UNITED STATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended June 30, 2001
Or
For the transitional period from _________________ to _________________
Commission File No. 000-23877
HERITAGE COMMERCE CORP
(408) 947-6900
None
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No
APPLICABLE ONLY TO CORPORATE ISSUERS:
The Registrant had 11,104,574 shares of Common Stock outstanding on August 9, 2001.
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TABLE OF CONTENTS
HERITAGE COMMERCE CORP AND SUBSIDIARIESQUARTERLY REPORT ON FORM 10-Q
Table of Contents
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HERITAGE COMMERCE CORP AND SUBSIDIARIESCondensed Consolidated Statements of Financial Condition (Unaudited)
ASSETS
See notes to condensed consolidated financial statements
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HERITAGE COMMERCE CORP AND SUBSIDIARIESCondensed Consolidated Income Statements (Unaudited)
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HERITAGE COMMERCE CORP AND SUBSIDIARIESCondensed Consolidated Statements of Cash Flows (Unaudited)
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HERITAGE COMMERCE CORP AND SUBSIDIARIESNotes to Condensed Consolidated Financial StatementsJune 30, 2001(Unaudited)
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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”, 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. The factors include, but are not limited to changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the US Government, real estate valuations, competition in the financial services industry, and other risks. 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.
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Heritage operates as the bank holding company for the four subsidiary banks: Heritage Bank of Commerce, Heritage Bank East Bay, Heritage Bank South Valley and Bank of Los Altos (collectively the “Banks”). All are California state chartered banks which offer a full range of commercial and personal banking services to residents and the business/professional community in Santa Clara, Contra Costa and Alameda Counties, California. The accounting and reporting policies of Heritage Commerce Corp and its subsidiaries conform to accounting principles generally accepted in the United States of America and prevailing practices within the banking industry. The financial information presented herein has been restated on a historical basis to reflect the merger with Western Holdings Bancorp, which closed in October 2000, as a pooling of interests as if the Companies had been combined for all periods presented.
OVERVIEW
Net income for the three and six months ended June 30, 2001 was $1,890,000 and $4,071,000, up 27% and 35%, from $1,489,000 and $3,006,000 for the same periods in the prior year. Earnings per diluted share for the three and six months ended June 30, 2001 was $0.17 and $0.36, up 31% and 33%, from $0.13 and $0.27 per diluted share for same periods in the prior year. Annualized return on average assets and return on average equity for the six months ended June 30, 2001 were 0.95% and 11.90% compared with returns of 0.84% and 10.38% for the same period in the prior year. Annualized return on average assets and return on average equity for the quarter ended June 30, 2001 were 0.88% and 10.71%, compared with returns of 0.79% and 10.12%, for the same period in the prior year.
For the six months ended June 30, 2001, as compared with the same period in the prior year, net interest income increased from $19,498,000 to $21,700,000, an increase of $2,202,000, or 11%. For the three months ended June 30, 2001, as compared with the same period in the prior year, net interest income increased from $10,380,000 to 10,620,000, an increase of $240,000, or 2%. The increase is attributable to the growth in earning assets, primarily loans, offset by a decline in interest rates earned reflecting the Federal Reserve Board of Governors’ reduction in short term interest rates of 275 basis points during the first six months of 2001 and the timing of the Company's ability to reprice its interest bearing deposits. The Company’s net interest margin was 5.52% for the six months ended June 30, 2001, compared with 5.91% for the six months ended June 30, 2000, reflective of the overall decline in the interest rate environment and the fact that the Company’s assets reprice more quickly than its liabilities.
Total assets as of June 30, 2001 were $867,631,000, an increase of $53,336,000, or 7%, from $814,295,000 at June 30, 2000, and an increase of $21,407,000, or 3%, from total assets of $846,224,000 at December 31, 2000. Total deposits as of June 30, 2001 were $770,168,000, an increase of $33,052,000, or 4%, from $737,116,000 at June 30, 2000, and an increase of $31,982,000, or 4%, from total deposits of $738,186,000 at December 31, 2000.
Total portfolio loans as of June 30, 2001 were $605,132,000, an increase of $83,594,000, or 16%, from $521,538,000 June 30, 2000. Total portfolio loans as of December 31, 2000 were $610,781,000. The Company’s allowance for loan losses was $10,347,000, or 1.71%, of total loans as of June 30, 2001. This compares with an allowance for loan losses of $7,738,000, or 1.48%, and $9,651,000, or 1.58% of total loans at June 30, 2000 and December 31, 2000. The Company’s non-performing assets were $66,000 as of June 30, 2001 compared to $1,092,000 as of June 30, 2000 and none as of December 31, 2000.
The Company’s shareholders’ equity at June 30, 2001 was $70,967,000, up from $60,276,000 as of June 30, 2000 and $65,733,000 as of December 31, 2000. Book value per share was $6.39 as of June 30, 2001, up from $5.71 as of June 30, 2000 and $6.01 as of December 31, 2000. The Company’s leverage capital ratio was 9.78% at June 30, 2001 compared to 9.06% at June 30, 2000 and 9.30% at December 31, 2000.
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RESULTS OF OPERATIONS
Net Interest Income and Net Interest Margin
The following table presents the Company’s average balance sheet, net interest income and the resultant yields and rates paid for the period presented:
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The Company’s net interest income for the three and six months ended June 30, 2001 was $10,620,000 and $21,700,000, an increase of $240,000 and $2,202,000, or 2% and 11% over the same periods in the prior year. When compared to the three and six months ended June 30, 2001, average earning assets increased by $99,404,000 and $129,376,000, or 14% and 19%. For the second quarter of 2001, the average yield on earning assets was 8.61%, down 84 basis points from 9.45% for the same period in 2000. Over the same periods, the rates paid on interest bearing liabilities declined 18 basis points to 4.48% from 4.66%. For the six months ended June 30, 2001 the average yield on earning assets was 8.91%, down 27 basis points from 9.18% for the same period in 2000. Over the same periods, the rates paid on interest bearing liabilities increased 21 basis points to 4.69% from 4.48%. Overall, the net interest margin decreased to 5.43% and 5.52% for the three and six months ended June 30, 2001, from to 6.02% and 5.91% for the same periods in the prior year. Even with the above decrease in net interest margin, net interest income increased due to the increases in the level of average loans. The increased level of loans was funded by a decrease in Federal funds sold.
The following table sets forth an analysis of the changes in interest income resulting from increases in the volume of interest earning liabilities and increases in the average rates earned and paid. The total change is shown in the column designated “Net Change” and is allocated in the columns to the left, to the portions respectively attributable to volume changes and rate changes that occurred during the period indicated. Changes due to both volume and rate have been allocated to the change in volume.
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Provision for Loan Losses
For the three and six months ended June 30, 2001, the provision for loan losses was $528,000 and $1,055,000, down $6,000 and $159,000 from $534,000 and $1,214,000 for the same periods in the prior year. See additional discussion at Allowance for Probable Loan Losses.
Noninterest Income
The following table sets forth the various components of the Company’s noninterest income for the periods indicated:
Noninterest income for the three and six months ended June 30, 2001 was $1,647,000 and $2,868,000, up 168% and 112% from $614,000 and $1,350,000 from the same periods in the prior year. The increase was primarily due to the increases in gains on sale of securities, SBA loans and servicing income recognized for the three and six months ended June 30, 2001 compared to the same period in 2000. The interest rate environment in 2001 has provided the opportunity for the Company to benefit from gains on sales of securities and increase its sales of SBA loans, resulting in gains and increased servicing income.
Noninterest Expense
The following table sets forth the various components of the Company’s noninterest expenses for the periods indicated:
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The following table indicates the percentage of noninterest expense in each category:
Noninterest expenses for the three and six months ended June 30, 2001 were $8,669,000 and $16,936,000, up $444,000 and $1,921,000, or 5% and 13%, from $8,225,000 and $15,015,000 for the same periods in the prior year. The overall increase in noninterest expenses reflects the growth in infrastructure to support the Company’s loan and deposit growth.
In the second quarter ended June 30, 2001, salaries and benefits increased $99,000 reflecting normal salary and benefit increases and the growth in the level of full time equivalent employees from 215 at June 30, 2000 to 232 at June 30, 2001. Salaries and benefits increased $1,165,000, or 14%, to $9,710,000 in the first six months of 2001, as compared to the same period in the prior year. As a percentage of total noninterest expenses, salaries and benefits were 53% and 55%, respectively, for the three months ended June 30, 2001 and 2000, respectively. Occupancy increased by $167,000, or 32%, as a result of increased rental costs. The increase was $304,000, or 29%, to $1,361,000 in the first six months of 2001, as compared to the same period in the prior year. Furniture and equipment increased by $50,000, or 13%. Stationery and supplies increased by $43,000, or 52%. The increase was $97,000, or 60%, to $258,000 in the first six months of 2001, as compared to the same period in the prior year. This reflects the growth the Company has sustained. Loan origination costs increased by $205,000, or 132%, as a result of the overall growth in the loan portfolio and increased as a percentage of total noninterest expenses from 2% to 4%. The increase was $298,000, or 83%, to $659,000 in the first six months of 2001, as compared to the same period in the prior year. Professional fees decreased by $318,000, or 55%. The decrease was $294,000, or 33%, to $595,000 in the first six months of 2001, as compared to the same period in the prior year. Client services increased $378,000, or 141%, and increased as a percentage of total noninterest expenses from 3% to 8%. The increase was $301,000, or 47%, to $939,000 in the first six months of 2001, as compared to the same period in the prior year. Advertising and promotion increased $181,000, or 45%, to $582,000 in the first six months of 2001, as compared to the same period in the prior year.
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Income Taxes
The provision for income taxes for the three and six months ended June 30, 2001 was $1,180,000 and $2,505,000, as compared to $746,000 and $1,613,000 for the same periods in the prior year. The difference in the effective tax rate compared to the statutory tax rate is primarily the result of the Company holding certain life insurance contracts and changes in the Company’s level of investments in municipal securities.
FINANCIAL CONDITION
Total assets increased $21,407,000, or 3%, to $867,631,000 at June 30, 2001 from $846,224,000 at December 31, 2000, and increased $53,336,000, or 7%, from $814,295,000 at June 30, 2000. Total portfolio loans decreased $5,649,000 or 1% to $605,132,000 at June 30, 2001 from $610,781,000 at December 31, 2000, but have increased $83,594,000 or 16% from $521,538,000 at June 30, 2000. Total deposits were $770,168,000 at June 30, 2001, an increase of 4% from $738,186,000 at December 31, 2000, and have increased 4% from $737,116,000 at June 30, 2000. The above reflects the continued strong internal growth of the Company, primarily in noninterest bearing demand deposits and brokered deposits, which used with the proceeds from investment securities sales and maturities and loan sales and payments funded the growth in Federal funds sold.
Securities Portfolio
The following table summarizes the composition of the Company’s investment securities and the weighted average yields at June 30, 2001:
Loans
Total loans (exclusive of loans held for sale) decreased 1% to $605,132,000 at June 30, 2201, as compared to $610,781,000 at December 31, 2000. The decrease in loan balances was a result of loan payments and payoffs exceeding the level of new originations during the first six months of 2001.
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The following table summarizes the composition of the Company’s loan portfolio at the rates indicated:
The Company’s loan portfolio is based in commercial (primarily to companies engaged in manufacturing, wholesale, and service businesses) and real estate lending, with the balance in consumer loans. Real estate construction loans have been paid off. However, while no specific industry concentration is considered significant, the Company’s lending operations are located in the Company’s market areas that are dependent on the technology and real estate industries and their supporting companies. Thus, the Company’s borrowers could be adversely impacted by a downturn in these sectors of the economy which could reduce the demand for loans and adversely impact the borrowers’ abilities to repay their loans.
The following table sets forth the maturity distribution of the Company’s loans at June 30, 2001:
The table shows the distribution of such loans between those loans with predetermined (fixed) interest rates and those with variable (floating) interest rates. Floating rates generally fluctuate with changes in the prime rate as reflected in the western edition of The Wall Street Journal. At June 30, 2001, approximately 88% of the Company’s loan portfolio consisted of floating interest rate loans.
Nonperforming assets
Nonperforming assets consist of nonaccrual loans, loans past due 90 days and still accruing, troubled debt restructurings and other real estate owned. The following table shows nonperforming assets at the dates indicated:
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Allowance for Loan Losses
Management conducts a critical evaluation of the loan portfolio monthly. This evaluation includes an assessment of the following factors: past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, collateral value, loan volumes and concentrations, recent loss experience in particular segments of the portfolio, bank regulatory examination results, and current economic conditions. Management has established an evaluation process designed to determine the adequacy of the allowance for loan losses. This process attempts to assess the risk of loss inherent in the portfolio by segregating the allowance for loan losses into four components: “watch”, “special mention”, “substandard” and “doubtful”.
It is the policy of management to maintain the allowance for loan losses at a level adequate for known and future risks inherent in the loan portfolio. Based on information currently available to analyze loan loss delinquency and a history of actual charge-offs, management believes that the loan loss provision and allowance are adequate; however, no assurance of the ultimate level of credit losses can be given with any certainty. Loans are charged against the allowance when management believes that the collectibility of the principal is unlikely.
The following table summarizes the Company’s loan loss experience as well as transactions in the allowance for loan losses and certain pertinent ratios for the periods indicated:
The following table summarizes the allocation of the allowance for loan losses (ALL) by loan type and the allocated allowance as a percent of loans outstanding in each loan category at the dates indicated:
The increase in the allowance for loan losses reflects the growth in the Company’s commercial and real estate mortgage loan portfolio and the Company’s assessment of the increased inherent credit risk resulting from the current economic environment, particularly in the Company’s primary market area and lending focus, and the potential effects of the continuing California energy situation.
All of the Company’s operations and virtually all of its customers are located in California. The availability of a sufficient supply of electrical power in California has been called into question by recent events, including the bankruptcy of one of the state’s major utilities. While neither the Company nor any of its customers have been materially adversely affected by the electrical power crisis to date, power supply issues could have an affect on future operations of the Company or its customers, including borrowers.
Deposits
Deposits totaled $770,168,000 at June 30, 2001, an increase of 4%, compared to deposits of $738,186,000 at December 31, 2000 and an increase of 4% compared to $737,116,000 at June 30, 2000. The increase in deposits was primarily due to increases in noninterest bearing deposits and brokered deposits. Noninterest bearing deposits increased to $234,125,000 at June 30, 2001, from $207,885,000 at December 31, 2000. Brokered deposits increased to $26,723,000 at June 30, 2001, from $9,238,000 at December 31, 2000.
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The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated:
Deposit Concentration and Deposit Volatility
The following table indicates the maturity schedule of the Company’s time deposits of $100,000 or more as of June 30, 2001.
The Company focuses primarily on servicing business accounts that are frequently over $100,000 in average size. Certain types of accounts that the Company makes available are typically in excess of $100,000 in average balance per account, and certain types of business clients whom the Company serves typically carry deposits in excess of $100,000 on average. The account activity for some account types and client types necessitates appropriate liquidity management practices by the Company to ensure its ability to fund deposit withdrawals.
Interest Rate Risk
The planning of asset and liability maturities is an integral part of the management of an institution’s net yield. To the extent maturities of assets and liabilities do not match in a changing interest rate environment, net yields may change over time. Even with perfectly matched repricing of assets and liabilities, risks remain in the form of prepayment of loans or investments or in the form of delays in the adjustment of rates of interest applying to either earning assets with floating rates or to interest bearing liabilities. The Company has generally been able to control its exposure to changing interest rates by maintaining primarily floating interest rate loans and a majority of its time certificates with relatively short maturities.
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The following table sets forth the interest rate sensitivity of the Company’s interest-earning assets and interest-bearing liabilities at June 30, 2001, using the rate sensitivity gap ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or when it is scheduled to mature within the specified time frame:
The foregoing table demonstrates that the Company had a positive cumulative one year gap of $32,626,000, or 3.76% of total assets, at June 30, 2001. In theory, this would indicate that $32,626,000 more in assets than liabilities would reprice if there was a change in interest rates over the next year. If interest rates were to increase, the positive gap would tend to result in a higher net interest margin. However, changes in the mix of earning assets or supporting liabilities can either increase or decrease the net margin without affecting interest rate sensitivity. This characteristic is referred to as a basis risk and, generally, relates to the repricing characteristics of short-term funding sources such as certificates of deposit.
Interest rate changes do not affect all categories of assets and liabilities equally or at the same time. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities, which may have a significant effect on the net interest margin and are not reflected in the interest sensitivity analysis table. Because of these factors, an interest sensitivity gap report may not provide a complete assessment of the exposure to changes in interest rates. To supplement traditional GAP analysis, the Company performs simulation modeling to estimate the potential effects of changing interest rate environments. The process allows the Company to explore the complex relationships within the GAP over time and various interest rate environments.
Liquidity risk represents the potential for loss as a result of limitations on the Company’s ability to adjust for future cash flows, to meet the needs of depositors and borrowers, and to fund operations on a timely and cost-effective basis. The liquidity policy approved by the board requires annual review of the Company’s liquidity by the asset/liability committee, which is composed of senior executives, and the finance and investment committee of the board of directors.
The Company’s internal asset/liability committee and the finance and investment committee of the board each meet monthly to monitor the Company’s investments, liquidity needs and to oversee its asset/liability management. The Company evaluates the rates offered on its deposit products on a weekly basis.
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Liquidity and Liability Management
To meet liquidity needs, the Company maintains a portion of its funds in cash deposits in other banks, in Federal funds sold, and in investment securities. At June 30, 2001, the Company’s primary liquidity ratio was 17.88%, comprised of $38.2 million in investment securities available-for-sale with maturities (or probable calls) of up to five years, less $10.1 million of securities that were pledged to secure public and certain other deposits as required by law and contract; Federal funds sold of $67.9 million, and $40.0 million in cash and due from banks, as a percentage of total unsecured deposits of $748 million.
Capital Resources
The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company:
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
No material changes have occurred during the quarter to the Company’s market risk profile or information. For further information refer to the Company’s annual report on Form 10-K.
Part II — Other Information
Item 1. — Legal Proceedings
To the best of the Company’s knowledge, there are no pending legal proceedings to which the Company is a party which may have a materially adverse effect on the Company’s financial condition, results of operations, or cash flows.
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Item 4. — Submissions of Matters to a Vote of Security Holders
The Company held its 2001 Annual Meeting of Shareholders on May 24, 2001 and on June 21, 2001 (the “2000 Annual Meeting”). There were 11,076,965 issued and outstanding shares of Company Common Stock on April 10, 2001, the Record Date for the 2001 Annual Meeting. Each of the shares voting at the meeting was entitled to one vote.
At the 2001 Annual Meeting, the following actions were taken:
Election of Directors
At the 2001 Annual Meeting, fifteen directors of the Company were elected. The following chart indicates the number of shares cast for each elected director:
Heritage Commerce Corp’s Articles of Incorporation
The number of shares cast for and against to amend Commerce Corp’s Articles of Incorporation to eliminate the availability of cumulative voting in the election of Commerce Corp’s directors was as follows:
Heritage Commerce Corp’s Bylaws
The number shares cast for and against to amend Commerce Corp’s Bylaws to provide for classification of the Board of Directors into three classes for purposes of the election of directors was as followings:
Increase the number of shares for grants of stock options
The number shares cast for and against to amend Commerce Corp 1994 Tandem Stock Option Plan to increase the number of shares available for grants of stock options was as followings:
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Ratification of Deloitte & Touche, LLP as the Company’s auditors
The number of shares cast for and against the ratification of the Board of Directors’ selection of Deloitte & Touche, LLP to serve as the Company’s auditors for the fiscal year ending December 31, 2001 was as follows:
Item 6. — Exhibits and Reports on Form 8-K
On July 23, 2001, the Company filed its earnings press release for the second quarter ended June 30, 2001 with the SEC on Form 8-K.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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EXHIBIT INDEX