================================================================================ 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 June 30, 2001. / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ____________ to ____________. Commission File Number 0-20288 ------- COLUMBIA BANKING SYSTEM, INC. ----------------------------- (Exact name of issuer as specified in its charter) Washington 91-1422237 - -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 1301 "A" Street Tacoma, Washington 98402 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (253) 305-1900 - -------------------------------------------------------------------------------- (Issuer's telephone number, including area code) 1102 Broadway Plaza Tacoma, Washington 98402 - -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the issuer: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares of the issuer's Common Stock outstanding at July 31, 2001 was 13,130,121 ================================================================================
TABLE OF CONTENTS PART I -- FINANCIAL INFORMATION Page Item 1. Condensed unaudited Financial statements Consolidated Condensed Statements of Operations - three months and six months ended June 30, 2001 and 2000 2 Consolidated Condensed Balance Sheets - June 30, 2001 and December 31, 2000 3 Consolidated Condensed Statements of Shareholders' Equity - twelve months ended December 31, 2000, and six months ended June 30, 2001 4 Consolidated Condensed Statements of Cash Flows - six months ended June 30, 2001 and 2000 5 Notes to Consolidated Condensed Financial statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 9 Item 3. Quantitative and Qualitative Disclosures about Market Risk 21 PART II -- OTHER INFORMATION Item 4. Submission of matters to a vote of security holders 22 Item 6. Exhibits and reports on Form 8-K 22 Signatures 23 1
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS Columbia Banking System, Inc. (Unaudited) <TABLE><CAPTION> Three Months Ended Six Months Ended June 30, June 30, (in thousands except per share) 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Interest Income Loans $ 25,534 $ 25,516 $ 51,892 $ 48,859 Securities available for sale 1,420 1,390 2,897 2,779 Securities held to maturity 67 67 135 131 Deposits with banks 94 37 838 54 - ---------------------------------------------------------------------------------------------- Total interest income 27,115 27,010 55,762 51,823 Interest Expense Deposits 11,995 11,287 25,569 21,296 Federal Home Loan Bank advances 623 1,141 1,313 2,032 Other borrowings 126 133 240 192 - ---------------------------------------------------------------------------------------------- Total interest expense 12,744 12,561 27,122 23,520 - ---------------------------------------------------------------------------------------------- Net Interest Income 14,371 14,449 28,640 28,303 Provision for loan losses 900 900 1,800 1,800 - ---------------------------------------------------------------------------------------------- Net interest income after provision for loan losses 13,471 13,549 26,840 26,503 Noninterest Income Service charges and other fees 1,755 1,488 3,351 3,016 Mortgage banking 640 245 1,201 400 Merchant services fees 1,121 910 2,063 1,682 Gain on sale of investment securities, net 60 37 Other 278 264 527 402 - ---------------------------------------------------------------------------------------------- Total noninterest income 3,854 2,907 7,179 5,500 Noninterest Expense Compensation and employee benefits 6,714 5,736 13,143 11,310 Occupancy 1,955 1,542 3,576 3,133 Merchant processing 439 495 966 889 Advertising and promotion 457 371 797 812 Data processing 468 564 930 1,093 Taxes, licenses & fees 523 588 1,069 1,016 Other 2,602 1,988 4,609 3,854 - ---------------------------------------------------------------------------------------------- Total noninterest expense 13,158 11,284 25,090 22,107 - ---------------------------------------------------------------------------------------------- Income before income taxes 4,167 5,172 8,929 9,896 Provision for income taxes 1,424 1,781 3,057 3,409 - ---------------------------------------------------------------------------------------------- Net Income $ 2,743 $ 3,391 $ 5,872 $ 6,487 ============================================================================================== Net income per common share: Basic $ 0.21 $ 0.27 $ 0.45 $ 0.51 Diluted 0.21 0.26 0.45 0.49 Average number of common shares outstanding 12,982 12,728 12,961 12,725 Average number of diluted common shares outstanding 13,200 13,108 13,186 13,114 </TABLE> See accompanying notes to consolidated condensed financial statements. 2
CONSOLIDATED CONDENSED BALANCE SHEETS Columbia Banking System, Inc. (Unaudited) <TABLE><CAPTION> June 30, December 31, (in thousands) 2001 2000 - ---------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Assets Cash and due from banks $ 60,142 $ 72,292 Interest-earning deposits with banks 3,579 48,153 - ---------------------------------------------------------------------------------------------- Total cash and cash equivalents 63,721 120,445 Securities available for sale (at fair value) 74,221 103,287 Securities held to maturity (fair value of $7,465 and $7,501 respectively) 7,334 7,435 Federal Home Loan Bank stock 8,827 8,539 Loans held for sale 24,912 14,843 Loans, net of unearned income 1,210,290 1,192,520 Less: allowance for loan losses 19,224 18,791 - ---------------------------------------------------------------------------------------------- Loans, net 1,191,066 1,173,729 Interest receivable 8,034 10,306 Premises and equipment, net 50,561 48,357 Real estate owned 2,239 1,291 Other 24,944 8,263 - ---------------------------------------------------------------------------------------------- Total Assets $ 1,455,859 $ 1,496,495 ============================================================================================== Liabilities and Shareholders' Equity Deposits: Noninterest-bearing $ 227,095 $ 232,247 Interest-bearing 1,036,292 1,094,776 - ---------------------------------------------------------------------------------------------- Total deposits 1,263,387 1,327,023 Federal Home Loan Bank advances 51,700 40,000 Other borrowings 8,000 4,500 Other liabilities 11,579 11,149 - ---------------------------------------------------------------------------------------------- Total liabilities 1,334,666 1,382,672 Shareholders' equity: Preferred stock (no par value) Authorized, 2 million shares; none outstanding June 30, December 31, Common stock (no par value) 2001 2000 ------------ ------------ Authorized shares 57,173 51,975 Issued and outstanding 13,118 11,867 109,747 92,673 Retained earnings 11,138 21,649 Accumulated other comprehensive income (loss) - Unrealized gains (losses) on securities available for sale, net of tax 308 (499) - ---------------------------------------------------------------------------------------------- Total shareholders' equity 121,193 113,823 - ---------------------------------------------------------------------------------------------- Total Liabilities and Shareholders' Equity $ 1,455,859 $ 1,496,495 ============================================================================================== </TABLE> See accompanying notes to consolidated condensed financial statements. 3
CONSOLIDATED CONDENSED STATEMENTS OF SHAREHOLDERS' EQUITY Columbia Banking System, Inc. (Unaudited) <TABLE><CAPTION> Common stock Accumulated -------------------------- Other Total Number of Retained Comprehensive Shareholders' (in thousands) Shares Amount Earnings Income (Loss) Equity - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Balance at January 1, 2000 10,603 $ 78,285 $ 23,916 $ (2,987) $ 99,214 Comprehensive income: Net income for 2000 10,070 Change in unrealized gains and (losses) on securities available for sale, net of tax of $1,295 2,488 Total comprehensive income 12,558 Issuance of stock under stock option and other plans 203 1,673 1,673 Tax benefits from exercise of stock options 378 378 Issuance of shares of common stock-- 10% stock dividend 1,061 12,337 (12,337) - -------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2000 11,867 92,673 21,649 (499) 113,823 - -------------------------------------------------------------------------------------------------------------------------- Comprehensive income: Net income for 2001 5,872 Change in unrealized gains and (losses) On securities available for sale, net of tax of $435 807 Total comprehensive income 6,679 Issuance of stock under stock option and other plans 59 691 691 Issuance of shares of common stock-- 10% stock dividend 1,192 16,383 (16,383) - -------------------------------------------------------------------------------------------------------------------------- Balance at June 30, 2001 13,118 $ 109,747 $ 11,138 $ 308 $ 121,193 ========================================================================================================================== </TABLE> See accompanying notes to consolidated condensed financial statements. 4
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS Columbia Banking System, Inc. (Unaudited) <TABLE><CAPTION> Six Months Ended June 30, (in thousands) 2001 2000 - ------------------------------------------------------------------------------------------------------------ <S> <C> <C> Operating Activities Net income $ 5,872 $ 6,487 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 1,800 1,800 Depreciation and amortization 925 1,048 Deferred income tax (benefit) expense 297 (75) Net realized (gains) losses on sale of assets (25) 1 Increase in loans held for sale (10,069) (8,162) Decrease in interest receivable 2,272 (1,673) Net changes in other assets and liabilities (16,921) 2,679 - ------------------------------------------------------------------------------------------------------------ Net cash provided by operating activities 15,849 2,105 Investing Activities Proceeds from sales of securities available for sale 56,687 Proceeds from maturities of securities available for sale 17,602 23 Purchases of securities available for sale (34,319) Proceeds from sales of mortgage-backed securities available for sale 10,376 Proceeds from maturities of mortgage-backed securities available for sale 725 324 Purchase of mortgage-backed securities available for sale (20,927) Proceeds from maturities of securities held to maturity 100 280 Purchases of securities held to maturity (291) Purchases of Federal Home Loan Bank stock (288) (1,351) Loans originated and acquired, net of principal collected (19,186) (107,988) Purchases of premises and equipment (4,344) (10,453) Other, net 445 6 - ------------------------------------------------------------------------------------------------------------ Net cash provided (used) by investing activities 6,870 (119,450) Financing Activities Net (decrease) increase in deposits (63,636) 135,438 Net increase in other borrowings 3,500 3,500 Net increase (decrease) in Federal Home Loan Bank advances 11,700 (4,700) Tax benefits from exercise of stock options 378 Proceeds from issuance of common stock, net 691 331 - ------------------------------------------------------------------------------------------------------------ Net cash provided (used) by financing activities (47,745) 134,947 - ------------------------------------------------------------------------------------------------------------ Increase (decrease) in cash and cash equivalents (56,724) 17,602 Cash and cash equivalents at beginning of period 120,445 43,197 - ------------------------------------------------------------------------------------------------------------ Cash and cash equivalents at end of period $ 63,721 $ 60,799 ============================================================================================================ Supplemental information: Cash paid for interest $ 26,802 $ 20,024 Cash paid for income taxes 3,048 4,025 Loans foreclosed and transferred to real estate owned 948 22 See accompanying notes to consolidated condensed financial statements. </TABLE> 5
NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS Columbia Banking System, Inc. Columbia Banking System, Inc. (the "Company") is a registered bank holding company whose wholly owned subsidiary, Columbia State Bank ("Columbia Bank"), conducts a full-service commercial banking business. Headquartered in Tacoma, Washington, the Company provides a full range of banking services to small and medium-sized businesses, professionals and other individuals through banking offices located in the Tacoma metropolitan area and contiguous parts of the Puget Sound region of Washington, as well as the Longview and Woodland communities in southwestern Washington. Substantially all of the Company's loans, loan commitments and core deposits are geographically concentrated in its service areas. 1. BASIS OF PRESENTATION The interim unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for condensed interim financial information and with instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments consisting only of normal recurring accruals necessary for a fair presentation of the financial condition and the results of operations for the interim periods included herein have been made. The results of operations for the three months ended June 30, 2001, are not necessarily indicative of results to be anticipated for the year ending December 31, 2001. For additional information, refer to the consolidated financial statements and footnotes thereto included in the Company's annual report on Form 10-K for the year ended December 31, 2000. 2. EARNINGS PER SHARE Earnings per share ("EPS") is computed using the weighted average number of common and diluted common shares outstanding during the period. Basic EPS is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. The only reconciling item affecting the calculation of earnings per share is the inclusion of stock options and restricted stock awards increasing the shares outstanding in diluted earnings per share of 218,000 and 380,000 for the three months ended June 30, 2001 and 2000, respectively, and 225,000 and 389,000 for the six months ended June 30, 2001 and 2000, respectively 3. STOCK DIVIDEND On May 15, 2001, the Company announced a 10% stock dividend payable on June 12, 2001, to shareholders of record as of May 29, 2001. Average shares outstanding and net income per share for all periods presented have been retroactively adjusted to give effect to this transaction. 4. BUSINESS SEGMENT INFORMATION The Company is managed along three major lines of business: commercial banking, retail banking, and real estate lending. The treasury function of the Company, although not considered a line of business, is responsible for the management of investments and interest rate risk. The principal activities conducted by commercial banking are the delivery of commercial business and private banking services with the emphasis on commercial business loans. Retail banking includes all deposit products, with their related fee income, and all consumer loan products as well as commercial loan products offered in the Bank's branch offices. Real estate lending includes single-family residential, multi-family residential, and commercial real estate loans, and the associated loan servicing activities. 6
The financial results of each segment were derived from the Company's general ledger system. Since the Company is not specifically organized around lines of business, most reportable segments are comprised of more than one operating segment. Expenses incurred directly by sales and back office support functions are not allocated to the major lines of business. Since Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information," requires no segmentation or methodology standardization, the organizational structure of the Company and its business line financial results are not necessarily comparable across companies. As such, the Company's business line performance may not be directly comparable with similar information from other financial institutions. Financial highlights by lines of business: <TABLE><CAPTION> CONDENSED STATEMENTS OF OPERATIONS: THREE MONTHS ENDED JUNE 30, 2001 Commercial Retail Real Estate (in thousands) Banking Banking Lending Other Total - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Net interest income after provision for loan losses $ 3,175 $ 7,648 $ 3,193 $ (545) $ 13,471 Other income 158 1,224 649 1,823 3,854 Other expense (630) (5,198) (680) (6,650) (13,158) - -------------------------------------------------------------------------------------------------------------------------- Contribution to overhead and profit $ 2,703 $ 3,674 $ 3,162 $ (5,372) 4,167 Income taxes (1,424) - -------------------------------------------------------------------------------------------------------------------------- Net income $ 2,743 ========================================================================================================================== Total assets $ 325,808 $ 646,165 $ 333,627 $ 150,259 $ 1,455,859 ========================================================================================================================== THREE MONTHS ENDED JUNE 30, 2000 Commercial Retail Real Estate (in thousands) Banking Banking Lending Other Total - -------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses $ 2,420 $ 10,764 $ 1,391 $ (1,026) $ 13,549 Other income 141 1,048 247 1,471 2,907 Other expense (415) (3,394) (511) (6,964) (11,284) - -------------------------------------------------------------------------------------------------------------------------- Contribution to overhead and profit $ 2,146 $ 8,418 $ 1,127 $ (6,519) 5,172 Income taxes (1,781) - -------------------------------------------------------------------------------------------------------------------------- Net income $ 3,391 ========================================================================================================================== Total assets $ 363,174 $ 587,697 $ 301,560 $ 129,084 $ 1,381,515 ========================================================================================================================== </TABLE> 7
<TABLE> <CAPTION> SIX MONTHS ENDED JUNE 30, 2001 Commercial Retail Real Estate (in thousands) Banking Banking Lending Other Total - -------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> Net interest income after provision for loan losses $ 5,919 $ 16,627 $ 5,643 $ (1,349) $ 26,840 Other income 304 2,339 1,225 3,311 7,179 Other expense (1,300) (10,097) (1,220) (12,473) (25,090) - -------------------------------------------------------------------------------------------------------------------------- Contribution to overhead and profit $ 4,923 $ 8,869 $ 5,648 $ (10,511) 8,929 Income taxes (3,057) - -------------------------------------------------------------------------------------------------------------------------- Net income $ 5,872 ========================================================================================================================== Total assets $ 325,808 $ 646,165 $ 333,627 $ 150,259 $ 1,455,859 ========================================================================================================================== SIX MONTHS ENDED JUNE 30, 2000 Commercial Retail Real Estate (in thousands) Banking Banking Lending Other Total - -------------------------------------------------------------------------------------------------------------------------- Net interest income after provision for loan losses $ 4,899 $ 20,393 $ 2,950 $ (1,739) $ 26,503 Other income 296 2,064 404 2,736 5,500 Other expense (1,044) (6,883) (1,041) (13,139) (22,107) - -------------------------------------------------------------------------------------------------------------------------- Contribution to overhead and profit $ 4,151 $ 15,574 $ 2,313 $ (12,142) 9,896 Income taxes (3,409) - -------------------------------------------------------------------------------------------------------------------------- Net income $ 6,487 ========================================================================================================================== Total assets $ 363,174 $ 587,697 $ 301,560 $ 129,084 $ 1,381,515 ========================================================================================================================== </TABLE> 5. Subsequent Event On August 9, 2001, the Company announced that it has received $22 million from its participation in a pooled trust preferred offering, in which it issued long-term floating rate capital securities with an initial rate of 7.29%. The Company also announced that its Board of Directors has approved a stock repurchase program, which will be funded by up to $9 million of the proceeds from the pooled trust preferred transaction. Under the stock repurchase program, the Company may systematically purchase up to 660,000 of its outstanding shares of Common Stock. These shares represent approximately 5% of the 13.1 million common shares outstanding. The Company intends to purchase the shares from time to time in the open market, under conditions which allow such repurchases to be accretive to earnings while maintaining capital ratios that exceed the guidelines for a well-capitalized financial institution. The remaining proceeds from the pooled trust preferred transaction will be used to retire outstanding short-term debt and for working capital. 8
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Columbia Banking System, Inc. This discussion should be read in conjunction with the unaudited consolidated condensed financial statements of Columbia Banking System, Inc. (the "Company") and notes thereto presented elsewhere in this report. In the following discussion, unless otherwise noted, references to increases or decreases in average balances in items of income and expense for a particular period and balances at a particular date refer to the comparison with corresponding amounts for the period or date one year earlier. THIS FORM 10-Q INCLUDES FORWARD LOOKING STATEMENTS, WHICH MANAGEMENT BELIEVES ARE A BENEFIT TO SHAREHOLDERS. THESE FORWARD LOOKING STATEMENTS DESCRIBE COLUMBIA'S MANAGEMENT'S EXPECTATIONS REGARDING FUTURE EVENTS AND DEVELOPMENTS SUCH AS FUTURE OPERATING RESULTS, GROWTH IN LOANS AND DEPOSITS, CONTINUED SUCCESS OF COLUMBIA'S STYLE OF BANKING AND THE STRENGTH OF THE LOCAL ECONOMY. THE WORDS "WILL," "BELIEVE," "EXPECT," "SHOULD," AND "ANTICIPATE" AND WORDS OF SIMILAR CONSTRUCTION ARE INTENDED IN PART TO HELP IDENTIFY FORWARD LOOKING STATEMENTS. FUTURE EVENTS ARE DIFFICULT TO PREDICT, AND THE EXPECTATIONS DESCRIBED ABOVE ARE NECESSARILY SUBJECT TO RISK AND UNCERTAINTY THAT MAY CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY AND ADVERSELY. IN ADDITION TO DISCUSSIONS ABOUT RISKS AND UNCERTAINTIES SET FORTH FROM TIME TO TIME IN COLUMBIA'S FILINGS WITH THE SEC, FACTORS THAT MAY CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE CONTEMPLATED BY SUCH FORWARD LOOKING STATEMENTS INCLUDE, AMONG OTHERS, THE FOLLOWING POSSIBILITIES: (1) LOCAL AND NATIONAL GENERAL AND ECONOMIC CONDITIONS ARE LESS FAVORABLE THAN EXPECTED OR HAVE A MORE DIRECT AND PRONOUNCED EFFECT ON COLUMBIA THAN EXPECTED AND ADVERSELY AFFECT COLUMBIA'S ABILITY TO CONTINUE ITS INTERNAL GROWTH AT HISTORICAL RATES AND MAINTAIN THE QUALITY OF ITS EARNING ASSETS; (2) CHANGES IN INTEREST RATES REDUCE INTEREST MARGINS MORE THAN EXPECTED AND NEGATIVELY AFFECT FUNDING SOURCES; (3) PROJECTED BUSINESS INCREASES FOLLOWING STRATEGIC EXPANSION OR OPENING OR ACQUIRING NEW BRANCHES ARE LOWER THAN EXPECTED; (4) COSTS OR DIFFICULTIES RELATED TO THE INTEGRATION OF ACQUISITIONS ARE GREATER THAN EXPECTED; (5) COMPETITIVE PRESSURE AMONG FINANCIAL INSTITUTIONS INCREASES SIGNIFICANTLY; AND (6) LEGISLATION OR REGULATORY REQUIREMENTS OR CHANGES ADVERSELY AFFECT THE BUSINESSES IN WHICH COLUMBIA IS ENGAGED. OVERVIEW Columbia Banking System, Inc. (the "Company") is a registered bank holding company whose wholly owned subsidiary, Columbia State Bank ("Columbia Bank"), conducts a full-service commercial banking business. Headquartered in Tacoma, Washington, the Company provides a full range of banking services to small and medium-sized businesses, professionals and other individuals through 30 banking offices located in the Tacoma metropolitan area and contiguous parts of the Puget Sound region of Washington, as well as the Longview and Woodland communities in southwestern Washington. Substantially all of the Company's loans, loan commitments and core deposits are geographically concentrated in its service areas. Columbia Bank is a Washington state-chartered commercial bank, the deposits of which are insured by the Federal Deposit Insurance Corporation (the "FDIC"). The Bank is subject to regulation by the FDIC and the Washington State Department of Financial Institutions (Division of Banks). Although Columbia Bank is not a member of the Federal Reserve System, the Board of Governors of the Federal Reserve System has certain supervisory authority over the Company, which can also affect Columbia Bank. 9
The Company was reorganized and additional management was added in 1993 in order to take advantage of commercial banking business opportunities resulting from increased consolidation of banks in the Company's principal market area, primarily through acquisitions by out-of-state holding companies, and the resulting dislocation of customers. In the five years ended December 31, 2000, the Company has achieved significant growth in profitability, assets, loans and deposits, as shown in the following chart. At/For Year Ended Five Year Compounded (dollars in thousands) December 31, 2000 Annual Growth Rate - ---------------------- ----------------- ------------------ Net Income $ 10,070 22% Assets 1,496,495 24 Loans 1,192,520 23 Deposits 1,327,023 24 The Company's goal is to become the premier super community bank headquartered in the Pacific Northwest while establishing a significant presence in selected northwest markets. Internal growth will be augmented by strategic business combinations. The Company will build on its reputation for excellent customer service in order to be recognized in all markets it serves as the bank of choice for retail deposit customers, small to medium-sized businesses and affluent households. The Company also expects to achieve superior financial performance at the earliest practical date, consistent with development of its northwest franchise. Management believes the ongoing consolidation among financial institutions in the northwest part of the U.S. has created significant gaps in the ability of large banks operating in the states comprising that area to serve certain customers, particularly the Company's target customer base of small and medium-sized businesses, professionals and other individuals. The Company's business strategy is to provide its customers with the financial sophistication and breadth of products of a regional banking company while retaining the appeal and service level of a community bank. Management believes that as a result of the Company's strong commitment to highly personalized relationship-oriented customer service, its varied products, its strategic branch locations and the long-standing community presence of its managers, lending officers and branch personnel, it is well positioned to attract new customers and to increase its market share of loans, deposits, and other financial services in the markets it now serves and in areas contiguous to those markets. The Company has closely followed the recent changes to federal banking laws which allow financial institutions to engage in a broader range of activities than previously permitted. The new legislation also authorizes the creation of financial holding companies to facilitate such expanded activity. As the Company pursues its aggressive growth strategy, it is likely that the Company will utilize the new financial holding company structure to accommodate an expansion of its products and services. The Company intends to effect its growth strategy through a combination of growth at existing branch offices, new branch openings (usually following the hiring of an experienced branch manager and/or lending officer with strong community ties and banking relationships), Columbia On Call(TM) telephone banking, Columbia OnLine(TM) internet banking, development of complementary lines of business, and acquisitions. In particular, the Company anticipates continued expansion in Pierce County, north into King County, south into Thurston County and northwest into Kitsap County. Aggressive expansion within the Seattle and "Eastside" areas of King County was begun in 2000 with the hiring of additional experienced bankers with extensive knowledge of the market. The planned growth in King County is expected to accelerate in the second half of 2001 and beyond. 10
The Company has 30 branches; 16 in Pierce County, 8 in King County, 4 in Cowlitz County, 1 in Kitsap County, and 1 in Thurston County. Since beginning its major Pierce County expansion in August 1993, the Company has expanded from 4 branches primarily through internal growth. In February 2001, construction was completed on a permanent West Olympia facility. During the second quarter of 2001, the Company opened new branches at 84th & Pacific in Tacoma, and in Issaquah, King County. During the first half of 2001, the Company continued its planned expansion in the King County market. During the second quarter of 2001, the Company opened a new branch in Issaquah. During the third quarter of 2001, the Company expects to open a private banking and commercial banking office in downtown Seattle, continue its expansion in Bellevue, and later this year, open an office in Redmond. In addition to the King County expansion, the Company continues to expand in its traditional market areas. In Pierce County, the 84th & Pacific branch opened in May 2001. The 13th & A branch (downtown Tacoma), 11th & Martin Luther King Way branch in Tacoma and a Bonney Lake facility are targeted for completion this summer. New branches normally do not contribute to net income for many months after opening. During the second quarter of 2001, the Company moved its headquarters to a new building at 13th & A Streets in downtown Tacoma. As the named tenant, the building provides excellent visibility and additional space to accommodate growth, as well as demonstrating the Company's commitment to revitalizing the communities it serves. In addition to the ongoing expansion of its branch network, the Company continuously reviews new products and services to give its customers more financial service options. Also, new technology and services are reviewed for business development and cost saving purposes. During 2000, the Company introduced its new online banking service, "Columbia On-Line (TM)". Customers are able to conduct a full range of services on a real time basis, including balance inquiries, transfers, bill paying, loan information, and check image viewing. This online service has also enhanced the delivery of cash management services to commercial customers. In order to fund its lending activities and to allow for increased contact with customers, the Company is establishing a branch system catering primarily to retail depositors, supplemented by business customer deposits and other borrowings. The Company believes this mix of funding sources will enable it to expand lending activities rapidly while attracting a stable core deposit base. In order to support its strategy of growth, without compromising its personalized banking approach or its commitment to asset quality, the Company has made significant investments in experienced branch, lending and administrative personnel and has incurred significant costs related to its branch expansion. Although the Company's expense ratios have improved since 1993, management anticipates that the expense ratios will remain relatively high by industry standards for the foreseeable future due to the Company's aggressive growth strategy and emphasis on convenience and personal service. The economy of the Company's principal market areas, while primarily dependent upon aerospace, foreign trade and natural resources, including agriculture and timber, has become more diversified over the past decade as a result of the success of software companies such as Microsoft and the establishment of numerous research and biotechnology firms. Additionally, four military bases are located in the market areas. The Washington economy and that of the Puget Sound region generally have experienced strong growth and stability in recent years, though growth in the first half of 2001 appears to have slowed noticeably. 11
RESULTS OF OPERATIONS The results of operations of the Company are dependent to a large degree on the Company's net interest income. The Company also generates noninterest income through service charges and fees, merchant services fees, and income from mortgage banking operations. The Company's operating expenses consist primarily of compensation and employee benefits expense, and occupancy expense. Like most financial institutions, the Company's interest income and cost of funds are affected significantly by general economic conditions, particularly changes in market interest rates, and by government policies and actions of regulatory authorities. Net income for the second quarter of 2001 was $2.7 million, or $0.21 per diluted share, compared to $3.4 million, or $0.26 per diluted share, for the second quarter of 2000, a decrease in net income of 19%. Net income for the six months ended June 30, 2001, was $5.9 million, or $0.45 per diluted share, a decrease of 9% compared to $6.5 million, or $0.49 per diluted share for the same period in 2000. The earnings decrease for the second quarter and six-month periods is due primarily to a declining net interest margin as a result of the rapid decline of interest rates during the first six months of 2001. NET INTEREST INCOME Net interest income for the second quarter of 2001 decreased 1% to $14.37 million, from $14.45 million in the second quarter of 2000. For the six months ended June 30, 2001, net interest income increased 1% to $28.6 million from $28.3 million for the same period in 2000. During the first six months of 2001 interest rates decreased dramatically as the "prime rate" declined 275 basis points. As a result, the Company's loan yields, approximately 40% of which adjust immediately with a change in the prime rate, decreased rapidly. Additionally, in the third and fourth quarters of 2000, competition for deposits to fund loan demand placed upward pressure on the cost of deposits and borrowings, thus increasing the Company's cost of funding. Since reductions in deposit and other funding costs lag reductions in interest-earning asset yields, when interest rates declined during the first six months of 2001, the yield on interest-earning assets declined faster than the recently increased cost of interest-bearing liabilities. During the first six months of 2001, the Company took steps to lower its cost of deposits. The effect of these adjustments will lag the effect of reduced loan yields. Net interest margin (net interest income divided by average interest-earning assets) decreased to 4.31% in the second quarter of 2001 from 4.67% in the second quarter of 2000. Average interest-earning assets grew to $1.3 billion, or 8%, during the second quarter of 2001, compared with $1.2 billion for the same period in 2000. The yield on average interest-earning assets decreased 61 basis points (a basis point is 1/100th of 1 percent) to 8.10% during the second quarter of 2001 compared with 8.71% during the same period of 2000. In comparison, average interest-bearing liabilities grew to $1.1 billion, or 5%, compared with $1.0 billion for the same period in 2000, and the average cost of interest-bearing liabilities decreased 20 basis points to 4.64% during the second quarter of 2001 from 4.84% in the same period of 2000. For the first six months of 2001, net interest margin decreased to 4.27% from 4.71% for the same period in 2000. Average interest-earning assets grew to $1.4 billion during the first six months of 2001, compared with $1.2 billion for the same period in 2000. The yield on average interest-earning assets decreased 31 basis points to 8.29% during the first six months of 2001 from 8.60% in the same period of 2000. In comparison, average interest-bearing liabilities grew to $1.1 billion, compared with $1.0 billion for the same period in 2000, and the cost of average interest-bearing liabilities increased to 4.89% during the first six months of 2001 from 4.68% in the same period of 2000. 12
The unusually rapid decrease in interest rates during the first six months of 2001 was the primary cause for the unfavorable impact in net interest income during the first six months of 2001. The Company's net interest margin hit a low of 4.24% for the first quarter 2001 and improved to 4.31% in the second quarter. Management expects continued improvement in net interest margin during the third quarter 2001 as interest rate reductions moderate and deposit cost repricing catches up with reductions in rates on interest-earning assets. Average interest-earning assets decreased $29.1 million, or 2%, to $1.3 billion compared with the first quarter of 2001. A reduction of $50.1 million in investments was partially offset by an increase of $21 million in average loans. The yield on average interest-earning assets decreased 38 basis points to 8.10% during the second quarter from 8.48% in the first quarter of 2001, and from 8.75% in the fourth quarter of 2000. During the second quarter, average interest bearing liabilities decreased $35.8 million, or 3%, to $1.1 billion compared with the first quarter of 2001, including a decrease of $47.9 million in interest-bearing deposits which was partially offset by an increase of $12.1 million in borrowings. The cost of average interest-bearing liabilities decreased 49 basis points to 4.64% during the second quarter of 2001 from 5.13% in the first quarter of 2001, and from 5.20% in the fourth quarter of 2000. During the second quarter the Bank purchased an income stream on a group of leases. The asset is classified as an "other asset" with a face value of $5.0 million. The income is recorded monthly as "interest income". LOOKING FORWARD The decline in short term interest rates during the second quarter of 2001, and potential further reductions, will continue to reduce the yield on approximately 40% of the Company's loans in the short term. As the reductions moderate, the cost of interest-bearing liabilities should decline more rapidly than the yield on interest-earning assets, thus leading to improvement in the Company's net interest margin. Management expects that the current rate environment together with slower than expected core deposit growth will slow improvement in the Company's earnings. As a result, management currently expects that the Company's 2001 earnings will be in the range of $0.95 - $1.05 per share. CONSOLIDATED AVERAGE BALANCES--NET CHANGES Columbia Banking System, Inc. <TABLE><CAPTION> Three Months Ended Increase Six Months Ended Increase June 30, (Decrease) June 30, (Decrease) (in thousands) 2001 2000 Amount 2001 2000 Amount ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> ASSETS Loans $ 1,237,702 $ 1,151,729 $ 85,973 $ 1,227,252 $ 1,116,732 $ 110,520 Securities 99,567 95,566 4,001 101,723 95,479 6,244 Interest-earning deposits with banks 7,789 2,383 5,406 30,536 1,753 28,783 ---------------------------------------------------------------------------------------------------------------------- Total interest-earning assets 1,345,058 1,249,678 95,380 1,359,511 1,213,964 145,547 Noninterest-earning assets 109,402 115,678 (6,276) 109,818 107,201 2,617 ---------------------------------------------------------------------------------------------------------------------- Total assets $ 1,454,460 $ 1,365,356 $ 89,104 $ 1,469,329 $ 1,321,165 $ 148,164 ====================================================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY Interest-bearing deposits $ 1,042,407 $ 968,198 $ 74,209 $ 1,066,229 $ 940,254 $ 125,975 Federal Home Loan Bank advances 50,106 69,622 (19,516) 45,081 64,528 (19,447) Other borrowings 8,000 6,500 1,500 7,025 4,788 2,237 ---------------------------------------------------------------------------------------------------------------------- Total interest-bearing liabilities 1,100,513 1,044,320 56,193 1,118,335 1,009,570 108,765 Noninterest-bearing deposits 221,342 205,326 16,016 220,366 198,642 21,724 Other noninterest-bearing liabilities 12,595 10,705 1,890 12,279 9,776 2,503 Shareholders' equity 120,010 105,005 15,005 118,349 103,177 15,172 ---------------------------------------------------------------------------------------------------------------------- Total liabilities and shareholders' equity $ 1,454,460 $ 1,365,356 $ 89,104 $ 1,469,329 $ 1,321,165 $ 148,164 ====================================================================================================================== </TABLE> 13
NONINTEREST INCOME Noninterest income increased $947,000, or 33% in the second quarter of 2001, and $1.7 million, or 31%, for the first six months of 2001 compared with the same period in 2000. Increases during the second quarter and the first six months of 2001 were primarily centered in mortgage banking operations and merchant services income. Mortgage banking income has been favorably impacted by increased residential mortgage originations due to the effect of lower long-term interest rates. Increases in merchant services income is due to the overall growth of the customer base and the continued emphasis on expanding the market for that product. Noninterest income increased 16% from the first quarter of 2001 to the second quarter of 2001. During the second quarter and first six months of 2001, the Company recorded net gains on sale of investment securities of $60,000 and $37,000, respectively. During the second quarter, the Bank purchased $12.3 million of "Bank Owned Life Insurance" (BOLI) in connection with an employee benefit plan. The asset is classified as an "other asset" and the income is tax-exempt and recorded as "other income". NONINTEREST EXPENSE Total noninterest expense increased $1.9 million, or 17%, for the second quarter of 2001, and $3.0 million, or 13%, for the first six months of 2001, compared with the same periods in 2000. The increases were primarily due to personnel and occupancy costs associated with the Company's expansion and other expenses. The personnel cost increases reflect significant hiring in the fourth quarter of 2000 and the first quarter 2001 of experienced bankers in connection with the Company's King County expansion. The Company's efficiency ratio (noninterest expense divided by the sum of net interest income plus noninterest income) was 72.4% and 70.1% for the second quarter and first six months of 2001, respectively, compared to 65.0% and 65.4% for the same periods in 2000. INCOME TAXES For the second quarter and first six months of 2001, the Company recorded income tax provisions of $1.4 million and $3.1 million, respectively, compared with $1.8 million and $3.4 million for the same periods in 2000. CREDIT RISK MANAGEMENT The extension of credit in the form of loans or other credit substitutes to individuals and businesses is a major portion of the Company's principal business activity. Company policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management. The Company manages its credit risk through lending limit constraints, credit review, approval policies and extensive, ongoing internal monitoring. The Company also manages credit risk through diversification of the loan portfolio by type of loan, type of industry, aggregation of debt limits to a single borrower and the type of borrower. In analyzing its existing portfolio, the Company reviews its consumer and residential loan portfolios by risk rating each loan and analyzing their performance as a pool of loans since no single loan is individually significant or judged by its risk rating size or potential risk of loss. In contrast, the monitoring process for the commercial business, private banking, real estate construction, and commercial real estate portfolios includes periodic reviews of individual loans with risk ratings assigned to each loan and performance judged on a loan by loan basis. The Company reviews these loans to assess the ability of the borrower to service all of its interest and principal obligations and as a result the risk rating may be adjusted accordingly. In the event that full collection of principal and interest is not reasonably assured, the loan is appropriately downgraded and, if warranted, placed on non-accrual status even though the loan may be current as to principal and interest payments. Additionally, the Company would assess whether an impairment of a loan as provided in SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", would warrant specific reserves or a write-down of the loan. See "Provision and Allowance For Loan Losses." 14
Loan policies, credit quality criteria, portfolio guidelines and other controls are established under the guidance of the Company's Chief Credit Officer and approved, as appropriate, by the Board. Credit Administration, together with appropriate loan committees, has the responsibility for administering the credit approval process. As another part of its control process, the Company uses an independent internal credit review and examination function to provide assurance that loans and commitments are made and maintained as prescribed by its credit policies. This includes a review of documentation when the loan is initially extended and subsequent on-site examination to ensure continued performance and proper risk assessment. LOAN PORTFOLIO ANALYSIS The Company is a full service commercial bank, which originates a wide variety of loans. Consistent with the trend begun in 1993, the Company continues to have success originating commercial business and commercial real estate loans. The following table sets forth the Company's loan portfolio composition by type of loan for the dates indicated: <TABLE> <CAPTION> June 30, % of December 31, % of (in thousands) 2001 Total 2000 Total -------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Commercial business $ 499,573 41.3% $ 496,125 41.6% Real estate: One-to four-family residential 59,027 4.9 55,922 4.7 Five or more family residential and commercial properties 434,356 35.9 428,884 36.0 -------------------------------------------------------------------------------------------- Total real estate 493,383 40.8 484,806 40.7 Real estate construction: One-to four-family residential 27,048 2.2 33,548 2.8 Five or more family residential and commercial properties 82,847 6.8 74,451 6.3 -------------------------------------------------------------------------------------------- Total real estate construction 109,895 9.0 107,999 9.1 Consumer 110,267 9.1 106,633 8.9 -------------------------------------------------------------------------------------------- Sub-total loans 1,213,118 100.2 1,195,563 100.3 Less: Deferred loan fees (2,828) (0.2) (3,043) (0.3) -------------------------------------------------------------------------------------------- Total loans $ 1,210,290 100.0% $ 1,195,520 100.0% ============================================================================================ Loans held for sale $ 24,912 $ 14,843 ============================================================================================ </TABLE> Total loans (excluding loans held for sale) at June 30, 2001 increased $14.8 million, or 1.2%, to $1.2 billion from year-end 2000. All loan categories contributed to the increase, except one-to four-family residential construction. COMMERCIAL LOANS: Commercial loans increased $3.4 million to $499.6 million from year-end 2000, representing 41.3% of total loans compared with 41.6% of total loans at December 31, 2000. Management is committed to providing competitive commercial lending in the Company's market areas. The Company expects to continue to expand its commercial lending products and to emphasize in particular its relationship banking with businesses, business owners and affluent individuals. 15
REAL ESTATE LOANS: Residential one- to four-family loans increased $3.1 million to $59.0 million at June 30, 2001, representing 4.9% of total loans, compared with $55.9 million, or 4.7% of total loans at December 31, 2000. These loans are used by the Company to collateralize advances from the FHLB. The Company's underwriting standards require that one- to four-family portfolio loans generally be owner-occupied. The loan amounts may not exceed 80% (90% with private mortgage insurance) of the appraised value or cost, whichever is lower, of the underlying collateral at origination. Generally, management's policy is to originate for sale to third parties residential loans secured by properties located within the Company's primary market areas. The Company makes multi-family and commercial real estate loans in its market areas. Multi-family and commercial real estate lending increased $5.5 million, or 1.3%, to $434.4 million at June 30, 2001, representing 35.9% of total loans, from $428.9 million, or 36.0% of total loans at December 31, 2000. The increase in multi-family and commercial real estate lending during 2001 reflects a mix of owner occupied and income property transactions. Generally, multi-family and commercial real estate loans are made to borrowers who have existing banking relationships with the Company. The Company's underwriting standards generally require that the loan-to-value ratio for multi-family and commercial loans not exceed 75% of appraised value or cost, whichever is lower, and that commercial properties maintain debt coverage ratios (net operating income divided by annual debt servicing) of 1.2 or better. Underwriting standards can be influenced by competition and other factors. The Company endeavors to maintain the highest practical underwriting standards while balancing the need to remain competitive in its lending practices. REAL ESTATE CONSTRUCTION LOANS: The Company originates a variety of real estate construction loans. One- to four-family residential construction loans are originated for the construction of custom homes (where the home buyer is the borrower) and provides financing to builders for the construction of pre-sold homes and speculative residential construction. Construction loans on one- to four-family residences decreased $6.5 million to $27.0 million at June 30, 2001, representing 2.2% of total loans, from $33.5 million, or 2.8% of total loans at December 31, 2000. Multi-family and commercial real estate construction loans increased $8.4 million to $82.8 million at June 30, 2001, representing 6.8% of total loans, from $74.5 million, or 6.3% of total loans at December 31, 2000. The Company endeavors to limit its construction lending risk through adherence to strict underwriting procedures. Consumer Loans: At June 30, 2001, the Company had $110.3 million of consumer loans outstanding, representing 9.1% of total loans, an increase of $3.6 million compared with $106.6 million, at December 31, 2000. Consumer loans made by the Company include automobile loans, boat and recreational vehicle financing, home equity and home improvement loans and miscellaneous personal loans. FOREIGN OUTSTANDING: Columbia Bank is not involved with loans to foreign companies and foreign countries. 16
NONPERFORMING ASSETS Nonperforming assets consist of: (i) nonaccrual loans, which generally are loans placed on a nonaccrual basis when the loan becomes past due 90 days or when there are otherwise serious doubts about the collectibility of principal or interest; (ii) restructured loans, for which concessions, including the reduction of interest rates below a rate otherwise available to that borrower or the deferral of interest or principal, have been granted due to the borrower's weakened financial condition (interest on restructured loans is accrued at the restructured rates when it is anticipated that no loss of original principal will occur); and (iii) real estate owned. The following tables set forth, at the dates indicated, information with respect to nonaccrual loans, restructured loans, total nonperforming loans (nonaccrual loans plus restructured loans), real estate owned, and total nonperforming assets of the Company: June 30, December 31, (in thousands) 2001 2000 - -------------------------------------------------------------------------------- Nonaccrual: One-to four-family residential $ 462 $ 410 Commercial real estate 355 698 Commercial business 10,835 11,091 Consumer 188 307 - -------------------------------------------------------------------------------- Total 11,840 12,506 Restructured: One-to four-family residential construction 1,026 1,136 Commercial business - -------------------------------------------------------------------------------- Total 1,026 1,136 - -------------------------------------------------------------------------------- Total nonperforming loans $ 12,866 $ 13,642 ================================================================================ Real estate owned $ 2,239 $ 1,291 - -------------------------------------------------------------------------------- Total nonperforming assets $ 15,105 $ 14,933 ================================================================================ The consolidated financial statements are prepared according to the accrual basis of accounting. This includes the recognition of interest income on the loan portfolio, unless a loan is placed on a nonaccrual basis. The policy of the Company generally is to discontinue the accrual of interest on all loans past due 90 days or more and place them on nonaccrual status. Nonaccrual loans and other nonperforming assets are centered in a small number of lending relationships which management considers to be adequately reserved. In the fourth quarter 2000, deterioration of a single large credit relationship with a principal amount of $8.0 million caused the Company to place the loan on nonaccrual and include it in impaired loans. Based on information currently known to the Company, management believes that additional collateral obtained to support the loan may reduce the Company's loss exposure. As liquidation of collateral and other collection efforts take place, a substantial portion of the balance owing on the credit is expected to be charged off of the Company's books in the near future and, if collection efforts are successful, recovered at a later date. Substantially all nonperforming loans are to borrowers within the State of Washington. Nonperforming loans were $12.9 million, or 1.06% of total loans (excluding loans held for sale) at June 30, 2001, compared to $13.6 million, or 1.14% of total loans at December 31, 2000. Restructured loans decreased to $1.0 million at June 30, 2001, from $1.1 million, at December 31, 2000. 17
Real estate owned, which is comprised of foreclosed real estate loans, increased $948,000 to $2.2 million at June 30, 2001, from $1.3 million at December 31, 2000. During the second quarter of 2001, the Company foreclosed on a $1.2 million commercial real estate loan and transferred the real estate to REO after recording a charge-off of $400,000. A sale is pending on the foreclosed real estate with the prospect of some recovery for the Company. At June 30, 2001, REO consisted of three foreclosed properties. Total nonperforming assets totaled $15.1 million, or 1.04% of period-end assets at June 30, 2001, compared to $14.9 million, or 1.00% of period-end assets at December 31, 2000. PROVISION AND ALLOWANCE FOR LOAN LOSSES The Company maintains an allowance for loan losses to absorb losses inherent in the loan portfolio. The size of the allowance is determined through quarterly assessments of the probable estimated losses in the loan portfolio. The Company's methodology for making such assessments and determining the adequacy of the allowance includes the following key elements: 1. Formula based allowances calculated on minimum thresholds and historical performance of the portfolio for the past five years. 2. Specific allowances for identified problem loans in accordance with SFAS No. 114, "Accounting by Creditors for Impairment of a Loan." 3. Unallocated allowance. On a quarterly basis (semi-annual in the case of economic and business conditions reviews) the senior credit officers of the Company review with Executive Management and the Board of Directors the various additional factors that management considers when determining the adequacy of the allowance. These factors include the following as of the applicable balance sheet date: 1. Existing general economic and business conditions affecting the Company's market place 2. Credit quality trends, including trends in nonperforming loans 3. Collateral values 4. Seasoning of the loan portfolio 5. Bank regulatory examination results 6. Findings of internal credit examiners 7. Duration of current business cycle The allowance is increased by provisions charged to expense, and is reduced by loans charged off, net of recoveries. While management believes it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in determining the allowance. 18
At June 30, 2001, the Company's allowance for loan losses was $19.2 million, or 1.59% of the total loans (excluding loans held for sale), and 149.4% of nonperforming loans. This compares with an allowance of $18.8 million, or 1.58% of the total loan portfolio, and 137.7% of nonperforming loans, at December 31, 2000. In the fourth quarter 2000, the Company took an additional loan loss provision of $6.0 million to increase its allowance for loan losses to reflect the deterioration of a single substantial credit relationship. The additional $6.0 million provision to the allowance for loan losses was set aside to provide against the loss that may result from the loan, and to further protect against pressures that might arise from a slowing economy. As a result of the deterioration of this single relationship, the Company undertook a comprehensive review of the process currently in place to detect and react to other potential loan portfolio deterioration. Based on that review, management is confident that the problems with the single loan are not symptomatic of other similar problems in the loan portfolio. In addition, management retained the Secura Group, a nationally recognized firm with expertise in commercial loan credit review, to conduct an independent assessment of the Company's loan and collateral monitoring procedures. A summary of the findings of that firm has been filed as an exhibit to this form 10-Q. Management is implementing the recommendations discussed in the exhibit, most notably a formal distinction between credit administration and loan production. The Chief Credit Officer will manage the credit process and will, together with the Senior Lending Officer, report directly to the President of Columbia Bank. Net loan charge-offs amounted to $1.4 million for the first six months of 2001 compared with net loan recoveries of $305,000 for the same period in 2000. During the first six months of 2001, the Company set aside $1.8 million as a provision for loan losses, unchanged from the same period in 2000. In view of apparent softness in the economy of its market area, the Company chose to maintain its provision for loan losses at this rate despite slowing loan growth. Management will regularly evaluate the necessity of any additions to the loan loss reserve based upon the Company's credit quality, loan growth, the economy and other factors. The following table provides an analysis of net losses by loan type at the dates indicated: <TABLE> <CAPTION> Three Months Ended Six Months Ended June 30, June 30, (in thousands) 2001 2000 2001 2000 - ---------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Beginning balance $ 18,958 $ 10,897 $ 18,791 $ 9,967 Charge-offs: One-to-four family residential construction (12) (12) Commercial business (656) (86) (1,454) (273) Consumer (3) (57) (10) (116) - ---------------------------------------------------------------------------------------------------------- Total charge-offs (659) (155) (1,464) (401) Recoveries: Commercial business 10 429 72 694 Consumer 15 1 25 12 - ---------------------------------------------------------------------------------------------------------- Total recoveries 25 430 97 706 - ---------------------------------------------------------------------------------------------------------- Net (charge-offs) recoveries (634) 275 (1,367) 305 Provision charged to expense 900 900 1,800 1,800 - ---------------------------------------------------------------------------------------------------------- Ending balance $ 19,224 $ 12,072 $ 19,224 $ 12,072 ========================================================================================================== </TABLE> 19
LIQUIDITY AND SOURCES OF FUNDS The Company's primary sources of funds are customer deposits and advances from the Federal Home Loan Bank of Seattle (the "FHLB"). These funds, together with loan repayments, loan sales, retained earnings, equity and other borrowed funds, are used to make loans, to acquire securities and other assets and to fund continuing operations. DEPOSIT ACTIVITIES The Company's deposit products include a wide variety of transaction accounts, savings accounts and time deposit accounts. Total deposits decreased $63.6 million, or 4.8%, to $1.263 billion at June 30, 2001 from $1.327 billion at December 31, 2000. The decrease was primarily centered in certificates of deposit balances, as the Company reduced the rates of interest offered on the certificates. Average core deposits (demand deposit, savings, and money market accounts) decreased to $681.5 million, during the second quarter of 2001, from $689.1 million in the first quarter of 2001, and from $683.2 million during the fourth quarter ending December 31, 2000. The Company has established a branch system catering primarily to retail depositors, supplemented by business customer deposits and other borrowings. The branch system deposits are intended to provide a stable core funding base for the Company. Together with that stable core deposit base, management's strategy for funding growth is to make use of brokered and other wholesale deposits. The Company's use of brokered and other wholesale deposits increased in 2000, and management anticipates continued use of such deposits to fund increasing loan demand. At June 30, 2001, brokered and other wholesale deposits (excluding public deposits) totaled $40.2 million, or 3.2% of total deposits, compared with $53.0 million, or 4% of total deposits at December 31, 2000. The brokered deposits have varied maturities up to 5 years. BORROWINGS The Company relies on FHLB advances to supplement its funding sources, and the FHLB serves as the Company's primary source of long-term borrowings. In addition, the Company uses short-term borrowings from the FHLB when necessary. FHLB advances are secured by one- to four-family real estate mortgages and certain other assets. At June 30, 2001, the Company had short-term advances of $51.7 million compared to a balance of $40.0 million at December 31, 2000. Management anticipates that the Company will continue to rely on the same sources of funds in the future, and will use those funds primarily to make loans and purchase securities. The Company has a $20 million line of credit with a large commercial bank. The interest rate on the line is indexed to the prime rate and at June 30, 2001, the balance outstanding was $8.0 million compared with a balance of $4.5 million at December 31, 2000. In the event of the discontinuance of the line by either party, the Company has up to two years to repay the debt. 20
CAPITAL Shareholders' equity at June 30, 2001, was $121.2 million compared with $113.8 million at December 31, 2000. The increase is due primarily to net income of $5.9 million during the first six months of 2001. Shareholders' equity was 8.32% and 7.61% of total period-end assets at June 30, 2001, and December 31, 2000, respectively. On August 9, 2001, the Company announced that it has received $22 million from its participation in a pooled trust preferred offering, in which it issued long-term floating rate capital securities with an initial rate of 7.29%. The Company also announced that its Board of Directors has approved a stock repurchase program, which will be funded by up to $9 million of the proceeds from the pooled trust preferred transaction. Under the stock repurchase program, the Company may systematically purchase up to 660,000 of its outstanding shares of Common Stock. These shares represent approximately 5% of the 13.1 million common shares outstanding. Banking regulations require bank holding companies to maintain a minimum "leverage" ratio of core capital to adjusted quarterly average total assets of at least 3%. At June 30, 2001, the Company's leverage ratio was 8.31%, compared with 7.77% at December 31, 2000. In addition, banking regulators have adopted risk-based capital guidelines, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. Tier I capital generally consists of common shareholders' equity, less goodwill and certain identifiable intangible assets, while Tier II capital includes the allowance for loan losses and subordinated debt, both subject to certain limitations. Regulatory minimum risk-based capital guidelines require Tier I capital of 4% of risk-adjusted assets and total capital (combined Tier I and Tier II) of 8% of risk-adjusted assets to be considered "adequately capitalized". The Company's Tier I and total capital ratios were 8.85% and 9.82%, respectively, at June 30, 2001, compared with 8.58% and 9.54%, respectively, at December 31, 2000. During 1992, the Federal Deposit Insurance Corporation (the "FDIC") published the qualifications necessary to be classified as a "well capitalized" bank, primarily for assignment of FDIC insurance premium rates beginning in 1993. To qualify as "well capitalized," banks must have a Tier I risk-adjusted capital ratio of at least 6%, a total risk-adjusted capital ratio of at least 10%, and a leverage ratio of at least 5%. Columbia Bank qualified as "well-capitalized" at June 30, 2001. Failure to qualify as "well capitalized" can negatively impact a bank's ability to expand and to engage in certain activities. Applicable federal and Washington state regulations restrict capital distributions by institutions such as Columbia Bank, including dividends. Such restrictions are tied to the institution's capital levels after giving effect to distributions. The Company's ability to pay cash dividends is substantially dependent upon receipt of dividends from the Bank. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK A number of measures are used to monitor and manage interest rate risk, including income simulations and interest sensitivity (gap) analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Basic assumptions in the model include prepayment speeds on mortgage-related assets, cash flows and maturities of other investment securities, loan and deposit volumes and pricing. These assumptions are inherently subjective and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors. At June 30, 2001, based on the measures used to monitor and manage interest rate risk, there has not been a material change in the Company's interest rate risk since December 31, 2000. For additional information, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations" referenced in the Company's annual report on Form 10-K for the year ended December 31, 2000. 21
PART II - OTHER INFORMATION Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company held its annual shareholders meeting on May 15, 2001, for the purpose of electing the Board of Directors. All thirteen persons nominated were elected to hold office for the ensuing year. Nominee Votes "For" Votes "Withheld" - -------------------------------------------------------------------------------- Richard S. DeVine 10,141,320 52,524 Melanie J. Dressel 9,778,257 415,687 Jack Fabulich 10,138,807 55,137 Jonathan Fine 9,961,940 232,004 John P. Folsom 10,142,147 51,797 J. James Gallagher 9,605,230 588,714 John A. Halleran 10,142,717 51,227 Thomas M. Hulbert 10,142,717 51,227 Thomas L. Matson 10,142,717 51,227 Donald Rodman 10,142,717 51,227 Sidney R. Snyder 10,142,147 51,797 William T. Weyerhaeuser 10,139,649 54,295 James M. Will 10,142,717 51,227 Item 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibit 10 (a) Amended and Restated Articles of Incorporation of Columbia Banking System, Inc. (b) Executive Summary - The Secura Group (b) Reports on Form 8-K None 22
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. COLUMBIA BANKING SYSTEM, INC. (Registrant) Date: August 13, 2001 By: /s/ J. James Gallagher ---------------------- ---------------------------------- J. James Gallagher Vice Chairman and Chief Executive Officer Date: August 13, 2001 By: /s/ Gary R. Schminkey ---------------------- ---------------------------------- Gary R. Schminkey Executive Vice President and Chief Financial Officer 23