UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
Hanmi Financial Corporation
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes (x) No ( )
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b.2 of the Exchange Act.).
As of August 6, 2004, there were 24,469,854 outstanding shares of the issuer’s Common Stock.
INDEX
HANMI FINANCIAL CORPORATION
HANMI FINANCIAL CORPORATION AND SUBSIDIARIES
See accompanying notes to consolidated financial statements.
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Notes to Consolidated Financial Statements
Note 1. Hanmi Financial Corporation
Hanmi Financial Corporation (“Hanmi Financial” or the “Company”) is a Delaware corporation that is the holding company for Hanmi Bank (the “Bank”) and is subject to the Bank Holding Company Act of 1956, as amended.
Hanmi Bank, the primary subsidiary of the Company, is a commercial bank licensed by the California Department of Financial Institutions. Hanmi Bank’s deposit accounts are insured under the Federal Deposit Insurance Act up to applicable limits thereof, and the Bank is a member of the Federal Reserve System.
Hanmi Bank is a community bank conducting general business banking with its primary market encompassing the multi-ethnic population of the Los Angeles, Orange, San Diego and Santa Clara counties. Hanmi Bank’s full-service offices are located in business areas where many of the businesses are run by immigrants and other minority groups, and its client base reflects the multi-ethnic composition of these communities. On April 30, 2004, the Company completed its acquisition of Pacific Union Bank (“PUB”), a $1.2 billion (assets) commercial bank headquartered in Los Angeles that, like Hanmi, serves primarily the Korean-American community. Hanmi Bank currently has twenty-seven full-service branch offices located in Los Angeles, Orange, Santa Clara and San Diego counties. Of the twenty-seven offices, Hanmi Bank opened twelve as de novo branches and acquired fifteen through acquisition. On June 17, 2004, the Company announced it would close seven branches.
Note 2. Basis of Presentation
In the opinion of management, the consolidated financial statements of Hanmi Financial Corporation and its subsidiaries reflect all the material adjustments necessary for a fair presentation of the results for the interim period ended June 30, 2004, but are not necessarily indicative of the results which will be reported for the entire year. In the opinion of management, the aforementioned consolidated financial statements are in conformity with accounting principles generally accepted in the United States of America. The interim information should be read in conjunction with the Company’s 2003 Annual Report on Form 10-K.
Descriptions of the Company’s significant accounting policies are included in Note 1, Summary of Significant Accounting Policies, in the Company’s 2003 Form 10-K. Certain reclassifications were made to the prior period presentation to conform to the current period’s presentation.
Note 3. Investment Securities
The following table presents the fair value and the unrealized loss on securities that were temporarily impaired at June 30, 2004.
The temporary impairment is a result of the change in market interest rates and is not a result of the underlying issuer's ability to repay. Accordingly, we have not recognized the temporary impairment in our results of operations.
Note 4. Employee Stock-Based Compensation
The Company measures its employee stock-based compensation arrangements under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no compensation expense has been recognized for the stock option plan, as stock options were granted at fair value at the date of grant. Had compensation expense for the Company’s stock option plan been determined based on the fair values estimated using the Black-Scholes model at the grant dates for previous awards, the Company’s net income and income per share would have been reduced to the pro forma amounts indicated for the periods as follows:
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Note 5. Earnings Per Share
Earnings per share (“EPS”) is calculated on both a basic and diluted basis. Basic earnings per share excludes dilution and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted from the issuance of common stock that then shared in earnings, excluding common shares in treasury.
The following table presents a reconciliation of the components used to derive basic and diluted earnings per share for the periods indicated.
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Note 6. Derivative Financial Instruments
The Company has entered into interest rate swaps to hedge the interest rate risk associated with the cash flows of specifically identified variable-rate loans. As of June 30, 2004, the Company had five interest rate swap agreements with a total notional amount of $70 million, wherein the Company receives a fixed rate of 5.77% and 6.37% at quarterly intervals for each $20 million notional amount and a fixed rate of 6.51%, 6.76%, and 7.29% for each $10 million notional amount, respectively. The swaps expire over the period March 14, 2008 through May 17, 2009. The Company pays a floating rate at quarterly intervals based on The Wall Street Journal published prime rate.
At June 30, 2004, the fair value of the interest rate swaps was in an unfavorable position of $893,000. A total of $544,000, net of tax, is included in other comprehensive loss. The fair value of the interest rate swaps is included in other liabilities in the accompanying consolidated statements of financial condition. Expenses of $23,000 related to swap ineffectiveness were recorded in the Company’s income statement for the quarter ended June 30, 2004.
Note 7. Current Accounting Matters
In accordance with Statement of Financial Accounting Standards No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities” (“SFAS No. 149”), interest rate lock commitments on mortgage loans that will be held for sale must be accounted for as derivatives and marked to market in accordance with Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”). All other interest rate lock commitments are excluded from SFAS No. 133, pursuant to SFAS No. 149.
The Securities and Exchange Commission (“SEC”) issued guidance in Staff Accounting Bulletin No. 105 (“SAB No. 105”) that requires that fair-value measurements include only differences between the guaranteed interest rates in loan commitments and a market interest rate, excluding any expected future cash flows related to the customer relationship or loan servicing. Servicing assets are to be recognized only after the servicing asset has been contractually separated from the underlying loan by sale or securitization of the loan with servicing retained. The guidance in SAB No. 105 must be applied to interest rate locks initiated after March 31, 2004 and is to be applied prospectively. The application of SAB No. 105 did not have a material effect on the Company.
Note 8. Business Combinations
On April 30, 2004, the Company completed its acquisition of Pacific Union Bank (“PUB”) and merged PUB with Hanmi Bank. The Company paid $164.5 million in cash to acquire 5,537,431 of the PUB shares owned by Korea Exchange Bank. All of the remaining PUB shares were converted in the acquisition into shares of the Company’s common stock based on an exchange ratio of 1.156 Hanmi shares for each PUB share.
Immediately prior to the completion of the acquisition, the Company issued a total of 3,947,369 shares of its common stock pursuant to a private placement for total proceeds of $75,000,000 before expenses and placement fees. As a result of the issuance of shares in the merger and the private placement, as well as normal stock option activity, the number of outstanding Company shares has increased to 24,438,017.
In addition, all outstanding PUB employee stock options were converted into 68,707 options to purchase Hanmi stock valued at $1.1 million in total. Based on Hanmi’s average price of $25.06 for the five-day trading period from April 28 through May 4, 2004, the total consideration paid for PUB was $324.7 million and resulted in the recognition of goodwill aggregating approximately $207.2 million. This amount, as well as the fair values of assets and liabilities recorded, may change as certain estimates are finalized.
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As of April 30, 2004, the fair value of PUB net assets acquired was as follows:
The core deposit intangible is being amortized over its estimated useful life of five years. None of the goodwill balance is expected to be deductible for income tax purposes.
The Company incurred the following merger-related costs:
Immediately following the acquisition of PUB, management initiated and approved plans to restructure the operations of the existing Hanmi and PUB branch networks and corporate headquarters to eliminate duplicative facilities, streamline operations, and reduce costs. Management anticipates that these actions, including the termination of approximately 100 management, headquarters, and branch employees, will be substantially complete by December 31, 2004. Through June 30, 2004, 13 employees had been terminated. On a pro forma basis, combined employee headcount of Hanmi and PUB decreased from 671 as of December 31, 2003 to 611 as of June 30, 2004, primarily as a result of attrition and the hiring freeze instituted January 2, 2004.
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Restructuring costs recognized as expenses during the second quarter of 2004 consisted primarily of employee severance and retention bonuses, data processing contract termination costs, the costs of vacating duplicative branches within Hanmi’s existing network, and the impairment of fixed assets (primarily leasehold improvements) associated with such branches. Of the $1,728,000 of total restructuring expenses provided, $54,000 was utilized and charged against the related liability in the second quarter of 2004.
Certain restructuring costs (primarily PUB employee severance, data processing contract termination costs, and the costs of vacating duplicative branches within PUB’s network) were recognized as liabilities assumed in the business combination or impairments of fixed assets associated with such branches. Accordingly, they have been considered part of the purchase price of PUB and recorded as an increase in the balance of goodwill. Of the $4,512,000 of total restructuring costs that have been treated as part of the purchase price, $1,112,000 was utilized and charged against the related liability in the second quarter of 2004.
Unaudited Pro Forma Combined Financial Data Reflecting the PUB Acquisition
The unaudited pro forma combined income statements presented below give effect to the acquisition of PUB as if it had been consummated as of January 1, 2003. The unaudited pro forma information is not necessarily indicative of the results of operations that would have resulted had the acquisition been completed as of January 1, 2003, nor is it necessarily indicative of future results of operations.
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Note 9. Junior Subordinated Debentures
On April 28, 2004, the Company formed Hanmi Capital Trust III (the “Trust”) to issue trust preferred securities. On April 28, 2004, the Trust issued $20 million of trust preferred securities pursuant to a private placement underwritten by Trapeza Funding V, LLC and included in a pool of trust preferred securities assembled by Trapeza. In addition, it issued to the Company $619,000 of trust common securities. The Trust used the proceeds to purchase $20.6 million of the Company’s junior subordinated debt due April 30, 2009, bearing interest at the three-month LIBOR plus 2.63%. These notes are the sole assets of the Trust and are subordinate to all of the Company’s existing and future obligations.
The Company treats the trust preferred securities as Tier 1 capital. The debt, the common securities issued by the Trust, and the related income effects are eliminated within the Company’s consolidated financial statements.
The notes have a 30-year maturity, and they are callable after five years. Upon repayment of the debentures at their stated maturity or following their earlier redemption, the Trust will use the proceeds of such repayment to redeem an equivalent amount of outstanding trust preferred securities and trust common securities.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following is management’s discussion and analysis of the major factors that influenced the Company’s results of operations and financial condition for the three months and six months ended June 30, 2004. This analysis should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 and with the unaudited financial statements and notes thereto set forth in this report.
Critical Accounting Policies
We have established various accounting policies which govern the application of accounting principles generally accepted in the United States of America in the preparation of our financial statements. Our significant accounting policies are described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Certain accounting policies require us to make significant estimates and assumptions which have a material impact on the carrying value of certain assets and liabilities, and we consider these to be critical accounting policies. The estimates and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Actual results could differ significantly from these estimates and assumptions which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and our results of operations for the reporting periods. Management has discussed the development and selection of these critical accounting policies with the Audit Committee of our Board of Directors.
We believe the allowance for loan losses is the critical accounting policy that requires the most significant estimates and assumptions, which are particularly susceptible to significant change in the preparation of our financial statements. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Allowance and Provision for Loan Losses” for a description of the Company’s methodology for determining the allowance for loan losses.
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Selected Financial Data
The following table sets forth certain selected financial data concerning the Company for the periods indicated:
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Forward-Looking Information
Certain matters discussed under this caption may constitute forward-looking statements under Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward looking statements relate to, among other things, expectations of the environment in which the Company operates and projection of future performance. There can be no assurance that the results described or implied in such forward-looking statements will, in fact, be achieved and actual results, performance, and achievements could differ materially because the business of the Company involves inherent risks and uncertainties. Risks and uncertainties include possible future deteriorating economic conditions in the Company’s areas of operation; interest-rate risk associated with volatile interest rates and related asset-liability matching risk; liquidity risks; risk of significant non-earning assets, and net credit losses that could occur, particularly in times of weak economic conditions or times of rising interest rates; risks of available-for-sale securities declining significantly in value as interest rates rise; difficulties in integrating the operations of acquired companies; and regulatory risks associated with the variety of current and future regulations to which the Company is subject. For additional information concerning these factors, see the Company’s filings with the Securities and Exchange Commission, and in particular, the Company’s Form 10-K under the heading “Factors That May Affect Future Results of Operation,” “Interest Rate Risk Management,” and “Liquidity and Capital Resources.”
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Results of Operations
Overview
The Company’s net income for the three months ended June 30, 2004 was $7.5 million, or $0.35 per diluted share, compared to $5.0 million, or $0.35 per diluted share, for the three months ended June 30, 2003. The 52.3% increase in net income for 2004 as compared to 2003 was primarily due to the acquisition of interest-earning assets totaling $1.1 billion as part of the merger with PUB. Hanmi’s results of operations include revenues and expenses derived from the assets acquired and liabilities assumed via the combination with PUB for the months of May and June 2004. Net interest income before provision for loan losses increased $10.3 million, or 74.6%, due to ongoing growth in loan production as well as the newly acquired interest-earning assets. Non-interest income increased by $1.2 million, or 20.6%, mainly due to an increase in service charges on deposit accounts. Non-interest expenses increased by $7.5 million, or 72.7%, including $1.7 million of non-recurring restructuring expenses. This increase was primarily attributable to the additional salaries and employee benefits, occupancy, professional fees, and data processing expenses incurred during the post-merger integration period. The annualized return on average assets was 1.13% for the three months ended June 30, 2004, compared to a return on average assets of 1.26% for the same period of 2003, a decrease of 13 basis points. The annualized return on average equity was 9.97%, and return on tangible equity was 19.72%, compared to 15.21% and 15.47%, respectively, in the three-month period a year ago.
The Company’s net income for the six months ended June 30, 2004 was $13.9 million, or $0.78 per diluted share, compared to $9.2 million, or $0.64 per diluted share, for the six months ended June 30, 2003. Net interest income before provision for loan losses increased $15.1 million, or 58.2%, to $41.1 million, and non-interest income increased by $1.5 million, or 14.7%, to $11.6 million. Non-interest expenses increased by $8.9 million, or 46.5%, including $1.7 million of non-recurring restructuring expenses. The annualized return on average assets was 1.26% for the six months ended June 30, 2004, compared to a return on average assets of 1.21% for the same period of 2003, an increase of five basis points. The annualized return on average equity was 12.41%, and return on tangible equity was 18.75%, compared to 14.48% and 14.76%, respectively, in the six-month period a year ago.
Net Interest Income before Provision for Loan Losses
The principal component of the Company’s earnings is net interest income, which is the difference between the interest and fees earned on loans and investments and the interest paid on deposits and other borrowed funds. When net interest income is expressed as a percentage of average interest-earning assets, the result is the net interest margin. The net interest spread is the yield on average interest-earning assets less the average cost of interest-bearing deposits and borrowed funds.
For the three months ended June 30, 2004, the Company’s net interest income before provision for loan losses was $24.2 million. This represented an increase of $10.3 million, or 74.6%, over net interest income before provision for loan losses of $13.9 million for the three months ended June 30, 2003. The net interest spread increased to 3.57% for the three months ended June 30, 2004, from 3.12% for the same period in 2003. The change was mainly due to an increase in rates received on loans and investments as the Company emphasized spread income and disposed of certain low-yielding investments in the first quarter of 2004. The net interest margin also increased 36 basis point to 4.10% for the three months ended June 30, 2004, from 3.74% for the same period in 2003, due to an increase in the volume of interest-earning assets with higher interest rates.
For the six months ended June 30, 2004, the Company’s net interest income before provision for loan losses was $41.1 million. This represented an increase of $15.1 million, or 58.2%, over net interest income before provision for loan losses of $26.0 million for the six months
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ended June 30, 2003. The interest rate spread increased to 3.56% for the six months ended June 30, 2004, from 2.97% for the same period in 2003. The change was mainly due to an increase in rates received on loans and investments. The net interest margin also increased 46 basis point to 4.08% for the six months ended June 30, 2004, from 3.62% for the same period in 2003 due to an increase in the volume of interest earning assets with higher interest rates.
Total interest income increased $12.6 million, or 65.8%, to $31.7 million for the three months ended June 30, 2004, from $19.1 million for the three months ended June 30, 2003. Total interest income increased $17.2 million, or 47.1%, to $53.8 million for the six months ended June 30, 2004, from $36.6 million for the six months ended June 30, 2003. The increase was mainly the result of an increase in the volume of interest-earning assets attributable to the acquisition of PUB. For the second quarter of 2004, average interest-earning assets increased by $882.1 million, or 59.6%, to $1.89 billion, compared to $1.06 billion a year ago. For the first half of 2004, average interest-earning assets increased by $579 million, or 40.3%, to $2.02 billion, compared to $1.44 billion a year ago.
The Company’s interest expense on deposits and other borrowed funds for the three months ended June 30, 2004 increased by $2.2 million, or 42.5%, to $7.5 million, from $5.3 million for the three months ended June 30, 2003. The Company’s interest expense on deposits and other borrowed funds for the six months ended June 30, 2004 increased by $2.1 million, or 19.8%, to $12.7 million, from $10.6 million for the six months ended June 30, 2003. The increases reflected an increase in interest-bearing liabilities related to the acquisition of PUB; however, a decrease in interest rates paid to depositors offset the increase in the volume of interest-bearing deposits and borrowings.
Average interest-bearing liabilities were $1.67 billion and $1.42 billion for the three months and six months ended June 30, 2004, respectively, which represented increases of $644.3 million, or 62.7%, and $424 million, or 42.4%, respectively, from average interest-bearing liabilities of $1.03 billion and $1.0 billion for the same periods a year ago. The cost of average interest-bearing liabilities decreased to 1.79% and 1.78% for the three months and six months ended June 30, 2004, respectively, compared to costs of 2.04% and 2.11% for the same periods of 2003. Overall, interest on deposits decreased mainly due to repricing of interest rates on long-term certificates of deposit to lower interest rates as the deposits matured and the acquisition of PUB’s deposits, which had a lower average interest rate compared to Hanmi’s deposits portfolio.
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The table below presents the average yield on each category of interest-earning assets, average rate paid on each category of interest-bearing liabilities, and the resulting net interest spread and net interest margin for the periods indicated. All average balances are daily average balances.
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The table below shows changes in interest income and interest expense and the amounts attributable to variations in interest rates and volumes for the periods indicated. The variances attributable to simultaneous volume and rate changes have been allocated to the change due to volume and the change due to rate categories in proportion to the relationship of the absolute dollar amount attributable solely to the change in volume and to the change in rate.
Provision for Loan Losses
The provision for loan losses represents the charge against current earnings that is determined by management, through a disciplined credit review process, to be the amount needed to maintain an allowance that is sufficient to absorb loan losses inherent in the Company’s loan portfolio. For the quarter ended June 30, 2004, the Company made a provision of $850,000, compared to $1.5 million in the same period in 2003. For the six months ended June 30, 2004, the Company’s loan loss provision was $1.8 million, and this represented a decrease of $930,000, or 34.7%, from $2.7 million in the same period in 2003. The Company’s management believes that the allowance is sufficient for inherent losses in the portfolio at June 30, 2004 (see Allowance and Provision for Loan Losses).
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Non-interest Income
Non-interest income includes revenues earned from sources other than interest income. It is mainly composed of service charges and fees on deposit accounts, fees charged on trade finance, and gain on sale of loans and investment securities. Non-interest income was $6.8 million and $11.6 million in the second quarter and first half of 2004, respectively, which represented increases of $1.2 million, or 20.6%, and $1.5 million, or 14.7%, compared to $5.6 million and $10.1 million recognized in the same periods in 2003.
The increase was mainly due to an increase of $1.0 million, or 40.3%, and an increase of $1.2 million, or 24.4%, in service charges on deposit accounts in the second quarter and first half of 2004, respectively. This increase was mainly due to an overall deposit increase, primarily as a result of the acquisition of PUB.
The Company earned trade finance fees, remittance fees, and other charges and fees aggregating $1.7 million and $3.0 million in the three months and six months ended June 30, 2004, respectively. This represented increases of 53.0% and 26.9% when compared to $1.1 million and $2.3 million earned in the second quarter and first half of 2003, respectively. These revenue increases were attributable to growth in the customer base, attributable primarily to the acquisition of PUB, and were offset by decreases in gain on sale of securities, which totaled $6,000 and $9,000 for the second quarter and first half of 2004, respectively, representing decreases of 99.2% and 99.0% from the same periods in 2003, when gain on sale of securities totaled $707,000 and $858,000, respectively.
The Company sells the guaranteed portion of the Small Business Administration (“SBA”) loans it originates in the secondary market, while the Company retains servicing rights. Second quarter 2004 gain on sale of loans decreased slightly to $833,000, compared to $878,000 in the second quarter of 2003. For the six months ended June 30, 2004, gain on sale of loans was $1.3 million, which was same as a year ago.
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The breakdown of non-interest income by category is reflected below:
Non-interest Expenses
Non-interest expenses increased from $10.3 million to $17.8 million, an increase of $7.5 million or 72.7%, over the second quarter of 2003. Non-interest expenses increased $8.9 million, or 46.5%, to $28.2 million for the first half of 2004, from $19.2 million in the first half of 2003. These increases were primarily attributable to increased expenses associated with the acquisition of PUB.
Salaries and employee benefits expenses for the second quarter and first half of 2004 increased $2.4 million, or 42.9%, and $3.4 million, or 33.1%, to $8.0 million and $13.6 million, from $5.6 million and $10.3 million for the same periods in 2003, due to a 66% increase in the number of employees following the acquisition of PUB.
Occupancy expenses for the second quarter and first half of 2004 increased $849,000, or 66.2%, and $1.0 million, or 42.6%, to $2.1 million and $3.5 million, compared to $1.3 million and $2.5 million in the same periods last year. This increase was mainly due to the acquisition of twelve former PUB branches.
Data processing expense for the second quarter of 2004 increased $289,000, or 37.3%, to $1.1 million, from $775,000 during the second quarter of 2003. Data processing expense for the first half of 2004 increased by $349,000, or 22.7%, to $1.9 million, from $1.5 million during the same period in 2003. Additional expense was incurred mainly due to an increase of loan and deposit volume related to the acquisition, offset by the Company’s continuous effort to save data processing expense. Quarterly supplies and communication expenses also increased 69.2%, to $621,000, in 2004, compared to $367,000 in the second quarter of 2003.
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Professional fees were $613,000 and $883,000 in the second quarter and first half of 2004, respectively, representing increases of $187,000, or 43.9%, and $160,000, or 22.1%, from $426,000 and $723,000 recognized in the same periods of 2003. The increase was caused primarily by increased legal fees associated with the merger with PUB and related securities offerings, as well as consulting fees related to the integration with PUB and data processing system conversions.
Advertising expenses increased from $362,000 and $773,000 in the second quarter and first half of 2003, respectively, to $878,000 and $1.4 million in the same periods of 2004, representing increases of $516,000, or 142.5%, and $650,000, or 84.1%, respectively. In 2004, Hanmi Bank conducted print, radio, and television campaigns and distributed various promotional items to publicize its merger with PUB and attract and retain customers.
In the second quarter of 2004, the Company recorded restructuring charges totaling $1.7 million in connection with the acquisition of PUB, consisting of employee severance and retention bonuses, data processing contract and leasehold termination costs, and fixed asset impairment charges associated with planned branch closures. The Company expects to incur approximately $325,000 additional retention bonus expenses under a retention plan adopted by PUB before the merger that calls for employees to receive bonuses for work performed through July 29, 2004. Such costs are treated as period costs and are recognized in the period services are rendered.
Core deposit premium amortization increased to $469,000 for the second quarter and $499,000 for the first half of 2004, compared $31,000 and $61,000 for the comparable prior year periods, an increase of $438,000 for each period. The increases are attributable to the acquisition of PUB.
Other operating expenses were $1.9 million and $3.0 million in the second quarter and first half of 2004, compared to $1.3 million and $2.2 million in the prior year, representing increases of $582,000, or 45.4%, and $787,000, or 35.4%, respectively. The increases are attributable primarily to additional operating expenses associated with the acquisition of PUB.
The breakdown of non-interest expense by category is reflected below:
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Provision for Income Taxes
For the three months and six months ended June 30, 2004, the Company recognized provisions for income taxes of $4.8 million and $8.9 million on net income before tax of $12.4 million and $22.8 million, respectively, representing an effective tax rate of 39.0%. The tax rate for the six month period in 2003 was 35.4%, and this lower tax rate for the six-month period in 2003 was mainly due to the recognition of income tax benefits generated by a real estate investment trust (“REIT”), a special purpose subsidiary of the Company.
As previously reported, the California Franchise Tax Board announced its position that certain transactions related to REIT will be disallowed under California law adopted in the fourth quarter of 2003. While management continues to believe that the tax benefits realized in previous years were appropriate, the Company deemed it prudent to participate in the statutory Voluntary Compliance Initiative — Option 2, requiring payment of all California taxes and interest on these disputed tax benefits, and permitting the Company to claim a refund while avoiding certain potential penalties. During the second quarter of 2004, the Company paid a $1.9 million state tax payment for the year 2002.
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Financial Condition
Summary of Changes in Balance Sheets - June 30, 2004 Compared to December 31, 2003
At June 30, 2004, the Company’s total assets were $3.10 billion, an increase of $1.31 billion, or 73.4%, from the December 31, 2003 balance of $1.79 billion. The increase was mainly due to the acquisition of PUB, with assets of $1.2 billion, and also attributable to the ongoing growth of loan production during the period. At June 30, 2004, loans, net of unearned fees, allowance for loan losses and loans held for sale, totaled $2.17 billion, an increase of $944 million, or 77.3%, from $1.22 billion at December 31, 2003. Of this increase, net loans acquired in the merger with PUB accounted for $865 million. Investment securities increased $45 million, or 10.9%, to $460 million from $415 million at December 31, 2003. The increase in assets was mainly funded by deposits, which increased by $899 million, or 62.2%, to $2.35 billion at June 30, 2004, from $1.45 billion at December 31, 2003. Deposits obtained as part of the merger with PUB were $936 million.
Investment Security Portfolio
The Company classifies its securities as held to maturity or available for sale in accordance with Statement of Financial Accounting Standards No. 115. Those securities that the Company has the ability and intent to hold to maturity are classified as “held-to-maturity securities.” All other securities are classified as “available-for-sale.” The Company owned no trading securities at June 30, 2004. Securities classified as held-to-maturity are stated at cost, adjusted for amortization of premiums and accretion of discounts, and available-for-sale securities are stated at fair value. The securities currently held by the Company consist primarily of U.S. government agency securities, mortgage-backed securities, collateralized mortgage obligations and municipal bonds.
As of June 30, 2004, held-to-maturity securities totaled $1.2 million, and available-for-sale securities totaled $458.5 million, compared to $1.3 million and $413.3 million at December 31, 2003, respectively.
The unrealized losses are only temporary impairment due to the change in market interest rates.
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Loan Portfolio
The Company carries all loans at face amount, less principal repayments collected, net of deferred loan origination fees and costs, and the allowance for loan losses. Interest on all loans is accrued daily. Once a loan is placed on non-accrual status, the accrual of interest is discontinued and previously accrued interest is reversed. Loans are placed on non-accrual status when principal and interest on a loan is past due 90 days or more, unless a loan is both well secured and in the process of collection.
The Company’s net loans, including loans held for sale of $31.6 million, were $2.20 billion at June 30, 2004. This represented an increase of $950 million, or 76.2%, over net loans of $1.25 billion at December 31, 2003, including $865 million of net loans acquired in the merger with PUB. In general, Hanmi’s existing branch network continued to experience strong growth, consistent with prior years, while branches acquired from PUB experienced limited borrower attrition.
Real estate loans increased $523.3 million, or 104.8%, to $1.0 billion at June 30, 2004, from $499.4 million at December 31, 2003, mainly due to the acquisition of PUB. Real estate loans held by existing Hanmi branches (i.e., branches other than the acquired PUB branches) increased $24.5 million, or 4.9%, during the six-month period. The slow growth of the real estate loan portfolio relative to other portfolio segments reflects management’s emphasis on controlling exposure to excessive concentration in commercial real estate.
Total commercial loans, composed of domestic commercial, trade-financing, and SBA commercial loans, were $1.12 billion at June 30, 2004, which represented an increase of $407 million, or 57.3%, from $711 million at December 31, 2003. Commercial loans held by existing Hanmi branches increased $87.8 million, an increase of 12.4%.
Consumer loans increased $32.4 million, or 59.0%, to $87.3 million at June 30, 2004. Of this increase, consumer loans held by existing Hanmi branches increased $6.5 million, an increase of 11.9%.
The following table shows the Company’s loan composition by type, including loans held for sale.
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At June 30, 2004, accruing loans 90 days past due or more were $325,000, a decrease of $232,000 from $557,000 at December 31, 2003. This was due in large part to the payoff of several trust receipt loans.
Non-accrual loans were $8.1 million at June 30, 2004, including $2.2 million acquired through the merger with PUB. Excluding non-accrual loans acquired via the merger, non-accrual loans decreased by $2.2 million to $5.9 million. The decrease was primarily due to the charge-off of a $2.0 million commercial term loan during the first quarter of 2004.
The table below shows the composition of the Company’s nonperforming assets as of the dates indicated.
Allowance and Provision for Loan Losses
The allowance for loan losses is maintained at a level that management believes is adequate to absorb estimated incurred loan losses inherent in various financial instruments. The adequacy of the allowance is determined through periodic evaluations of the Company’s portfolio and other pertinent factors, which are inherently subjective, as the process calls for various significant estimates and assumptions. Among others, the estimates involve the amounts and timing of expected future cash flows and the fair value of collateral on impaired loans, estimated losses on loans based on historical loss experience, various qualitative factors, and uncertainties in estimating losses and inherent risks in the various credit portfolios, which may be subject to substantial change.
On a quarterly basis, the Company utilizes a classification migration model and individual loan review analysis tools, as starting points for determining the allowance for loan loss adequacy. The Company’s loss migration analysis tracks twelve quarters of loan losses to determine historical loss experience in every classification category (i.e., pass, special mention, substandard, and doubtful) for each loan type, except consumer loans (automobile, mortgage, and credit card), which are analyzed as homogeneous loan pools. These calculated loss factors are then applied to outstanding loan balances, unused commitments, and off-balance sheet exposures, such as letters of credit. The individual loan review analysis is the other axis of the allowance allocation process, applying specific monitoring policies and procedures in analyzing the existing loan portfolios.
The results from the above two analyses are thereafter compared to independently generated information such as peer group comparisons and the federal regulatory interagency policy for loan and lease losses. Further assignments are made based on general and specific economic conditions, as well as performance trends within specific portfolio segments and individual concentrations of credit. Management utilized the same methodology to determine the allowance for loan loss adequacy for the loan portfolios acquired from PUB.
The allowance for loan losses was $25.4 million at June 30, 2004, including $10.6 million acquired through the acquisition of PUB. This is an increase of $10.7 million, or 72.4%, compared to $14.7 million
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at December 31, 2003. The increase in the allowance for loan losses at June 30, 2004 was due primarily to the acquisition of PUB, which had an allowance for loans losses of $10.6 million at April 30, 2004, the charge-off of loans in the amount of $1.6 million, for which a specific allocation had been provided, and the provision for the first half of 2004, which was $1.8 million.
The loan loss estimation is based on historical losses and specific allocations of the allowance are performed on a quarterly basis. Adjustments to allowance allocations for specific segments of the loan portfolio may be made as a result thereof, based on the accuracy of forecasted loss amounts and other loan- or policy-related issues.
The Company determines the appropriate overall allowance for loan losses based on the foregoing analysis, taking into account management’s judgment. The allowance methodology is reviewed on a periodic basis and modified as appropriate. Based on this analysis, including the aforementioned factors, the Company believes that the allowance for loan losses is adequate as of June 30, 2004.
The Company concentrates the majority of its earning assets in loans. In all forms of lending, there are inherent risks. The Company concentrates the preponderance of its loan portfolio in either commercial loans or real estate loans. A small part of the portfolio is represented by installment loans mainly for the purchase of automobiles.
While the Company believes that its underwriting criteria are prudent, outside factors can adversely impact credit quality. The Company has attempted to mitigate collection problems by supporting its loans with fungible collateral. Additionally, a portion of the portfolio is represented by loans guaranteed by the SBA, which further reduces the Company’s potential for loss. The Company also utilizes credit review in an effort to maintain loan quality. Loans are reviewed throughout the year with new loans and those that are delinquent receiving special attention. In addition to the Company’s internal grading system, loans criticized by this credit review are downgraded with appropriate allowances added if required.
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Although management believes the allowance is adequate to absorb losses as they arise, no assurance can be given that the Company will not sustain losses in any given period, which could be substantial in relation to the size of the allowance.
Deposits
At June 30, 2004, the Company’s total deposits increased $899 million, or 62.2%, to $2.35 billion from $1.45 billion at December 31, 2003. Of this increase, deposits acquired in the merger with PUB accounted for $936 million. Demand deposits increased to $763 million at June 30, 2004 from $475 million at December 31, 2003. Demand deposits held by existing Hanmi branches increased $34 million, an increase of 7.2%, while there was limited attrition among former PUB depositors.
Money market accounts increased to $506 million at June 30, 2004 from $206 million at December 31, 2003, an increase of 145%. Growth in money market accounts at existing Hanmi branches totaled $146 million, or 70.7%, from the December 31, 2003 balance of $206 million. Time deposits increased to $926 million at June 30, 2004, an increase of $258 million, or 38.6%, from the December 31, 2003 balance of $668 million.
During the quarter, the Company reevaluated the profitability of its relationships with certain large former PUB depositors, which caused targeted declines of $50 million in brokered certificates of deposit and $54 million in certain volatile money market accounts following the acquisition.
Core deposits (defined as demand, money market, and savings deposits) grew $641 million, or 82.4%, to $1,419 million from $778 million during the six months ended June 30, 2004. The overall deposit increase and a change of deposit composition was mainly due to an expansion of the branch network through the merger with PUB and the results of a special deposit campaign for money market accounts during the first quarter of 2004.
Borrowings
The Company’s borrowings mostly take the form of advances from the Federal Home Loan Bank of San Francisco (“FHLB”), overnight federal funds, and junior subordinated debt associated with trust preferred securities.
FHLB advances increased $113 million, or 76.4%, during the first half of 2004, to $261 million at June 30, 2004, from $148 million at December 31, 2003. The increase includes PUB’s outstanding borrowings from the FHLB of $105 million at April 30, 2004. During the first half of 2004, three trusts established by the Company issued $80 million of trust preferred securities to investors. The Company’s
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outstanding subordinated debt related to these offerings, used to finance the purchase of PUB, was $82 million at June 30, 2004.
Liquidity and Capital Resources
Liquidity of the Company is defined as the ability to supply cash as quickly as needed without severely deteriorating its profitability. The Company’s major liquidity on the asset side stems from available cash positions, Federal funds sold and short-term investments categorized as available-for-sale securities, which can be disposed of without significant capital losses in the ordinary course of business. Liquidity sources on the liability side include borrowing capacities, which include Federal funds lines, repurchase agreements, and Federal Home Loan Bank advances. Thus, maintenance of high quality securities that can be used for collateral in repurchase agreements is another important feature of liquidity management.
Liquidity risk may occur when the Bank has few short-duration securities available for sale and/or is not capable of raising funds as quickly as necessary at acceptable rates in the capital or money markets. Also, a heavy and sudden increase in cash demands for loans, deposits or other purposes such as corporate acquisitions can tighten the liquidity position. Several ratios are reviewed on a daily, monthly, and quarterly basis to manage the liquidity position and to preempt any liquidity crisis. Six specific statistics, which include the loans-to-assets ratio, off-balance sheet items, dependence on non-core deposits, foreign deposits, lines of credit, and liquid assets are reviewed regularly for liquidity management purposes.
The maintenance of a proper level of liquid assets is critical for both the liquidity and the profitability of the Company. Since the primary objective of the investment portfolio is to ensure proper liquidity of the Company, management maintains appropriate levels of liquid assets to avoid exposure to higher than necessary liquidity risk.
At June 30, 2004, short-term investments totaled 4% of assets, compared to 6% at December 31, 2003. Core deposits, expressed as a percentage of total assets, increased to 41% at June 30, 2004 from 40% at December 31, 2003, while short-term non-core funding decreased to 36% of assets from 45% of assets over the same period. The ratio of short-term investments to short-term non-core funding increased slightly, to 21% from 20%. Off-balance sheet items, primarily unused credit lines, were 15% of assets, at June 30, 2004.
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The Company saw a steady demand for loans during first half of 2004. Net loans as a percentage of total assets increased slightly, to 71% of assets at June 30, 2004 from 70% of assets at December 31, 2003.
In anticipation of the acquisition of PUB, the Bank reduced its investment portfolio in the first quarter of 2004 by $52.1 million, primarily through sales of certain mortgage-backed securities and collateralized mortgage obligations, reducing its regulatory capital requirements. In addition, in the first half of 2004, the Company raised a total of $80.0 million through the issuance of trust-preferred securities and $75.0 million through a private placement of common stock. These funds increased the Bank’s Tier 1 regulatory capital by $155.5 million and were used to finance a portion of the $164.5 million cash portion of the purchase price of PUB.
As part of the acquisition of PUB, the Bank acquired a portfolio of liquid assets, including $27.5 million cash and balances due from banks and $76.9 million overnight Federal funds sold. During the second quarter, management reevaluated the profitability of the Bank’s relationships with certain former PUB customers. As a result, there was a $54.0 million targeted decline in certain volatile money market deposit accounts and a $50.0 million decline in brokered certificates of deposit following the acquisition, which reduced the need to maintain highly liquid assets.
In order to ensure adequate levels of capital, the Company conducts an ongoing assessment of projected sources and uses of capital in conjunction with projected increases in assets and levels of risk. Management considers, among other things, on an ongoing basis, cash generated from operations, access to capital from financial markets or the issuance of additional securities, including common stock or notes, to meet the Company’s capital needs. Total shareholders’ equity was $373.8 million at June 30, 2004. This represented an increase of $234.3 million, or 168.0%, over total shareholders’ equity of $139.5 million at December 31, 2003.
The regulatory agencies require a minimum ratio of qualifying total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1 capital to risk-adjusted assets of 4%. In addition to the risk-based guidelines, regulators require banking organizations to maintain a minimum amount of Tier 1 capital to total assets, referred to as the leverage ratio, of 4%. For a bank rated in the highest of the five categories used by regulators to rate banks, the minimum leverage ratio is 3%. In addition to these uniform risk-based capital guidelines that apply across the industry, the regulators have the discretion to set individual minimum capital requirements for specific institutions at rates significantly above the minimum guidelines and ratios.
At June 30, 2004, Tier 1 capital (shareholders’ equity less intangible assets) was $236.3 million. This represented an increase of $99.7 million, or 73%, over total Tier 1 capital of $136.6 million at December 31, 2003. At June 30, 2004, the Company had a ratio of total capital to total risk-weighted assets of 11.19% and a ratio of Tier 1 capital to total risk weighted assets of 10.11%. The Tier 1 leverage ratio was 9.66% at June 30, 2004.
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The following table presents the amounts of regulatory capital and the capital ratios for the Company, compared to the regulatory capital requirements as of June 30, 2004.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
General
Interest rate risk indicates the Company’s exposure to market interest rate fluctuations. The movement of interest rates directly and inversely affects the economic value of fixed-income assets, which is the present value of future cash flow discounted by the current interest rate. Under the same conditions, the higher the current interest rate, the higher the denominator of discounting. Interest rate risk management is intended to decrease or increase the level of the Company’s exposure to fluctuations in market interest rates. The level of interest rate risk can be managed through the changing of gap positions, the volume of fixed-income assets, etc. For successful management of interest rate risk, the Company uses various methods with which to measure existing and future interest rate risk exposures. In addition to regular reports used in business operations, re-pricing gap analysis, stress testing, and simulation modeling are the main measurement techniques used to quantify interest rate risk exposure.
The following table shows the status of the Company’s gap position at June 30, 2004.
The re-pricing gap analysis measures the static timing of re-pricing risk of assets and liabilities, i.e., a point-in-time analysis measuring the difference between assets maturing or re-pricing in a period and liabilities maturing or re-pricing within the same time period. Assets are assigned to maturity and re-pricing categories based on their expected repayment or re-pricing dates, and liabilities are assigned based on their maturity dates. Core deposits that have no maturity dates (demand deposits, savings, MMDA, and NOW accounts) are assigned to categories based on expected decay rates.
During the quarter ended June 30, 2004, the cumulative amount of re-pricing assets as a percentage of earning assets decreased in both the less-than-three-months and the three-to-twelve-months re-pricing periods. When compared to the previous quarter, the percentage of net earning assets in the less-than-three-months period declined slightly from 40.87% to 37.97%. The cumulative percentage in the three-to-twelve-months period was 14.56%, compared to 18.83% at March 31, 2004. The issuance of trust preferred securities in the amount of $20 million contributed to these decreases in the gap position.
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The following table summarizes the most recent status of the Company’s gap position as of June 30, 2004.
To supplement traditional gap analysis, the Company performs simulation modeling to estimate the potential effects of interest rate changes. The following table summarizes one of the stress simulations performed by the Company to forecast the impact of changing interest rates on net interest income and the market value of interest-earning assets and interest-bearing liabilities reflected on the Company’s balance sheet. This sensitivity analysis is compared to policy limits, which specify the maximum tolerance level for net interest income exposure over a one-year horizon, given the basis point adjustments in interest rates presented below.
Current Exposure of the Company toHypothetical Changes in Interest Rates
(dollars in thousands)
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In the above stress simulation, for a 100 basis point decline in interest rates, the Company may be exposed to a 7.38% decline in net interest income and a 3.62% increase in the economic value of shareholders’ equity. For a 100 basis point increase in interest rates, net interest income may increase by 5.87%, but the economic value of shareholders’ equity may decrease by 3.14%. For a 200 basis point increase in interest rates, net interest income may increase by 11.76%, but economic value of shareholders’ equity may decrease by 5.91%. For a 200 basis point decrease in interest rates, net interest income may decrease by 15.81%, but economic value of shareholders’ equity may increase by 9.02%. As shown in the above table, all figures remained well within internal policy guidelines.
The estimated sensitivity does not necessarily represent a Company forecast and the results may not be indicative of actual change to the Company’s net interest income. These estimates are based upon a number of assumptions, including the nature and timing of interest rate levels including yield curve shape, prepayments on loans and securities, pricing strategies on loans and deposits, and replacement of asset and liability cash flows. While the assumptions used are based on current economic and local market conditions, there is no assurance as to the predictive nature of these conditions, including how customer preferences or competitor influences might change
Contractual Obligations
There were no material changes to the Company’s long-term debt described in its Annual Report on Form 10-K for the year ended December 31, 2003, other than the issuance in the period ended June 30, 2004 of $82.4 million junior subordinated debt discussed above.
Dividends
On June 16, 2004, the Company declared a quarterly cash dividend of $0.10 per common share for the second quarter of 2004. The dividend was paid on July 15, 2004. Future dividend payments are subject to the Company’s future earnings and legal requirements and the discretion of the Board of Directors.
Item 4. Controls and Procedures
The Company’s Chief Executive Officer and its Principal Financial Officer directly supervised and participated in evaluating the effectiveness of the design and operation of our disclosure controls and procedures as of June 30, 2004 and concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Principal Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
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PART II
Item 1. Legal Proceedings
None.
Item 2. Changes in Securities and Use of Proceeds
In the quarter ended June 30, 2004, Hanmi Financial Corporation formed Hanmi Capital Trust III, which issued a total of $20 million trust preferred securities on April 30, 2004 pursuant to a private placement underwritten by Trapeza Funding V, LLC and included in pools of trust preferred securities assembled by Trapeza.
The Company issued junior subordinated notes bearing interest at the three-month LIBOR plus 2.63% totaling $20,619,000 in exchange for funds raised in the trust preferred offering and the Company’s $619,000 common equity investment in the trust.
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
On April 7, 2004, the Company held a special meeting of shareholders to vote upon a proposal to approve the issuance of Hanmi Financial common stock to PUB shareholders pursuant to the Agreement and Plan of Merger, dated December 22, 2003, by and among Hanmi Financial, Hanmi Bank, and PUB and in a concurrent private placement of 3,947,369 shares at $19 per share pursuant to Securities Purchase Agreements, dated December 22, 2003, with specified purchasers, in order to finance a portion of the cash consideration paid in the acquisition of PUB. 9,650,564 votes were cast in favor of the proposal, 35,734 votes were cast against it, and there were 10,928 abstentions and 4,475,667 broker non-votes.
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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Exhibit Index
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