, the Company’s net income increased at a compound average annual rate of 13.6%. Among the reasons for this favorable trend of increase in net income have been:

Measures and ratios of profitability, specifically return on assets, return on equity, the operating efficiency ratio and net interest margin with and without the RAL and RT program, may be found in Table 16G.

CRITICAL ACCOUNTING POLICIES

A number of critical accounting policies are used in the preparation of the Consolidated Financial Statements which this discussion accompanies.

The Use of Estimates

The preparation of Consolidated Financial Statements in accordance with GAAP requires Management to make certain estimates and assumptions that affect the amounts of reported assets and liabilities as well as contingent assets and liabilities as of the date of these financial statements. These estimates and assumptions also affect the reported amounts of revenues and expenses during the reporting period(s). Although Management believes these estimates and assumptions to be reasonably accurate, actual results may differ.

The principal areas in which estimates are used are as follows:

Collectibility of Loans and the Allowance for Credit Losses:  With respect to delinquent loans, we are required to estimate whether the principal and interest due on the loans will be collected. If a loan is deemed uncollectible, it must be charged-off. If we estimate that a loan will be collected but it is later determined that it will not be collected, then the Company’s loan assets will have been overstated because only collectible amounts are to be reported. If we estimate that a loan is not collectible and therefore charge it off, but subsequently payments are received, then the loan balances were understated and provision expense was overstated.

With respect to loans that are not deemed to be wholly uncollectible, an estimate of the amount of the probable losses incurred in the Company’s loan portfolio must still be made. This estimate is used to determine the amount of the allowance for credit losses and therefore the periodic charge to income for the provision for credit losses expense. A description of the method of developing the estimate is described in the section below titled “Allowance for Credit Losses” and in Note 1. If the actual losses incurred in future periods materially exceed the estimate of probable losses developed by Management, then the Allowance for Credit Losses will have been understated and the Company will have to record additional provision expense as the actual amount of losses are recognized. If the losses currently in the portfolio are materially less than the estimate, then the Company will reverse the excess allowance through provision expense in future periods.

Events or circumstances that can cause this estimate of losses to be substantially different than eventually occur are primarily a lack of sufficient information about borrowers’ financial condition or as such financial condition may change over time. This occurs because the borrower does not provide the information on a timely basis or because it is incomplete or inaccurate.

As discussed in the section below titled “Credit Losses,” the Company experienced such a change in estimate in 2004. In earlier years, we had estimated that certain loans were uncollectible and that

12

Table of Contents

we would be paid less than the outstanding amount for certain other loans. Consequently we had charged-off the first group of loans and allocated allowance for credit loss to the second group equal to our estimate of what we would not be paid. In 2004, a significant amount of payments were received on some of these loans. These collections or recoveries were added back to the allowance for credit loss. This resulted in a lower provision expense than would have otherwise been the case because this added allowance was then available to cover estimated losses on other loans. In essence, a portion of the allowance was provided by the recoveries rather than by provision expense.

Realizing the benefit of Deferred Tax Assets:  The Company’s deferred tax assets are explained in the section below titled “Income Tax” and in Note 15. The Company uses an estimate of future earnings to support its position that the benefit of its deferred tax assets will be realized. If future income should prove non-existent or not sufficient to recover the amount of the deferred tax assets within the tax years to which they may be applied, the assets will not be realized and the Company’s net income will be reduced.

Actuarial estimates used in Retiree Health Plan:  The Company uses certain estimates regarding its employees to determine its liability for Post Retirement Health Benefits. These estimates include life expectancy, length of time before retirement, long-term rate of return on assets, and future rates of growth of medical costs. Should these estimates prove materially wrong such that the liability is understated, the Company will either incur more expense to provide the benefits or it will need to amend the plan to limit benefits.

Prepayment and other estimates used in securitization:  The Company used certain estimates in determining the residual value of the securitization of indirect auto loans described in Note 10. The assumptions and estimates used for the discount, prepayment, and default rates are shown in that note. As explained in Note 10, the securitization ended in 2004. Had the estimates for prepayment and default rates been too low by a material amount, the Company would have had to write down through earnings the residual value and a loss would have to be recognized. Had the estimates for the prepayment and default rates been too high by a material amount, the Company would have had to write up the residual value and a gain would be recognized. As it happened, the estimates were very close and no significant adjustment was required.

Prepayment assumptions used in determining the amortization of premium and discount for securities:  Mortgage-backed or asset-backed securities make up 66% of the Company’s investment securities. These securities are subject to the prepayment of principal of the underlying loans as described in Note 10. The rate at which prepayments are expected to occur in future periods impacts the amount of premium to be amortized in the current period. This is because holders of securities are required to recognize an amortization amount each period that would result in the same effective interest rate for the security if prepayments in fact occur as estimated. If prepayments in a future period are higher than estimated, then the Company must amortize a larger amount of premium in that future period. In that way, the total premium amortized to date as of the end of that future period will equal the amount that would have been amortized had the higher prepayment rate been experienced during all past periods over which the security was held. If future prepayments are less than estimated, then less premium will be amortized in the future period to similarly result in an amount of premium amortization life-to-date as if the lower rate of prepayments had been experienced from the purchase of the security. The result then of an over or under estimate is to introduce volatility to interest income.

13

Table of Contents

Estimates of the fair value of assets:  Certain assets of the Company are recorded at fair value, or the lower of cost or fair value. In some cases, the fair value used is an estimate. Included among these assets are securities that are classified as available-for-sale, goodwill and other intangible assets, and other real estate owned and impaired loans. These estimates may change from period to period as they are impacted by changes in interest rates and other market conditions. Losses not anticipated or greater than anticipated could result if the Company were forced to sell one of these assets and discovered that its estimate of fair value had been too high. Gains not anticipated or greater than anticipated could result if the Company were to sell one of these assets and discovered that its estimate of fair value had been too low. Estimates of fair value are arrived at as follows:

Assumptions regarding mortgage and other servicing rights:  For the Company, mortgage and other servicing rights (“MSRs”) arise only from the sale of loans as described below on page 41. However, there is a secondary market for MSRs wherein a financial institution may purchase the right to service loans for and receive a fee from the holder of the loans. The market value for such servicing is based on the coupon rates, maturity, and prepayment rates experienced for the loans being serviced. The value of the servicing rights recorded by the Company at the time of the sale is based on Management’s best estimate of the market value of servicing rights for similar pools of loans in the secondary market. If the Company overestimates the value of the MSRs, it will recognize too large a gain at the time of sale and will hold an asset against which a charge will later have to be taken. If the Company underestimates the value of the MSRs, it will have recognized too small a gain and will later recognize income from the servicing that should have been recognized in the period in which the loans were sold.

Available-for-sale securities:  The fair values of most securities classified as available-for-sale are based on quoted market prices. These quoted market prices are derived from two independent sources and compared for consistency. If the two sources differ significantly, or if quoted market prices are not available, alternative methods are used including seeking bids from brokers on a representative security or extrapolating the value from the quoted prices of similar instruments. The Company also uses estimates of the future rate of prepayments on the loans underlying the various mortgage-backed securities to determine the expected life of that security. That estimated life then determines the rate of amortization or accretion to recognize against the premium or discount of those instruments.

Goodwill and other intangible assets:  As discussed in Note 9, the Company must assess goodwill and other intangible assets each year for impairment. This assessment involves estimating cash flows for future periods, preparing analyses of market multiples for similar operations, and estimating the fair value of the reporting unit to which the goodwill is allocated. If the future cash flows were materially less than the estimates, the Company would be required to take a charge against earnings to write down the asset to the lower fair value.

Other real estate owned and impaired loans:  The fair value of other real estate owned or collateral supporting impaired loans is generally determined from appraisals obtained from independent appraisers. The Company also must estimate the costs to dispose of the property. This is generally done based on experience with similar properties. When determining the valuation allowance for impaired loans, the Company may use the discounted cash flow method which may include estimates of borrower revenue, expenses, capital expenditures and disposals of capital assets, along with estimates of future economic conditions including forecasts of interest rates and other economic factors that management believes would impact estimated future customer cash flows.

Estimates relating to Self-Insurance for Workers’ Compensation:  The Company self-insures for a portion of its workers’ compensation exposure. Because not all injuries are immediately reported to the Company, it must accrue an estimate of the claims loss for injuries that have occurred but not been reported and for the estimated eventual cost of reported claims. The estimate is based on actuarial data provided by the insurance company that covers the Company for large claims above the Company’s self-insured amount. If Management underestimates the cost of claims, they will need to recognize an expense for these claims in subsequent periods. If the estimate is too large, the Company will report a reduction in expense in subsequent years for the excess.

14

Table of Contents

Alternative Methods of Accounting

The accounting and reporting policies of the Company are in accordance with GAAP and conform to practices within the banking industry. As such there are few alternatives available to the Company in its accounting. The few areas where choices are available are as follows:

Depreciation of fixed assets:  The Company selects lives of assets over which to depreciate or amortize the cost based on the expected period it will benefit the Company. The Company’s methods of depreciation and the lives of fixed assets are described in Note 1. If a method is used or a life is chosen that results in a material amount of the cost not having been amortized when the asset provides no further benefit to the Company, then a loss will be incurred for the unamortized cost of the asset when it is disposed of or replaced.

Amortization of the cost of other assets:  The Company’s methods of amortizing assets other than fixed assets are described in various notes to the Consolidated Financial Statements as appropriate. As with fixed assets, if the method of amortization or the amortization term results in unamortized cost when the asset has no further value, a loss will be recognized.

Stock options:  When the Company adopted Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123) in 1996, it elected to continue to use the method of accounting for stock options that did not recognize compensation expense at the time options were granted. As required by SFAS 123, pro forma amounts of compensation expense and the pro forma impact on net income and earnings per share are disclosed each year as if the Company had instead elected to use the accounting method that recognizes compensation expense. The pro forma compensation expense is computed using the binomial model for pricing options. This model—as well as other statistical models—assumes that the options are freely tradable. In fact, employees may not transfer the options. For the year 2004, had the Company elected the second method of accounting for its stock options, the impact would be to lower net income by $2.25 million and earnings per share by approximately 2.6%.

EXTERNAL FACTORS IMPACTING THE COMPANY

The major external factors impacting the Company include economic conditions, regulatory considerations, and trends in the banking and financial services industries.

Economic Conditions

From a national perspective, the most significant economic factors impacting the Company in the last three years have been a slow growth in the economy during 2002 and 2003 and the actions of the FOMC to increase the pace of that growth followed by faster growth in 2004 accompanied by FOMC increases in short-term interest rates to limit potential inflationary impacts from that growth. The FOMC had lowered its target short-term rate once in 2002 by 0.50% and in 2003 by 0.25% to its lowest rate in 45 years. These changes, especially after the extreme rate of decline in 2001 when the Fed lowered rates by 4.25%, impacted the Company as market rates for loans, investments and deposits responded to the Fed’s actions. These impacts are discussed in detail in the sections below titled “The Impact of Changes in Asset and Liability Balances to Net Interest Income and Net Interest Margin” and “Interest Rate Risk.” In 2004, the FOMC raised short-term interest rates by 1.25%. These increases did not have a significant impact on the Company in 2004 for reasons discussed in those same sections.

Selected customers in the hospitality and tourist industries continued to be impacted in 2002 and 2003 by the consequences of the events of September 11, 2001. Agriculture faced price pressures during 2002, but there was price firming in the row crops segment during 2003 and 2004. The wine industry remains unsettled with inventory high and new vines coming into production. The high tech segment continued to show uncertain and varying results. Housing markets have showed some slowdown in sales and refinancings in 2004, but generally prices continue to increase with the high-end residential properties showing some volatility. During 2003, loan demand for commercial real estate markets slowed compared to 2002, but picked up again in 2004. Vacancy rates in the Company’s core market areas remained in the 5%-6% percent range. Loan demand from small

15

Table of Contents

businesses continued to grow at a moderate rate, except for leasing, for which outstanding balances grew 55% in 2004. Consumer loan demand aside from residential real estate also picked up in 2004.

Regulatory Considerations

Bank Regulation:  Changes in regulations and/or the regulatory environment impact the Company. The OCC is the primary regulator for PCBNA because it is a nationally chartered bank. The FRBSF is the regulator for the Bancorp because it is a bank holding company.

Regulation impacts the Company in several ways:

The actions which the various banking agencies can take with respect to financial institutions which fail to maintain adequate capital and comply with the other requirements are discussed below in the section titled “Regulation.”

Non-banking regulation:  As a public company, the Company is also subject to many laws and regulations related to securities issuance. Especially important in 2003 and 2004 is the Sarbanes-Oxley Act of 2002. Passed in response to corporate accounting and reporting failures, the act requires all large public companies as of December 31, 2004 to document their internal controls over financial reporting, evaluate the design and effectiveness of those controls, periodically test all significant controls to ensure they are functioning, and provide a certification by the Chief Executive Officer and Chief Financial Officer of the documentation, evaluation, and testing. The act further requires companies’ independent registered public accounting firm to evaluate this assertion.

The required certification is included in this Annual Report on Form 10-K on page 144 and the conclusion of the Company’s independent registered public accounting firm regarding this assertion is included in its opinion on page 76.

Competition

The Company faces competition from other financial institutions and from businesses in other industries that have developed financial products. Banks once had an almost exclusive franchise for deposit products and provided the majority of business financing. With deregulation in the 1980’s, other kinds of financial institutions began to offer competing products. Also, increased competition in consumer financial products has come from companies not typically associated with the banking and financial services industry, companies as diverse as AT&T, General Motors and various software developers. Similar competition is faced for commercial financial products from insurance companies and investment bankers. Competition from companies that are not banks is also developing for payments processing. Often this activity is associated with Internet auction sites and other e-commerce. Community banks, including the Company, attempt to offset these trends by developing new products that capitalize on the service quality that a local institution can offer. Among these are new loan, deposit, and investment products. The Company’s primary competitors are different for each specific product and market area. While this offers special challenges for the Company in marketing of products, it offers protection from one competitor dominating the Company in its market areas.

16

Table of Contents

For deposit products, the primary competition is from other local independent banks and the local branches of larger national and regional banks. For consumer loans, the primary competition is from larger banks that because of their investments in automation can offer very fast decisions and low prices. For commercial loans, the primary competition is again from both local banks and regional/national banks based on local contacts for the former and price for the latter. For residential real estate, competition comes from both larger banks with their automation and from independent loan brokers that capitalize on relationships with realtors and title insurance firms. For fiduciary services, competition comes from local offices of larger financial institutions that capitalize on brand familiarity and from small independent money managers that suggest banks are too conservative in their money management style.

RISK MANAGEMENT

We see the process of addressing the potential impacts of the external factors listed above as part of our management of risk. In addition to common business risks such as disasters, theft, and loss of market share, the Company is subject to special types of risk due to the nature of its business. New and sophisticated financial products are continually appearing with different types of risk which need to be defined and managed if we choose to offer them to our customers. Also, the risks associated with existing products must be reassessed periodically. The Company cannot operate risk-free and make a profit. Instead, the process of risk definition and assessment allows the Company to select the appropriate level of risk for the anticipated level of reward and then decide on the steps necessary to manage this risk. The Company’s Chief Risk Officer and the other members of its Senior Leadership Council under the direction and oversight of the Board of Directors lead the risk management process.

Some of the risks faced by the Company are those faced by most enterprises—reputational risk, operational risk, and legal risk. The special risks related to the financial products offered by the Company are credit risk and interest rate risk. Credit risk relates to the possibility that a debtor will not repay according to the terms of the debt contract. Credit risk is discussed in the sections related to loans and the allowance for credit loss. Interest rate risk relates to the adverse impacts of changes in interest rates on financial instruments. The types of interest rate risk will be explained in the next two sections. The effective management of these and the other risks mentioned above is the backbone of the Company’s business strategy.

THE IMPACT OF CHANGES IN ASSETS AND LIABILITIES TO NET INTEREST INCOME AND NET INTEREST MARGIN

The Company earns its income primarily from two sources. The first of these sources is from the management of its financial assets and liabilities and the second is from charging fees for services provided. The first source involves functioning as a financial intermediary; that is, the Company accepts funds from depositors or obtains funds from other creditors and then either lends the funds to borrowers or invests those funds in securities or other financial instruments. Income is earned as a spread between the interest earned from the loans or investments and the interest paid on the deposits and other borrowings. The second source, fee income, is discussed in other sections of this analysis, specifically in “Noninterest Revenue” and “Tax Refund Anticipation Loans and Refund Transfers.”

We monitor asset and deposit levels, developments and trends in interest rates, liquidity, capital adequacy and marketplace opportunities. We respond to all of these to protect and increase income while managing risks within acceptable levels as set by the Company’s policies. In addition, alternative business plans and contemplated transactions are analyzed for their impact on the level of risk assumed by the Company. This process, known as asset/liability management, is carried out by changing the maturities and relative proportions of the various types of loans, investments, deposits and other borrowings in the ways described below. The Management staff responsible for asset/liability management operates under the oversight of the Asset/Liability Committee and provides regular reports to the Board of Directors. Board approval is obtained for major actions or the occasional exception to policy.

17

Table of Contents

Changes in Net Interest Income and Net Interest Margin

Net interest income is the difference or spread between the interest and fees earned on loans and investments (the Company’s earning assets) and the interest expense paid on deposits and other liabilities. Net interest income or the amount by which interest income will exceed interest expense depends on two factors: (1) the volume or balance of earning assets compared to the volume or balance of interest-bearing deposits and liabilities, and (2) the interest rate earned on those interest earning assets compared with the interest rate paid on those interest-bearing deposits and liabilities.

The Company’s earning assets generally exceed its interest-bearing liabilities by 25%—33%. This occurs as the Company is able to fund a significant proportion of its earning assets with noninterest demand accounts.

The comparison of rates earned and rates paid is usually done with an analysis of the Company’s net interest margin. Net interest margin is net interest income expressed as a percentage of average earning assets. It is used to measure the difference between the average rate of interest earned on assets and the average rate of interest that must be paid on liabilities used to fund those assets. The net interest income is expressed using a tax equivalent adjustment (Note B) to reflect the fact that the interest income on some municipal securities and loans is exempt from Federal income tax.

Table 1 compares the changes in tax equivalent net interest income and tax-equivalent net interest margin from 2002 to 2003 and from 2003 to 2004.

TABLE 1—Changes in Tax Equivalent Net Interest Income and Net Interest Margin

Tax equivalent net interest income increased each year, 6.8% from 2002 to 2003 and 17.1% from 2003 to 2004 as would be expected given the growth in earning assets—12.4% from 2002 to 2003 and 22.5% from 2003 to 2004. However, the Company’s net interest margin decreased from 5.47% in 2002 to 5.20% in 2003, and decreased to 4.97% for 2004. This would suggest that either the average rate earned on the assets declined or that the average rate paid on the liabilities increased, because net interest income did not increase as much as earning assets.

Management uses the information in Tables 2 and 3 to analyze these changes in net interest income and net interest margin. Table 2, “Distribution of Average Assets, Liabilities, and Shareholders’ Equity and Related Interest Income, Expense and Rates,” sets forth the average daily balances (Note C) for the major asset and liability categories, the related income or expense where applicable, and the resultant yield or cost attributable to the average earning assets and interest-bearing liabilities. Changes in the average balances and the rates received or paid depend on market opportunities, how well the Company has managed interest rate risks, product pricing policy, product mix, and external trends and developments.

Table 3, “Volume and Rate Variance Analysis of Net Interest Income,” analyzes the changes in net interest income from 2002 to 2003 and from 2003 to 2004 that are reported in Table 2. The analysis shows the impact of volume and rate changes on the major categories of assets and liabilities from one year to the next. The table explains how much of the difference or variance in interest income or expense from one year to the next for each major category of assets or liabilities is due to changes in the balances (volume) or to changes in rates.

18

Table of Contents

For example, Table 2 shows that interest income from taxable securities increased by $15.7 million from $34.5 million for 2003 to $50.2 million for 2004 while the average balance increased from $913 million to $1.2 billion and the average rate earned increased from 3.78% to 4.02%. Table 3 shows that the $15.7 million increase in interest income was actually the sum of a $13.4 million increase in interest income from the larger balance of securities held in 2004 compared to 2003 and an increase of $2.3 million due to an increase in the average rate received.

A shift in the relative size of the major balance sheet categories has an impact on net interest income and net interest margin. For example, to the extent that funds invested in securities can be repositioned into loans, earnings increase because of the higher rates paid on loans. However, changing the asset mix in this way comes at the price of additional risks that must be successfully managed. Additional credit risk is incurred with loans compared to the very low risk of loss on securities, and the Company must carefully monitor the underwriting process to ensure that the benefit of the additional interest earned is not offset by additional credit losses. Also, because loans cannot be sold as easily as securities, the Company incurs more liquidity risk. Another example relates to the liability side of the balance sheet. In general, depositors are willing to accept a lower rate on their funds than are other providers of funds because of the Federal Deposit Insurance Corporation (“FDIC”) insurance coverage. To the extent that the Company can fund asset growth by deposits, especially the lower cost transaction accounts, rather than borrowing funds from other financial institutions, the average rates paid on funds will be less, and net interest income more. The lower cost transaction accounts, however, are demand accounts. While they generally are the result of stable relationships, these funds may be withdrawn by depositors at any time, whereas higher costs forms of borrowing have set maturities around which the Company can plan.

The Impact of Overall Trends in the Balances and Rates of Assets and Liabilities—2002 to 2003

The FOMC’s decrease in late 2002 of its target rate by 50 basis points and a further 25 basis point decrease in June 2003 limited the Company’s ability to increase net interest income despite the growth in assets. As shown in Table 2, tax equivalent interest income increased by $5.3 million from 2002 to 2003. However, interest income for RALs was $12.1 million in 2003 more than in 2002. This means that interest income from other loans, securities, and money market investments decreased by $6.8 million year-to-year. Interest expense also decreased from 2002 to 2003, but only by $8.9 million, and exclusive of the lower interest expense related to borrowings incurred to fund RALs, interest expense declined $8.1 million. This greater decline in interest expense than interest income resulted in an increase in net interest income exclusive of RALs of $1.3 million.

Average earning assets increased by approximately $478 million. Average loans outstanding during 2003 increased $209 million over the average during 2002 and average securities increased $261 million. Among the loan categories, it was primarily residential real estate and commercial loans that increased, the former by $43.5 million in average balances and the latter by $158 million. The relatively large increase in securities was the result of the leveraging plan executed by the Company during 2003. The purchase of these securities and the funding used in the plan are discussed in the securities section of this discussion starting on page 32.

Average interest-bearing liabilities increased by $323 million—$212 million in deposits and $111 million in long-term debt and other borrowings. As mentioned above, deposits generally are less expensive than borrowings and the Company is always promoting deposit relationships. Borrowings are used to supplement deposit growth and, as described below in the section titled “Interest Rate Risk,” to help manage interest rate risk.

The net interest margin decreased from 5.47% in 2002 to 5.20% in 2003. The reduction in interest rates at the end of 2002 and in 2003 impacted new products sold and the renewal/replacement of those loans, securities, deposits, and borrowings that matured during 2003 by lowering interest received and interest paid. The leverage plan added net interest income, as well as assets and liabilities in this low interest rate environment. Together these events—(1) lower interest income from the decrease in rates offset by more net interest income from the additional securities purchased and (2) the lower rates paid on deposits and borrowings—increased the numerator of the net interest margin fraction, net interest income (exclusive of RAL interest income and expense), by $1.3 million or 0.7%. The denominator of the fraction, average earning assets, increased by 12.4%. The result was a lower net interest margin.

19

Table of Contents

The Impact of Overall Trends in the Balances and Rates of Assets and Liabilities—2003 to 2004

As noted above, the Company’s tax equivalent net interest income increased from 2003 to 2004, but the net interest margin declined. The net interest margin also decreased from 5.20% in 2003 to 4.97% in 2004 while net interest income increased. The FOMC raised short-term interest rates by 1.25% during 2004. However, this all occurred in the second half of the year, meaning that the factors that contributed to a lower net interest margin in 2003 than in 2002 continued during the first half of 2004.

Of these factors, two were primary. The first was inability to decrease the average rate paid on interest-bearing liabilities proportionately to the decreases in the average rate on earning assets because deposit rates had already been decreased as low as possible in 2003. This caused a reduction of net interest income without a reduction of earning assets. In other words, a decrease in the numerator of the net interest margin computation with no corresponding decrease in the denominator.

The second factor brought forward from 2003 was the leveraging strategy already mentioned. In essence this involves adding earning assets at a relatively low yield or spread to generate net interest income. However, because of the low yield, it increases net interest income less than it increases earning assets, thus lowering the net interest margin. The strategy, initiated in 2003, had a full year’s impact on 2004.

In addition to these two factors, a third factor in 2004 causing the decrease in net interest margin was the acquisition of PCCI. The business model chosen by PCCI was very profitable, but had a lower net interest margin than the Company’s. PCCI elected to take less credit risk than the Company and therefore had less provision for loan loss at the cost of lower loan yields. On the liability side, it funded its activities not through retail deposit products, but through a mixture of certificates of deposit and borrowings that paid a higher average rate than the Company paid on its funding. These two choices—accepting lower interest income for lower provision expense and trading higher cost funding for lower operational costs of nonretail deposits—simply moved its profitability out of net interest income. Consequently, the addition to the Company’s balance sheet of these lower yielding assets and higher cost liabilities resulted in an increase to net interest income, but a lowering of the net interest margin in 2004 compared to 2003.

20

Table of Contents

[THIS PAGE INTENTIONALLY LEFT BLANK]

21

Table of Contents

TABLE 2—Distribution of Average Assets, Liabilities, and Shareholders’ Equity and Related Interest Income, Expense, and Rates (Notes B and D)

22

Table of Contents