UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
or
Commission File Number 1-6887
BANK OF HAWAII CORPORATION
(Exact name of registrant as specified in its charter)
1-(888)-643-3888
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Common Stock, $.01 Par Value; outstanding at October 24, 2003—55,925,677 shares
Bank of Hawaii Corporation
Form 10-Q
INDEX
Part I.—Financial Information
Item 1.
Financial Statements (Unaudited)
Consolidated Statements of Income—Three and Nine months ended September 30, 2003 and 2002
Consolidated Statements of Condition—September 30, 2003, December 31, 2002, and September 30, 2002
Consolidated Statements of Shareholders’ Equity—Nine months ended September 30, 2003 and 2002
Consolidated Statements of Cash Flows—Nine months ended September 30, 2003 and 2002
Notes to Consolidated Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures of Market Risk
Item 4.
Controls and Procedures
Part II.—Other Information
Item 6.
Exhibits and Reports on Form 8-K
Signatures
2
Bank of Hawaii Corporation and Subsidiaries
Consolidated Statements of Income (Unaudited)
Nine Months Ended
September 30,
(dollars in thousands except per share amounts)
Interest Income
Interest and Fees on Loans and Leases
Income on Investment Securities—Held to Maturity
Income on Investment Securities—Available for Sale
Deposits
Funds Sold
Other
Total Interest Income
Interest Expense
Security Repurchase Agreements
Funds Purchased
Short-Term Borrowings
Long-Term Debt
Total Interest Expense
Net Interest Income
Provision for Loan and Lease Losses
Net Interest Income After Provision for Loan and Lease Losses
Non-Interest Income
Trust and Asset Management
Mortgage Banking
Service Charges on Deposit Accounts
Fees, Exchange, and Other Service Charges
Investment Securities Gains
Insurance
Total Non-Interest Income
Non-Interest Expense
Salaries
Pensions and Other Employee Benefits
Net Occupancy Expense
Net Equipment Expense
Restructuring and Other Related Costs
Information Technology Systems Replacement Project
Total Non-Interest Expense
Income Before Income Taxes
Provision for Income Taxes
Net Income
Basic Earnings Per Share
Diluted Earnings Per Share
Dividends Per Share
Basic Weighted Average Shares
Diluted Weighted Average Shares
See accompanying notes to the consolidated financial statements.
3
Consolidated Statements of Condition (Unaudited)
(dollars in thousands)
Assets
Interest-Bearing Deposits
Investment Securities—Held to Maturity (Market Value of $749,036, $236,016 and $286,526, respectively)
Investment Securities—Available for Sale
Loans Held for Sale
Loans
Allowance for Loan and Lease Losses
Net Loans
Total Earning Assets
Cash and Non-Interest Bearing Deposits
Premises and Equipment
Customers’ Acceptance Liability
Accrued Interest Receivable
Foreclosed Real Estate
Mortgage Servicing Rights
Goodwill
Other Assets
Total Assets
Liabilities
Domestic Deposits
Non-Interest Bearing Demand
Interest Bearing Demand
Savings
Time
Foreign Deposits
Time Due to Banks
Other Savings and Time
Total Deposits
Securities Sold Under Agreements to Repurchase
Current Maturities of Long-Term Debt
Banker’s Acceptances Outstanding
Retirement Benefits Payable
Accrued Interest Payable
Taxes Payable
Other Liabilities
Total Liabilities
Shareholders’ Equity
Common Stock ($.01 par value); authorized 500,000,000 shares; issued / outstanding: September 2003—81,568,791 / 55,985,364; December 2002—81,294,730 / 63,015,442; September 2002—81,310,042 / 66,048,072
Capital Surplus
Accumulated Other Comprehensive Income (Loss)
Retained Earnings
Deferred Stock Grants
Treasury Stock, at Cost (Shares: September 2003—25,583,427; December 2002—18,279,288; September 2002—15,261,970)
Total Shareholders’ Equity
Total Liabilities and Shareholders’ Equity
4
Consolidated Statements of Shareholders’ Equity (Unaudited)
Common
Stock
Capital
Surplus
Accum.
Compre-
hensive
Income(Loss)
Retained
Earnings
Deferred
Grants
Treasury
Income
Balance at December 31, 2002
Comprehensive Income:
Other Comprehensive Income, Net of Tax:
Change in Unrealized Gains and Losses on Investment Securities
Total Comprehensive Income
Common Stock Issued:
26,311 Retirement Savings Plan
775,872 Stock Option Plan
67,510 Dividend Reinvestment Plan
7,174 Directors’ Restricted Shares and Deferred Compensation Plan
266,400 Employees’ Restricted Shares
Treasury Stock Purchased (8,166,579 shares)
Cash Dividends Paid
Balance at September 30, 2003
Balance at December 31, 2001
Foreign Currency Translation Adjustment
33,402 Retirement Savings Plan
1,369,679 Stock Option Plan
77,270 Dividend Reinvestment Plan
4,101 Directors’ Restricted Shares and Deferred Compensation Plan
(71,300) Employees’ Restricted Shares
Treasury Stock Purchased (8,581,000 shares)
Balance at September 30, 2002
5
Consolidated Statements of Cash Flows (Unaudited)
Operating Activities
Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities:
Depreciation and Amortization
Amortization of Deferred Loan and Lease Fees
Amortization and Accretion of Investment Securities
Deferred Income Taxes
Investment Security Gains
Proceeds From Sales of Loans Held for Sale
Originations of Loans Held for Sale
Net Change in Other Assets and Liabilities
Net Cash Provided by Operating Activities
Investing Activities
Proceeds from Redemptions of Investment Securities Held to Maturity
Purchases of Investment Securities Held to Maturity
Proceeds from Sales and Redemptions of Investment Securities Available for Sale
Purchases of Investment Securities Available for Sale
Net (Increase) Decrease in Loans
Premises and Equipment, Net
Net Cash Provided (Used) by Investing Activities
Financing Activities
Net Increase in Demand Deposits
Net Increase in Savings Deposits
Net Decrease in Time Deposits
Net Increase (Decrease) in Foreign Deposits
Proceeds from Long-Term Debt
Repayments of Long-Term Debt
Net Decrease in Short-Term Borrowings
Proceeds from Issuance of Common Stock
Repurchase of Common Stock
Cash Dividends
Net Cash Used by Financing Activities
Effect of Exchange Rate Changes on Cash
Decrease in Cash and Cash Equivalents
Cash and Cash Equivalents at Beginning of Year
Cash and Cash Equivalents at End of Period
6
(Unaudited)
Bank of Hawaii Corporation (the “Company”) is a bank holding company. The Company’s principal subsidiary is Bank of Hawaii (the “Bank”) which provides a broad range of financial products and services to customers in Hawaii and the Pacific Islands (Guam, nearby islands and American Samoa). Significant intercompany accounts and transactions have been eliminated in consolidation.
Basis of Presentation
The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, the consolidated financial statements reflect normal recurring adjustments necessary for a fair presentation of the results for the interim periods.
Certain prior period amounts have been reclassified to conform to current period classifications.
These statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s 2002 Annual Report on Form 10-K. Operating results for the nine months ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003.
Recent Accounting Standards
In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51 (“FIN 46”). FIN 46 provides a new framework for identifying a variable interest entity (“VIE”) and determining when a company should include assets, liabilities, noncontrolling interest and results of activities of a VIE in its consolidated financial statements. FIN 46 was effective immediately for VIEs created after January 31, 2003 and is effective December 31, 2003 for VIEs created prior to February 1, 2003. Management does not anticipate a material impact on the Company’s financial statements from the adoption of this new interpretation.
In April 2003, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS No. 149”) which 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. Management does not anticipate a material impact on the Company’s financial statements from the adoption of this pronouncement.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity (“SFAS No. 150”). SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity in its statement of financial position. The Company adopted SFAS No. 150 effective July 1, 2003 and the adoption of the standard did not have a material effect on the Company’s financial statements.
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Stock-Based Compensation
The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB No. 25”) and related interpretations. As permitted by APB No. 25, stock-based employee compensation expense is generally not included in reported net income as options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. Over the last several years, new accounting standards were developed that permit fair value expense recognition of employee stock options. Under current guidance which does not require fair value expense recognition, there are three methods available for transition to the new accounting standards—prospective, modified prospective and retroactive restatement. If the standards were adopted as of January 1, 2003, each transition method would have a different impact on the Company’s financial statements, including reductions in net income ranging from $2.6 million to $8.2 million for the nine months ended September 30, 2003.
The following table illustrates the effect on net income and earnings per share if the Company had fully applied these new accounting standards:
(dollars in thousands except per share and per option data)
Net Income, as reported
Add: Stock-Based Employee Compensation Expense Included in Reported Net Income, Net of Related Tax Effects
Deduct: Total Stock-Based Employee Compensation Expense Determined Under Fair Value Method For All Awards, Net of Related Tax Effects 1
Pro Forma Net Income
Earnings per share:
Basic-as reported
Basic-pro forma 1
Diluted-as reported
Diluted-pro forma 1
Weighted Average Fair Value per Option Granted During the Period 1
Assumptions:
Average Risk Free Interest Rate
Average Expected Volatility
Expected Dividend Yield
Expected Life
8
In July 2002, the Company entered into a contract with Metavante Corporation to serve as the Company’s primary technology systems provider. The conversion to the Metavante systems was completed in July 2003 and all project costs have been incurred as of September 30, 2003. Total project costs by period in connection with the transition to this outsourcing arrangement are summarized below:
Information Technology Systems Replacement Project (Unaudited)
(dollars in millions)
Associated
Costs 1
Costs Incurred:
Three Months Ended:
September 30, 2002
December 31, 2002
Year Ended December 31, 2002
March 31, 2003
June 30, 2003
September 30, 2003
Nine Months Ended September 30, 2003
Total Costs Incurred
Total Expected Project Costs
Changes in related liability balances during the nine months ended September 30, 2003 were as follows:
Liability Balance at December 31, 2002
Accruals
Payments
Liability Balance at September 30, 2003
The information under the caption “Business Segments” in Management’s Discussion and Analysis is incorporated herein by reference.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward Looking Statements
This report contains forward-looking statements concerning, among other things, the economic environment in our service area, the expected level of loan loss provisioning, anticipated costs and annual savings of our information technology systems replacement project, and anticipated dividends, revenues and expenses during the remainder of 2003. We believe the assumptions underlying our forward-looking statements are reasonable. However, any of the assumptions could prove to be inaccurate and actual results may differ materially from those projected for a variety of reasons, including, but not limited to: 1) unanticipated changes in business and economic conditions, the competitive environment, fiscal and monetary policies, or legislation in Hawaii and the other markets we serve; 2) changes in our credit quality or risk profile which may increase or decrease the required level of allowance for loan and lease losses; 3) changes in market interest rates that may deteriorate our credit markets and ability to maintain our net interest margin; 4) changes to the amount and timing of our proposed equity repurchases; 5) inability to achieve expected benefits of our information technology systems replacement project and other business process changes due to adverse changes in implementation processes or costs, operational savings, or timing; 6) actions by the United States military and real or threatened terrorist activity affecting business conditions; and 7) adverse weather and other natural conditions impacting our and our customers’ operations. We do not undertake any obligation to update any forward-looking statements to reflect later events or circumstances.
Table 1
Highlights (Unaudited)
Earnings Highlights and Performance Ratios
Return on Average Assets
Return on Average Equity
Net Interest Margin
Efficiency Ratio
Efficiency Ratio excluding ITSRP and Restructuring Costs
Statement of Condition Highlights and Performance Ratios
Book Value Per Common Share
Allowance / Loans Outstanding
Average Equity / Average Assets
Employees (FTE)
Branches and offices
Market Price Per Share of Common Stock for the Quarter Ended:
10
ANALYSIS OF STATEMENT OF INCOME
Taxable-equivalent net interest income for the three and nine month periods ended September 30, 2003 declined $1.1 million, or 1%, and $7.6 million, or 3%, respectively, from the same periods in 2002. The decline in net interest income was primarily due to the low interest rate environment, in particular the low interest rates of mortgage loans and short-term investments whose rates were at their lowest levels in several decades. Partially offsetting the effect of lower interest rates was a positive impact on net interest income from a change in the mix of average interest earning assets and interest bearing liabilities, which declined 8% and 9%, respectively, for the nine months ended 2003 from the same period last year. The decrease in average balances was primarily due to utilization of excess liquidity for stock repurchases and debt reductions. The Company’s net interest margin was 4.15% for the quarter ended September 30, 2003, a 12 basis point increase from the comparable period a year ago. The net interest margin for the first nine months of 2003 was 4.19%, a 22 basis point increase from the same period in 2002. The improvement in the net interest margin was largely due to lengthening the maturities of certain short-term investments, reduction in short-term borrowings and time deposits, as well as debt reductions, which lowered the Company’s cost of funds. Presented in Table 2 are average balances, yields earned, and rates paid for the three and nine months ended September 30, 2003 and September 30, 2002. An analysis of changes in net interest income is presented in Table 3 for the nine months ended September 30, 2003 compared to the same 2002 period.
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Table 2
Consolidated Average Balances and Interest Rates—Taxable Equivalent Basis (Unaudited)
Three Months Ended
Three Months Ended 1
Nine Months Ended 1
Earning Assets
Interest Bearing Deposits
Investment Securities
Held to Maturity
Available for Sale
Net Loans and Lease Financing
Commercial and Industrial
Construction
Commercial Mortgage
Residential Mortgage
Installment
Home Equity
Purchased Home Equity
Lease Financing
Total Net Loans and Lease Financing
Cash and Non-interest Bearing Deposits
Interest Bearing Liabilities
Demand
Total Domestic Deposits
Other Time and Savings
Total Foreign Deposits
Total Interest Bearing Deposits
Total Interest Bearing Liabilities
Interest Rate Spread
Non-Interest Bearing Demand Deposits (Domestic)
12
Table 3
Analysis of Change in Net Interest Income—Tax Equivalent Basis (Unaudited)
Change in Interest Income:
Total Change in Interest Income
Change in Interest Expense:
Total Change in Interest Expense
Change in Net Interest Income
13
Consistent with the previous four quarters, no Provision for Loan and Lease Losses (“Provision”) was recorded for the three months ended September 30, 2003. This resulted in a reduction in the Allowance for Loan and Lease Losses (“Allowance”) equal to the amount of net charge-offs of $5.3 million for the third quarter and $10.2 million for the first nine months of 2003. No Provision was recorded in the third quarter of 2002 and the Provision for the first nine months of 2002 was $11.6 million. For further information on Credit Quality, refer to the section on “Corporate Risk Profile-Credit Risk.”
Non-interest income for the three and nine month periods ended September 30, 2003 increased $6.8 million and $1.3 million, respectively, from the same periods of 2002.
The decline in trust and asset management income in the third quarter and first nine months of 2003 from the same periods of 2002 was primarily attributable to a decrease in the market values of assets under administration and lower investment advisory fees on money market assets due to declining short-term interest rates.
Mortgage banking income increased $2.2 million, or 60%, in the third quarter of 2003 compared to the same period in 2002. For the nine months ended September 30, 2003, mortgage banking income declined $2.2 million, or 15%, compared to the same period in 2002. During the first nine months of 2003, mortgage interest rates declined to near record lows. As a result, mortgage loan activity was strong, with high levels of loan originations, but also high levels of loan prepayments. Because mortgage loan production was higher in 2003 than in 2002, sales of newly originated loans and related gains were also higher. Net servicing income was lower in 2003 compared to 2002 due to increased amortization of mortgage servicing rights resulting from the high level of prepayments. The decrease in mortgage banking income in the first nine months of 2003 from the prior year was attributable to a first quarter 2002 recovery in loan valuations that amounted to $4.4 million, following a market value adjustment made at December 31, 2001.
Service charges on deposit accounts increased by 9% in the first nine months of 2003 compared to the same period last year largely attributable to a 7% increase in deposit balances from September 30, 2002 to September 30, 2003. In addition, overdraft fees increased from a new fee structure implemented in late 2002 and account analysis fees increased because customers received lower offsetting earnings credits as a result of the lower interest rate environment.
The increase in fees, exchange, and other service charges in the third quarter and the first nine months of 2003 compared to the same periods in 2002 was mainly due to a prepayment penalty on a commercial real estate loan in the third quarter of 2003.
Insurance income increased 49% and 29%, respectively, in the third quarter and first nine months of 2003 compared to 2002. The third quarter increase is attributable to settlements for prior period claim experience and increased premiums of the commercial insurance business. In addition, in the first nine months of 2003, in conjunction with consumer loan growth, credit life and disability insurance premium income has increased.
Other operating income for the nine months ended September 30, 2003 declined 11% from the same period in 2002 primarily due to decreased sales of annuities and other brokerage services.
Non-interest expense declined $2.9 million or 3% in the third quarter of 2003 compared to the same period in 2002, primarily due to a reduction in costs associated with the information technology systems replacement project and the related reduction in salary and equipment expenses. Non-interest expense increased $1.9 million in the first nine months of 2003 compared to the same period in 2002 resulting from a $15.3 million increase in the systems replacement project costs which was offset by declines in other expense categories. The project was completed in the third quarter of 2003 and no additional conversion expenses are expected. Refer to Note 2 to the Consolidated Financial Statements for additional information on the systems replacement project.
14
Salaries and employee benefits expense decreased 1% for the first nine months of 2003 compared to the same period in 2002 mainly due to a 6% decrease in the number of employees. Partially offsetting the decrease in base salary expense was an increase in compensation expense for the accelerated vesting of restricted stock as a result of meeting certain stock performance thresholds and an increase in commission expense associated with higher mortgage loan originations.
Net equipment expense declined 13% for the first nine months of 2003 compared to the same period in 2002 primarily due to reduced depreciation costs resulting from the systems replacement project. Refer to Note 2 to the Consolidated Financial Statements for additional information on the systems replacement project.
Other operating expense decreased by $6.0 million in the first nine months of 2003 compared to the same period in 2002 primarily due to a decline in expenses relating to professional services, sales and service training, legal services, advertising and marketing and Federal Deposit Insurance Corporation insurance. Partially offsetting the decline was a $1.5 million contribution to the Bank of Hawaii Charitable Foundation.
Income Tax
Income tax expense remained relatively flat for the first nine months of 2003 as compared to the same period in 2002. The effective tax rate was 34.5% which approximates the rate expected for the full year 2003.
BALANCE SHEET ANALYSIS
Short-Term Interest Earning Assets
Short-term interest-earning assets, consisting of interest-bearing deposits and funds sold, totaled $208.7 million at September 30, 2003, compared to $745.0 million and $1.1 billion at December 31, 2002 and September 30, 2002, respectively. The decline was mainly due to the use of funds to repurchase the Company’s stock, invest in longer-term assets and reduce debt.
Investments
The Company’s investment portfolio is managed in an effort to meet strategic asset/liability objectives, to provide both interest income and balance sheet liquidity and to collateralize customer deposits. Securities available for sale at September 30, 2003 were $2.0 billion, compared to $2.3 billion at December 31, 2002, and $2.2 billion at September 30, 2002. The 11% decrease from year-end 2002 is attributable to prepayments of investment securities. The proceeds were utilized to purchase investment securities which were designated as held to maturity. Securities held to maturity were $754.7 million at September 30, 2003, an increase from $229.7 million at December 31, 2002 and $277.9 million at September 30, 2002. At September 30, 2003 and December 31, 2002 investment securities with a book value of $1.3 billion and $1.5 billion, respectively, were pledged as collateral for repurchase agreements.
Loans held for sale, primarily residential mortgage loans, totaled $23.1 million at September 30, 2003, a decrease of $17.0 million and $7.7 million from December 31, 2002 and September 30, 2002, respectively. The decrease from prior periods is due to increased sales activities in the secondary market.
As of September 30, 2003, loans outstanding increased to $5.6 billion from $5.4 billion at year-end 2002. The increase was attributable to increases in residential and commercial mortgages, home equity loans, and other consumer loans, including automobile and direct personal loans.
Table 4 presents the composition of the loan portfolio by major loan categories and Table 5 presents the composition of consumer loans by geographic area.
15
Table 4
Loan Portfolio Balances (Unaudited)
Domestic
Commercial
Total Commercial
Consumer
Other Consumer
Total Consumer
Total Domestic
Foreign
Total Loans
Table 5
Consumer Loans by Geographic Area (Unaudited)
Hawaii
Guam
U.S. Mainland
American Samoa and Other Pacific Islands
Total
16
As of September 30, 2003, the Company’s portfolio of residential loans serviced for third parties totaled $3.1 billion, a decrease of $0.8 billion and $1.0 billion from December 31, 2002 and September 30, 2002, respectively. The carrying value of mortgage servicing rights amounted to $23.3 million at September 30, 2003, a decrease of $5.6 million and $6.6 million from December 31, 2002 and September 30, 2002, respectively. These decreases are attributable to the high level of mortgage prepayments that have resulted from the low interest rate environment in 2003. The Company did not incur an impairment charge related to mortgage servicing rights thus far in 2003. The prepayment speed of Hawaii mortgages continues to be lower than national speeds.
As of September 30, 2003, deposits totaled $7.1 billion, a $0.2 billion increase from December 31, 2002 and a $0.5 billion increase from September 30, 2002. The Company’s deposit growth has primarily been in demand and savings deposits, while higher cost time deposits have been reduced.
Borrowings
Short-term borrowings, including securities sold under agreements to repurchase, funds purchased, and other short-term borrowings, totaled $0.8 billion at September 30, 2003 and December 31, 2002, and $1.2 billion at September 30, 2002. The reduction in short-term borrowings reflected the modest net funding needs of the Company. For additional information, refer to the section on “Corporate Risk Profile—Liquidity Management”.
The Company’s capital position remains strong. A further discussion of the Company’s capital is included in the “Corporate Risk Profile—Capital Management” section of this report.
Guarantees
The Company’s standby letters of credit totaled $107.9 million as of September 30, 2003.
BUSINESS SEGMENTS
The Company’s business segments are defined as Retail Banking, Commercial Banking, Investment Services Group, and Treasury and Other Corporate. The management accounting process measures the performance of the operating segments based on the management structure of the Company and is not necessarily comparable with similar information for any other financial institution. This process uses various techniques to assign balance sheet and income statement amounts to the business segments, including allocations of overhead, the Provision and capital. This process is dynamic and requires certain allocations based on judgment and subjective factors. Unlike financial accounting, there is no comprehensive, authoritative guidance for management accounting that is equivalent to accounting principles generally accepted in the United States.
17
The business segments are primarily managed with a focus on performance measures, including risk adjusted return on capital (“RAROC”) and net income after capital charge (“NIACC”). RAROC is the ratio of net income to risk-adjusted equity. Equity is allocated to each business segment based on an assessment of its inherent risk. NIACC is net income available to common shareholders less a charge for allocated capital. The cost of capital is determined by multiplying management’s estimate of the shareholder’s minimum required rate of return on capital invested (11% for 2003 and 12% for 2002) by the segment’s allocated equity. The Company assumes a cost of capital that is equal to the long-term government bond rate plus an additional level of return for the average risk premium of an equity investment adjusted for the Company’s market risk. The net interest income of the business segments reflects the results of a funds transfer pricing process that matches assets and liabilities with similar interest rate sensitivity and maturity characteristics and reflects the allocation of net interest income related to the Company’s overall asset and liability management activities on a proportionate basis. During the third quarter of 2003, the Company changed the credit assigned for the value of deposits. Previously reported 2003 results have been reclassified to conform to the current methodology. The basis for the allocation of net interest income is a function of management decisions and assumptions which are subject to change based on changes in current interest rate and market conditions. The Provision charged to the Treasury and Other Corporate segment represents changes in the level of the Allowance. The Provision recorded in the Retail Banking, Commercial Banking, and Investment Services Group segments represents actual net charge-offs of these segments.
The financial results for the three and nine months ended September 30, 2003 and 2002 are discussed below and are presented in Table 6 and Table 6a, respectively.
Retail Banking
The Company’s Retail Banking segment offers a broad range of financial products and services to consumers and small businesses. Loan and lease products include residential mortgage loans, home equity lines of credit, automobile loans and leases, and installment loans. Deposit products include checking, savings and time deposit accounts. The Retail Banking segment also provides merchant services to its small business customers. Products and services from the Retail Banking segment are delivered to customers through 74 Hawaii branch locations and over 500 bank ATMs in the State of Hawaii, e-bankoh (on-line banking service), and 24-hour telephone banking service.
The improvement in the segment’s financial measures for the three and nine months ended September 30, 2003 compared to the same periods in 2002 was primarily due to an increase in net interest income and non-interest income. In addition, for the nine months of 2003 compared to the same period in 2002 the improvement was due to the decrease in non-interest expense resulting from reductions in technology support and advertising costs. These positive trends were partially offset by an increase in the Provision and system replacement project expenses in 2003. The increase in net interest income for the Retail Banking segment was reflective of higher average loan and lease balances and lower deposit interest expense. Average loans and leases increased by $304.7 million, or 10.4%, as compared to the third quarter of 2002, largely as a result of strong growth in the Retail Banking segment’s automobile, direct personal, small business and home equity portfolios, augmented by a purchase of home equity loans in December 2002. The increase in non-interest income was primarily due to an increase in mortgage banking income, service charges, fees and insurance income. The third quarter 2003 to third quarter 2002 increase in non-interest expense was primarily due to an increase in commissions resulting from higher mortgage loan origination volume in 2003.
Commercial Banking
The Commercial Banking segment offers products including corporate banking and commercial real estate loans, lease financing, auto dealer financing, deposit and cash management products, and property and casualty insurance products. Lending, deposit and cash management services are offered to middle-market and large companies in Hawaii. Commercial real estate mortgages are focused on customers that include investors, developers and builders primarily domiciled in Hawaii. The Commercial Banking unit also serves customers through its 14 branches in the Pacific Islands. As part of the initiatives for improving efficiency, the representative office in Tokyo was closed in the third quarter of 2003.
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The improvement in the segment’s financial measures for the three and nine months ended September 30, 2003 compared to the same periods in 2002 was a result of an increase in non-interest income, decreases in the Provision and non-interest expense, moderately offset by lower net interest income. The increase in non-interest income was due to a prepayment penalty fee on a commercial real estate loan, and an increase in insurance income and other fees. The decline in the Provision was a result of improved credit quality of the loan portfolio. The decline in non-interest expense was due to savings from lower staffing levels and other direct expenses including the realization of system conversion benefits, as well as savings from allocated expenses.
Investment Services Group
The Investment Services Group includes private banking, trust services, asset management, institutional investment advice, and retail brokerage. A significant portion of this segment’s income is derived from fees, which are generally based on the market values of assets under management. The private banking and personal trust group assists individuals and families in building and preserving their wealth by providing investment, credit, and trust expertise to high-net-worth individuals. The asset management group manages portfolios and creates investment products. Institutional sales and service offers investment advice to corporations, government entities, and foundations. Also included in the segment is Bankoh Investment Services, Inc., a full service brokerage offering equities, mutual funds, and annuities.
The decline in the segment’s financial measures for the three and nine months ended September 30, 2003 compared to the same periods in 2002, was primarily due to a decrease in non-interest income attributable to a decrease in trust and asset management fee income which resulted from declines in the value of assets under management and from decreased sales and fee income. The decrease in non-interest expense for the first nine months of 2003 compared to the same period in 2002 was mainly due to a decrease in outside service fees and commissions.
Treasury and Other Corporate
The primary income earning component of this segment is Treasury, which consists of corporate asset and liability management activities including interest rate risk management and foreign exchange business. This segment’s assets and liabilities (and related net interest income) consist of interest bearing deposits, investment securities, federal funds sold and purchased, government deposits, and short and long-term borrowings. The primary source of foreign exchange income relates to customer driven currency requests from merchants and island visitors. The net residual effect of transfer pricing of assets and liabilities is included in Treasury, along with eliminations of inter-company transactions.
This segment also includes divisions that provide a wide-range of support (Technology and Operations, Human Resources, Finance and Legal, and Risk Management) to the other income earning segments. Expenses incurred by these support units are charged to the business segments through an internal cost allocation process. This segment also includes the system replacement project expenses that are not incurred by or allocated to the Retail, Commercial and Investment Services Group segments.
The improvement in the segment’s financial measures for the third quarter of 2003 compared to the same quarter in 2002 was primarily due to an increase in non-interest income resulting from securities gains recorded in the third quarter of 2003. The lower capital charge was due to the reduction of the Company’s excess capital as a result of the continuing share repurchase activity. The decline in the segment’s financial measures for the nine month period of 2003 compared to the same period in 2002 was attributable to the increase in system replacement project expenses.
On a consolidated basis, the Company considers NIACC a measure of value creation. For the nine months ended September 30, 2003, consolidated NIACC was a positive $8.7 million, a result of improved financial performance primarily in the third quarter of 2003 and more efficient use of capital.
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Table 6
Business Segment Selected Financial Information (Unaudited)
Three Months Ended September 30, 2003
Allocated Net Income
Allowance Funding Value
GAAP Provision
Economic Provision
Tax Effect of Adjustments
Income Before Capital Charge
Capital Charge
Net Income (Loss) After Capital Charge (NIACC)
RAROC (ROE for the Company)
Total Assets at September 30, 2003
Three Months Ended September 30, 2002 1
Income (Loss) Before Capital Charge
Total Assets at September 30, 2002
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Table 6a
Income (Loss) Before Income Taxes
Allocated Net Income (Loss)
Nine Months Ended September 30, 2002 1
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FOREIGN OPERATIONS
As of September 30, 2003, the countries in which the Company maintains its largest exposure on a cross-border basis include the Netherlands, United Kingdom, Australia and Canada. Table 7 presents, as of September 30, 2003, December 31, 2002, and September 30, 2002, a geographic distribution of the Company’s cross-border assets for selected countries. The primary component of cross-border assets as of September 30, 2003 was interest bearing deposits of $201.1 million.
Table 7
Geographic Distribution of Cross-Border International Assets (Unaudited)1
Country
Australia
Canada
France
Germany
Netherlands
Singapore
United Kingdom
All Others
Because the U.S. dollar is used in the Pacific Island Division locations (Guam and American Samoa, which are U.S. territories, and other nearby islands), these operations are not considered foreign for financial reporting purposes.
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CORPORATE RISK PROFILE
Credit Risk
Credit Risk is defined as the risk that borrowers or counterparties will not be able to repay their obligations to the Company. Credit exposures reflect legally binding commitments for loans, leases, banker’s acceptances, financial and standby letters of credit, and overnight overdrafts.
The Company’s asset quality continued to improve as evidenced by lower levels of internally criticized loans and non-performing assets, and a continued positive trend in the level of commercial net charge-offs. The Company’s lower risk position relative to a year ago in the corporate portfolio reflects the execution of portfolio strategy to shift to lower risk industries as well as reduce large borrower concentrations, syndicated national credits, and exposure to certain industries. Management continues to monitor the portfolio in an effort to identify and disengage from deteriorating credits. In the Hawaii commercial portfolio, overall risk has been generally stable primarily due to the resiliency of the Hawaii economy. In the retail portfolios, higher retail net charge-offs were due to a combination of growth and the non-recurring charge-off of the remaining balance of the portfolios for four Pacific Island branches where operations were previously discontinued.
Although the Company’s credit risk profile continues to improve overall, two components, airline/aircraft and Guam, continue to carry higher risk characteristics. Information about these components is summarized in Table 8.
Risk in the airline industry, while recently showing less negative trends, continues to remain high as the industry struggles with elevated cost structures, growing competition from low cost carriers that reduced higher-margin business travel, potential global mergers and marketing alliances, and a less certain geopolitical environment. The risk of additional domestic and/or international airline bankruptcies may place further downward pressure on aircraft values and lease rents.
In Guam, which is materially dependent on tourism and military spending, economic stress continues. The Guam hotel portfolio had $17.8 million in exposure at September 30, 2003 of which $6.0 million, or 33%, was guaranteed by financial institutions or entities with limited exposure to tourism.
At September 30, 2003, the largest syndicated loan outstanding amounted to $26.7 million to a prominent Hawaii based hotel operator while the second largest was $23.3 million to a Hawaii shopping center operator. The ten largest syndicated loans outstanding totaled $146.2 million to the real estate, hospitality, and gaming industries. As of September 30, 2003, one unfunded syndicated commitment, which had $6.1 million in exposure (less than 1% of total syndicated commitments), was internally classified.
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Table 8
Selected Concentrations of Credit Exposure (Unaudited)
Exposure
Air Transportation
Regional Passenger Carriers
United States Based Passenger Carriers
International Based Passenger Carriers
Cargo Carriers
Total Air Transportation
Hotel
Other Commercial
Total Guam
Syndicated Exposure
Exposure includes loans, leveraged leases and operating leases.
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Non-Performing Assets
Non-performing assets (“NPAs”) were $40.1 million at September 30, 2003, a decline of $14.3 million, or 26%, from the end of 2002. The improvement in non-performing assets was largely the result of loans that were returned to accrual status or paid-off, and a reduction in foreclosed assets due to sales. The addition of one $7.6 million credit to a Hawaii-based company in the second quarter of 2003 partially offset total reductions.
Compared to the same quarter last year, non-performing assets decreased by $23.2 million, or 37%. Improvement from the prior year quarter was largely due to payments, the return of loans to accrual status, and charge-offs. At September 30, 2003, the ratio of non-performing assets to total loans and foreclosed real estate was 0.72%, down from 1.01% at December 31, 2002 and 1.20% at September 30, 2002.
NPAs in Guam were $14.4 million at September 30, 2003, a decline of $1.1 million from June 30, 2003 primarily due to the sale of foreclosed assets. As a percent of total NPAs, Guam loans represented 36%, a decrease from 48% at December 31, 2002.
Non-accrual loans were $31.4 million at September 30, 2003, down $13.6 million, or 30%, from $45.0 million at December 31, 2002, and by $14.3 million, or 31%, from $45.7 million at September 30, 2002. Non-accrual loans as a percentage of total loans were 0.56% at September 30, 2003, down from 0.84% at December 31, 2002 and 0.87% at September 30, 2002.
Foreclosed assets were $8.7 million at September 30, 2003, a decrease of $0.7 million from $9.4 million at December 31, 2002 and a decrease of $8.9 million from $17.6 million for the same period last year. The decline from the same period in the prior year was due primarily to the sale of the majority of the Company’s largest parcel of foreclosed real estate in the fourth quarter of 2002.
Impaired loans at September 30, 2003 of $19.5 million decreased $22.4 million, or 53%, from $41.9 million at December 31, 2002. These loans had a related Allowance that totaled $1.7 million at September 30, 2003, a decrease of $6.6 million from year end 2002. Compared to September 30, 2002, impaired loans decreased by $34.0 million, or 64%, from $53.5 million and had a related Allowance of $7.0 million.
Accruing loans past due 90 days or more were $3.9 million at September 30, 2003, an increase of $0.7 million from June 30, 2003 and $2.1 million from December 31, 2002. The increase for both periods was primarily due to installment loans resulting from the seasoning of the Fall 2002 direct mail campaign. Despite this increase, delinquencies remain low at 20 basis points of the outstanding balance.
For further information on non-performing assets refer to Table 9.
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Table 9
Consolidated Non-Performing Assets and Accruing Loans Past Due 90 Days or More (Unaudited)
Non-Accrual Loans
Total Non-Accrual Loans
Total Non-Performing Assets
Accruing Loans Past Due 90 Days or More
Total Accruing and Past Due
Ratio of Non-Accrual Loans to Total Loans
Ratio of Non-Performing Assets to Total Loans andForeclosed Real Estate
Ratio of Non-Performing Assets and Accruing Loans
Past Due 90 Days or More to Total Loans
Quarter to Quarter Changes in Non-Performing Assets
Balance at Beginning of Quarter
Additions
Reductions
Payments and Sales of Loans
Return to Accrual
Sales of Foreclosed Assets
Charge-offs
Total Reductions
Balance at End of Quarter
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The Company maintains an Allowance adequate to cover management’s estimate of probable credit losses inherent in its lending portfolios based on a comprehensive quarterly analysis of historical loss experience supplemented by judgmental expectations of portfolio performance and economic conditions as of a given balance sheet date.
The Allowance at September 30, 2003 of $132.7 million decreased from $142.9 million at December 31, 2002, and $154.5 million at September 30, 2002. The current quarter and year-over-year decreases were consistent with improvements in credit quality and the estimated impact of current economic conditions on portfolio performance. The ratio of the Allowance to total loans was 2.38% at September 30, 2003, a decrease from 2.67% at December 31, 2002 and 2.94% at September 30, 2002. A summary of the activity for the Allowance is presented in Table 10.
Net charge-offs for the third quarter of 2003 were $5.3 million, or 0.38% (annualized), of total average loans compared to $4.5 million, or 0.33% (annualized), of total average loans in the third quarter of 2002. Net charge-offs included $3.6 million of loans, primarily consumer, remaining in the Pacific Islands branches that were closed in 2002. Net charge-offs for the first nine months of 2003 were $10.2 million, or 0.25% (annualized), of total average loans, a decrease from $16.1 million, or 0.39% (annualized), of total average loans in the comparable period last year. This improvement reflects management’s execution of portfolio strategies in an effort to shift to lower risk industries, reduce large borrower concentrations and syndicated national credits, and the resiliency of the Hawaii economy, as well as enhanced credit management and collection process in the retail portfolios.
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Table 10
Consolidated Allowance for Loan and Lease Losses (Unaudited)
2003
June 30,
2002 1
Balance at Beginning of Period
Loans Charged-Off
Total Charge-Offs
Recoveries on Loans Previously Charged-Off
Total Recoveries
Net Loan Charge-Offs
Balance at End of Period
Average Loans Outstanding
Ratio of Net Charge-Offs to Average Loans Outstanding (annualized)
Ratio of Allowance to Loans Outstanding
Totals may not add due to rounding.
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Market Risk
Market risk is the potential of loss arising from adverse changes in interest rates and prices. The Company is exposed to market risk in the normal course of conducting its business activities. The Company’s market risk management process involves measuring, monitoring and controlling risks that can significantly impact the Company’s financial position and operating results. In this management process, market risks are balanced with expected returns in an effort to enhance earnings performance and shareholder value, while limiting the volatility of each. The activities associated with these market risks are categorized into “trading” and “other than trading”.
The Company’s trading activities include foreign currency and foreign exchange contracts that expose the Company to a minor degree of foreign currency risk. These transactions are executed on behalf of customers and for the Company’s own account. The remaining exposure from foreign currency trading positions during the first nine months of 2003 was immaterial.
The Company’s “other than trading” activities include normal business transactions that expose the Company’s balance sheet to interest rate risk.
Interest Rate Risk
The Company’s balance sheet is sensitive to changes in the general level of interest rates arising primarily from the Company’s normal business activities of making loans and taking deposits. Many other factors also affect the Company’s exposure to changes in interest rates, such as general economic and financial conditions, customer preferences, historical pricing relationships and the monetary and fiscal policies of the United States government and the Federal Reserve System.
Table 11 presents, as of September 30, 2003, December 31, 2002 and September 30, 2002, the estimate of the change in net interest income (“NII”) that would result from a gradual 200 basis point increase or decrease in interest rates, moving in parallel fashion over the entire yield curve, over the next 12-month period, relative to the measured base case scenario for NII. The 200 basis point increase would equate to an average increase of $4.2 million in NII per quarter. The Company’s balance sheet continues to be asset-sensitive. The resulting estimated NII exposure is within the guidelines approved by the Company’s Asset Liability Management Committee.
Table 11
Market Risk Exposure to Interest Rate Changes (Unaudited)
Interest Rate Change
(in basis points)
Estimated Exposure as a Percent of Net Interest Income
Estimated Exposure to Net Interest Income Per Quarter
In managing interest rate risk, the Company generally uses on-balance sheet transactions to manage its risk position. Approaches that are used to shift balance sheet mix or alter the interest rate characteristics of assets and liabilities include changing product pricing strategies and modifying investment portfolio strategies. The use of financial derivatives has been limited over the past several years.
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Liquidity Management
Liquidity is managed in an effort to ensure that the Company has continuous access to sufficient, reasonably priced funding to conduct its business in a normal manner.
The Bank is a member of the Federal Home Loan Bank of Seattle (“FHLB”), which is a source of short and long-term funding. Outstanding borrowings from the FHLB were $68.5 million at September 30, 2003, compared to $42.5 million at December 31, 2002 and $34.5 million at September 30, 2002. The increase from year-end 2002 was mainly attributable to a $50.0 million long-term advance, the proceeds of which were used to repay a portion of a $100.0 million long-term 6 7/8% subordinated debt that matured in June 2003. The advance is for a 7 year term and bears a 4% rate of interest.
Additionally, the Bank maintains a $1 billion senior and subordinated bank note program. Under this facility, the Bank may issue additional notes provided that at any time the aggregate amount outstanding does not exceed $1 billion. Subordinated notes outstanding under this bank note program totaled $125.0 million at September 30, 2003, December 31, 2002 and September 30, 2002.
Capital Management
The Company and the Bank are subject to regulatory capital requirements administered by the federal banking agencies. The Company’s objective is to hold sufficient capital on a regulatory basis to exceed the minimum guidelines of a “well-capitalized” financial institution, while over the long term optimize shareholder value, support asset growth, reflect risks inherent in its markets, provide protection against unforeseen losses and comply with regulatory requirements.
At September 30, 2003, shareholders’ equity totaled $823.8 million, a 19% net decrease from December 31, 2002. The decrease in shareholders’ equity during the first nine months of 2003 was primarily attributable to the Company’s repurchase of its common stock under the repurchase programs, offset by earnings for the year 2003.
In September 2003, the Company’s Board of Directors authorized an additional stock repurchase of up to $200 million of its common stock. This authorization, combined with the Company’s previously announced authorizations of $800 million, brings the total repurchase authority to $1.0 billion.
During the nine months ended September 30, 2003, 8.1 million shares of common stock were repurchased at an average cost of $32.53 per share, totaling $262.9 million. As of September 30, 2003, the Company had repurchased a total of 28.2 million shares since July 2001, under all share repurchase programs, totaling $790.8 million at an average cost of $28.02 per share. Subsequent to September 30, 2003 through October 24, 2003, 183,800 shares where repurchased at an average cost of $35.62 per share for a total of $6.5 million resulting in remaining buyback authority under the existing repurchase programs of $202.7 million.
In October 2003, the Company’s Board of Directors declared a quarterly cash dividend of $0.30 per share on the Company’s outstanding shares, an increase from $0.19 per share in the previous quarters. The dividend will be payable on December 12, 2003 to shareholders of record at the close of the business on November 21, 2003.
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Table 12
Regulatory Capital and Ratios (Unaudited)
Regulatory Capital
Add: 8.25% Capital Securities of Bancorp Hawaii Capital Trust I
Less: Goodwill
Unrealized Valuation and Other Adjustments
Tier I Capital
Allowable Reserve for Loan Losses
Subordinated Debt
Total Capital
Risk Weighted Assets
Key Capital Ratios
Average Equity/Average Assets Ratio
Tier I Capital Ratio
Total Capital Ratio
Leverage Ratio
Economic Update
The Hawaii economy remained strong during the third quarter of 2003. The construction and real estate investment sectors continued to surge over the summer months, especially in the neighbor island residential markets. Tourism, as measured by passenger arrivals, also increased during the quarter. August 2003 was a record month for Hawaii tourism. Hawaii’s seasonally-adjusted unemployment increased slightly to 4.3% in August, while nonagricultural payrolls rose more than 2% in August 2003 from the prior year level.
Earnings Outlook
The Company now believes that its earnings for 2003 should exceed the previously published earnings guidance of $131 million. Based on current conditions, the Company does not expect to record a Provision in 2003. However, the actual amount of the Provision depends on determinations of credit risk that are made near the end of each quarter. Earnings per share and return on equity projections continue to be dependent upon the terms and timing of share repurchases.
Item 3. Quantitative and Qualitative Disclosures of Market Risk
See Management’s Discussion and Analysis of Results of Operations and Financial Condition-Market Risk.
Item 4. Controls and Procedures
The Company’s management, including the Chief Executive Officer and Chief Financial Officer, evaluated the Company’s disclosure controls and procedures (as defined in Rule 13a - 15(e) under the Securities and Exchange Act of 1934, as amended) as of September 30, 2003. Based on this evaluation the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective. There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s 2003 third quarter that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.
31
Items 1 to 5 omitted pursuant to instructions.
Item 6—Exhibits and Reports on Form 8-K
Exhibit Number
Filed July 29, 2003, under Item 12 of Form 8-K, regarding the Company’s financial results for the quarter ended June 30, 2003
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date October 27, 2003
/s/ Michael E. O’Neill
Michael E. O’Neill
Chairman, Chief Executive Officer and President
/s/ Allan R. Landon
Allan R. Landon
Vice Chairman, Treasurer and Chief Financial Officer
/s/ Richard C. Keene
Richard C. Keene
Executive Vice President and Controller
33