1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2001 -------------------------------------------------- Or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transitional period from To ------------------ ------------------------- Commission File No. 000-23877 ------------------------------------------------------------- HERITAGE COMMERCE CORP - -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) California 77-0469558 - ------------------------------------------------ ------------------------------ (State or other jurisdiction of incorporation or (I.R.S. Employer organization) Identification No.) 150 Almaden Blvd., San Jose, California 95113 - -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) (408) 947-6900 - -------------------------------------------------------------------------------- (Registrant's telephone number, including area code) None - -------------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] Yes [ ] No APPLICABLE ONLY TO CORPORATE ISSUERS: The Registrant had 11,079,603 shares of Common Stock outstanding on May 7, 2001.
2 HERITAGE COMMERCE CORP AND SUBSIDIARIES QUARTERLY REPORT ON FORM 10-Q Table of Contents - -------------------------------------------------------------------------------- <TABLE> <CAPTION> Part I - Financial Information Page <S> <C> Item 1. Financial Statement (Unaudited) -- Condensed Consolidated Statements of Financial Condition 3 Financial Statement (Unaudited) -- Condensed Consolidated Income Statements 4 Financial Statement (Unaudited) -- Condensed Consolidated Statements of Cash Flows 5 Condensed Consolidated Notes to Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 7 Item 3. Quantitative and Qualitative Disclosures About Market Risk 17 Part II - Other Information Item 1. Legal Proceedings 18 Item 6. Exhibits and Reports on Form 8-K 18 Signatures 18 </TABLE>
3 HERITAGE COMMERCE CORP AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION ASSETS <TABLE> <CAPTION> March 31, 2001 December 31, 2000 -------------- ----------------- (Unaudited) <S> <C> <C> Cash and due from banks $ 45,229,000 $ 38,671,000 Interest bearing deposits in banks 3,876,000 2,098,000 Federal funds sold 85,400,000 19,300,000 ------------- ------------- Total cash and cash equivalents 134,505,000 60,069,000 Securities available-for-sale, at fair value 82,126,000 90,894,000 Securities held-to-maturity, at amortized cost (fair value of $20,041,000 for March 31, 2001 and $20,075,000 for December 31, 2000, respectively) 19,563,000 19,908,000 Loan held for sale, at fair value 41,496,000 35,931,000 Loans, net of deferred fees 575,769,000 610,781,000 Allowance for probable loan losses (10,240,000) (9,651,000) ------------- ------------- Loans, net 565,529,000 601,130,000 Premises and equipment, net 6,232,000 6,415,000 Accrued interest receivable and other assets 11,023,000 12,920,000 Other investments 22,310,000 18,957,000 ------------- ------------- TOTAL $ 882,784,000 $ 846,224,000 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Liabilities: Deposits Demand, noninterest bearing $ 232,691,000 $ 207,885,000 Demand, interest bearing 64,867,000 68,587,000 Savings and money market 223,674,000 219,299,000 Time deposits, under $100,000 77,884,000 70,552,000 Time deposits, $100,000 and over 169,483,000 162,625,000 Brokered deposits 21,609,000 9,238,000 ------------- ------------- Total deposits 790,208,000 738,186,000 Federal Home Loan Bank borrowing --- 18,000,000 Mandatorily redeemable cumulative trust preferred securities of Subsidiary Grantor Trust 14,000,000 14,000,000 Accrued interest payable and other liabilities 9,534,000 10,305,000 ------------- ------------- Total liabilities 813,742,000 780,491,000 ------------- ------------- Commitments and contingencies Shareholders' equity: Preferred Stock, no par value; 10,000,000 shares authorized; None outstanding --- --- Outstanding Common Stock, no par value; 30,000,000 shares authorized; Shares issued and outstanding: 11,076,965 at March 31, 2001 and 10,939,124 at December 31, 2000 62,983,000 62,469,000 Accumulated other comprehensive income, net of taxes 1,129,000 515,000 Retained Earnings 4,930,000 2,749,000 ------------- ------------- Total shareholders' equity 69,042,000 65,733,000 ------------- ------------- TOTAL $ 882,784,000 $ 846,224,000 ============= ============= </TABLE> See notes to condensed consolidated financial statements 3
4 HERITAGE COMMERCE CORP AND SUBSIDIARIES CONDENSED CONSOLIDATED INCOME STATEMENTS (UNAUDITED) <TABLE> <CAPTION> Three months ended March 31, 2001 2000 ----------- ----------- <S> <C> <C> Interest income: Loans, including fees $15,818,000 $11,382,000 Securities, taxable 1,416,000 1,195,000 Securities, non-taxable 152,000 146,000 Interest bearing deposits in banks 36,000 3,000 Federal funds sold 740,000 1,251,000 ----------- ----------- Total interest income 18,162,000 13,977,000 ----------- ----------- Interest expense: Deposits 6,593,000 4,799,000 Mandatorily redeemable trust preferred securities 376,000 19,000 Other 113,000 41,000 ----------- ----------- Total interest expense 7,082,000 4,859,000 ----------- ----------- Net interest income before provision for probable loan losses 11,080,000 9,118,000 Provision for probable loan losses 527,000 680,000 ----------- ----------- Net interest income after provision for probable loan losses 10,553,000 8,438,000 ----------- ----------- Noninterest income: Gain on sale of loans 273,000 52,000 Other investments 268,000 214,000 Service charges and other fees on deposit accounts 208,000 171,000 Gain on sale of securities available-for-sale 142,000 --- Servicing income 114,000 --- Other income 216,000 299,000 ----------- ----------- Total noninterest income 1,221,000 736,000 ----------- ----------- Noninterest expenses: Salaries and employee benefits 5,081,000 4,015,000 Occupancy 680,000 543,000 Furniture and equipment 441,000 331,000 Professional fees 330,000 306,000 Loan origination costs 299,000 206,000 Client services 292,000 369,000 Advertising and promotion 223,000 179,000 Stationery & supplies 133,000 79,000 Telephone 89,000 86,000 Other 699,000 676,000 ----------- ----------- Total noninterest expenses 8,267,000 6,790,000 ----------- ----------- Income before income taxes 3,507,000 2,384,000 Provision for income taxes 1,326,000 867,000 ----------- ----------- Net income $ 2,181,000 $ 1,517,000 =========== =========== Earnings per share: Basic $ 0.20 $ 0.15 =========== =========== Diluted $ 0.19 $ 0.14 =========== =========== </TABLE> See notes to condensed consolidated financial statements 4
5 HERITAGE COMMERCE CORP AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) <TABLE> <CAPTION> Three Months ended March 31, 2001 2000 ---- ---- <S> <C> <C> Cash flows from operating activities: Net income $2,181,000 $ 1,517,000 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 420,000 352,000 Provision for probable loan losses 527,000 680,000 Gain on sale of securities available-for-sale (142,000) --- Net amortization of premiums / accretion of discounts (86,000) 25,000 Proceeds from sales of loans held for sale 10,157,000 --- Originations of loans held for sale (15,872,000) (3,730,000) Maturities of loans held for sale 150,000 13,000 Effect of changes in: Accrued interest receivable and other assets 1,894,000 177,000 Accrued interest payable and other liabilities (1,157,000) (8,631,000) ------------ ------------- Net cash used in operating activities (1,928,000) (9,597,000) Cash flows from investing activities: Net changes in loans 35,075,000 (42,155,000) Purchases of securities available-for-sale (20,362,000) (27,285,000) Maturities/paydowns/calls of securities available-for-sale 3,785,000 176,000 Proceeds from sales of securities available-for-sale 26,586,000 --- Proceeds from maturities or calls of securities held-to-maturity 334,000 410,000 Purchases of corporate owned life insurance (3,004,000) (2,524,000) Purchases of other investments (349,000) (304,000) Purchases of property and equipment (237,000) 140,000 ------------ ------------- Net cash provided by (used in) investing activities 41,828,000 (71,822,000) Cash flows from financing activities: Net increase in deposits 52,022,000 63,252,000 Proceeds from issuance of mandatorily redeemable cumulative trust preferred securities of Subsidiary Grantor Trust --- 7,000,000 Proceeds from exercise of stock options 514,000 26,000 Net change in FHLB borrowings (18,000,000) (5,000,000) ------------ ------------- Net cash provided by financing activities 34,536,000 65,278,000 ------------ ------------- Net increase (decrease) in cash and cash equivalents 74,436,000 (16,141,000) Cash and cash equivalents, beginning of period 60,069,000 155,224,000 ------------ ------------- Cash and cash equivalents, end of period $134,505,000 $ 139,083,000 ============ ============= - ------------------------------------------------------------------------------------------------ Supplemental disclosures of cash paid during the period for: Interest $ 7,037,000 $ 4,271,000 Income taxes --- 774,000 </TABLE> See notes to condensed consolidated financial statements 5
6 HERITAGE COMMERCE CORP AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS MARCH 31, 2001 (UNAUDITED) 1) BASIS OF PRESENTATION The unaudited condensed consolidated financial statements of Heritage Commerce Corp and its wholly owned subsidiaries: Heritage Bank of Commerce (HBC), Heritage Bank East Bay (HBEB), Heritage Bank South Valley (HBSV), and Bank of Los Altos (BLA), and Heritage Capital Trust I and Heritage Statutory Trust I, which are Delaware Statutory business trusts formed for the exclusive purpose of issuing and selling trust preferred securities, have been prepared pursuant to the rules and regulations for reporting on Form 10-Q. Accordingly, certain information and notes required by accounting principles generally accepted in the United States of America ("GAAP") for complete financial statements are not included herein. The interim statements should be read in conjunction with the financial statements and notes thereto included in the Company's Form 10-K Annual Report for the year ended December 31, 2000. The unaudited condensed 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. HBC, HBEB, HBSV, and BLA are commercial banks, which offer similar products to customers located in Santa Clara, Alameda, and Contra Costa counties of California. No customer accounts for more than 10 percent of revenue for HBC, HBEB, HBSV, BLA or the Company. Management evaluates the Company's performance as a whole and does not allocate resources based on the performance of different lending or transaction activities. Accordingly, the Company and its subsidiary banks all operate as one business segment. In the Company's opinion, all adjustments necessary for a fair presentation of these condensed consolidated financial statements have been included and are of a normal and recurring nature. Certain reclassifications have been made to prior year amounts to conform to current year presentation. The results for the three months ended March 31, 2001 are not necessarily indicative of the results expected for any subsequent period or for the entire year ending December 31, 2001. 2) EARNINGS PER SHARE Basic earnings per share is computed by dividing net income by the weighted average common shares outstanding. Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method. For each of the periods presented, net income is the same for basic and diluted earnings per share. Reconciliation of weighted average shares used in computing basic and diluted earnings per share is as follows: <TABLE> <CAPTION> Three months ended March 31, 2001 2000 ---------- ---------- <S> <C> <C> Weighted average common shares outstanding - used in computing basic earnings per share 11,011,558 10,386,062 Dilutive effect of stock options outstanding, using the treasury stock method 340,547 944,027 ---------- ---------- Shares used in computing diluted earnings per share 11,352,105 11,330,089 ========== ========== </TABLE> 6
7 3) COMPREHENSIVE INCOME Comprehensive Income includes net income and other comprehensive income, which represents the change in its net assets during the period from non-owner sources. The Company's only source of other comprehensive income is derived from unrealized gains and losses on investment securities available-for-sale. Reclassification adjustments resulting from gains or losses on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose are excluded from comprehensive income of the current period. The Company's total comprehensive income was as follows: <TABLE> <CAPTION> For the Three Months Ended March 31, 2001 2000 ---- ---- <S> <C> <C> Net Income $ 2,181,000 $ 1,517,000 ----------- ----------- Other comprehensive income, net of tax: Net unrealized holding gain (loss) on available-for-sale securities during the period 705,000 (176,000) Less: reclassification adjustment for realized gains on available-for-sale securities included in net income during the period (91,000) --- ----------- ----------- Other comprehensive income (loss) 614,000 (176,000) ----------- ----------- Comprehensive income $ 2,795,000 $ 1,341,000 =========== =========== </TABLE> 4) RECLASSIFICATIONS Certain amounts in the December 31, 2000 and March 31, 2000 financial statements have been reclassified to conform to the March 31, 2001 financial statement presentation. 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. 7
8 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 months ended March 31, 2001 was $2,181,000, up 44% or $664,000 from $1,517,000 for the first quarter of 2000. Earnings per diluted share for the first quarter of 2001 were $0.19, up 36% or $0.05 from $0.14 per diluted share for the prior year period. Annualized return on average assets and return on average equity for the quarter ended March 31, 2001 were 1.03% and 13.06%, respectively, compared with returns of 0.90% and 10.72%, respectively, for the same period in 2000. For the first quarter of 2001 as compared with the same period of the previous year, net interest income grew by $1,962,000, or 22%. The increase is attributable to an increase in earning assets, primary loans, partially offset by a decline in rates earned. The Company's net interest margin was 5.68% for the quarter ended March 31, 2001, compared with 5.82% for the quarter ended March 31, 2000. Total assets as of March 31, 2001 were $882,784,000, an increase of $147,454,000, or 20%, from March 31, 2000, and an increase of $36,560,000, or 4%, from total assets of $846,224,000 at December 31, 2000. Total deposits as of March 31, 2001 were $790,208,000, an increase of $125,596,000, or 19%, from March 31, 2000, and an increase of $52,022,000, or 7%, from total deposits of $738,186,000 at December 31, 2000. Total portfolio loans as of March 31, 2001 were $575,769,000, an increase of $132,362,000, or 30%, compared to March 31, 2000. Total portfolio loans as of December 31, 2000 were $610,781,000. The Company's allowance for loan losses was $10,240,000, or 1.78%, of total loans as of March 31, 2001. This compares with an allowance for loan losses of $7,204,000, or 1.62%, and $9,651,000, or 1.58% of total loans at March 31, 2000 and December 31, 2000, respectively. The Company's non-performing assets (NPA's) were $1,693,000 as of March 31, 2001. NPA's were $1,336,000 as of March 31, 2000. The Company had no NPA's as of December 31, 2000. The Company's shareholders' equity as of March 31, 2001 increased to $69,042,000 from $57,912,000 as of March 31, 2000 and from $65,733,000 as of December 31, 2000. Book value per share totaled $6.23 as of March 31, 2001, compared to $5.58 as of March 31, 2000 and $6.01 as of December 31, 2000. The Company's leverage capital ratio was at 9.51% at March 31, 2001. This compared with a leverage ratio of 9.67% at March 31, 2000 and 9.3% at December 31, 2000. 8
9 RESULTS OF OPERATIONS NET INTEREST INCOME AND NET INTEREST MARGIN The following table presents the Company's average balance sheet, net interest income and the resultant yields for the periods presented: <TABLE> <CAPTION> For the Three Months Ended For the Three Months Ended March 31, 2001 March 31, 2000 --------------------------------------------------------------------- Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ (Dollars in thousands) Balance Expense Rate Balance Expense Rate - ----------------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Assets: Loans, gross $627,110 $ 15,818 10.23% $447,304 $ 11,382 10.23% Investments securities 106,478 1,568 6.13% 91,732 1,341 5.89% Interest bearing deposits in banks 2,828 36 5.16% 203 3 5.94% Federal funds sold 55,468 740 5.41% 89,730 1,251 5.61% -------- -------- -------- -------- Total interest earning assets 791,884 $ 18,162 9.30% 628,969 $ 13,977 8.94% -------- -------- -------- -------- Cash and due from banks 41,436 30,325 Premises and equipment, net 6,370 6,585 Other assets 18,535 15,250 -------- -------- Total assets $858,225 $681,129 ======== ======== Liabilities and shareholders' equity: Deposits: Demand, interest bearing $ 66,474 $ 345 2.11% $ 52,431 $ 248 1.91% Savings and money market 225,310 2,212 3.98% 200,631 1,871 3.75% Time deposits, under $100,000 77,440 1,168 6.12% 68,496 894 5.25% Time deposits, $100,000 and over 172,984 2,567 6.02% 122,739 1,629 5.34% Brokered deposits 19,404 301 6.29% 10,403 157 6.05% Other borrowings 20,618 489 9.61% 4,400 60 5.45% -------- -------- -------- -------- Total interest bearing liabilities 582,230 $ 7,082 4.93% 459,100 $ 4,859 4.26% -------- -------- -------- -------- Demand deposits 197,903 159,764 Other liabilities 10,365 5,497 -------- -------- Total liabilities 790,498 624,361 Shareholders' equity 67,727 56,768 -------- -------- Total liabilities and shareholders' equity $858,225 $681,129 ======== ======== Net interest income / margin $ 11,080 5.68% $ 9,118 5.82% ======== ======== </TABLE> Note: Yields and amounts earned on loans include loan fees of $1,144,000 and $898,000 for the three-month periods ended March 31, 2001 and 2000, respectively. Interest income is reflected on an actual basis, not a fully taxable equivalent basis, and does not include a fair value adjustment. Nonaccrual loans of $1,693,000, and $1,336,000 for the period ended March 31, 2001, and March 31, 2000 respectively, are included in the average balance calculation above. The Company's net interest income for the first quarter of 2001 was $11,080,000, an increase of $1,962,000 or 22% over the first quarter of 2000. When compared to the first quarter of 2000, average earning assets increased by $160,290,000 or 25% while the net yield on average earning assets decreased to 5.68% in the first quarter of 2001, from 5.82% in the first quarter of 2000. The increase in net interest income was primarily a result of the increases in average loans funded by a decrease in Federal funds sold and the increases in all deposit products, most notably in time deposits, 100,000 and over, brokered deposits, other borrowings and non interest bearing demand deposits. 9
10 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. <TABLE> <CAPTION> Three Months Ended March 31, 2001 vs. 2000 ---------------------------------------------------------- Increase (Decrease) Due to Change In: (Dollars in thousands) Average Volume Average Rate Net Change ------------------------------------------------------------------------------------------------- <S> <C> <C> <C> INTEREST EARNING ASSETS Loans, gross $ 4,436 $ -- $ 4,436 Investments securities 217 10 227 Interest bearing deposits in banks 34 (1) 33 Federal funds sold (457) (54) (511) ------------------------------------------------------------------------------------------------- Total interest earning assets $ 4,230 $ (45) $ 4,185 ------------------------------------------------------------------------------------------------- INTEREST BEARING LIABILITIES Demand, interest bearing $ 73 $ 24 $ 97 Money Market and Savings 243 98 341 Time deposits, under $100,000 135 139 274 Time deposits, $100,000 and over 746 192 938 Brokered Deposits 139 5 144 Other borrowings 384 45 429 ------------------------------------------------------------------------------------------------- Total interest bearing liabilities $ 1,720 $ 503 $ 2,223 ------------------------------------------------------------------------------------------------- Net interest income $ 2,510 $ (548) $ 1,962 ======= ======= ======= </TABLE> PROVISION FOR PROBABLE LOAN LOSSES During the first quarter of 2001, the provision for probable loan losses was $527,000, down $153,000 from $680,000 for the first quarter of 2000. 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: <TABLE> <CAPTION> Increase (decrease) ---------------------------- Three months ended March 31, 2001 versus 2000 ------------------------------------------------------------- (Dollars in thousands) 2001 2000 Amount Percent -------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Gain on sale of loans $ 273 $ 52 $ 221 425% Other investment income 268 214 54 25% Service charges and other fees 208 171 37 22% Gain on sale of securities available-for-sale 142 -- 142 --% Servicing income 114 -- 114 --% Other income 216 299 (83) (28%) -------------------------------------------------------------------------------------------------------------- Total $1,221 $ 736 $ 485 66% ============================================================================================================== </TABLE> Noninterest income for the quarter ended March 31, 2001 was $1,221,000, up $485,000, or 66%, from $736,000 for the quarter ended March 31, 2000. This increase was the result of the Company increasing the volume of originations and sales of SBA loans resulting in a $273,000 gain on sale of loans recognized in the first quarter of 2001, compared to $52,000 for the same period in the prior year. Gain on sales of securities was $142,000 in the first quarter of 2001, while there was no sale of securities in the first quarter of 2000. The Company had $114,000 in noninterest income from Internet banking services in the first quarter of 2001 which was not offered in the first quarter of 2000. 10
11 NONINTEREST EXPENSE The following table sets forth the various components of the Company's noninterest expenses for the periods indicated: <TABLE> <CAPTION> For The Three Months Ended March 31, --------------------------------------------------- Percent Increase Increase (Decrease) (Dollars in thousands) 2001 2000 (Decrease) ---------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Salaries and benefits $ 5,081 $ 4,015 $ 1,066 27 % Occupancy 680 543 137 25 % Furniture and equipment 441 331 110 33 % Professional fees 330 306 24 8 % Loan origination costs 299 206 93 45 % Client services 292 369 (77) (21)% Advertising and promotion 223 179 44 25 % Stationery & supplies 133 79 54 68 % Telephone 89 86 3 3 % All other 699 676 23 3 % ---------------------------------------------------------------------------------- Total $ 8,267 $ 6,790 $ 1,477 22% ================================================================================== </TABLE> The following table indicates the percentage of noninterest expense in each category: <TABLE> <CAPTION> For The Three Months Ended March 31, ----------------------------------------------- (Dollars in thousands) 2001 % of Total 2000 % of Total ---------------------------------------------------------------------------- <S> <C> <C> <C> <C> Salaries and benefits $5,081 61.46% $4,015 59.13% Occupancy 680 8.23% 543 8.00% Furniture and equipment 441 5.33% 331 4.87% Professional fees 330 3.99% 306 4.51% Loan origination costs 299 3.62% 206 3.03% Client services 292 3.53% 369 5.43% Advertising and promotion 223 2.70% 179 2.64% Stationery & supplies 133 1.61% 79 1.16% Telephone expense 89 1.08% 86 1.27% All other 699 8.95% 676 9.96% ---------------------------------------------------------------------------- Total $8,267 100.00% $6,790 100.00% ============================================================================ </TABLE> Noninterest expenses for the first quarter of 2001 were $8,267,000, up $1,477,000, or 22%, from $6,790,000 for the first quarter of 2000. The overall increase in noninterest expenses is in response to the significant growth in the Company. Salaries and benefits increased $1,066,000 reflecting normal salary and benefit increases and the growth in the level of full time equivalent employees from 209 at March 31, 2000 to 231 at March 31, 2001. As a percentage of total noninterest expenses, salaries and benefits increased from 59.13% to 61.46%. Occupancy increased by $137,000, as a result of increased rental costs. Furniture and equipment increased by $110,000 and increased as a percentage of total noninterest expenses from 4.87% to 5.33%. Stationery and supplies increased by $54,000 and increased as a percentage of total noninterest expenses from 1.16% to 1.61%. Loan origination costs increased by $93,000 as a result of the overall growth in the loan portfolio and increased as a percentage of total noninterest expenses from 3.03% to 3.62%. Professional fees increased by $24,000 but decreased as a percentage of total noninterest expense from 4.51% to 3.99%. Client services decreased $77,000 and decreased as a percentage of total noninterest expenses from 5.43% to 3.53%. INCOME TAXES The provision for income taxes for the three months ended March 31, 2001 was $1,326,000 as compared to $867,000 for the first quarter of 2000. The Company's effective tax rates were 37.81% and 36.37%, respectively, for the quarter ended March 31, 2001 and 2000. The difference in the effective tax rate compared to the statutory tax rate and the reduction in the effective tax rate is primarily the result of the activities related to the Company's holdings in certain life insurance contracts and the Company's level of investments in municipal securities. 11
12 FINANCIAL CONDITION Total assets increased $36,560,000, or 4%, to $882,784,000 at March 31, 2001 from $846,224,000 at December 31, 2000, and increased $147,454,000, or 20%, from $735,330,000 at March 31, 2000. Total portfolio loans decreased $35,012,000 or 6% to $575,769,000 at March 31, 2001 from $610,781,000 at December 31, 2000, but have increased $132,362,000 or 30% from $443,407,000 at March 31, 2000. Total deposits were $790,208,000 at March 31, 2001, an increase of 7% from $738,186,000 at December 31, 2000, and have increased 19% from $664,612,000 at March 31, 2000. The above reflects the continued strong internal growth of the Company primarily in noninterest bearing demand deposits and brokered deposits used with the proceeds from the loan payments to fund the growth in Federal funds. SECURITIES PORTFOLIO The following table summarizes the composition of the Company's investment securities and the weighted average yields at March 31, 2001: <TABLE> <CAPTION> March 31, 2001 ---------------------------------------------------------------------------------------------- Maturity ---------------------------------------------------------------------------------------------- After One Year and After Five Years and Within One Year Within Five Years Within Ten Years After Ten Years Total - --------------------------------------------------------------------------------------------------------------------------------- (Dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield - --------------------------------------------------------------------------------------------------------------------------------- Securities available-for-sale: <S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> Agencies $ 5,034 6.68% $ 31,486 6.35% $ --- ---% $ --- ---% $ 36,520 6.40% U.S. treasury 5,022 5.42% 513 6.34% --- ---% --- ---% 5,535 5.50% Mortgage-backed securities --- ---% 6,618 6.22% 6,006 7.34% 12,791 7.37% 25,415 7.06% Commercial paper --- ---% 1,019 6.71% --- ---% --- ---% 1,019 6.71% Municipals - nontaxable 2,295 4.63% 3,310 4.74% 6,875 4.61% 1,157 5.12% 13,637 4.69% -------- -------- -------- -------- -------- Total available-for-sale $ 12,351 5.79% $ 42,946 6.21% $ 12,881 5.88% $ 13,948 7.18% $ 82,126 6.26% Securities held-to-maturity: CMOs $ --- ---% $ 1,002 6.33% $ 501 6.55% $ 646 6.55% $ 2,149 6.45% Mortgage-backed securities --- ---% 5,514 6.34% --- ---% --- ---% 5,514 6.34% Municipals - taxable 1,880 6.49% 2,609 6.55% --- ---% --- ---% 4,489 6.52% Municipals - nontaxable --- --% 1,481 4.72% 5,930 4.49% --- ---% 7,411 4.54% -------- -------- -------- -------- -------- Total held-to-maturity $ 1,880 6.49% $ 10,606 6.16% $ 6,431 4.65% $ 646 6.55% $ 19,563 5.71% -------- -------- -------- -------- -------- Total securities $ 14,231 5.88% $ 53,552 6.20% $ 19,312 5.47% $ 14,594 7.16% $101,689 6.16% ======== ======== ======== ======== ======== </TABLE> Note: Yield on non-taxable municipal securities are not presented on a fully tax equivalent basis. LOANS Total gross loans decreased 6% to $575,769,000 at March 31, 2001, 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 quarter of 2001. The following table indicates the Company's loan portfolio for the periods indicated: <TABLE> <CAPTION> (Dollars in thousands) March 31, 2001 % of Total December 31, 2000 % of Total - ---------------------- -------------- ---------- ----------------- ---------- <S> <C> <C> <C> <C> Commercial $ 183,080 32% $ 200,846 33% Real estate - mortgage 228,382 40% 230,468 38% Real estate - land and construction 156,920 27% 171,325 28% Consumer 7,427 1% 8,172 1% --------- --- --------- ---- Total loans 575,809 100% 610,811 100% Deferred loan fees (40) (30) Allowance for loan losses (10,240) (9,651) --------- --------- Loans, net $ 565,529 $ 601,130 ========= ========= </TABLE> 12
13 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. 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 March 31, 2001: <TABLE> <CAPTION> Over One Year Due in But Less Than (Dollars in thousands) One Year or Less Five Years Over Five Years Total - ------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Commercial $171,357 $ 11,466 $ 257 $183,080 Real estate mortgage 129,635 81,999 16,748 228,382 Real estate - land and construction 156,827 93 --- 156,920 Consumer 6,017 1,409 1 7,427 - ------------------------------------------------------------------------------------------------------- Total loans $463,836 $ 94,967 $ 17,006 $575,809 ======================================================================================================= Loans with variable interest rates $446,652 $ 59,114 $ 502 $506,268 Loans with fixed interest rates 17,184 35,853 16,504 69,541 - ------------------------------------------------------------------------------------------------------- Total loans $463,836 $ 94,967 $ 17,006 $575,809 ======================================================================================================= </TABLE> 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 March 31, 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: <TABLE> <CAPTION> March 31, December 31, (Dollars in thousands) 2001 2000 2000 - ---------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> Nonaccrual loans $1,693 $1,336 $ --- Loans 90 days past due and still accruing --- --- --- Restructured loans --- --- --- ------ ------ ------ Total nonperforming loans 1,693 1,336 --- Foreclosed assets --- --- --- ------ ------ ------ Total nonperforming assets $1,693 $1,336 $ --- ====== ====== ====== Nonperforming assets as a percentage of period end loans plus foreclosed assets 0.30% 0.22% ---% </TABLE> The Company had $1,693,000 and $1,336,000 nonperforming assets (NPA's) as of March 31, 2001 and 2000. The Company had no NPA's as of December 31, 2000. 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". 13
14 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: <TABLE> <CAPTION> Year ended December Three months ended March 31, 31, ---------------------------- -------- (Dollars in thousands) 2001 2000 2000 ------- ------- ------- <S> <C> <C> <C> Balance, beginning of period / year $ 9,651 $ 6,511 $ 6,511 Net recoveries (charge-offs) 62 13 (19) Provision for probable loan losses 527 680 3,159 ------- ------- ------- Balance, end of period / year $10,240 $ 7,204 $ 9,651 ======= ======= ======= RATIOS: Net recoveries (charge-offs) to average loans outstanding 0.01% ---% ---% Allowance for loan losses to average loans 1.66% 1.63% 1.80% Allowance for loan losses to total loans 1.78% 1.62% 1.58% Allowance for loan losses to non-performing loans 605% 539% ---% </TABLE> 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: <TABLE> <CAPTION> March 31, 2001 March 31, 2000 December 31, 2000 ------------------------------------------------------------------------------------- Percent of ALL in Percent of ALL in Percent of ALL in each category to each category to each category to (Dollars in thousands) Amount total loans Amount total loans Amount total loans - ---------------------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Commercial $ 4,662 2.55% $ 3,276 1.78% $ 4,244 2.11% Real estate - mortgage 1,530 0.67% 1,105 0.68% 1,509 0.65% Real estate - land and construction 1,969 1.25% 1,493 1.29% 2,084 1.22% Consumer 167 2.25% 145 2.29% 158 1.93% Unallocated 1,912 ----% 1,185 --- 1,656 --- ------- ------- ------- Total $10,240 1.78% $ 7,204 1.62% $ 9,651 1.58% ======= ======= ======= </TABLE> The increase in the allowance for loan losses reflects the overall growth in the Company's real estate and land and construction loan portfolio since March 31, 2000. Although the portfolio has declined in the first quarter of 2001, management believes the inherent risks within the portfolio have increased due to the current economic environment particularly as it affects the technology sector and real estate markets served by the Company. Coupled with the current energy situation and increased layoffs in California, management has increased the allocated reserves for commercial lending and increased the unallocated reserves as these factors have worsened. DEPOSITS Deposits totaled $790,208,000 at March 31, 2001, up 7% from $738,186,000 at December 31, 2000 and up 19% from $664,612,000 as of March 31, 2000. The increase in deposits was primarily due to increases in noninterest bearing deposits, time deposits and brokered deposits. Noninterest bearing deposits were $232,691,000 at March 31, 2001, up 12% from $207,885,000 at December 31, 2000. Time deposits were $247,367,000 at March 31, 2001, up 6% from $233,177,000 at December 31, 2000. Brokered deposits were $21,609,000 at March 31, 2001, up 134% from $9,238,000 at December 31, 2000. 14
15 The following table summarizes the distribution of average deposits and the average rates paid for the periods indicated: <TABLE> <CAPTION> Three months ended Year ended March 31, 2001 December 31, 2000 -------------------------------------------------- Average Average Rate Average Average Rate (Dollars in thousands) Balance Paid Balance Paid - ------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> Demand, noninterest bearing $197,903 --- $183,422 --- Demand, interest bearing 66,474 2.11% 55,616 1.82% Saving and money market 225,310 3.98% 228,336 4.16% Time deposits, under $100,000 77,440 6.12% 73,058 5.85% Time deposits, $100,000 and over 172,984 6.02% 151,275 5.75% Brokered deposits 19,404 6.29% 10,544 6.55% -------- -------- Total average deposits $759,515 3.52% $702,251 3.44% ======== ======== </TABLE> DEPOSIT CONCENTRATION AND DEPOSIT VOLATILITY The following table indicates the maturity schedule of the Company's time deposits of $100,000 or more as of March 31, 2001. <TABLE> <CAPTION> (Dollars in thousands) Balance % of Total ------------------------------------------------------------------------------------------- <S> <C> <C> Three months or less $ 96,188 50% Over three months through twelve months 83,538 44% Over twelve months 11,366 6% ------------------------------------------------------------------------------------------- Total $ 191,092 100% ========== === </TABLE> Due to the Company's focus on servicing business accounts, 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. 15
16 The following table sets forth the interest rate sensitivity of the Company's interest-earning assets and interest-bearing liabilities at March 31, 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: <TABLE> <CAPTION> Within Due in Three Due After Three to Twelve One to Five Due After Not (Dollars in thousands) Months Months Years Five Years Rate-Sensitive Total - ------------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> INTEREST EARNING ASSETS: Federal funds sold $ 85,400 $ --- $ --- $ --- $ --- $ 85,400 Interest bearing deposits in banks 3.876 --- --- --- --- 3,876 Securities 5,011 7,848 40,852 47,978 --- 101,689 Total loans 462,919 42,373 94,968 17,005 --- 617,265 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest earning assets 557,206 50,221 135,820 64,983 --- 808,230 - ------------------------------------------------------------------------------------------------------------------------------------ Cash and due from banks --- --- --- --- 45,229 45,229 Other assets --- --- --- --- 29,325 29,325 - ------------------------------------------------------------------------------------------------------------------------------------ Total assets $ 557,206 $ 50,221 $ 135,820 $ 64,983 $ 74,554 $ 882,784 ==================================================================================================================================== INTEREST BEARING LIABILITIES: Demand, interest bearing $ 64,867 $ --- $ --- $ --- $ --- $ 64,867 Savings and money market 223,674 --- --- --- --- 223,674 Time deposits 127,098 123,766 18,112 --- --- 268,976 - ------------------------------------------------------------------------------------------------------------------------------------ Total interest bearing liabilities 415,639 123,766 18,112 --- --- 557,517 - ------------------------------------------------------------------------------------------------------------------------------------ Noninterest demand deposits 84,895 --- --- --- 147,796 232,691 Other liabilities --- --- --- --- 23,534 23,534 Shareholders' equity --- --- --- --- 69,042 69,042 - ------------------------------------------------------------------------------------------------------------------------------------ Total liabilities and shareholders' equity $ 500,534 $ 123,766 $ 18,112 $ --- $ 240,372 $ 882,784 ==================================================================================================================================== Interest rate sensitivity GAP $ 56,672 $ (73,545) $ 117,708 $ 64,983 $(165,818) $ --- ==================================================================================================================================== Cumulative interest rate sensitivity GAP $ 56,672 $ (16,873) $ 100,835 $ 165,818 $ --- $ --- Cumulative interest rate sensitivity GAP ratio 6.42% (1.92)% 11.43% 18.79% ---% ---% </TABLE> The foregoing table demonstrates that the Company had a negative cumulative one-year gap of $16,873,000, or 1.92% of total assets, at March 31, 2001. In theory, this would indicate that $16,873,000 more in liabilities than assets would reprice if there was a change in interest rates over the next year. If interest rates were to decrease, the negative 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. 16
17 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 March 31, 2001, the Company's primary liquidity ratio was 22.54%, comprised of $58.6 million in investment securities available-for-sale with maturities (or probable calls) of up to five years, less $19.3 million of securities that were pledged to secure public and certain other deposits as required by law and contract; Federal funds sold of $85.4 million, and $49.1 million in cash and due from banks, as a percentage of total unsecured deposits of $771 million. The increase in the liquidity ratio from 15.04% at December 31, 2000 was a result of the excess of loan repayments over originations, which was invested in Federal funds sold during the first three months of 2001. CAPITAL RESOURCES The following table summarizes risk-based capital, risk-weighted assets, and risk-based capital ratios of the Company: <TABLE> <CAPTION> March 31, December 31, ------------------------------------------ (Dollars in thousands) 2001 2000 2000 - ---------------------------------------------------------------------------- <S> <C> <C> <C> <C> Capital components: Tier 1 Capital $ 81,435 $ 66,200 $ 78,982 Tier 2 Capital 9,377 6,761 9,427 -------- -------- -------- Total risk-based capital 90,812 $ 72,961 $ 88,409 ======== ======== ======== Risk-weighted assets 750,126 $564,247 $753,947 Average assets $856,586 $681,129 $850,072 Minimum Regulatory Requirements ------------ Capital ratios: Total risk-based capital 12.1% 12.9% 11.7% 8.0% Tier 1 risk-based capital 10.8% 11.7% 10.5% 4.0% Leverage ratio (1) 9.5% 9.7% 9.3% 4.0% </TABLE> (1) Tier 1 capital divided by average assets (excluding goodwill). 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. 17
18 PART II - OTHER INFORMATION Item 1. - Legal Proceedings To the best of the Company's knowledge, there are no pending legal proceedings to which the Company is a party which may have a materially adverse effect on the Company's financial condition, results of operations, or cash flows. Item 6. - Exhibits and Reports on Form 8-K (a) Exhibits included with this filing: None (b) Reports on Form 8-K On January 26, 2001 the Company filed its earnings press release for the fourth quarter ended December 31, 2000 with the SEC on Form 8-K. On March 26, 2001, the Registrant filed a Current Report on form 8-K under Item 5, to report Heritage Bank South Valley to open new branch office in Gilroy. On April 24, 2001, the Company filed its earnings press release for the first quarter ended March 31, 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. Heritage Commerce Corp ------------------------------------------------- (Registrant) May 15, 2001 /s/ Brad L. Smith - ---------------------------- ------------------------------------------------- Date Brad L. Smith, Chairman of the Board and CEO May 15, 2001 /s/ Lawrence D. McGovern - ---------------------------- ------------------------------------------------- Date Lawrence D. McGovern, Chief Financial Officer 18