SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIESEXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
Commission file number: 000-33063
SIERRA BANCORP(Exact name of Registrant as specified in its charter)
86 North Main Street, Porterville, California 93257(Address of principal executive offices) (Zip Code)
(559) 782-4900 (Registrant’s telephone number, including area code)
Not Applicable (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.
YES þ NO o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
YES o NO þ
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Common stock, no par value, 9,297,227 shares outstanding as of July 31, 2003
FORM 10-Q
Table of Contents
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PART I -FINANCIAL INFORMATION Item 1
The accompanying notes are an integral part of these unaudited consolidated financial statements.
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SIERRA BANCORP CONSOLIDATED STATEMENTS OF INCOME & COMPREHENSIVE INCOME (dollars in thousands, except per share data)
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SIERRA BANCORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS June 30, 2003
Note 1 – The Business of Sierra Bancorp
Sierra Bancorp (the “Company”) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is headquartered in Porterville, California. The Company was incorporated in November 2000 and acquired all of the outstanding shares of Bank of the Sierra (the “Bank”) in August 2001. The Company’s principal subsidiary is the Bank, and the Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. At the present time, the Company’s only other direct subsidiary is Sierra Capital Trust I, which was formed in November 2001 solely to facilitate the issuance of trust-preferred securities.
Bank of the Sierra is a California state-chartered bank that was incorporated in September 1977 and opened for business in January 1978, and is currently the largest independent bank headquartered in Tulare County. It is a multi-community independent bank that offers a full range of banking services to individuals and businesses primarily in the central and southern sections of California’s San Joaquin Valley. With the opening of its second Fresno branch in June 2003, the Bank now operates seventeen full service branch offices throughout this geographic footprint. We have received regulatory approval for an eighteenth branch in the City of Clovis in the vicinity of Clovis Avenue and Scott Avenue, and should be able to commence operations in that location in the first half of 2004. In addition to its full-service branch offices, the Bank has an agricultural credit center, a bank card center, and a unit specializing in Small Business Administration loans at its corporate headquarters. The Bank’s deposit accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to maximum insurable amounts.
Sierra Real Estate Investment Trust, a Maryland real estate investment trust (“REIT”) which is a subsidiary of the Bank, was formed in June 2002 with the primary business purpose of investing in the Bank’s real-estate related assets, and enhancing and strengthening the Bank’s capital position and earnings. Sierra Real Estate Investment Trust was capitalized in August 2002, when the Bank exchanged real-estate related assets for 100% of the common and preferred stock of the REIT. The Bank subsequently distributed more than 100 shares of preferred stock among its directors and officers in January of 2003.
The Company’s principal source of income is dividends from the Bank, but the Company intends to explore supplemental sources of income in the future. The expenditures of the Company, including (but not limited to) the payment of dividends to shareholders, if and when declared by the Board of Directors, and the cost of servicing debt, will generally be paid from dividends paid to the Company by the Bank.
References herein to the “Company” include the Company and its consolidated subsidiaries, unless the context indicates otherwise.
Note 2 – Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such period. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for any other quarter, or for the full year. Certain amounts reported for 2002 have been reclassified to be consistent with the reporting for 2003. The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2002 as filed with the Securities and Exchange Commission.
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Note 3 – Current Accounting Developments
In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123. This Statement amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions of SFAS No. 148 are effective for fiscal years ending after December 15, 2002. The interim disclosure provisions are effective for financial reporting containing financial statements for interim periods beginning after December 15, 2002. Because the Company accounts for the compensation cost associated with its stock option plan under the intrinsic value method, the alternative methods of transition will not apply to the Company. The additional interim financial statement disclosure requirements of the Statement are included herein. In management’s opinion, the adoption of this Statement did not have a material impact on the Company’s consolidated financial position or results of operations.
On April 30, 2003, the FASB issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This Statement amends and clarifies the accounting for derivative instruments by providing guidance related to circumstances under which a contract with a net investment meets the characteristics of a derivative as discussed in Statement 133. The Statement also clarifies when a derivative contains a financing component. The Statement is intended to result in more consistent reporting for derivative contracts and must be applied prospectively for contracts entered into or modified after June 30, 2003, except for hedging relationships designated after June 30, 2003. In management’s opinion, the adoption of this statement did not have a material effect on the Company’s consolidated financial position or results of operations.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). This Statement is effective for financial instruments entered into or modified by the Company after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company has previously accounted for its mandatorily redeemable cumulative trust-preferred securities in a manner consistent with the Statement and, in management’s opinion, adoption of this Statement did not have a material effect on the Company’s consolidated financial position or results of operations.
Note 4 – Supplemental Disclosure of Cash Flow Information
During the six months ended June 30, 2003 and 2002, cash paid for interest expense on interest bearing liabilities was $4.1 million and $4.2 million, respectively, while cash paid for income taxes during the six months ended June 30, 2003 and 2002 was $2.6 million and $3.5 million, respectively. There was $183,000 of real estate acquired in the settlement of loans for the half-year ended June 30, 2003, and $807,000 acquired for the half-year ended June 30, 2002. There were loans totaling $150,000 for the half-year ended June 30, 2003, and no loans made to finance the sale of other real estate for the half-year ended June 30, 2002.
Note 5 – Stock Based Compensation
The Company’s stock-based employee compensation plan, the 1998 Stock Option Plan, was assumed from Bank of the Sierra in August 2001 in conjunction with the Company’s acquisition of all of the outstanding shares of the Bank. The 1998 Stock Option Plan is accounted for under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant.
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Pro forma adjustments to the Company’s consolidated net earnings and earnings per share are disclosed during the years in which the options become vested. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
Note 6 – Earnings Per Share
Earnings per share for all periods presented in the Consolidated Statements of Income are computed based on the weighted average number of shares outstanding during each period retroactively restated for stock splits and dividends. Diluted earnings per share include the effect of the potential issuance of common shares, which for the Company is limited to shares that would be issued on the exercise of outstanding vested stock options. For the second quarter and first half of 2003, the dilutive effect of options outstanding calculated under the treasury stock method totaled 780,321 shares and 709,726 shares, respectively, which were added to basic weighted average shares outstanding for purposes of calculating diluted earnings per share. Likewise, for the second quarter and first half of 2002, shares totaling 508,852 and 414,732, respectively, were added to basic weighted average shares outstanding in order to calculate diluted earnings per share.
Note 7 – Comprehensive Income
Comprehensive income includes net income and other comprehensive income. 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 comprehensive income was as follows:
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Note 8 – Financial Instruments With Off-Balance-Sheet Risk
The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business, in order to meet the financing needs of its customers. These financial instruments consist of commitments to extend credit and standby letters of credit. They involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet.
The Bank’s exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and letters of credit as it does for loans included on the balance sheet.
The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):
Commitments to extend credit consist primarily of unfunded single-family residential construction loans and home equity lines of credit, and commercial real estate construction loans and commercial revolving lines of credit. Construction loans are established under standard underwriting guidelines and policies and are secured by deeds of trust, with disbursements made over the course of construction. Commercial revolving lines of credit have a high degree of industry diversification. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are generally secured and are issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. Credit card commitments represent available balances on credit cards and are unsecured.
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PART I - FINANCIAL INFORMATION
ITEM 2
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties. Words such as “expects”, “anticipates”, “believes”, and “estimates” or variations of such words and similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed, forecasted in, or implied by such forward-looking statements.
A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be acknowledged when evaluating the potential future financial performance of the Company. These include but are not limited to the possibility of deterioration in economic conditions in the Company’s service areas; risks associated with fluctuations in interest rates; liquidity risks; increases in non-performing assets and net credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; the loss in market value of available-for-sale securities that could result if interest rates change substantially or an issuer has real or perceived financial difficulties; and regulatory risks associated with the multitude of current and future regulations to which the Company is subject.
CRITICAL ACCOUNTING POLICIES
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information contained within these statements is, to a significant extent, based on approximate measures of the financial effects of transactions and events that have already occurred. Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In Management’s opinion, the Company’s critical accounting policies deal with the following areas: The establishment of the Company’s allowance for loan losses, as explained in detail in the “Provision for Loan Losses” and “Allowance for Loan Losses” sections of this discussion and analysis; the annual evaluation of goodwill for impairment; and the accrual of the Company’s tax liability, particularly as it relates to the inclusion of benefits from the REIT.
OVERVIEW OF THE RESULTS OF OPERATIONS AND FINANCIAL CONDITION
RESULTS OF OPERATIONS SUMMARY
Net income for the quarter ended June 30, 2003 was $2.5 million compared with $2.3 million for the quarter ended June 30, 2002. Basic and diluted earnings per share were $.27 and $.25 for the second quarter of 2003 compared to $.24 and $.23 for the second quarter of 2002. The Company’s earnings improved by 9% in the second quarter 2003 relative to the same period in 2002. The Company’s annualized return on average equity was 17.56% and annualized return on average assets was 1.41% for the quarter ended June 30, 2003, compared to an 18.62% return on average equity and 1.35% return on average assets for the quarter ended June 30, 2002. Return on equity was lower despite the increase in return on assets because average equity was 16% higher in the second quarter of 2003 than in the second quarter of 2002, while average assets were only 5% higher. Average equity increased mainly from growth in retained earnings, but also grew due to the exercise of stock options.
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One of the main contributors to the Company’s second quarter earnings improvement in 2003 was a $400,000 increase in net interest income. The Company’s net interest margin increased by 15 basis points, from 5.55% to 5.70%, and $10 million growth in average earning assets was also a factor in the improvement in net interest income. The net interest margin increase was due mainly to favorable volume shifts in assets and liabilities, rather than favorable movement in interest rates. Enhancing the rise in net interest income was a $225,000 decrease in the loan loss provision for the quarter. The amount of the loan loss provision is determined pursuant to a periodic comprehensive analysis of the allowance for loan losses, as described in detail the Allowance for Loan Losses section herein. It was lowered despite an increase in outstanding loan balances, mainly because the loan increase was centered in real estate loans that have a very low historical loss ratio, and because loans migrating into the non-performing assets category were already on the Company’s “watch list” and thus are adequately provided for.
Non-interest income for the second quarter of 2003 was $325,000 higher than in the second quarter of 2002, despite a $236,000 drop in gains on investments. The increase in non-interest income includes $167,000 of growth in service charges on deposits, and a $103,000 increase in earnings on bank-owned life insurance (“BOLI”). The increase in non-interest income was more than offset, however, by an $828,000 unfavorable variance in non-interest expenses. Not all expenses increased; item processing outsourcing costs were $360,000 lower due to the conversion to in-house item processing, although this savings was partially consumed by additional staffing, occupancy and supplies costs resulting from running the operation in-house. Salaries and benefit expenses had the highest increase of any single expense category, rising by $584,000. A lower credit for loan origination costs contributed $130,000 to the increase in salaries, and accruals for salary continuation plans for certain key officers increased by $110,000, but most of the increase was due to strategic staff additions. Occupancy expenses increased by $225,000.
Despite the $122,000 increase in income before taxes, net income was $205,000 higher because of an $83,000 drop in the income tax provision. The Company’s second quarter provision for income taxes was $932,000, or 27% of pre-tax income in 2003, compared to $1.0 million, or 31% of pre-tax income in 2002. Enterprise zone interest deductions and low-income housing investment tax credits have had a positive impact on tax accruals for both quarters, but the reduction in the tax provision for the current quarter was mainly due to the tax benefit derived from the Company’s real estate investment trust (“REIT”) that was capitalized in August of 2002. No assurance can be given that the tax benefits available from the REIT will continue to be available in the future, however, and it is conceivable but unlikely that at some future date a reinterpretation of existing tax laws by the California legislature could require that the tax benefits already realized from the REIT be reversed.
As with second quarter numbers, net income for the first half of 2003 compares very favorably to the first half of 2002. Net income for the six months ended June 30, 2003 was $4.9 million, an increase of $493,000, or 11%, compared to $4.4 million for the same period in 2002. The Company’s return on average equity and return on average assets for the first half of 2003 were 18.11% and 1.43%, as compared to 18.62% and 1.35% for the first half of 2002. Basic and diluted earnings per share for the six month period ended June 30, 2003 were $.53 and $.49, compared to $.48 and $.46 for the same period in the prior year.
The variances in the Company’s results of operations for the first half of 2003 relative to the first half of 2002 mirror the second quarter differences, for the most part, but are greater in magnitude. Net interest income increased by $627,000 due to a 9 basis point increase in the Company’s net interest margin and a $10 million increase in average earning assets. The loan loss provision was $425,000 lower for first six months of 2003 than in the first six months of 2002. A $420,000 increase in non-interest income, fueled by a $313,000 increase in service charges on deposits and a $331,000 increase in income from BOLI, also supported overall earnings growth. It should be noted that income from the sale of loans was down by over $400,000 in the first half of 2003, due to outsourcing arrangements entered into for the bulk of the Bank’s mortgages in March of 2002. However, reflected in other fees and charges is $77,000 that the Bank earned in referral fees under those arrangements in the first half of 2003.
Despite a $703,000 reduction in item processing costs, non-interest expenses were almost $1.5 million higher in the first six months of 2003 than in the first six months of 2002, due again mainly to substantially higher salaries and benefits and occupancy costs. A $352,000 drop in the credit for loan origination costs is again evident in higher
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staffing expenses, and a combined $145,000 increase in workers compensation and group medical insurance costs was also a major contributor to the increase in salaries and benefits.
FINANCIAL CONDITION SUMMARY
The Company’s total assets increased by $34 million, or nearly 5%, from December 31, 2002 to June 30, 2003. Gross loans increased by $45 million, or 9%, due primarily to a large number of commercial real estate loans funded in the latter part of the second quarter, including $18 million in loan participations purchased. The $27 million of growth from internally-generated loans was due in part to creative loan structuring. Construction loan activity added to the increase, as disbursement levels rose for loans booked earlier in the year. The Company has recently added leasing to its array of credit products to ensure that customer needs are satisfied and organic growth can maintain a strong pace, although no assurance can be given that such growth will continue.
The increase in loans was partially offset by a $12 million decline in cash and due from banks. The decrease in cash and due from banks was due to a $4 million reduction in vault cash resulting in part from more aggressive management of that area, and a $9 million drop in cash items in process of collection resulting from temporary fluctuations at year-end 2002.
Although there was a $25 million drop in time deposits over $100,000 caused by the run-off of brokered deposits in the first half of 2003, core deposits grew by $29 million. This included an increase of $9 million, or 6%, in non-interest demand deposits. Savings deposits also grew by $9 million, which on a smaller base resulted in exceptional 24% growth for that category. Money market deposits rose by $13 million, or 10%. Part of this growth in core deposits has been due to marketing campaigns implemented in the fourth quarter of 2002 and run through the second quarter of 2003, as well as the recent implementation of a formal program to enhance cross-selling efforts. The brokered deposits were not renewed at maturity since they were not needed to fund asset growth at the time. However, the Company’s recent balance sheet growth was funded with overnight borrowings, which will likely be replaced with additional brokered deposits with staggered maturities that can again be allowed to run-off as core deposits are generated to replace them.
Due primarily to the retention of earnings, the Company’s total shareholders’ equity increased from $53 million at December 31, 2002 to $57 million at June 30, 2003. This is an increase of nearly $4 million, or about 7%. The Company’s total risk-based capital ratio at June 30, 2003 was 11.65%, a slight decline from the year-end ratio of 11.98% due to growth in assets.
EARNINGS PERFORMANCE
As previously noted and also as reflected in the Consolidated Statements of Income, during the quarter and for the six months ended June 30, 2003 the Company generated net income of $2.5 million and $4.9 million, as compared to $2.3 million and $4.4 million for the same periods in 2002. The Company earns income from two primary sources: net interest income, which is the difference between interest income generated from the successful deployment of earning assets and interest expense created by interest-bearing liabilities; and net non-interest income, which is basically fees and charges earned from customer services less the operating costs associated with providing a full range of banking services to customers.
NET INTEREST INCOME AND NET INTEREST MARGIN
The Company’s net interest income depends on the yields, volumes, and mix of its earning asset components, as well as the rates, volumes, and mix associated with its funding sources. The Company’s net interest margin is its net interest income expressed as a percentage of average earning assets. The Average Balances and Rates table which immediately follows reflects the Company’s quarterly average balance sheet volumes, the interest income or interest expense and net interest income associated with earning assets and interest-bearing liabilities, the average yield or rate for each category of interest-earning asset and interest-bearing liability, and the net interest margin for the periods noted.
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Net interest income for the second quarter of 2003 was $8.6 million compared to $8.2 million for the second quarter of 2002, which constitutes an increase of $400,000, or about 5%. The Company’s tax-equivalent net interest margin for the second quarter of 2003 was 5.70%, a 15 basis point improvement compared to the 5.55% margin in the second quarter of the previous year. Although management is optimistic that the Company’s net interest margin can be maintained in this range, there is no assurance going forward that fluctuations in market interest rates or other supply and demand issues will not have a negative impact on the Company’s net interest margin and/or net interest income.
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The Volume and Rate Variances table which follows sets forth the dollar amount of changes in interest earned and paid for each major category of interest-earning assets and interest-bearing liabilities and the amount of change attributable to changes in average balances (volume) or changes in average interest rates. The calculation is as follows: the change due to an increase or decrease in volume is equal to the increase or decrease in the average balance times the prior period rate; the change due to an increase or decrease in the rate is equal to the increase or decrease in the average rate times the current period balance. The variances attributable to both the volume and rate changes have been allocated to the change in rate.
Rate changes are shown to have caused a drop of $134,000 in net interest income for the second quarter of 2003 relative to the second quarter of 2002, which may be counter-intuitive given the increase in the Company’s net interest margin. However, the net interest margin is also impacted by changes in the mix of interest-earning assets and interest-bearing liabilities, as well as by changes in the relative level of non-earning assets (including cash and due from banks) and non-interest liabilities (including demand deposits). On the asset side of the average balance sheet, a shift out of fed funds sold, which had a .99% yield for the quarter, and other investments yielding around 4%, into real estate loans having an average yield of 7.36%, had a positive impact on the weighted average yield on earning assets.
On the other hand, the Company experienced a $21 million increase in average non-earning assets, which grew from 9% to 12 % of average assets. This was primarily due to a $13 million increase in BOLI and an increase in low-
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income housing tax credit funds, both of which have a positive impact on Company profitability albeit not through interest income. The remainder of the increase is split between an increase in the average balance of cash and due from banks, and the average balance of fixed assets which increased pursuant to the conversion to in-house item processing and other technology investments undertaken in 2002. This increase in non-earning assets would have had a negative impact on the Company’s net interest margin had it not been offset by a $25 million increase in the average balance of non-interest demand deposits on the liability side. Also having a positive effect on interest expense, and by extension the Company’s net interest margin, was a $32 million reduction in the average balance of Certificates of Deposit, which had a weighted average cost of 2.07% for the quarter, and a $41 million increase in other core deposits having a weighted average cost of .84%.
The $134,000 negative rate variance was offset by a favorable variance of $534,000 due to a higher volume of earning assets. While average earning assets for the second quarter of 2003 were $10 million higher than in the second quarter of 2002, the average balance of interest-bearing liabilities was actually $1 million lower. This growth imbalance in and of itself had a positive effect on net interest income, and indicates that increases in average non-interest bearing liabilities and equity funded all of the growth in both interest-earning and other assets.
The discussion relating to quarterly variances also bears applicability to year-to-date results, which are next reviewed. The Average Balances and Rates table which immediately follows presents the Company’s average balance sheet volumes, the interest income or interest expense and net interest income associated with earning assets and interest-bearing liabilities, the average yield or rate for each category of interest bearing asset or liability, and the net interest margin for the first six months of 2003 and 2002.
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Volume and rate variances for the six months ended June 30, 2003 and June 30, 2002 were presented side by side with the quarterly variances in the Volume & Rate Variances table shown previously. Net interest income for the first half of 2003 was $16.8 million compared to $16.2 million for the first half of 2002, which constitutes an increase of $627,000, or about 4%. Volume changes added about $850,000 to net interest income, while rate changes had a negative impact of $223,000. Earning asset balances were $10 million higher in the first half of 2003 than in the first half of 2002. The same shift from lower to higher-earning assets can be seen for the first half as for the second quarter, with average loans increasing by $24 million, or 8%, and average investments and fed funds sold declining by $14 million, or 13%. Movement in average deposit balances from the first half of 2002 to the first half
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of 2003 also had a favorable impact on the Company’s net interest margin. Aggregate average time deposits fell by $21 million, while lower-cost money market demand, savings, and NOW accounts increased by $38 million and interest-free demand deposits increased by $24 million. The average balance of Repo’s declined by $13 million in the first half of 2003 relative to the first half of 2002, as some large customers transferred their invested cash from Repo’s into money market accounts.
PROVISION FOR LOAN LOSSES
Credit risk is inherent in the business of making loans. The Company sets aside an allowance for potential loan losses through periodic charges to earnings, which are reflected in the income statement as the provision for loan losses. Specifically, the provision for loan losses represents the amount charged against current period earnings to achieve an allowance for loan losses that in management’s judgement is adequate to absorb losses inherent in the Bank’s loan portfolio.
For the quarter ended June 30, 2003 the Company’s provision for loan losses was $725,000, which is $225,000 lower than the $950,000 loan loss provision recognized in the second quarter of 2002. On a year-to-date basis through June 30th, the loan loss provision for 2003 was $1.1 million, which was $425,000 lower that the $1.6 million provided in 2002. The loan loss provision was lower in 2003 despite the large increase in outstanding loan balances toward the end of the second quarter of 2003, mainly because most of the loan increase was in real estate loans whose loss history does not justify a large allocation of the allowance for losses. The procedures for monitoring the adequacy of the allowance, and detailed information on the allowance, are included below in “Allowance for Loan Losses”.
NON-INTEREST INCOME AND EXPENSE
The Company’s results reflected an increase in non-interest income, which was $325,000 higher in the quarter ended June 30, 2003 than for the quarter ended June 30, 2002, and $420,000 higher in the first half of 2003 than the first half of 2002. Total non-interest income increased from 1.44% to 1.63% of average earning assets for the quarter, and from 1.44% to 1.56% of average earning assets for the half.
Total non-interest expenses increased from $6.2 million in the second quarter of 2002 to $7.0 million in the second quarter of 2003, an increase of $828,000, or 13%. For the first half the increase was nearly $1.5 million, with total non-interest expenses growing to $13.8 million in the first half of 2003 from $12.3 million in the first half of 2002. As a percentage of average earning assets, total overhead expenses were 4.52% and 4.05% for the second quarters of 2003 and 2002, respectively, and 4.54% and 4.05% for the first six months of 2003 and 2002, respectively.
Because the increase in expenses was disproportionately greater than the increase in net interest plus other income, the Company’s overhead efficiency ratio also rose for the quarter. The overhead efficiency ratio represents total non-interest expense divided by the sum of net interest income and total non-interest income. Neither the provision for loan losses nor securities gains or losses are factored into the equation. Calculated on a tax-equivalent basis, the Company’s overhead efficiency ratio was 61.2% in the second quarter of 2003 versus 57.3% in the second quarter of 2002, and 62.1% for the first half of 2003 as compared to 58.5% for the first half of 2002. The following table provides details on changes in the Company’s non-interest income and non-interest expenses for the second quarter and first six months of both 2003 and 2002.
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Included in the increase in non-interest income are increases in service charges on deposit accounts both for the second quarter and year-to-date. The second quarter increase was $167,000, while the increase for the first half was $313,000, which both represent a 12% rise and are largely attributable to the approximate 14% growth in average transaction account balances. Other service charges and fees increased by $327,000, or 77%, in the second quarter of 2003 relative to the second quarter of 2002, and by $599,000, or 68%, for the first half of 2003 compared to the first half of the prior year. This increase is primarily due to earnings on $13 million of BOLI, which was purchased in the third and fourth quarters of 2002 and increased income by $103,000 for the quarter and $331,000 for the half. However, it is also reflective of additional credit and check card fees, which were higher as the result of strategic pricing modifications and elevated activity levels. Those increases boosted income by $61,000 for the quarter, and by $115,000 for the first half.
Loan sales income declined by $46,000 and $408,000, respectively, for the quarter and six months ended June 30, 2003. The first half decline is a 79% drop relative to the volume of loan sales income for the first six months of the prior year. Since the Company entered into a strategic alliance with MoneyLine Lending Services in March of 2002 and no longer directly originates residential real estate mortgages, the decline in loan sales income was expected. Mortgage loan costs declined as well, however, and contributed to a drop of $162,000, or 51%, in loan processing costs for the first half of 2003. The Company still receives fee income for successful mortgage applications it refers
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to MoneyLine, which is included in “other service charges, commissions, and fees”. Those fees were approximately $33,000 higher for the second quarter of 2003 than for the second quarter of 2002, and increased by $63,000 to a total of $77,000 for the first half.
Loan servicing income fell by $7,000 and $28,000, respectively, for the second quarter and first six months of 2003 in comparison to the second quarter and first six months of 2002. This was due to the continued decline in the volume of loan servicing. The number of loans serviced for others fell from 151 at June 30, 2002 to 112 at June 30, 2003, with the dollar volume dropping from $54 million to $36 million as of the same dates, respectively. The Company is no longer significantly engaged in the servicing of residential real estate loans and does not contemplate a return to that service in the foreseeable future. Management expects to sell a limited number of such loans on a servicing-released basis in the future, but will refer the majority of its residential mortgage loan applications to MoneyLine Lending Services for origination.
Other non-interest income, which includes gains and losses on investments, gains on the disposition of fixed assets and real properties, and rental income generated by the Company’s alliance with Investment Centers of America, declined by $116,000 for the second quarter of 2003 relative to the second quarter of 2002, and fell by $56,000 for the first half. If not for the decline in investment gains, however, other non-interest income would have increased by $120,000 for the quarter and by $124,000 for the half. Income received from Investment Centers of America, which is in the form of percentage rents based on gross commissions generated, contributed about half of that with increases of $60,000 for the quarter and $65,000 for the half.
Investment gains/losses are shown as a separate line item on the consolidated statements of income in Part 1 of this section. They were primarily impacted by a non-recurring event in June of 2002, when the Company received $240,000 in the form of a liquidating cash dividend from its investment in Sphinx, International, Inc. (“Sphinx”). The Company also wrote-off the approximate $90,000 remaining book value of its investment in Sphinx in the first quarter of 2002. Sphinx was formerly known as Phoenix International Ltd., Inc., a computer software company which specialized in the production and marketing of client user software for financial institutions. In 2001, Sphinx sold substantially all of its assets (including all of its operating business) and certain of its liabilities to London Bridge Phoenix Software, Inc., and a partial distribution of the sale proceeds has been remitted to Sphinx shareholders. The write-off was made pursuant to the receipt of correspondence from Sphinx International, Inc., which was in the process of dissolution, outlining potential liabilities that exceeded its remaining assets. The liquidating cash dividend was paid subsequent to the successful resolution of some of those liabilities. In the first quarter of 2003 the Company also wrote off its $40,000 investment in California Bankers Insurance Agency, subsequent to the receipt from them of correspondence alerting the Company to their dissolution.
The largest increase for any specific category of expenses was in salaries and employee benefits, which were $584,000, or 22%, higher in the second quarter of 2003 than in the second quarter of 2002. The increase for the first six months of 2003 relative to the first six months of 2002 was $1.4 million, or 26%. A significant amount of the increase in salaries and benefits was due to a drop in the average volume of loans originated during 2003. FAS 91 requires that costs directly associated with the origination of a loan be deferred from current period expenses and amortized over the life of the loan as an adjustment to yield. These costs consist primarily of salaries, and the FAS 91 credit against current period salaries fell by $130,000 in the second quarter of 2003 relative to the second quarter of 2002, and by $352,000 for the first six months of 2003 in comparison to 2002. Other significant changes in the salaries and benefits area include the following: salary continuation plan accruals for certain senior officers added approximately $110,000 to quarterly and $218,000 to year-to-date salaries expense; additional salaries and benefits associated with in-house item processing added approximately $70,000 for the quarter and $140,000 for the first six months; and increases in combined workers compensation and group health insurance costs added $145,000 to first half expenses for 2003 relative to 2002. Additionally, employees were added to staff the new branch and accommodate increased volume in other branches, to enhance the credit function, and to centralize loan documentation, among other things. Regular annual increases for existing staff also added approximately 4% to 5% to base salaries. The Company had 333 full-time equivalent employees at June 30, 2003, and 297 full-time equivalents at June 30, 2002.
Occupancy expenses increased by $225,000, or 22% for the second quarter, and by $410,000, or 20%, for the first six months of 2003 relative to 2002. Some of the increase is attributable to the item processing conversion. The
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remainder is spread among various items, including the following: depreciation for equipment and tenant improvements at new facilities, the cost of maintenance and repairs, additional rent for new facilities and rental increases at other branch locations, property tax increases, and higher utilities costs.
The cost of outsourcing item processing, which was included as a data processing expense and totaled $360,000 and $704,000, respectively, for the second quarter and first six months of 2002, was reduced to zero during the first six months of 2003. Other data processing costs increased by $108,000 for the quarter and $130,000 for the first six months, primarily due to increased charges for the Company’s account activity at the Federal Reserve Bank and increased internet and online banking charges. The Company is poised to make an additional investment in the core processing area, in order to improve processing efficiency and position us for future growth. This will likely increase period expenses in 2004 as well as ongoing data processing costs, although the amounts cannot yet be determined with reasonable accuracy.
Loan processing costs declined by $49,000 in the second quarter of 2003 compared to the second quarter of 2002, and by $162,000 in the first half of 2003 compared to the first half of 2002. The main reason for the drop was a change in the tracking and collection process for these fees that are typically passed on to loan customers.
The “other” category under other operating costs increased by $119,000 and $223,000, respectively, for the quarter and six months ended June 30, 2003 relative to the same periods in the prior year. This increase is mostly the result of accounting for the Company’s investments in low-income housing tax credit funds, which are written down by the amount of partnership losses when such are reasonably determined. The offsets for the write-downs are charges to other operating expenses.
Accounting and internal review fees were about the same for the quarter, but increased by $102,000 year-to-date due primarily to accrual adjustments in the first quarter of 2002. Legal costs, on the other hand, fell by $35,000 and $202,000, respectively, for the quarter and six months ended June 30, 2003. The large decrease for the first half is mainly the result of lower legal costs for loan collection efforts. The cost of other professional services was $155,000 higher for the quarter and $187,000 higher on a year-to-date basis, mainly due to accruals for a directors’ retirement plan that was formalized in the last quarter of 2002 but also as the result of rising costs for insurance coverage and consultants. Also of note is the fact that sundry and teller losses declined by $44,000 for the second quarter and $20,000 for the first half of 2003. Lastly, stationery and supply costs were $44,000 higher for the second quarter of 2003 versus the same quarter in the previous year, and $85,000 higher on a year-to-date basis, due in part to printing costs for the Company’s 25th anniversary letterhead and updated marketing brochures.
PROVISION FOR INCOME TAXES
The Company sets aside a provision for income taxes on a monthly basis. The amount of such provision is determined by applying the Company’s statutory income tax rates to pre-tax book income as adjusted for permanent differences between pre-tax book income and actual taxable income. Such permanent differences include but are not limited to tax-exempt income, increases in the cash surrender value of bank-owned life insurance, California Enterprise Zone deductions, certain expenses that are not allowed as tax deductions, and tax credits. An additional permanent difference arose as a result of the formation of a real estate investment trust (“REIT”) which began operations in August 2002. Thus, the Company adjusted its tax accrual effective August 2002 to allow for the year-to-date impact of the REIT. No assurance can be given that the tax benefits available from the REIT will continue to be available in the future. In addition, there is a possibility that a future modification of existing tax laws by the California legislature could require the that the tax benefits already realized from the REIT be reversed, though, in the opinion of management, it is unlikely.
Largely because of the impact of the REIT, the Company’s second quarter tax accrual fell by $83,000, or 8%, to $932,000 in 2003 from over $1.0 million in 2002, despite an increase of 4% in pre-tax income for those same time periods. The year-to-date tax accrual as of the end of June was 25.5% of pre-tax income for 2003 and 33.0% of pre-tax income for 2002.
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BALANCE SHEET ANALYSIS EARNING ASSETS
The major components of the Company’s earning asset base are its investment securities portfolio and loan portfolio. The detailed composition and growth characteristics of both of these portfolios are significant to any analysis of the financial condition of the Company. The Company’s investments are analyzed in this section, while the loan portfolio is discussed in a later section of this Form 10-Q.
Although the Company currently has the intent and the ability to hold its marketable investment securities to maturity, all are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. Pursuant to SFAS 115, the balance of available for sale securities is shown on the Company’s financial statements at its estimated fair market value, with monthly tax-effected “mark-to-market” adjustments made vis-à-vis the “accumulated other comprehensive income” account in shareholders’ equity.
The investment portfolio consists of debt and marketable equity securities, as well as fed funds sold. The investment portfolio serves several purposes: 1) it provides liquidity to even out cash flows from the loan and deposit activities of customers; 2) it provides a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) it is a large base of assets, the maturity and interest rate characteristics of which can be changed more readily than the loan portfolio to better match changes in the deposit base and other funding sources of the Bank; 4) it is an alternative interest-earning use of funds when loan demand is light; and 5) it can provide partially tax exempt income. The following table sets forth the Company’s investment portfolio by investment type (excluding fed funds sold) as of the periods noted:
Inclusive of fed funds sold, total investments were $86 million at June 30, 2003, an increase of $1.7 million, or 2%, from the $84 million reported at December 31, 2002. Since there was $2.5 million in fed funds sold on June 30, 2003 and none on December 31, 2002, all of the increase can be attributed to fed funds sold. Securities that were pledged as collateral for repurchase agreements, public deposits and for other purposes as required or permitted by law totaled $66 million at June 30, 2003, and $57 million at December 31, 2002.
There is a noticeable shift out of U.S. government agency securities and into mortgage-backed securities from the end of 2002 to the end of the first half of 2003. Agency bonds that matured or were called were generally replaced with mortgage-backed securities rather than additional agency bonds, due to the relatively favorable yields available on similar-duration mortgage-backed securities. Additionally, corporate bonds were not replaced as they matured or were called and thus also experienced an overall decline of $2 million in balances.
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LOAN PORTFOLIO
The Company’s total gross loans grew by nearly $45 million, or 9%, from December 31, 2002 to June 30, 2003. Although loan demand was relatively weak earlier in the year, a large number of construction loans that were booked toward the end of the first quarter were more fully disbursed and thus had a greater impact on outstanding balances by the end of the second quarter. Additionally, the Company approved and funded a fairly significant volume of commercial real estate loans in the second quarter, mostly in the month of June, including $18 million in participations purchased. With the exception of the participations, the loan growth was generated by the Company’s lending staff within our current service area through increased calling efforts, creative structuring, and focused marketing efforts. The Company expects to present limited leasing options to its customers early in the third quarter of 2003 in an effort to further stimulate demand, although no assurance can be given that additional significant growth in loan and lease balances will materialize. The Company is also investigating the selective addition of branches in growth markets where it already has a presence but has relatively low penetration. We opened a second Fresno branch in June, and have received regulatory approval for a branch in the City of Clovis, which is adjacent to Fresno. At the south end of our footprint, Bakersfield represents an expanding market that appears to have high growth potential. Other locales that have experienced consistent retail and commercial growth, yet which appear to be under-banked, are also being examined as possibilities for future branch sites.
A comparative schedule of the distribution of the Company’s loans at June 30, 2003 and December 31, 2002 is presented in the Loan Distribution table. The amounts shown in the table are before deferred or unamortized loan origination, extension, or commitment fees and origination costs for loans in that category. The figures noted for each category are also presented as percentages of total loans, for ease of reviewer analysis.
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As explained previously, real estate loans secured by commercial/professional office properties experienced the strongest growth. That segment of the Company’s loan portfolio grew by $41 million, or 17%, from December 31, 2002 to the end of the second quarter of 2003, and increased from 47% to 50% of the total portfolio. Despite the appearance of a heavy real estate concentration, many of these loans are commercial loans where real estate collateral has been taken as an abundance of caution. Management expects to see continued growth in this category, particularly in the Fresno and Bakersfield markets where the Company currently has a relatively small share of an expanding market, although no assurance can be given that this will indeed occur. The largest decrease for any single category of loans was the $2.3 million drop in real estate loans secured by residential properties. That category continues to decline due to the Company’s referral of the majority of its potential mortgage loans to MoneyLine, and fell from 17.8% to 15.9% of total loans. SBA loan balances fell by $1.2 million, or 5%, as this market segment has become increasingly competitive. Agricultural loan balances, while increasing by $1 million, or 10%, remain a relatively small portion of the Company’s loan portfolio at slightly over 2%. Due to lingering problems in the agricultural industry, the Company continues to be highly selective in its agricultural lending activities. Although not reflected in the loan totals above, the Company also originates and sells agricultural and residential mortgage loans to certain other investors and provides servicing for a small number of SBA loans and a certain number of agricultural mortgage loans. The balance of loans serviced for others was $36 million as of June 30, 2003, compared to $43 million at December 31, 2002.
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OFF-BALANCE SHEET ARRANGEMENTS
In the normal course of business, the Bank makes commitments to extend credit as long as there are no violations of any conditions established in the outstanding contractual arrangement. Unused commitments to extend credit totaled $196 million at June 30, 2003 as compared to $176 million at December 31, 2002, although it is expected that not all of these commitments will ultimately be drawn upon. These commitments represented approximately 35.1% and 34.4% of outstanding gross loans at each of the periods noted, respectively. The Bank’s stand-by letters of credit at June 30, 2003 and December 31, 2002 were $11.8 million and $6.5 million, respectively. This represented 5.7% of total commitments at June 30, 2003 and 3.6% of total commitments at December 31, 2002.
The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted because there is no guarantee that the lines of credit will ever be used. For more information regarding the Company’s off-balance sheet arrangements, see Note 8 to the financial statements located elsewhere herein.
NON-PERFORMING ASSETS
Non-performing assets are comprised of the following: Loans for which the Company is no longer accruing interest; loans 90 days or more past due and still accruing interest (although loans are generally placed on non-accrual when they become 90 days past due); loans restructured where the terms of repayment have been renegotiated resulting in a deferral of interest or principal; and other real estate owned (“OREO”). Management’s classification of a loan as non-accrual or restructured is an indication that there is reasonable doubt as to the Company’s ability to collect principal or interest on the loan. At that point, the Company stops accruing income from the interest on the loan, reverses any uncollected interest that had been accrued but unpaid, and recognizes interest income only as cash interest payments are received and as long as the collection of all outstanding principal is not in doubt. These loans may or may not be collateralized, but in all cases collection efforts are continuously pursued. The following table presents comparative data for the Company’s non-performing assets:
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As can be seen from the schedule, all loans past due more than 90 days have been placed on non-accrual status, whether or not interest is still being collected. Total non-performing assets rose to $10.2 million at June 30, 2003 from $7.9 million at December 31, 2002, an increase of about $2.3 million or 29%. Non-performing balances would have declined had it not been for the addition of a total of $3.1 million in commercial loans to a single borrower. The loans are secured by equipment, certain commercial buildings, and other real estate, and the Company is meeting on a regular basis with the borrower who is in negotiations with other parties to sell a portion of the collateral. We are optimistic that the total fair market value of the collateral exceeds the current unpaid loan balances. Total non-performing assets increased to 1.82% of total gross loans and other real estate (“ORE”) at June 30, 2003 from 1.53% at December 31, 2002, but decreased from 2.02% at June 30, 2002. Approximately $1.7 million of the total non-performing balance is guaranteed by the U.S. Government, and a large amount is also secured by real estate.
The performance of any individual loan can be impacted by circumstances beyond the Company’s control, including the interest rate environment or factors particular to a borrower, such as their suppliers or personal state of affairs. The Company anticipates influxes of non-accrual loans in the normal course of business as it further increases its lending activities and borrower performance issues periodically arise. It also expects to acquire some level of “other real estate” as collection activities are undertaken to resolve problem and non-accrual credits.
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Allowance for Loan Losses
The allowance for loan losses is established through a provision for loan losses based on management’s evaluation of known and inherent risks in the Company’s loan portfolio. The allowance is increased by provisions charged against current earnings, and reduced by net charge-offs. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when cash payments are received subsequent to the charge off.
We employ a systematic methodology for determining the allowance for loan losses that includes a monthly review process and monthly adjustment of the allowance. Our process includes a periodic review of individual loans that have been specifically identified as problem loans or have characteristics that could lead to impairment, as well as detailed reviews of other loans (either individually or in pools). While this methodology utilizes historical and other objective information, the establishment of the allowance for loan losses and the classification of loans is also to some extent based on management’s judgment and experience.
Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements and borrowers’ sensitivity to quantifiable external factors including commodity prices as well as acts of nature (freezes, earthquakes, fires, etc.) that occur in a particular period.
Qualitative factors include the general economic environment in our markets and, in particular, the state of the agriculture industry and other key industries in the Central San Joaquin Valley. The way a particular loan might be structured, the extent and nature of waivers of existing loan policies, the results of bank regulatory examination, model imprecision, and the rate of portfolio growth are additional qualitative factors that are considered.
The table that follows summarizes the activity in the allowance for loan losses for the periods indicated:
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Allowance for Loan Losses (dollars in thousands, unaudited)
(1) Includes Small Business Administration Loans
At June 30, 2003, the allowance for loan losses was nearly $6.0 million, or 1.07% of gross loans, a slight dollar increase but slight percentage decrease relative to the $5.9 million allowance at December 31, 2002 that was 1.16% of gross loans. Despite the dollar increase in the allowance, it fell to 68.68% of non-performing loans at June 30, 2003 from 91.84% at December 31, 2002, due to the aforementioned increase in non-performing balances. The Company’s provision for loan losses, which increases the allowance, was $725,000 in the second quarter of 2003, a $225,000 reduction relative to the $950,000 provision in the second quarter of 2002. The Company had net charge-offs of approximately $680,000 against the allowance in the second quarter of 2003 versus $530,000 in the second quarter of 2002. On a year-to-date basis through the end of June, the Company’s provision for loan losses was $1.1 million in 2003 and $1.6 million in 2002, a reduction of $425,000, while year-to-date net loan charge-offs were $1.1 million in 2003 versus $1.4 million in 2002.
The Company considers its allowance for loan losses of $6.0 million at June 30, 2003 to be adequate to cover losses inherent in its loan portfolio. However, no assurance can be given that the Company will not sustain losses in any given period that could be substantial in relation to the size of the allowance.
OTHER ASSETS
The other assets category includes a $5.3 million investment in CRA-qualified low-income housing tax credit funds at June 30, 2003, a slight decline from the $5.5 balance on the Company’s books at December 31, 2002. The decrease is the result of the particular accounting methodology used for this investment, whereby the committed cost of the investment is initially capitalized and subsequently adjusted for the allocable share of losses or income from the limited partnership. As of June 30, 2003, the Company also shows a $1.1 million liability for funds committed but not yet disbursed for these investments. On July 14, 2003 the Company committed to an additional $3 million
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investment in the same type of low-income housing tax credit funds. This new commitment required an initial capital investment of $1.1 million and has an estimated internal rate of return in excess of 11%, assuming no gain on the sale of any of the properties subsequent to a 15-year holding period.
Also included in other assets is an investment in bank-owned life insurance (BOLI). In the third and fourth quarters of 2002, the Company purchased $13 million of BOLI. Combined with the BOLI it obtained in connection with the acquisition of Sierra National Bank in 2000 and including increases in the net cash surrender values of all policies, the Company’s total investment in BOLI at June 30, 2003 is approximately $15 million. BOLI is a single premium life insurance product that has characteristics similar to an investment security, except that income is in the form of increases in net cash surrender value combined with death benefits rather than interest payments. Annual increases in the cash surrender value are currently close to 6% and have a guaranteed floor of between 4% and 5%. Increases in the net cash surrender value and death benefits are non-taxable, and the current tax-equivalent “yield” of the Bank’s BOLI investments based on increases in the net cash surrender value alone is between 8% and 9%. A portion of the death benefits has been allocated to employees whose lives are insured by the Company’s BOLI, and the income from net cash surrender value increases is being used to offset the cost of certain employee benefit plans.
DEPOSITS AND INTEREST BEARING LIABILITIES
DEPOSITS
Another important balance sheet component impacting the Company’s net interest margin is its deposit base. The Company’s net interest margin is improved to the extent that growth in deposits can be concentrated in less volatile and somewhat more traditional core deposits, which include demand deposit accounts, interest-bearing demand accounts (NOW accounts), savings accounts, money market demand accounts (MMDA’s), and time deposits under $100,000.
Overall, deposits increased to $610 million at June 30, 2003 from $606 million at December 31, 2002. This represents an increase of $4 million, or less than 1%. Despite the relatively small increase in deposit balances, core deposits actually increased by a combined $29 million, or 6%. From the end of 2002 to June 30, 2003, non-interest bearing demand deposits increased by $9 million and rose slightly from 28% to 29% of total deposits. During the same time frame interest-bearing demand accounts increased by nearly $4 million, or 7%, savings balances increased by $9 million, or 24%, and money market demand balances increased by almost $13 million, or 10%. Combined, these categories increased from 35% to 38% of total deposits. Since the Company’s only new branch for the first half of the year did not commence operations until June, the increase in core deposits was achieved through growth in the other branch offices. To assist the branches in their efforts, a marketing campaign promoting transaction accounts has been running continuously during the first half of 2003 and a formal program aimed at improving cross-selling efforts has also been implemented. It is management’s opinion that the net increase in core deposits has at least in part been the result of a “flight to quality”, as the economy in general and equity markets in particular have engendered uncertainty. More aggressive deposit retention efforts may be needed as alternative investment products regain popularity.
The only core deposit category experiencing a drop was time deposits under $100,000. Those balances declined by $6 million, or about 7%, although this could be a case of customers valuing liquidity over yield as non-maturity core deposit categories more than made up for this loss. Non-core deposit balances, specifically time deposits in denominations of $100,000 or greater, fell by nearly $25 million as maturing brokered deposits were allowed to roll off.
Information concerning average balances and rates paid on deposits by deposit type for the three months and six months ended June 30, 2003 and 2002 is contained in the “Average Rates and Balances” tables appearing above in the section entitled “Net Interest Income and Net Interest Margin.”
OTHER INTEREST-BEARING LIABILITIES
The Company’s other interest-bearing liabilities include overnight borrowings from other banks (“fed funds purchased”), borrowings from the Federal Home Loan Bank (“FHLB”), securities sold under agreement to
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repurchase, and trust-preferred securities (see Capital Resources section for more detailed explanation of trust-preferred securities). There has been no change in the Company’s $15 million balance of trust-preferred securities over the past year. Changes in other borrowings are explained in further detail below.
The Company occasionally uses fed funds purchased and short-term FHLB borrowings to support liquidity needs created by seasonal deposit flows, to temporarily satisfy funding needs from increased loan demand, and for other short-term purposes. Uncommitted lines are available from several correspondent banks. The FHLB line is committed, but the amount of available credit is dependent on the level of pledged collateral. There was a total of $34 million in overnight Federal Home Loan Bank borrowings at June 30, 2003, which was being used to fund the substantial growth in the Company’s loan portfolio that occurred in the month of June. This represents an increase of over $29 million relative to the $5 million balance of overnight borrowings at the end of 2002. Since growth in core deposits is typically slower and doesn’t always coincide with loan demand, the Company has in the past successfully followed the pattern of funding irregular growth in assets with overnight borrowings, which are then replaced with brokered time deposits having original maturities in the 3-month to 1-year time frame. The brokered deposits are allowed to roll off as growth in core deposits occurs. It is expected that this formula will again be applied, although no assurance can be given that the anticipated growth in core deposits will occur.
In addition, repurchase agreements, which represent “sweep accounts”, or non-deposit investment accounts secured by pledged investment securities, totaled approximately $14 million at June 30, 2003. While this was $400,000 lower than at the end of December, the nature of this product lends itself to frequent fluctuations in balances.
OTHER NON-INTEREST BEARING LIABILITIES
Other non-interest bearing liabilities are primarily comprised of accrued interest payable, accrued income taxes, other expenses accrued but unpaid, and certain clearing amounts. Accrued interest payable decreased from the end of 2002 to June 30, 2003 because of lower interest rates. During the same period, all other non-interest bearing liabilities fell by $2.5 million due mainly to accruals for 2002 expenses, including income taxes, that were on the Company’s books at the end of 2002 but were subsequently paid in 2003. Generally speaking, the balance of “other liabilities” represents a small percentage of overall liabilities and is not material to the discussion of funding sources.
LIQUIDITY AND MARKET RISK MANAGEMENT
INTEREST RATE RISK MANAGEMENT
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in trading of financial instruments, nor does the company have any exposure to exchange rates.
The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. To identify areas of potential exposure to rate changes, the Company performs an earnings simulation analysis and a market value of portfolio equity calculation on a monthly basis. This identifies more dynamic interest rate risk exposures than those apparent in standard re-pricing gap analyses.
The Company uses Bancware’s Convergence modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company’s net interest margin. These simulations can also provide both static and dynamic information on the projected fair market values of the Company’s financial instruments under different interest rate scenarios. The simulation program imports maturity dates and interest rates for individual loans and deposits, and incorporates assumptions on the re-pricing characteristics of embedded options to determine the effects of a given interest rate change on the Company’s interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company’s investment, loan, deposit
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and borrowed funds portfolios. These rate projections can be shocked (an immediate and sustained change in rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels). The Company typically uses seven standard interest rate scenarios in conducting its simulations, namely “stable”, upward shocks of 100, 200 and 300 basis points, and downward shocks of 100, 200, and 300 basis points.
The Company’s policy is to limit the change in the Company’s net interest income for the next 12 months to plus or minus 5% based on a 100 basis point (b.p.) shock, plus or minus 10% based on a 200 b.p. shock, and plus or minus 15% based on a 300 b.p. shock in interest rates. As of June 30, 2003, the Company had the following estimated net interest income sensitivity profile:
The above profile illustrates that if there were an immediate downward adjustment of 200 basis points in interest rates and the Company did nothing further with regard to the active management of its assets or liabilities, net interest income would likely decrease by around $4.6 million, or approximately 12.38%, over the next twelve months. By the same token, if there were an immediate increase of 200 basis points in interest rates, the Company’s net interest income would likely gain approximately $19,000, or 0.05%, over the next year. According to the net interest income simulations the Company is asset sensitive, which is supported by fact the Company has, in the past, seen erosion in its interest margin as rates are declining while benefiting in a rising rate environment. The changes in net interest income under rising and declining rate scenarios are typically expected to be more symmetrical. The exposure to declining rates appears disproportionate in these simulations, however, because most of the Company’s deposit rates are currently so close to a floor of zero. As rates on interest-bearing liabilities hit this floor the Company’s yields on earning assets continue to fall, creating significant compression in the Company’s net interest margin. In rising rate scenarios the gain in net interest income is uneven because the Company’s prime rate is currently 75 basis points higher that the Wall Street Journal prime rate. We have assumed that as rates rise we will gradually allow the Company’s prime rate to return to its normal parity with the Wall Street Journal prime, thus creating a slight dip in net interest income between the 100 and 300 basis point rising rate scenarios.
In reality, management does not expect current historically low rates to fall significantly. If they do the Company would likely continue to limit movement in the Bank of the Sierra Prime Rate, although no assurance can be given that this would, indeed occur. Approximately $235 million in variable-rate loan balances are tied to that rate. If the Bank of the Sierra Prime Rate is not lowered further from its current level, the Company’s interest rate risk profile changes dramatically:
The economic values of the Company’s loan and deposit portfolios will also vary under the different interest rate scenarios previously discussed. The amount of change is dependent upon the characteristics of each class of financial instrument, including the stated interest rate relative to current market rates, the likelihood of prepayment, whether the rate is fixed or floating, the maturity date of the instrument and the particular circumstances of the Company’s customers. The economic value simulations tend to change over time as the characteristics of the Company’s balance sheet evolve, and as interest rate and yield curve assumptions are updated.
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LIQUIDITY
Liquidity refers to the Company’s ability to maintain a cash flow that is adequate to fund operations and meet obligations and other commitments in a timely and cost-effective fashion. The Company requires sources of funds to meet short-term cash needs that may result from loan growth or deposit outflows, or other asset purchases or liability repayments. These funds are traditionally made available by drawing down from the Company’s correspondent bank deposit accounts, reducing the volume of fed funds sold, selling securities, liquidating other assets, or borrowing funds from other institutions. The extent to which these funds are available to meet the Company’s cash needs determines its liquidity. In addition, should the need arise for immediate cash, the Company could sell either permanently or under agreement to repurchase those investments in its portfolio which are not being pledged as collateral.
As of June 30, 2003, non-pledged securities comprised $18 million of the Company’s investment portfolio balances. Other forms of balance sheet liquidity on that date include vault cash and balances due from banks, overnight fed funds sold totaling $2.5 million, immediately marketable loan balances in the amount of approximately $23 million, and the net cash surrender value of BOLI. In addition to the liquidity inherent in its balance sheet, the Company has off-balance-sheet liquidity in the form of lines of credit from correspondent banks. Availability on these lines totaled approximately $29 million at June 30, 2003. An additional $138 million in credit is available from the Federal Home Loan Bank if the Company increases its pledged real-estate related collateral in a like amount. The Company manages its liquidity in such a fashion as to be able to meet any unexpected sudden change in levels of assets or liabilities.
CAPITAL RESOURCES
At June 30, 2003, the Company had total shareholders’ equity of $56.9 million, comprised of $3.5 million in common stock, $51.7 million in retained earnings, and $1.7 million in accumulated other comprehensive income. Total shareholders’ equity at the end of 2002 was $53.3 million. The increase in shareholders’ equity from December 31, 2002 to June 30, 2003 was due primarily to a $3 million increase in retained earnings, but also includes a $660,000 increase in common stock due to the issuance of shares from exercised stock options, net of the cost of shares repurchased.
The Company uses a variety of measures to evaluate its capital adequacy, with risk-based capital ratios calculated separately for the Company and the Bank. Management reviews these capital measurements on a quarterly basis and takes appropriate action to ensure that they are within established internal and external guidelines. The Company’s current capital position exceeds minimum thresholds established by industry regulators, and by current regulatory definitions the Bank is well capitalized, the highest rating of the categories defined under Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991.
The Federal Deposit Insurance Corporation (FDIC) has promulgated risk-based capital guidelines for all state non-member banks such as the Bank. These guidelines establish a risk-adjusted ratio relating capital to different categories of assets and off balance sheet exposures. There are two categories of capital under the guidelines, Tier 1 Capital includes common stockholders’ equity and qualifying minority interests in consolidated subsidiaries (which, for the Company, means trust-preferred securities), less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on available for sale investment securities carried at fair market value. Of the Company’s Tier 1 capital at June 30, 2003, $15 million, or approximately 23%, consisted of trust-preferred securities. Trust-preferred securities are considered to be Tier 1 capital for regulatory purposes, to the extent that they do not exceed 25% of total Tier 1 capital. They are, however, classified as long-term debt in accordance with generally accepted accounting principles. Tier 2 Capital includes preferred stock, certain types of debt equity, and the allowance for loan losses, subject to certain limitations.
The following table sets forth the Company’s and the Bank’s regulatory capital ratios as of the dates indicated:
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At the current time, there are no commitments that would necessitate the use of material amounts of the Company’s capital.
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PART I – FINANCIAL INFORMATION Item 3
QUALITATIVE & QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
The information concerning quantitative and qualitative disclosures about market risk is included as part of Part I, Item 2 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Market Risk Management”.
PART I – FINANCIAL INFORMATION Item 4
CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15-d-14(c)) as of the filing date of this report (the “Evaluation Date”) have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were adequate and effective to ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them by others within those entities, particularly during the period in which this quarterly report was being prepared.
Disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.
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PART II -OTHER INFORMATION
ITEM 1 :LEGAL PROCEEDINGS
In the normal course of business, the Company is involved in various legal proceedings. In the opinion of management, any liability resulting from such proceedings would not have a material adverse effect on the Company’s financial condition or results of operation.
ITEM 2 :CHANGES IN SECURITIES
Not applicable
ITEM 3 :DEFAULTS UPON SENIOR SECURITIES
ITEM 4 :SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company’s annual meeting of shareholders was held on May 28, 2003. Proxies were solicited by the Company’s management pursuant to Regulation 14 under the Securities Exchange Act of 1934. There was no solicitation in opposition to Management’s nominees for directorship as listed in the proxy statement, and all of such nominees were elected pursuant to the vote of shareholders. The directors noted below were elected to two-year terms. The votes tabulated were:
The number of broker non-votes received with respect to this item was 69,810.
The terms of the following directors continued after the shareholders’ meeting: Morris A. Tharp, Gregory A. Childress, Robert L. Fields, James C. Holly, and Howard H. Smith.
ITEM 5 :OTHER INFORMATION
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ITEM 6 :EXHIBITS AND REPORTS ON FORM 8-K
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(b) Reports on Form 8-K
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SIGNATURES
Pursuant to the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:
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