Heritage Commerce - 10-Q quarterly report FY

The following management discussion and analysis gives effect to the restatement and reclassifications in Notes 1 and 2 to the condensed consolidated financial statements.

Discussions of certain matters in this Report on Form 10-Q may constitute forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and as such, may involve risks and uncertainties. Forward-looking statements, which are based on certain assumptions and describe future plans, strategies, and expectations, are generally identifiable by the use of words such as "believe", "expect", "intend", "anticipate", "estimate", "project", “assume”, “plan”, “predict”, “forecast” or similar expressions. These forward-looking statements relate to, among other things, expectations of the business environment in which the Company operates, projections of future performance, potential future performance, potential future credit experience, perceived opportunities in the market, and statements regarding the Company's mission and vision. The Company's actual results, performance, and achievements may differ materially from the results, performance, and achievements expressed or implied in such forward-looking statements due to a wide range of factors. These factors include, but are not limited to changes in interest rates, reducing interest margins or increasing interest rate risk, general economic conditions nationally or in the State of California, legislative and regulatory changes adversely affecting the business in which the Company operates, monetary and fiscal policies of the US Government, real estate valuations, the availability of sources of liquidity at a reasonable cost, competition in the financial services industry, the occurrence of events such as the terrorist acts of September 11, 2001, and other risks. All of the Company's operations and most of its customers are located in California. In addition, acts and threats of terrorism or the impact of military conflicts have increased the uncertainty related to the national and California economic outlook and could have an effect on the future operations of the Company or its customers, including borrowers. The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

 

 

When evaluating financial condition and performance, management looks at certain key metrics and measures. The Company’s evaluation includes an analysis including comparisons with peer group financial institutions and with its own performance objectives established in the internal planning process.

 

The primary activity of the Company is commercial banking. The Company’s operations are located primarily in the southern and eastern regions of the general San Francisco Bay area of California. The largest city in this area is San Jose and the Company’s market includes the headquarters of a number of technology based companies in the region known commonly as Silicon Valley. The Company’s customers are primarily closely held businesses and professionals.

 

Through its asset and liability management process, the Company monitors a number of ratios to analyze the Company’s performance over time and also to compare the Company against similarly sized and situated companies in the banking industry. Management considers the following ratios to be important benchmarks for the Company’s performance and financial conditions:

 

 

 

 

 

There is no single ratio or metric that summarizes the performance of the Company. The ratios above each take an element of the Company’s performance and quantify it so that it can be compared over time and benchmarked against other peer companies. Management uses these and other ratios and metrics in assessing and planning the Company’s performance.

 

The Company believes that the initiatives it undertook in 2004, coupled with increases in short term interest rates including the target Federal funds rate and the prime rate, has improved its performance year to date.

 

 

 

Heritage Commerce Corp’s financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our consolidated financial statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. In certain instances, we use a discount factor and prepayment assumptions to determine the present value of assets and liabilities. A change in the discount factor or prepayment speeds could increase or decrease the values of those assets and liabilities which would result in either a beneficial or adverse impact to our financial results. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. We apply Accounting Principles Board (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations to account for our stock option plan awards. Other estimates that we use include the expected useful lives of our depreciable assets. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of when the transactions would be recorded could change.

 

 

The allowance for loan and lease losses is an estimate of the losses that may be sustained in the Company’s loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (SFAS) No. 5 “Accounting for Contingencies”, which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the impaired loan balance.

 

The Company’s allowance for loan and lease losses has three basic components: the formula allowance for various pools of loans, the specific allowance for individual impaired loans, and the unallocated allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The formula allowance uses an historical loss view as an indicator of future losses and as a result formula losses could differ from the losses incurred in the future. The specific allowance uses various techniques to arrive at an estimate of loss. Historical loss information and fair market value of collateral are used to estimate those losses. The use of these values is inherently subjective and our actual losses could differ from the estimates. The unallocated allowance captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in either the formula or specific allowances. For further information regarding our allowance for credit losses, see Allowance for loan and lease losses on page 26.

 

The amounts of gains recorded on sales of loans and the initial recording of servicing assets and interest only strips are based on the estimated fair values of the respective components. In recording the initial value of the servicing assets and the fair value of the interest-only (I/O) strips receivable, the Company uses estimates which are based on management’s expectations of future prepayment and discount rates. In evaluating the servicing assets, management used a discounted cash flow modeling technique, which requires estimates regarding the amount and timing of future cash flows, including assumptions about loan repayment rates and cost to service, as well as interest rate assumptions that contemplate the risks involved. For the quarter ended September 30, 2005, management’s estimate of constant prepayment rate (“CPR”) was 15% and the weighted average discount rate assumption was 9%. These prepayment and discount rates were based on current market conditions and historical market performance of pools of serviced loans. If actual prepayments with respect to sold loans occur more quickly than projected, the carrying value of the servicing assets may have to be adjusted through a charge to earnings. A corresponding decrease in the value of the I/O strip receivable would also be expected.

Under APB No. 25, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company’s stock at the date of the grant over the amount required to be paid to the Company by the optionee upon exercising the option. Because the Company’s stock option plans provide for the issuance of options at a price of no less than the fair market value at the date of the grant, no compensation expense is required to be recognized for stock options on the date of grant.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment.” This Statement requires that compensation costs related to share-based payment transactions be recognized in the financial statements. Measurement of the cost of employee service will be based on the grant-date fair value of the equity or liability instruments issued. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award. Additionally, liability awards will be remeasured each reporting period. Statement 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supercedes APB Opinion No. 25 "Accounting for Stock Issued to Employees." On April 14, 2005, the SEC issued rule 2005-57, which allows companies to delay implementation of Statement 123R to the beginning of the next fiscal year. The Company has not yet concluded on the method of adoption allowed by Statement 123R and is currently evaluating the impact of this accounting guidance on its financial condition and results of operations.

 

 

 

For the three and nine months ended September 30, 2005, consolidated net income was $4,195,000 and $10,189,000, respectively, compared to $3,092,000 and $5,832,000, respectively, for the three and nine months ended September 30, 2004, an increase of 36% and 75%, respectively. Earnings per diluted share were $0.35 and $0.84, respectively, for the three and nine months ended September 30, 2005, compared to $0.26 and $0.49, respectively, for the three and nine months ended September 30, 2004, an increase of 35% and 71%, respectively. The increase for the three months and nine months ended September 30, 2005 from the same periods in 2004 was attributed to increases in the volume of average earning assets and increases in key market interest rates in 2005. Annualized return on average assets and return on average equity for the three months ended September 30, 2005 were 1.45% and 15.64%, respectively, compared to 1.12% and 13.10%, for the same period in 2004. Annualized return on average assets and return on average equity for the nine months ended September 30, 2005 were 1.20% and 13.13%, respectively, compared to 0.74% and 8.43%, for the same period in 2004.

Net interest income increased $1,563,000, or 15%, and $5,232,000, or 17%, for the three and nine months ended September 30, 2005 compared to the same period in 2004. The Company's net interest margin was 4.61% and 4.52%, respectively, for the three and nine months ended September 30, 2005, an increase of 36 and 34 basis points from 4.25% and 4.18% respectively, for the three and nine months ended September 30, 2004. The increase in net interest margin for the three and nine months ended September 30, 2005 reflects an increase in the yield on earning assets of 99 and 80 basis points offset by a corresponding increase in the cost of interest bearing liabilities of 83 and 62 basis points. The increase in net interest income for the three and nine months ended September 30, 2005 compared to the same period in 2004 is the result of higher short-term interest rate increases and an increase in the volume of earning assets. The increase in net interest margin and volume of earning assets was primarily attributable to an increase in the average level of loans and securities in 2005 compared to the comparable periods in 2004. These increases were funded by an increase in interest bearing liabilities.

 

Total assets at September 30, 2005 were $1,160,591,000, an increase of $72,553,000, or 7%, from $1,088,038,000 as of September 30, 2004, and an increase of $52,418,000, or 5%, from total assets of $1,108,173,000 as of December 31, 2004. Total deposits at September 30, 2005 were $975,194,000, an increase of $72,538,000, or 8%, from $902,656,000 as of September 30, 2004, and an increase of $56,659,000, or 6%, from total deposits of $918,535,000 as of December 31, 2004.

Total loans at September 30, 2005 were $737,979,000, an increase of $13,767,000, or 2%, compared to $724,212,000 as of September 30, 2004, and an increase of $12,449,000, or 2%, from $725,530,000 as of December 31, 2004. The Company's allowance for loan and lease losses was $11,112,000, or 1.51% of total loans at September 30, 2005, compared to $12,973,000, or 1.79% of total loans, and $12,497,000, or 1.72% of total loans, at September 30, 2004 and December 31, 2004, respectively. The decrease in the overall level of the allowance of loan losses since December 31, 2004 is primarily attributable to the charge-off of one commercial loan in 2005, which was partially offset by the provisions made during the first and second quarter of 2005. Nonperforming assets including nonaccrual loans, loans past due 90 days or more and still accruing, restructured loans, foreclosed assets, and other real estate owned at September 30, 2005 were $2,715,000, compared to $2,637,000 at September 30, 2004 and $1,330,000 at December 31, 2004.

 

The Company's shareholders' equity at September 30, 2005 was $107,057,000, compared to $96,411,000 at September 30, 2004 and $98,579,000 as of December 31, 2004. The increase in shareholders’ equity from these prior periods was primarily attributable to net income and proceeds from the exercise of common stock options, partially offset by the repurchase of common stock. Book value per share increased to $9.09 at September 30, 2005, from $8.27 at September 30, 2004 and $8.45 at December 31, 2004. The Company's leverage capital ratio was 11.2% at September 30, 2005 compared to 10.6% at September 30, 2004 and 10.9% at December 31, 2004.