UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended March 31, 1999 or [ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transitional period from to Commission File No. 000-23877 HERITAGE COMMERCE CORP (Exact name of registrant as specified in its charter) California 77-0469558 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 150 Almaden Blvd., San Jose, California 95113 (Address of principal executive offices) (Zip Code) (408) 947-6900 (Registrant's telephone number, including area code) None (Former name, former address and former fiscal year,if changed since last report.) 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. [X] Yes [ ] No APPLICABLE ONLY TO CORPORATE ISSUERS: The Registrant had 5,585,184 shares of Common Stock outstanding on May 3, 1999.
HERITAGE COMMERCE CORP AND SUBSIDIARY QUARTERLY REPORT ON FORM 10-Q Table of Contents Part I - Financial Information Page Item 1. Condensed Consolidated Statements of Financial Condition 1 At March 31, 1999 and December 31, 1999 Condensed Consolidated Statements of Income 2 For the three months ended March 31, 1999 and 1998 Condensed Consolidated Statements of Cash Flows 3 For the three months ended March 31, 1999 and 1998 Condensed Consolidated Notes to Financial Statements 4 Item 2. Management's Discussion and Analysis of Financial Condition 6 and Results of Operations Item 3. Quantitative and Qualitative Disclosures About Market Risk 15 Part II - Other Information Item 1. Legal Proceedings 16 Item 2. Submission of Matters to a Vote of Security Holders 16 Item 3. Other Information 16 Item 4. Exhibits and Reports on Form 8-K 16 Signatures 17
HERITAGE COMMERCE CORP AND SUBSIDIARY Condensed Consolidated Statements of Financial Condition <TABLE> <CAPTION> ASSETS March 31, 1999 December 31, 1998 (Unaudited) <S> <C> <C> Cash and due from banks $ 14,837,000 $ 18,039,000 Federal funds sold 14,415,000 28,600,000 Total cash and cash equivalents 29,252,000 46,639,000 Securities available-for-sale, at fair value 52,413,000 50,249,000 Securities held-to-maturity, at amortized cost 13,867,000 26,544,000 (fair value of $14,166,000 and $27,240,000, respectively) Loan held for sale, at fair value 12,306,000 33,079,000 Loans 231,274,000 236,307,000 Allowance for loan losses (4,277,000) (3,825,000) Loans, net 226,997,000 232,482,000 Premises and equipment, net 3,102,000 3,238,000 Accrued interest receivable and other assets 11,490,000 7,240,000 Other investments 8,941,000 5,460,000 TOTAL $ 358,368,000 $ 404,931,000 LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Deposits $ 322,046,000 $ 350,047,000 Deposits held for sale --- 18,911,000 Accrued interest payable and other liabilities 5,393,000 5,276,000 Total liabilities 327,439,000 374,234,000 Commitments and contingencies Shareholders' equity: Preferred Stock, 10,000,000 shares authorized; none outstanding --- --- Common Stock, no par value; 30,000,000 shares authorized;shares issued and outstanding: 5,561,656 at March 31, 1999 and 5,554,552 at December 31, 1998 29,455,000 29,418,000 Accumulated other comprehensive income, net of taxes 225,000 658,000 Retained Earnings 1,249,000 621,000 Total shareholders' equity 30,929,000 30,697,000 TOTAL $ 358,368,000 $ 404,931,000 See notes to condensed consolidated financial statements </TABLE>
HERITAGE COMMERCE CORP AND SUBSIDIARY Condensed Consolidated Statements of Income (Unaudited) <TABLE> <CAPTION> Three months ended March 31, 1999 1998 <S> <C> <C> Interest income: Loans, including fees $ 6,031,000 $ 3,550,000 Securities, taxable 624,000 1,233,000 Securities, non-taxable 173,000 120,000 Federal funds sold 336,000 217,000 Total interest income 7,164,000 5,120,000 Interest expense: Deposits 2,160,000 1,342,000 Other 11,000 --- Total interest expense 2,171,000 1,342,000 Net interest income before provision for loan losses 4,993,000 3,778,000 Provision for loan losses 643,000 160,000 Net interest income after provision for loan losses 4,350,000 3,618,000 Other income: Gain on sale of loans held for sale 46,000 --- Gain on sale of securities available for sale 771,000 18,000 Service charges and other fees 69,000 50,000 Other investment income 80,000 52,000 Other income 258,000 11,000 Total other income 1,224,000 131,000 Other expenses: Salaries and employee benefits 2,422,000 1,580,000 Client services 661,000 325,000 Furniture and equipment 297,000 171,000 Advertising and promotion 149,000 152,000 Occupancy 232,000 150,000 Professional fees 170,000 164.000 Loan origination costs 116,000 82,000 Stationery & supplies 79,000 55,000 Telephone expense 50,000 46,000 Other 411,000 293,000 Total other expenses 4,587,000 3,018,000 Net income before income taxes 987,000 731,000 Income taxes 360,000 278,000 Net income $ 627,000 $ 453,000 Earnings per share: Basic $ 0.11 $ 0.09 Diluted $ 0.10 $ 0.08 See notes to condensed consolidated financial statements </TABLE>
HERITAGE COMMERCE CORP Condensed Consolidated Statements of Cash Flows (Unaudited) <TABLE> <CAPTION> Three Months ended March 31, 1999 1998 <S> <C> <C> Cash flows from operating activities: Net income $ 627,000 $ 453,000 Adjustments to reconcile net income to net cash used by operating activities: Depreciation and amortization 203,000 125,000 Provision for loan losses 643,000 160,000 Gain on sale of securities available-for-sale (771,000) (18,000) Net amortization of premiums / accretion of discounts (34,000) (27,000) Proceeds from sales of loans 2,317,000 (18,000) Originations of loans held for sale (322,000) (1,813,000) Maturities of loans held for sale 2,158,000 18,000 Increase in accrued interest receivable and other assets (4,248,000) (97,000) Decrease (increase)in accrued interest payable and other liabilities 403,000 (299,000) Net cash provided by (used by) operating activities 976,000 (1,516,000) Cash flows from investing activities: Net decrease (increase) in loans 21,462,000 (12,310,000) Purchases of investment securities available-for-sale (21,252,000) (11,637,000) Maturities of investment securities available-for-sale 2,984,000 3,046,000 Sales of investment securities available-for-sale 27,749,000 18,000 Purchases of investment securities held-to-maturity --- (3,083,000) Maturities of investment securities held-to-maturity 1,115,000 1,867,000 Purchases of corporate owned life insurance (3,480,000) (52,000) Capital expenditures (67,000) (809,000) Net cash provided by (used by) investing activities 28,511,000 (22,960,000) Cash flows from financing activities: Net (decrease) increase in deposits (46,912,000) 61,187,000 Proceeds from exercise of stock options 38,000 --- Net cash (used by) provided by financing activities (46,874,000) 61,187,000 Net (decrease) increase in cash and cash equivalents (17,387,000) 36,711,000 Cash and cash equivalents, beginning of period 46,639,000 43,185,000 Cash and cash equivalents, end of period $ 29,252,000 $ 79,896,000 Other cash flow information: Interest paid in cash $ 2,246,000 $ 1,239,000 Income taxes paid in cash 728,000 385,000 See notes to condensed consolidated financial statements </TABLE>
HERITAGE COMMERCE CORP AND SUBSIDIARY Notes to Condensed Consolidated Financial Statements March 31, 1999 (Unaudited) 1) Basis of Presentation The unaudited condensed consolidated financial statements of Heritage Commerce Corp and its wholly owned subsidiaries, Heritage Bank of Commerce and Heritage Bank East Bay, have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by generally accepted accounting principles for complete financial statements are not included herein. The interim statements should be read in conjunction with the financial statements and notes thereto included in the Company's Form 10-K Annual Report for the year ended December 31, 1998. In the Company's opinion, all adjustments necessary for a fair presentation of these condensed consolidated financial statements have been included and are of a normal and recurring nature. Certain reclassifications have been made to prior year amounts to conform to current year presentation. The results for the three months ended March 31, 1999 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 1999. 2) Share and Per Share Amounts Earnings per common share (basic) are calculated based on the weighted average number of shares outstanding during the period. Earnings per common and common equivalent share (diluted) are calculated based on the weighted average number of shares outstanding during the period, plus equivalent shares representing the dilutive effect of stock options. All share numbers have been restated for the stock split in February, 1999. Reconciliation of weighted average shares used in computing earnings per share are as follows: <TABLE> <CAPTION> Years ended March 31, 1999 1998 <S> <C> <C> Weighted average common shares outstanding 5,556,919 4,943,844 Diluted effect of stock options outstanding 855,479 554,925 Shares used in computing diluted earnings per share 6,412,398 5,498,769 </TABLE> 3) Adoption of FAS 133 In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 133 , "Accounting for Derivative Instruments and Hedging Activities." The Company adopted the provisions of SFAS No. 133 effective February 1, 1999. Because of the Company's minimal use of derivatives, the adoption of SFAS No. 133 did not significantly impact the Company's earnings or financial position. As allowed by SFAS No. 133 the Company transferred approximately $11.67 million of certain securities from the held-to-maturity to available-for-sale classification. The realized and unrealized gains on the securities transferred were not material to the Company.
4) Comprehensive Income In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income", which requires that an enterprise report and display, by major components and as a single total, the change in its net assets during the period from non-owner sources. This Statement is effective for fiscal years beginning after December 15, 1997. The adoption of this Statement in the first quarter of 1999 resulted in a change in the financial statement presentation, but did not have an impact on the Company's consolidated financial position, results of operations or cash flows. Certain amounts in the prior period have been reclassified to conform to the current presentation under SFAS No. 130. Total comprehensive income for the three months ended March 31, 1999 and 1998 was $195,000 and $488,000, respectively. The following is a summary of the components of accumulated other comprehensive income: <TABLE> <CAPTION> For the Three Months Ended March 31,1999 March 31,1998 <S> <C> <C> Net Income $ 627,000 $ 453,000 Other comprehensive income, net of tax: Net unrealized gain on securities available-for-sale during the period 338,000 46,000 Less:reclassification adjustment for realized gains on available for sale securities included in net income during the period (770,000) (11,000) Other comprehensive income (432,000) 35,000 Comprehensive income $ 195,00 $ 488,000 </TABLE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Net income for the quarter ended March 31, 1999 was $627,000, or $0.10 per diluted share, as compared to net income of $453,000, or $0.08 per diluted share, for the same period in 1998. The increase was attributable to growth in the level of earning assets overall, and of loans in particular, funded by new deposits at favorable weighted average rates of interest. Return on average assets annualized for the first three months of 1999 and 1998 was 0.69%. Annualized return on average equity for the first three months of 1999 was 8.20%, compared to 8.08% for the first three months of 1998. Average interest earning assets for the quarter ended March 31, 1999 were up $93,595,000, or 40%, over 1998, with much of the increase primarily attributable to growth in loans. The average rate earned on loans in the first quarter of 1999 was 10.03%, compared to 10.93% in the first quarter of 1998. The average rate on earning assets was 8.81% for the quarter ended March 31, 1999, compared to 8.79% for the quarter ended March 31, 1998. Average interest bearing liabilities increased $84,193,000, or 57%, from three months ended March 31,1998 to the same periods in 1999, with the increase attributable to growth in interest bearing demand deposits, money market accounts, growth in time deposits of $100,000 or more, and growth in time deposits in support of the internet credit card program. The average rate paid on interest bearing liabilities increased to 3.78% at March 31, 1999 from 3.65% at March 31, 1998. The Company's net interest margin was 6.14% from the first three months ended March 31, 1999, compared with 6.49% for the first three months ended March 31,1998. The Company's non-performing assets increased to $2,269,000 at March 31, 1999 from zero at March 31, 1998, due to local market conditions, the increase in size of the loan portfolio and an increase in dilinquent consumer loans. Shareholders' equity increased $232,000 to $30,929,000, or 8.64% of assets, at March 31, 1999, from $30,697,000 or 7.58% of assets, at December 31, 1998. The Company's Tier 1 and total risk-based capital ratios were 10.30% and 11.55% at March 31, 1999, compared to 9.2% and 10.4%, respectively, at December 31, 1998, and 13.1% and 14.6%, respectively, at March 31, 1998. Due to the overall growth in total assets, more specifically the growth in the loan portfolio, the Company's leverage capital ratio stood at 8.32% at March 31, 1999. This compares with a leverage ratio of 9.0% at December 31, 1998 and 8.4% at March 31, 1998.
RESULTS OF OPERATIONS Net Interest Income and Net Interest Margin The following table presents the Company's average balance sheet, net interest income and the resultant yields for the periods presented: <TABLE> <CAPTION> <S> <C> <C> <C> <C> <C> <C> For the Three Months Ended For the Three Months Ended March 31, 1999 March 31, 1998 Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ (Dollars in thousands) Balance Expense Rate Balance Expense Rate Assets: Loans, net $ 243,894 $ 6,031 10.03% $ 131,672 $ 3,550 10.93% Investments securities 56,957 797 5.68% 88,375 1,353 6.21% Federal funds sold 28,984 336 4.71% 16,193 217 5.43% Total interest earning assets $ 329,835 $ 7,164 8.81% $ 236,240 $ 5,120 8.79% Cash and due from banks 17,040 19,518 Premises and equipment, net 3,233 2,299 Other assets 17,510 7,950 Total assets $ 367,618 $ 266,007 Liabilities and shareholders' equity: Deposits: Demand, interest bearing $ 9,464 $ 34 1.47% $ 6,205 $ 29 1.89% Savings and Money market 131,273 987 3.05% 95,640 739 3.13% Time deposits, $100,000 and over 52,678 630 4.85% 39,523 489 5.01% Time deposits, less than $100,000 32,591 426 5.30% 7,512 85 4.60% Brokered Deposits 6,167 83 5.44% - - - Other borrowings 911 11 4.87% 11 - 5.63% Total interest bearing liabilities $233,084 $ 2,171 3.78% $ 148,891 $ 1,342 3.65% Demand deposits 96,908 92,020 Other liabilities 6,583 2,364 Total liabilities 336,575 243,275 Shareholders' equity 31,043 22,732 Total liabilities and shareholders' equity $367,618 $ 266,007 Net interest income/margin $ 4,993 6.14% $ 3,778 6.49% Note: Yields and amounts earned on loans include loan fees of $455,000 and $277,000 for the three month periods ended March 31, 1999 and 1998, respectively. </TABLE> The Company's net interest income for the first quarter of 1999 was $4,993,000, an increase of $1,215,000 over the first quarter of 1998. When compared to the first quarter of 1998, average earning assets increased by $93,595,000. The net yield on average earning assets was 6.14% in the first quarter of 1999, compared to 6.49% in the first quarter of 1998. The increase in net interest income was primarily due to an increase in the volume of interest earning assets, predominantly loans. The following table sets forth an analysis of the changes in interest income and interest expense. The total change is shown in the column designated "Net Change" and is allocated in the columns to the left, to the portions respectively attributable to volume changes and rate changes that occurred during the period indicated. Changes due to both volume and rate have been allocated between the volume and rate categories in proportion to the relationship of the changes due solely to the changes in volume and rate, respectively. <TABLE> <CAPTION> Three Months Ended March 31, 1999 vs. 1998 Increase (Decrease) Due to Change In: (Dollars in thousands) Average Volume Average Rate Net Change <S> <C> <C> <C> Interest earning assets Loans, net $ 2,775 $ (294) $ 2,481 Investments securities (441) (115) (556) Federal funds sold 148 (29) 119 Total interest earning assets $ 2,482 $ (438) $ 2,044 Interest bearing liabilities Demand, interest bearing $ 12 $ (7) $ 5 Money Market and Savings 268 (20) 248 Time deposits, $100,000 and over 157 (16) 141 Time deposits, less than $100,000 328 133 341 Brokered Deposits 83 - 83 Other borrowings 11 - 11 Total interest bearing liabilities $ 859 $ (30) $ 829 Net interest income $ 1,623 $ (408) $ 1,215 </TABLE>
Provision for Loan Losses During the first quarter of 1999, the provision for loan losses was $643,000, up $483,000 from $160,000 for the first quarter of 1998. The increase in the provision was due to the overall growth of the loan portfolio. Noninterest Income The following table sets forth the various components of the Company's noninterest income for the periods indicated: <TABLE> Increase Three months ended March 31, 1999 versus 1998 (Dollars in thousands) 1999 1998 Amount Percent <S> <C> <C> <C> <C> Service charges and other fees $ 69 $ 50 $ 19 38% Gain on sale of securities available-for-sale 771 18 753 4,183% Gain on sale of loans 46 - 46 -- Other investment income 80 52 28 54% Other income 258 11 247 2,245% Total $ 1,224 $ 131 $ 1,093 834% </TABLE> Noninterest income for the first three months ended March 31, 1999 was $1,224,000, up $1,093,000, or 834%, from $131,000 for the first three months ended March 31, 1998. This increase was primarily the result of gains recognized on the sale of securities available-for-sale (up $753,000) and the increase in other income (up $247,000). The sale of securities represents favorable market conditions to sell securities. The increase in other income is primarily due to fee income associated with the Company's internet credit card program. Noninterest Expense The following table sets forth the various components of the Company's noninterest expenses for the periods indicated: <TABLE> <CAPTION> For The Three Months Ended March 31, Increase Percent Increase (Dollars in thousands) 1999 1998 (Decrease) (Decrease) <S> <C> <C> <C> <C> Salaries and benefits $ 2,422 $ 1,580 $ 842 53% Client services 661 360 301 84% Furniture and equipment 297 170 127 75% Occupancy 232 150 82 55% Advertising and promotion 149 173 (24) (14%) Loan origination costs 116 82 34 41% Professional fees 170 164 6 4% Stationery & Supplies 79 55 24 44% Telephone expense 50 46 4 9% All other 411 238 203 85% Total $ 4,587 $ 3,018 $ 1,569 52% </TABLE> Noninterest expenses for the first quarter of 1999 were $4,587,000, up $1,569,000, or 52%, from $3,018,000 for the first quarter of 1998. The increase in noninterest expenses reflects the growth in infrastructure to support the Company's loan and deposit growth and the opening of Heritage Bank East Bay. Noninterest expenses consist primarily of salaries and employee benefits (53% and 52% of total noninterest expenses for the first quarter of 1999 and 1998, respectively) and client services (14% and 12% of total non-interest expenses for the first quarter of 1999 and 1998, respectively). The increase in salaries and benefits expenses was primarily attributable to an increase in the number of employees. The Company employed 142 people at March 31, 1999, up 37 from 105 employees at March 31, 1998. Client services expenses include courier and armored car costs, imprinted check costs, and other client services costs, all of which are directly related to the amount of funds on deposit at the Company. The increase in furniture and equipment expenses and in occupancy expenses was primarily attributable to an increase in the number of employees and new banking locations.
FINANCIAL CONDITION Total assets decreased 11% to $358,368,000 at March 31, 1999, compared to $404,931,000 at December 31, 1998. The reduction was primarily due to the sale of approximately $42,000,000 in bankruptcy deposits. Securities Portfolio The following table summarizes the amounts and distribution of the Company's investment securities and the weighted average yields as of March 31, 1999: <TABLE> <CAPTION> <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> March 31, 1999 Maturity Within After One Year After Five One and Within Years and After Total Year Five Years Within Ten Years Ten Years Amortized Cost (Dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield Securities available for sale: U.S. Treasury $ 28,291 5.47% $ 13,203 5.98% $ --- --- $ --- --- $41,494 5.63% U.S. government agencies 511 6.52% 3,040 6.31% --- --- --- --- 3,551 6.34% Municipals - taxable --- --- 1,883 6.20% --- --- --- --- 1,883 6.20% Municipals - non-taxable --- --- --- --- 3,217 4.68% 2,268 4.78% 5,485 4.72% Total available for sale $ 28,802 5.49% $ 18,126 6.06% $ 3,217 4.68% $2,268 4.78% $52,413 5.60% Securities held to maturity: Municipals - taxable $ --- --- $ 5,927 6.46% $ 517 6.45% $ --- --- $ 6,444 10.2% Municipals - non-taxable --- --- 268 4.90% 6,037 4.51% 1,118 4.59% 7,423 1.32% Total held to maturity $ --- --- $ 6,195 6.39% $ 6,554 4.66% $1,118 4.59% $13,867 5.43% Total securities $ 28,802 5.49% $ 24,321 6.14% $ 9,771 4.67% $3,386 4.72% $66,280 5.57% Note: Yield on non-taxable municipals securities are not a fully tax equivalent basis. </TABLE> Loans Total gross loans decreased 2% to $231,347,000 at March 31, 1999, as compared to $236,402,000 at December 31, 1998. The decrease in loan balances was due to the payoff of loans related to the consumer credit card portfolio. The following table indicates the Company's loan portfolio for the periods indicated: <TABLE> <CAPTION> March 31, % of December 31, % of (Dollars in thousands) 1999 Total 1998 Total <S> <C> <C> <C> <C> Commercial $ 89,240 39% $ 79,567 34% Real estate - mortgage 58,239 25% 57,216 24% Real estate - land and construction 53,286 23% 49,270 21% Consumer 30,582 13% 50,349 21% Total loans 231,347 100% 236,402 100% Deferred loan fees (73) (95) Allowance for loan losses (4,277) (3,825) Loans, net $ 226,997 $ 232,482 </TABLE> The change in the Company's loan portfolio is primarily due to the increase in the commercial loan portfolio offset by a decline in the consumer credit card portfolio.
The Company's loan portfolio is concentrated in commercial (primarily manufacturing, wholesale, and service) and real estate lending, with the balance in consumer loans. Due to increased customer dispersion outside of the Company's primary market area attributed to the introduction of the internet credit card, the Company has decreased the geographic risks inherent in its loan portfolio. However, while no specific industry concentration is considered significant, the Company's lending operations are located in the Company's market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company's borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers' abilities to repay their loans. In February 1998, the Company entered into a contract with Internet Access Financial Corporation to provide a credit card over the Internet. The customers for the credit cards were not limited to Northern California, the Company's primarily market area, as the product was available to anyone across the country. The growth in 1998 in the consumer loan portfolio was attributable to the introduction of this Internet credit card. As noted in the above table, the consumer loans category declined from $50,349,000 to $30,582,000 as of March 31, 1999. The decline is due to the credit card owners reducing their liability. As of March 31, 1999, the Company had $2,269,000 in non-accrual loans. At March 31, 1999, the Company had no non-accrual loans. At March 31, 1999, the Company had no assets classified as "Other Real Estate Owned." As of March 31,1999, the Company had no troubled debt restructuring and no loans 90 days past due and still accruing. The increase in the total loan portfolio is primarily responsible for the increase in non-performing assets. Allowance for Loan Losses Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. Management has established an evaluation process designed to determine the adequacy of the allowance for loan losses. This process attempts to assess the risk of loss inherent in the portfolio by segregating the allowance for loan losses into four components: "watch", "special mention", "substandard" and "doubtful". It is the policy of management to maintain the allowance for possible loan losses at a level adequate for known and future risks inherent in the loan portfolio. Based on information currently available to analyze loan loss delinquency and a history of actual charge-offs, management believes that the loan loss provision and allowance are adequate; however, no assurance of the ultimate level of credit losses can be given with any certainty. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely. The following table summarizes the Company's loan loss experience as well as transactions in the allowance for loan losses and certain pertinent ratios for the periods indicated: <TABLE> <CAPTION> Year ended Three months ended March 31, December 31, (Dollars in thousands) 1999 1998 1998 <S> <C> <C> <C> Balance, beginning of period/year $ 3,825 $ 2,285 $ 2,285 Charge-offs (191) --- (173) Less recoveries --- 95 137 Net loans charged-off (191) 95 (36) Provision for loan losses 643 160 1,576 Balance, end of period / year $ 4,277 $ 2,540 $ 3,825 Ratios: Net charge-offs to average loans outstanding 0.08% (0.07)% 0.02% Allowance for loan losses to average loans 1.84% 1.93% 2.11% Allowance for loan losses to total loans 1.85% 1.78% 1.62% Allowance for loan losses to non-performing loans 188.49% N/A 297.04% </TABLE> The increase in charge-offs relates primarily to the Company's consumer credit card portfolio.
The following table summarizes the allocation of the allowance for possible loan losses by loan type and the allocated allowance as a percent of loans outstanding in each loan category at the dates indicated: <TABLE> <CAPTION> March 31, 1999 December 31, 1998 Percent of Loan Percent of loan each category to each category to (Dollars in thousands) Amount total loans Amount total loans <S> <C> <C> <C> <C> Commercial $ 1,829 2.05% $ 1,567 1.98% Real estate - mortgage 231 0.40% 224 0.39% Real estate - land and construction 917 1.72% 815 1.65% Consumer 1,013 3.31% 1,146 2.28% Unallocated 287 -- 73 -- Total $ 4,277 1.85% $ 3,825 1.62% </TABLE> The increase in the loan loss reserve reflects increasing in a percentage basis the reserve for the Company's consumer credit card portfolio. It also reflects the increased non-performing assets in the general loan portfolio. The Company maintains an allowance for possible loan losses to provide for estimated losses in the loan portfolio. Additions to the allowance are made by charges to operating expenses in the form of a provision for loan losses. All loans that are judged to be uncollectable are charged against the allowance and any recoveries are credited to the allowance. Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. The unallocated allowance is based upon management's evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The conditions evaluated in connection with the unallocated allowance may include existing general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle, and bank regulatory examination results. Deposits Deposits totaled $322,047,000 at March 31, 1999, a decrease of 8%, as compared to total deposits of $350,047,000 at December 31, 1998. The decrease in deposits was primarily due to the sale of the bankruptcy deposits. Noninterest bearing deposits were $107,050,000 at March 31, 1999, a decrease of 11% as compared to $120,854,000 at December 31, 1998. Interest bearing deposits were $214,997,000 at March 31, 1999, a decrease of 6% as compared to $229,193,000 at December 31, 1998. <TABLE> <CAPTION> The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated: Three months ended Year ended March 31, 1999 December 31,1998 Average Average Average Average (Dollars in thousands) Balance Rate Paid Balace Rate Paid <S> <C> <C> <C> <C> Demand, non-interest bearing $ 96,908 --- $ 102,834 --- Demand, interest bearing 9,464 1.47% 7,368 1.85% Saving and money market 131,273 3.05% 122,157 3.46% Time deposits, $100,000 and over 52,678 4.85% 48,861 5.04% Time deposits,less than $100,000 32,591 5.30% 16,638 5.28% Brokered deposits 6,167 5.44% 3,826 5.87% Total average deposits $ 329,081 2.64% 301,684 2.63% </TABLE>
Deposit Concentration and Deposit Volatility The following table indicates the maturity schedule of the Company's time deposits of $100,000 or more as of March 31, 1999: <TABLE> <CAPTION> (Dollars in thousands) Balance % of Total <S> <C> <C> Three months or less $ 36,935 60% Over three months through twelve months 23,236 38% Over twelve months 900 2% Total $ 61,071 100% </TABLE> The Company focuses primarily on servicing business accounts that are frequently over $100,000 in average size. Certain types of accounts that the Company makes available are typically in excess of $100,000 in average balance per account, and certain types of business clients whom the Company serves typically carry deposits in excess of $100,000 on average. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals. Interest Rate Risk The planning of asset and liability maturities and the matching of interest rates to correspond with this maturity matching is an integral part of the active management of an institution's net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates in relatively short maturities The following table sets forth the interest rate sensitivity of the Company's interest-earning assets and interest-bearing liabilities as of March 31, 1999, using the rate sensitivity gap ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or when it is scheduled to mature within the specified time frame: <TABLE> <CAPTION> <S> <C> <C> <C> <C> <C> <C> Within Due in Three Due After Three to Twelve One to Five Due After Not Rate- (Dollars in thousands) Months Months Years Five Years Sensitive Total Interest earning assets: Federal funds sold $ 14,415 $ --- $ --- $ --- $ --- $ 14,415 Securities 5,523 23,278 24,322 13,157 --- 66,280 Total loans 190,795 12,878 24,867 15,040 --- 243,580 Total interest earning assets 210,733 36,156 49,189 28,197 --- 324,275 Cash and due from banks 14,837 14,837 Other assets 19,256 19,256 Total assets $ 210,733 $ 36,156 $ 49,189 $ 28,197 $ 34,093 $ 358,368 Interest bearing liabilities: Demand, interest bearing $ 8,994 $ --- $ --- $ --- $ --- $ 8,994 Savings and money market 113,589 --- --- --- --- 113,589 Time deposits 48,376 42,682 1,356 --- --- 92,414 Total interest bearing liabilities 170,959 42,682 1,356 --- --- 214,997 Noninterest demand deposits 107,049 107,049 Other liabilities 5,393 5,393 Shareholders' equity 30,929 30,929 Total liabilities and shareholders' equity $ 170,959 $ 42,682 $ 1,356 $ --- $ 143,371 $ 358,368 Interest rate sensitivity GAP $ 39,774 $ (6,526) $47,833 $ 28,197 $(109,278) --- Cumulative interest rate sensitivity GAP $ 39,774 $ 33,248 $81,081 $109,278 --- --- Cumulative interest rate sensitivity GAP ratio 11.10% 9.28% 22.63% 30.49% </TABLE>
The foregoing table demonstrates that the Company had a positive cumulative one year gap of $33 million, or 9.28% of total assets, at March 31, 1999. In theory, this would indicate that $33 million more in assets than liabilities would reprice if there was a change in interest rates over the next year. If interest rates were to increase, the positive gap would tend to result in a higher net interest margin. However, changes in the mix of earning assets or supporting liabilities can either increase or decrease the net margin without affecting interest rate sensitivity. This characteristic is referred to as a basis risk and, generally, relates to the repricing characteristics of short-term funding sources such as certificates of deposit. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities which are not reflected in the interest sensitivity analysis table. These prepayments may have significant effects on the Company's net interest margin. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the Company's exposure to changes in interest rates. liquidity and Liability Management To meet liquidity need, the Company maintains a portion of its funds in cash deposits in other banks, in Federal funds sold, and in investment securities. As of March 31, 1999, the Company's primary liquidity ratio was 15.2%, comprised of $45.4 million in investment securities available-for-sale of maturities (or probable calls) of up to five years, less $30.3 million of securities that were pledged to secure public and certain other deposits as required by law and contract; Federal funds sold of $14.4 million , and $14.8 million in cash and due from banks, as a percentage of total unsecured deposits of $291.8 million. Capital Resources The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company: <TABLE> <CAPTION> March 31, December 31, (Dollars in thousands) 1999 1998 1998 <S> <C> <C> <C> <C> Capital components: Tier 1 Capital $ 30,535 $ 22,354 $ 29,850 Tier 2 Capital 3,713 2,540 3,825 Total risk-based capital $ 34,248 $ 24,894 $ 33,675 Risk-weighted assets $ 296,388 $ 170,353 $ 323,688 Average assets $ 366,918 $ 265,791 $ 332,062 Minimum Regulatory Requirements Capital ratios: Total risk-based capital 11.6% 14.6% 10.4% 8.0% Tier 1 risk-based capital 10.3% 13.1% 9.2% 4.0% Leverage ratio (1) 8.3% 8.4% 9.0% 4.0% (1) Tier 1 capital divided by average assets (excluding goodwill). </TABLE> On April 29, 1999, the Company filed with the SEC a registration statement for $10 million in common stock offered by the Company. The offering will be made on a best-efforts basis by the officers and directors of the Company and is not underwritten. If the offering is successful, the Company intends to use the proceeds to capitalize a new bank in Morgan Hill, California, and for general corporate purposes. The registration statement has not become effective. The securities may not be sold nor may offers to buy be accepted before the registration statement becomes effective. This report does not constitute an offer to sell or the solicitation of an offer to buy nor shall there be any sale of the securities in any state in which an offer, solicitation or sale would be unlawful before registration or qualification under the securities laws of any such state.
Year 2000 The possible inability of computers, software, and other equipment utilizing microprocessors to recognize and properly process data fields containing a two-digit year is commonly referred to as the year 2000 problem. On January 1, 2000, such systems may be unable to accurately process certain date-based information. This discussion of the implications of the year 2000 problem for the Company contains numerous forward-looking statements based on inherently uncertain information. The cost of the project and the date on which the Company plans to complete the internal year 2000 modifications are based on management's best estimates of future events. The Company cannot guarantee these estimates and actual results could differ. Although management believes it will be able to make the necessary modifications in advance, failure to modify the systems may have a material adverse effect on the Company. The Company has developed a plan to assess its year 2000 preparedness, consisting of the following phases: - Awareness of the year 2000 problems - Risk assessment of internal and external systems - Renovation of problems found in the risk assessment phase - Validation of renovated systems - Implementation of validated systems Resolution of the year 2000 problem is among the Company's highest priorities, and the Company is preparing for the century change with a comprehensive enterprise-wide year 2000 program. The Company has identified all of the major systems and has sought external and internal resources to renovate and test the systems. The Company is testing purchased software and systems supported by external parties as part of the program. The Company is evaluating customers and vendors that have significant relationships with the Company to determine whether they are adequately preparing for the year 2000. In addition, the Company is developing contingency plans to reduce the impact of some potential events that may occur. The Company cannot guarantee, however, that the systems of vendors or customers with whom it does business will be completed on a timely basis, or that contingency plans will shield operations from failures that may occur. The Company has identified over 90 individual year 2000 projects. The projects vary in size, importance and materiality, from large undertakings, such as remediating complicated data systems, to smaller, but still important, projects such as installing compliant computer utility systems. All of the projects currently identified have begun, and approximately 90% have been completed. The Company assigns projects a priority, indicating the importance of the function to the Company's continuing operation. This prioritization facilitates reporting on projects based on their relative importance. The Company has prioritized projects as "High Priority - IN House", "High Priority - Not In House" and "Medium Priority". Both High Priority categories have projects classified as "Mission Critical". Mission Critical projects are defined as: - systems vital to the continuance of a broad core business activity; - functions, the interruption of which for longer than 3 days would threaten the Company's viability; or - functions that provide the environment and infrastructure necessary to continue the broad core business activities. Testing of all mission critical systems was complete as of March 12, 1999 and the Company has completed a follow-up assessment of many of its clients' year 2000 preparedness. Currently, the Company's focus is on vendor follow-up and contingency plans. The Company has communicated with all vendors with whom it does significant business to determine their year 2000 compliance readiness and the extent to which the Company is vulnerable to any third-party year 2000 risks. Of all the vendors that present year 2000 risks, approximately 75% have passed testing. The Company does not significantly rely on "embedded technology" in its critical processes. All building systems in the Company's main offices use mechanical systems rather than embedded technology and therefore do not pose any year 2000 risks.
Risks The principal risks associated with the year 2000 problem can be grouped into three categories: - the Company does not successfully ready its operations for the next century, - disruption of the Company's operations due to operational failures of third parties, and - business interruption among fund providers and obligors such that expected funding and repayment does not take place The only risk largely under the Company's control is preparing the Company's internal operations for the year 2000. The Company, like other financial institutions, is heavily dependent on its computer systems. The complexity of these systems and their interdependence make it impractical to convert to alternative systems without interruptions if necessary modifications are not completed on schedule. Management believes the Company will be able to make the necessary modifications on schedule. Failure of third parties may jeopardize the Company's operations, but the seriousness of this risk depends on the nature and duration of the failures. The most serious impact on the Company's operations from vendors would result if basic services such as telecommunications, electric power, and services provided by other financial institutions and governmental agencies were disrupted. Some public disclosure about readiness preparation among basic infrastructure and other suppliers is now available. The Company is unable, however, to estimate the likelihood of significant disruptions among its basic infrastructure suppliers. In view of the unknown probability of occurrence and impact on its operations, the Company considers the loss of basic infrastructure services to be the most reasonably likely worst case year 2000 scenario. Operational failures among the Company's customers could affect their ability to continue to provide funding or meet obligations when due. The information the Company develops in the customer assessments described earlier allows the Company to identify those customers that exhibit a risk of not making adequate preparations for the century change. The Company is taking appropriate actions to manage these risks. Contingency Plans The Company is developing year 2000 remediation contingency plans and business resumption contingency plans specific to the year 2000. Remediation contingency plans address the actions the Company would take if the current approach to remediating a system is falling behind schedule or otherwise appears to be in jeopardy of failing to deliver year 2000-ready systems when needed. Business resumption contingency plans address the actions that the Company would take if critical business functions cannot be carried out in the normal manner upon entering the next century due to system or supplier failure. Cost The total cost to the Company of year 2000 compliance issues, which includes testing, system replacement and any anticipated lost revenue, has been approximately $20,000 and is not anticipated to increase substantially through the completion of all projects. These costs and the date on which the Company plans to complete the Year 2000 modifications and testing process are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third-party modification plans, and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ from those plans. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK No material changes have occurred during the quarter to the Company's market risk profile or information. For further information refer to the Company's annual report on Form 10-K.
Part II - Other Information Item 1. - Legal Proceedings To the best of the Company's knowledge, there are no pending legal proceedings to which the Company is a party which may have a materially adverse effect on the Company's financial condition, results of operations, or cash flows. Item 2. - Changes in Securities and Use of Proceeds Not Applicable Item 3. - Defaults Upon Senior Securities Not Applicable Item 4. - Submission of Matters to a Vote of Security Holders Not Applicable Item 5. - Other Information Not Applicable Item 6. - Exhibits and Reports on Form 8-K (a) Exhibits included with this filing: Exhibit Number Name 10.1 Employment agreement January 1, 1999 with John E. Rossell 10.2 Employment agreement January 1, 1999 with Brad L. Smith 27.1 Financial Data Schedule (b) Reports on Form 8-K On January 6, 1999, the Company filed Form 8-K to report the appointment of Brad L. Smith as chairman and related management information. On January 29,1999, the Company filed Form 8-K to report year-end earnings and a three-for-two stock split. On April 27, 1999, the Company filed its quarterly earnings press release with the SEC on Form 8-K.
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. Heritage Commerce Corp (Registrant) May 13, 1999 /s/ John E. Rossell Date John E. Rossell, III, President and CEO May 13, 1999 /s/ Lawrence D. McGovern Date Lawrence D. McGovern, Chief Financial Officer