Enterprise Bancorp 10-Q 2005
U.S. Securities and Exchange Commission
Washington, D.C. 20549
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2005
o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 0-21021
Enterprise Bancorp, Inc.
(Exact name of registrant as specified in its charter)
222 Merrimack Street, Lowell, Massachusetts, 01852
(Address of principal executive offices) (Zip code)
(Registrants telephone number, including area code)
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 ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes ý No o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No ý
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date: November 4, 2005, Common Stock - Par Value $0.01: 3,769,545 shares outstanding.
ENTERPRISE BANCORP, INC.
ENTERPRISE BANCORP, INC.
September 30, 2005 and December 31, 2004
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
Three and Nine months ended September 30, 2005 and 2004
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
Nine months ended September 30, 2005
(1) Common stock was issued during the period to shareholders under the dividend reinvestment plan and as a restricted stock award to an executive officer.
See the accompanying notes to the unaudited consolidated financial statements
ENTERPRISE BANCORP, INC.
Nine months ended September 30, 2005 and 2004
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
(1) Organization of Holding Company
Enterprise Bancorp, Inc. (the company) is a Massachusetts corporation organized at the direction of Enterprise Bank and Trust Company, (the bank), for the purpose of becoming the holding company for the bank. The bank, a Massachusetts trust company, has three wholly owned subsidiaries, Enterprise Insurance Services LLC, organized for the purpose of engaging in insurance sales activities, Enterprise Investment Services LLC, which offers non-deposit investment products and related securities brokerage services to its customers, and Enterprise Security Corporation, which invests in a portfolio of equity securities.
(2) Basis of Presentation
The accompanying unaudited consolidated financial statements and these notes should be read in conjunction with the companys December 31, 2004 audited consolidated financial statements and notes thereto contained in the companys 2004 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2005. Interim results are not necessarily indicative of results to be expected for the entire year. The company has not changed its significant accounting and reporting policies from those disclosed in its 2004 annual report.
In the opinion of management, the accompanying consolidated financial statements reflect all necessary adjustments consisting of normal recurring accruals for a fair presentation. All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements.
Certain fiscal 2004 information has been reclassified to conform to the 2005 presentation.
(3) Stock Based Compensation
The company measures compensation cost for stock options using the intrinsic value method under which no compensation cost is recorded if, at the grant date, the exercise price of the options is equal to or greater than the fair market value of the companys common stock.
Had the company determined compensation expense based on the fair value at the grant date for its stock options under SFAS 123, the companys net income would have been reduced to the pro forma amounts indicated in the following table:
There were 118,150 options granted during the nine months ended September 30, 2005. The per share weighted average grant date fair value of stock options was determined to be $5.58, and the key assumptions used in the valuation for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 4.12%, 15.00%, 1.67% and 6, respectively.
There were 104,940 options granted during the nine months ended September 30, 2004. The per share weighted average fair value of stock options was determined to be $3.01 at the date of grant, and the assumptions used in the valuation for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 3.59%, 15.00%, 1.58% and 6, respectively.
During 2005 management replaced the Binomial option valuation model (a lattice style model) with the Black-Scholes option valuation model. The company has determined that option values calculated prior to 2005 under the Binomial model are not materially different to those that would have been calculated using the Black-Scholes model.
On September 7, 2005, 8,750 shares were issued to an executive officer as a restricted stock award. The shares were issued at a market price of $28.50 per share and vest twenty percent per year starting on the first anniversary date of the award.
(4) Accounting Rule Changes
In March 2004, the Financial Accounting Standards Board, (FASB) issued Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, to determine the meaning of other-than-temporary impairment and its application to debt and equity securities within the scope of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. The task force concluded that an investment is impaired if the fair value of the investment is less than cost. If impaired, the investor must make an evidence-based judgment to determine if the impairment is recoverable within a reasonable period of time considering the severity and duration of the impairment in relation to the forecasted recovery of fair value. The impairment should be considered other than temporary if the investor does not have the ability and intent to hold an investment for a reasonable period of time sufficient for a forecasted recovery of fair value up to (or beyond) the cost of the investment. For those investments for which impairment is considered other than temporary, the company would recognize in earnings an impairment loss equal to the difference between the investments cost and its fair value. EITF No. 03-1 other-than-temporary impairment evaluations were effective for reporting periods beginning after September 15, 2004.
In September 2004, the FASB issued FSP (FASB Staff Position) EITF Issue 03-1-1, Effective Date of Paragraphs 10-20 of EITF Issue No. 03-1 due to industry responses to EITF No. 03-1. The FSP provided guidance for the application of EITF No. 03-1 as it relates to debt securities that are impaired because of interest rate and/or sector spread increases (non-credit impairment). It also delayed the effective date of EITF No. 03-1 for non-credit impaired debt securities until a final consensus could be reached.
In November 2005, the FASB took the staffs recommendation to nullify the guidance of paragraphs 10- 18 of EITF 03-1 on the determination of whether an investment is other-than-temporarily impaired and issued a final FASB Staff Position (FSP) FAS 115-1The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, which will replace certain guidance set forth in paragraphs 10-18 of EITF Issue No. 03-1 and clarify that for non-credit impaired debt securities, other-than-temporary impairment can generally be avoided if the investor has the ability and intent to hold the investment until recovery of fair value or maturity. The final FSP FAS 115-1 will be effective for reporting periods beginning after December 15, 2005.
In December 2004, the FASB issued Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, (SFAS 123(R)). The standard, an amendment of FASB Nos. 123 and 95, eliminates the ability of companies to account for stock-based compensation transactions using the intrinsic value method and requires instead that such transactions be accounted for using a fair-value based method. Under the intrinsic value method, no compensation cost is recorded if, at the grant date, the exercise price of the options is equal to or greater than the fair market value of the companys common stock; however, pro forma net income and earnings per share information is supplementally disclosed as if the fair-value based method of accounting had been used. The fair value method requires companies to recognize compensation expense over the service period (usually the vesting period), equal to the fair value at the grant date for stock options issued in exchange for employee services. The statement is applicable to public companies prospectively for any annual period beginning after June 15, 2005. As of the effective date, all public entities that used the fair-value-based method for either recognition or disclosure under Statement 123 will apply this Statement using a modified version of prospective application method. Under this transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under Statement 123 for either recognition or pro forma disclosures.
For periods before the required effective date, entities may elect to apply the modified retrospective application transition method, which may be applied either (a) to all prior years for which Statement 123 was effective or (b) only to prior interim periods in the year of initial adoption if the required effective date of this Statement does not coincide with the beginning of the entitys fiscal year. An entity that chooses to apply the modified retrospective method to all prior years for which Statement 123 was effective shall adjust financial statements for prior periods to give effect to the fair-value-based method of accounting for awards granted, modified or settled in cash on a basis consistent with the pro-forma disclosures required for those periods by Statement 123. The company currently uses the intrinsic value method to measure compensation cost. See note 3, Stock Based Compensation, above, for pro forma information regarding compensation expense using the fair value method under SFAS 123.
In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107 to provide public companies additional guidance in applying the provisions of Statement 123(R). Among other things, the SAB describes the SEC staffs expectations in determining the assumptions that underlie the fair value estimates and discusses the interaction of Statement 123(R) with existing SEC guidance. The company intends to adopt SFAS 123(R) utilizing the modified version of prospective application method and is currently analyzing the full effect of the implementation of SFAS 123(R) on its financial statements.
In March 2005, the Federal Reserve Board adopted a final rule that allows the continued limited inclusion of trust preferred securities in the tier 1 capital of bank holding companies. Under the final rule, trust preferred securities and other restricted core capital elements will be subject to stricter quantitative limits. The Boards final rule limits restricted core capital elements to 25 percent of all core capital elements, net of goodwill less any associated deferred tax liability. The adoption of this rule is not expected to have a material impact on the company.
(5) Critical Accounting Estimates
In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. These estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ from those estimates. Certain of the critical accounting estimates are more dependent on managements judgment and in some cases may contribute to volatility in the companys reported financial performance should the assumptions and estimates used change over time due to changes in circumstances. As discussed in the companys 2004 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the impairment valuation of goodwill.
(6) Earnings Per Share
Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect the effect on weighted average shares outstanding of the number of additional shares outstanding if dilutive stock options were converted into common stock using the treasury stock method. The table below presents the increase in average shares outstanding, using the treasury stock method, for the diluted earnings per share calculation for the quarter and year to date periods ending ended September 30 and the effect of those shares on earnings:
At September 30, 2005, 213,602 of the companys outstanding stock options were excluded from the calculation of diluted earnings per share due to the exercise price exceeding the average market price. These options, which are not currently dilutive, may potentially dilute earnings per share in the future.
(7) Dividends/Dividend Reinvestment Plan
On April 19, 2005, the board of directors of the company approved an annual dividend of $0.48 per share, payable on June 24, to shareholders of record as of the close of business on June 3, 2005.
The company maintains a dividend reinvestment plan (the DRP). The DRP enables stockholders, at their discretion, to elect to reinvest dividends paid on their shares of the companys common stock by purchasing additional shares of common stock from the company at a purchase price equal to fair market value.
In 2005, shareholders utilized the DRP to reinvest $871,000, of the $1.8 million dividend paid by the company in June, into 29,960 shares of the companys common stock.
(8) Guarantees, Commitments and Derivatives
Standby letters of credit are conditional commitments issued by the company to guarantee the performance by a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. If the letter of credit is drawn upon, the bank creates a loan for the customer with the same criteria associated with similar loans. The fair value of these commitments was estimated to be the fees charged to enter into similar agreements. At September 30, 2005 and 2004 the fair value of these commitments was not material.
The company generally originates fixed rate residential mortgage loans with the anticipation of selling such loans. The company generally does not pool mortgage loans for sale but instead sells the loans on an individual basis and generally does not retain the servicing of these loans. Interest rate lock commitments related to the origination of mortgage loans that will be sold are considered derivative instruments. The company estimates the fair value of these derivatives using the difference between the guaranteed interest rate in the commitment and the current market interest rate. To reduce the net interest rate exposure arising from its loan sale activity, the company enters into the commitment to sell these loans at essentially the same time that the interest rate lock commitment is quoted on the origination of the loan. The commitments to sell loans are also considered derivative instruments, with estimated fair values based on changes in current market rates. At September 30, 2005, the estimated fair value of the companys derivative instruments was considered to be immaterial.
Managements discussion and analysis should be read in conjunction with the companys consolidated financial statements and notes thereto contained in this report and the companys 2004 Annual Report on Form 10-K.
Special Note Regarding Forward-Looking Statements
This report contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements concerning plans, objectives, future events or performance and assumptions and other statements that are other than statements of historical fact. Forward-looking statements may be identified by reference to a future period or periods or by use of forward-looking terminology such as anticipates, believes, expects, intends, may, plans, pursue, views and similar terms or expressions. Various statements contained in Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations and Item 3 Quantitative and Qualitative Disclosures About Market Risk, including, but not limited to, statements related to managements views on the banking environment and the economy, market expansion and opportunities, the interest rate environment, credit risk and the level of future non-performing assets and charge-offs, potential asset and deposit growth, future non-interest expenditures and non-interest income growth, and borrowing capacity are forward-looking statements. The company wishes to caution readers that such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties that may adversely affect the companys future results. The following important factors, among others, could cause the companys results for subsequent periods to differ materially from those expressed in any forward-looking statement made herein: (i) changes in interest rates could
negatively impact net interest income; (ii) changes in the business cycle and downturns in the local, regional or national economies, including deterioration in the local real estate market, could negatively impact credit and/or asset quality and result in credit losses and increases in the companys reserve for loan losses; (iii) changes in consumer spending could negatively impact the companys credit quality and financial results; (iv) increasing competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services could adversely affect the companys competitive position within its market area and reduce demand for the companys products and services; (v) deterioration of securities markets could adversely affect the value or credit quality of the companys assets and the availability of funding sources necessary to meet the companys liquidity needs; (vi) changes in technology could adversely impact the companys operations and increase technology-related expenditures; (vii) increases in employee compensation and benefit expenses could adversely affect the companys financial results; (viii) changes in laws and regulations that apply to the companys business and operations could increase the companys regulatory compliance costs and adversely affect the companys business environment, operations and financial results; and (ix) changes in accounting standards, policies and practices, as may be adopted or established by the regulatory agencies, the Financial Accounting Standards Board or the Public Company Accounting Oversight Board could negatively impact the companys financial results. Therefore, the company cautions readers not to place undue reliance on any such forward-looking information and statements.
Accounting Policies/Critical Accounting Estimates
The company has not changed its significant accounting and reporting policies from those disclosed in its 2004 Annual Report on Form 10-K. In applying these accounting policies, management is required to exercise judgement in determining many of the methodologies, assumptions and estimates to be utilized. As discussed in the companys 2004 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the impairment valuation of goodwill. Managements estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ from those estimates.
Composition of Earnings
The company had net income of $6.085 million for the nine months ended September 30, 2005 compared to $5.503 million for the same period in 2004, an increase of 11%. The companys earnings are largely dependent on its net interest margin or spread, which is the difference between the yield on interest earning assets (loans, investment securities and short-term investments) and the cost of funding those assets (total deposits and borrowings). The companys earnings are, therefore, subject to the risks associated with changes in the interest rate environment. In addition, other components effecting net income include the level of the provision for loan losses, non-interest income, non-interest expenses and income taxes.
The companys tax equivalent net interest margin increased by 32 basis points to 4.79% for the current nine-month period, compared to 4.47% for the same period in 2004. The increase in margin through September 30, 2005 resulted primarily from a 44 basis point increase in the yield on interest earning assets, partially offset by a 13 basis point increase in the cost of funds (i.e.: total deposits and borrowings). The increase in asset yields was driven primarily by higher market rates, especially variable rate loans tied to the Prime Lending Rate, which has increased 275 basis points since June 2004. Conversely, market rates on deposit products, especially non-certificate products, have advanced at a slower pace over the period. In addition, the companys average non-interest bearing deposits, a key component in maintaining a low overall cost of funds, increased $21.4 million, or 15%, over the comparable nine month period in the prior year.
Net interest income, which is the margin or spread in dollar terms (i.e., interest income less interest expense) amounted to $27.8 million for the nine months ended September 30, 2005. The increase in net interest income was $4.4 million, or 19%, compared to the same period in 2004, and was attributed primarily to an $88.5 million, or 17%, increase in average loan balances.
The provision for loan losses charged to operations reflects managements assessment of the adequacy of the allowance for loan losses to support the estimated credit risk inherent in the loan portfolio, including the level of
charge-offs during the period. The provision for loan losses was $835 thousand for the nine months ended September 30, 2005 and $1.350 million for the same period in 2004. Net recoveries for the first nine months of 2005 were $1 thousand as compared to net charge-offs of $592 thousand in the first nine months of 2004.
Management further discusses the provision for loan losses and its assessment of the allowance at September 30, 2005 under the heading Asset Quality and the Allowance for Loan Losses in the Financial Condition section of this Item 2 below.
The companys earnings are also directly impacted by non-interest income, consisting of traditional banking fee income such as deposit and loan fees, net gains/losses on the sales of investment securities and loans, and non-deposit revenue streams such as investment management, trust and insurance services. Non-interest income was $4.8 million and $5.3 million for the nine months ended September 30, 2005 and 2004, respectively. The decrease in 2005 was primarily due to reductions in net gains on sales of investment securities and loans and decreases in deposit service fees due to the higher earnings credit rates applied to business checking accounts in the current period, partially offset by an increase in the other income category. The other income category includes merchant credit card deposit fees and electronic banking fees, commercial letter of credit fees, check printing fees, and income related to bank-owned life insurance. The increase was due primarily to the increases in merchant and electronic banking fee income, partially due to the sale of a merchant credit card services portfolio, income related to bank-owned life insurance, and an increase in fee income due to the companys growth and increase in transaction volume.
Operating expenses are also a key component of the companys financial results. Non-interest expense amounted to $22.3 million and $18.7 million for the nine months ended September 30, 2005 and 2004, respectively. The 19% increase primarily reflects increases in compensation costs and the infrastructure necessary to support the companys ongoing growth and strategic initiatives, 2004 branch expansion into the new markets of Andover, MA and Salem, NH, the opening of our second Tewksbury, MA branch in July 2005, as well as increases in professional costs associated with the financial reporting requirements of the Sarbanes-Oxley Act.
The companys primary sources of funds are deposits, borrowings from the Federal Home Loan Bank of Boston (FHLB), securities sold under agreements to repurchase, earnings and proceeds from the sales, maturities and paydowns on loans and investment securities. The company uses these funds to originate loans, purchase investment securities, conduct operations, expand the companys branch network, and pay dividends to shareholders.
Total assets increased $64.6 million, or 8%, since December 31, 2004, and amounted to $912.8 million at September 30, 2005. The December 31, 2004 balance was impacted by the inflow of $32 million to a demand deposit account in late December, which was withdrawn in early January 2005.
Total loans increased by $95.1 million, or 17%, over December 31, 2004. The growth was primarily in the commercial real estate portfolio and reflects the companys expansion into new markets, continued growth in mature markets and the companys continued commitment to developing strong commercial lending relationships with growing businesses, corporations, non-profit organizations, professionals and individuals.
Investments, consisting of investment securities and total short-term investments, decreased by $44.2 million, or 19%, since December 31, 2004 as proceeds from principal paydowns, calls and maturities were used primarily to fund loan growth.
Deposits increased by $43.0 million, or 6%, since December 31, 2004. The increase was concentrated primarily in the lower cost checking and non-interest bearing deposit balances. The December 31, 2004 balance reflects a $32 million demand deposit inflow that was withdrawn in early January 2005.
Borrowed funds increased $13.0 million since December 31, 2004. The increase was due primarily to loan growth exceeding deposit growth during the period.
Opportunities and Risks
Management views the current banking landscape as an opportunistic period and believes that the company has established a market presence in the Merrimack Valley and North Central regions of Massachusetts and in southern New Hampshire. Management also believes the companys business model, strong service culture, skilled
management team and brand name create opportunities for the company to be the leading provider of banking and investment management services in its growing market area. Management continually strives to differentiate the company from competitors by providing innovative commercial and consumer banking, investment, and insurance products delivered through prompt and personal service based on managements familiarity and understanding of the banking needs of its customers, which include businesses, professionals, and consumers.
Management recognizes that substantial competition exists in the marketplace and views this as a key business risk. This market competition includes the expanded lending capabilities of credit unions, the shift to commercial lending by traditional savings banks, the presence of large regional and national commercial banks, as well as non-bank financial service competitors.
In this competitive marketplace, the company has continued to maintain very strong commercial loan growth through ongoing business development efforts and continued market expansion within existing and into new markets. The company expanded its market presence with two new branches that opened in Andover, MA and Salem, NH in 2004 and a second Tewksbury, MA office in July 2005, bringing the companys total branch network to fourteen. In addition, the company continues to look for market and branch opportunities that will increase franchise value and shareholder returns. Such expansion typically increases the companys operating expenses, primarily in salary and benefits, marketing, and occupancy, before the growth benefits are fully realized in those markets.
In addition to growth and competition, the companys significant challenges continue to be the effective management of interest rate, credit and operational risk.
The companys interest rate risk management process involves evaluating various interest rate scenarios, competitive dynamics and market opportunities. At current interest rate levels, management considers the companys primary interest rate risk exposure to be margin or spread compression that may result from an interest yield curve that decreases, flattens or inverts.
Generally, under a decreasing interest rate scenario, both asset and liability yields re-price lower, but eventually interest rates reach a level that make further liability reductions minimal. Such a scenario occurred in the banking industry from 2000 to 2004. Significant margin contraction occurred as average interest rates approached historic lows, earning assets continued to re-price downward and interest-bearing liabilities eventually had little room to move significantly lower. In addition, as market rates declined prepayments on loans and mortgage backed investment securities accelerated, forcing companies to reinvest the proceeds at lower market rates. In 2004, the downward trend in interest rates stabilized and short-term market rates began to move upward.
Under the flat yield curve scenario, margin compression would eventually occur as short and long-term rates move toward similar levels. At current interest rate levels, this scenario would most likely occur with shorter-term liability costs increasing from market movements and competitive pressures, while longer term asset yields remain relatively stable or decrease. Over the last twelve months the yield curve has slowly moved in this direction as evidenced by the spread between the three month U.S. Treasury rate and the ten year U.S. Treasury rate contracting by 164 basis points.
The financial magnitude of this recent yield curve flattening has been somewhat mitigated by the companys product mix. Approximately 33% of loans reprice within thirty days of a change in the Prime Lending Rate, a short-term rate; approximately 45% of the companys deposits consist of lower cost checking accounts, which are considered unlikely to incur significant interest rate increases; other deposit products such as savings, money markets and certificates of deposit, have increased in rate, but at a slower pace than wholesale market rates. Over a longer period, the company expects that increases in deposit rates which could exceed increases in asset yields under a flattening yield curve scenario may eventually lead to margin compression.
An inverted yield curve would result in longer-term rates being less than shorter-term rates. As previously discussed, the companys primary revenue driver is net interest income, which is the difference between asset and liability returns. Under an inverted yield curve certain market liability yields would exceed certain asset returns. Again, the companys product mix would lessen the potential negative financial impact but to a lesser extent than under the flat curve scenario.
The management of interest rate risk is a significant component of the companys risk management process and is discussed in more detail in Item 3, Quantitative and Qualitative Disclosures About Market Risk.
The credit risk of the portfolio depends on a wide variety of factors, including, among others, current and expected economic conditions, the real estate market, the financial condition of borrowers, the ability of borrowers to adapt to changing conditions or circumstances affecting their business, the continuity of borrowers management teams and the credit management process. Management regularly monitors these factors, among others, through ongoing credit reviews by the credit department, an external loan review service, members of senior management and the loan and executive committees of the board of directors. The credit risk inherent in the loan portfolio is quantified through the allowance for loan losses, which is primarily increased through the provision for loan losses, as a direct charge to earnings. Management determined that the allowance for loan losses of $11.8 million, or 1.77% of total loans at September 30, 2005, was adequate to absorb reasonably anticipated losses due to the credit risk associated with the loan portfolio at that date. Management further discusses its assessment of the allowance at September 30, 2005 under the heading Asset Quality and the Allowance for Loan Losses in the Financial Condition section of this Item 2 below.
Management also recognizes, as a key component of the risk management process, the importance of effectively mitigating operational risk, particularly as it relates to technology administration, information security, and business continuity.
Management utilizes a combination of third party security assessments, key technologies and ongoing internal evaluations in order to continually monitor and safeguard information on its operating systems and that of third party service providers. The company contracts with outside parties to perform a broad scope of both internal and external security assessments on a regular basis. These third parties test the companys security controls and network configuration, and assess internal practices and other key items. The company also utilizes firewall technology to protect against unauthorized access and commercial software that continuously scans for computer viruses on the companys information systems. The company maintains an Information Security and Technology Practices policy applicable to all employees. The policy outlines the employees responsibilities and key components of the companys Information Security and Technology Practices Program, which include the following: identification and assessment of risk; institution of policies and procedures to manage and control the risk; risk assessment of outsourced service providers; development of strategic security contingency plans; training of all officers and employees; and reporting to the board of directors. Significant technology issues, related changes in risk and results of third party security assessments are reported to the Boards Banking Technology and Audit Committees. The Board, through these committees, reviews the status of the Information Security and Technology Practices Program and makes adjustments to the policy as deemed necessary.
The company has a Business Continuity Plan that consists of the information and procedures required to enable rapid recovery from an occurrence which would disable the company for an extended period. The plan establishes responsibility for assessing a disruption of business, contains alternative strategies for the continuance of critical business functions, assigns responsibility for restoring services, and sets priorities by which impacted services will be restored.
Short-term investments classified as cash equivalents consist of overnight and term federal funds sold, money market mutual funds and discount U.S. agency notes maturing in less than ninety days. The remaining balance carried as other short-term investments consists of auction rate preferred securities with redemption options (auction dates) every 49 days, but which may not readily be converted to cash at par value until the next successful auction. Together, total short-term investments amounted to $12.5 million, or 1% of total assets, as of September 30, 2005 compared to $40.3 million, or 5% of total assets, at December 31, 2004. The reduction at September 30, 2005 was due to the redemption of $8.2 million of auction rate preferred securities and a decrease in overnight investments to assist in funding loan growth during the period.
At September 30, 2005, all of the companys investment securities were classified as available-for-sale and carried at fair value. The investment portfolios fair market value at September 30, 2005 was $171.2 million, representing 19%
of total assets, and consisted of $166.8 million in fixed income securities and $4.4 million in professionally managed equity securities.
During the nine months ended September 30, 2005 the company purchased $12.2 million and sold $1.4 million of securities, recognizing $227 thousand in net gains. Principal paydowns, calls and maturities totaled $25.0 million during the period, and were primarily comprised of principal payments in the mortgage backed securities portfolio.
The net unrealized gain on the portfolio at September 30, 2005 was $480 thousand compared to a net unrealized gain of $2.6 million at December 31, 2004. The decrease was primarily due to higher market interest rates at September 30, 2005 as compared to December 31, 2004. The net unrealized gains/losses in the companys fixed income portfolio fluctuate as interest rates rise and fall. Due to the fixed rate nature of the portfolio, as rates rise, or the securities approach maturity, the market value of the portfolio declines, and as rates fall the value of the portfolio rises. The net unrealized gains/losses in the companys equities portfolio fluctuate based on the performance of the individual equities that comprise the portfolio.
Generally unrealized gains or losses will only be realized if the securities are sold. However, if an unrealized loss on a fixed income or equity security is deemed to be other-than-temporary, the company marks the investment down to its carrying value through a charge to earnings.
Total loans were $665.6 million, or 73% of total assets, at September 30, 2005, an increase of $95.1 million, or 17%, compared to December 31, 2004, and an increase of $113.6 million, or 21%, compared to September 30, 2004.
The following table sets forth the loan balances by certain loan categories at the dates indicated and the percentage of each category to gross loans, excluding deferred fees.
The companys primary lending focus is on the development of high quality commercial real estate, construction and commercial & industrial lending relationships with businesses, corporations, partnerships, non-profit organizations, professionals and individuals.
Commercial real estate loans were $310.8 million at September 30, 2005, compared to $257.7 million at December 31, 2004, an increase of $53.1 million, or 21%. Commercial real estate loans are typically secured by apartment buildings, office facilities, shopping malls, or other commercial property.
Commercial & industrial loans totaled $163.3 million at September 30, 2005, compared to $142.9 million at December 31, 2004, an increase of $20.4 million, or 14%. Commercial & industrial loans include working capital loans, equipment financing (including equipment leases), term loans, and revolving lines of credit. Also included in
commercial loans are loans under various U.S. Small Business Administration programs amounting to $8.2 million at September 30, 2005 and $10.0 million at December 31, 2004.
Commercial construction loans amounted to $93.6 million at September 30, 2005, compared to $80.6 million at December 31, 2004, an increase of $13.0 million, or 16%. Construction loans include the development of residential housing and condominium projects, the development of commercial and industrial use property and loans for the purchase and improvement of raw land. Over the past twelve months commercial construction loans grew by $20.9 million, or 29%. The company attributes this growth to an experienced team of lenders focused on this market segment, the economic expansion of this sector and the companys expansion into new geographic market areas.
At September 30, 2005, the company had commercial loan balances participated out to various banks amounting to $16.0 million compared to $20.0 million at December 31, 2004. These portions participated out to other institutions are not carried as assets on the companys financial statements. Commercial loans originated by other banks in which the company is the participating institution are carried on the balance sheet and amounted to $14.9 million at September 30, 2005, compared to $19.1 million at December 31, 2004. The companys participation in these loans may range from 5% to 100% of the total loan commitment, with no single participation exceeding $5.0 million. The company performs an independent credit analysis of each commitment prior to participation in the loan.
Asset Quality and the Allowance for Loan Losses
The following table sets forth non-performing assets and allowance ratios at the dates indicated:
Total non-performing loans were $1.8 million at September 30, 2005 compared to $2.1 million and $1.9 million at December 31, 2004 and September 30, 2004, respectively. The decline since September 2004 reflects the continued credit quality improvement and principal paydowns during the period.
The ratio of delinquent loans 30-89 days past due as a percentage of total loans decreased from 0.76% at December 31, 2004, to 0.58% at September 30, 2005. The December ratio included three large individual commercial real estate loans, which were 31 days past due at December 31, 2004 and were subsequently brought current in January 2005.
Management continues to closely monitor the credit quality of individual non-performing relationships, industry concentrations, the local real estate market and current economic conditions. The level of delinquent and non-performing assets is largely a function of economic conditions and the overall banking environment. Despite prudent loan underwriting adverse changes within the companys market area or deterioration in the local, regional or national economic conditions could negatively impact the companys level of non-performing assets in the future.
The allowance for loan losses to non-performing loan ratio increased to 665.86% at September 30, 2005 compared to 510.42% and 563.69% at December 31, and September 30, 2004, respectively. The increase in the ratio occurred despite a reduction in the allowance for loan losses to total loans ratio and reflects the decrease in non-performing loans as a percentage of total loans.
The allowance for loan losses to total loan ratio decreased to 1.77% at September 30, 2005 compared to 1.91% and 1.95% at December 31, and September 30, 2004, respectively. The reduction in the ratio reflects managements assessment of the continued improvement of the credit risk inherent in the portfolio. The credit risk in the portfolio depends on a wide variety of factors, including, among others, current and expected economic conditions, the real estate market, the financial condition of borrowers, the ability of borrowers to adapt to changing conditions or circumstances affecting their business, the continuity of borrowers management teams and the credit management process.
The following table summarizes the activity in the allowance for loan losses for the periods indicated:
Management regularly reviews the levels of non-accrual loans, levels of charge-offs and recoveries, peer results, levels and composition of outstanding loans and known and inherent risks in the loan portfolio. Based on the foregoing, the allowance for loan losses of 1.77% was deemed adequate to absorb reasonably anticipated losses from specifically known and other credit risks associated with the portfolio as of September 30, 2005.
There have been no material changes to the companys allowance for loan loss methodology used to estimate loan loss exposure as reported in the companys Annual Report on Form 10-K for the year ended December 31, 2004. The provision for loan losses is a significant factor in the companys operating results.
For further discussion regarding the provision for loan losses and managements assessment of the adequacy of the allowance for loan losses see the discussions under the heading, Opportunities and Risks, contained in the Overview section of this Item 2 above and in the section entitled Critical Accounting Estimates in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, contained in the companys 2004 Annual Report on Form 10-K.
Total deposits amounted to $811.6 million at September 30, 2005 compared to $768.6 million at December 31, 2004. The $43.0 million increase resulted from a $24.8 million, or 7%, increase in lower cost checking and non-interest bearing demand deposit balances, a $8.4 million, or 3%, increase in savings and money market balances, and a $9.8 million, or 7%, increase in certificates of deposits. The December 31, 2004 balance was partially impacted by the inflow of $32 million to a demand deposit account in late December, which was withdrawn in early January 2005. Since September 30, 2004, total deposits have increased $71.2 million, or 10%.
The following table sets forth the deposit balances by certain categories at the dates indicated and the percentage of each category to total deposits.
Borrowed funds, consisting of securities sold under agreements to repurchase (repurchase agreements) and FHLB borrowings, amounted to $16.6 million at September 30, 2005 compared to $3.7 million at December 31, 2004. The balance increase at September 30, 2005 primarily resulted from a $14.0 million increase in overnight FHLB advances necessary to fulfill the companys cash management requirements at the end of the period, partially offset by a $1.0 million reduction in customer repurchase agreements.
Liquidity is the ability to meet cash needs arising from, among other things, fluctuations in loans, investments, deposits and borrowings. Liquidity management is the coordination of activities so that cash needs are anticipated and met readily and efficiently. Liquidity policies are set and monitored by the companys asset-liability committee. The companys liquidity is maintained by projecting cash needs, balancing maturing assets with maturing liabilities, monitoring various liquidity ratios, monitoring deposit flows, maintaining liquidity within the investment portfolio and maintaining borrowing capacity at the FHLB.
The companys asset-liability management objectives are to maintain liquidity, provide and enhance access to a diverse and stable source of funds, provide competitively priced and attractive products to customers, conduct funding at a low cost relative to current market conditions and engage in sound balance sheet management strategies. Funds gathered are used to support current asset levels and to take advantage of selected leverage opportunities. The company funds earning assets with deposits, borrowed funds and stockholders equity. At September 30, 2005, the bank had the capacity to borrow additional funds from the FHLB of up to $90.4 million, and had the ability to issue up to approximately $120 million in brokered certificates of deposits through an arrangement with Merrill Lynch. The company does not currently have any brokered deposits outstanding. The bank also has a repurchase agreement in place with Lehman Brothers. Under this arrangement, the bank is able to borrow funds from Lehman Brothers in return for the pledge of certain investment securities as collateral. There were no balances outstanding or securities pledged to Lehman Brothers at September 30, 2005. Management believes that the company has adequate liquidity to meet its commitments.
As of September 30, 2005, both the company and the bank qualify as well capitalized under applicable Federal Reserve Board and FDIC regulations. To be categorized as well capitalized, the company and the bank must maintain minimum total, Tier 1 and, in the case of the bank, leverage capital ratios as set forth in the table below.
The companys and the banks actual capital amounts and ratios as of September 30, 2005 are presented in the tables below.
* For the Bank to qualify as well capitalized it must maintain a leverage capital ratio (Tier 1 capital to average assets) of at least 5%. This requirement does not apply to the company.
Results of Operations
Nine Months Ended September 30, 2005 vs. Nine Months Ended September 30, 2004
Unless otherwise indicated, the reported results are for the nine months ended September 30, 2005 with the comparable period and prior year being the nine months ended September 30, 2004.
The company reported net income of $6.085 million compared to $5.503 million in the prior year. The company had basic earnings per common share of $1.64 and $1.51, and diluted earnings per common share of $1.59 and $1.45 for the nine months ended September 30, 2005 and 2004, respectively.
Net Interest Income
The companys net interest income was $27.8 million, an increase of $4.4 million, or 19% over the prior year. Total interest and dividend income for the 2005 period increased by $5.6 million, while total interest expense for the period increased $1.2 million.
The companys tax equivalent net interest margin increased by 32 basis points to 4.79% for the current period, compared to 4.47% for the same period in 2004. The increase in margin through September 30, 2005 resulted primarily from a 44 basis point increase in the yield on interest earning assets, partially offset by a 13 basis point increase in the cost of funds (i.e., total deposits and borrowings). The increase in asset yields was driven primarily by higher market rates, especially variable rate loans tied to the Prime Lending Rate, which has increased 275 basis points since June 2004. Conversely, market rates on deposit products have advanced at a slower pace over the period. In addition the companys average non-interest bearing deposits, a key component in maintaining a low overall cost of funds, increased $21.4 million, or 15%.
Interest income amounted to $34.7 million, an increase of $5.6 million, or 19%, compared to $29.1 million in the prior year. The increase resulted primarily from a 10% increase in the average interest earning assets balances over the prior year and the 44 basis point increase in the average tax equivalent yield on interest earning assets.
The primary factor in the average interest earning assets growth was an increase of $88.5 million, or 17%, in average loan balances to $605.6 million. Average loan yields increased to 6.44%, or 35 basis points, as variable rate loans
indexed to the prime rate repriced to the higher market rates over the period. Interest income on loans amounted to $29.2 million, an increase of $5.6 million over the prior year.
The average balance of investment securities and short-term investments (together, investments) decreased $15.7 million, or 8%, to $192.3 million while the tax equivalent yield realized increased 32 basis points to 4.40% due to the increase in market interest rates. Investment income amounted to $5.6 million, an increase of $30 thousand over the prior year.
Interest expense amounted to $6.9 million, an increase of $1.2 million, or 22%, compared to $5.7 million in the prior year. The increase resulted primarily from a 13 basis point increase in the total cost of deposits and borrowings and, to a lesser extent, from a 9% increase in average balances of deposits and borrowings.
Savings, Personal Interest Checking, and Money Market Demand Accounts comprised 59% of average total deposits and borrowings at September 30, 2005. The average balance on these accounts increased $36.6 million, or 9%, to $459.4 million and the yield increased 15 basis points to 1.00%. The increase in yield resulted primarily from higher market rates and competitive pricing. The related interest expense amounted to $3.4 million, an increase of $749 thousand over the prior year.
The average balance of time deposits, borrowed funds (repurchase agreements and FHLB borrowings) and junior subordinated debentures collectively increased $6.4 million, or 4%, to $162.5 million, while the average yield increased 31 basis points to 2.84% from 2.53% over the prior year. The average balance increase was due primarily to an increase in FHLB borrowings. These funds generally are short-term, priced at current market rates and therefore, adjust rapidly to changing interest rates. For the period ended September 30, 2005, the average borrowed funds balance comprised only 2% of total deposits and borrowings. The 31 basis point increase in yield was led primarily by certificate of deposit yields, which increased to 2.19% from 1.92%, due to the increase in market interest rates. Interest expense related to time deposits, borrowed funds and junior subordinated debentures was $3.5 million, an increase of $502 thousand over the prior year.
Lastly, average non-interest bearing deposit balances, which comprise 20% of total deposits and borrowings, increased $21.4 million, or 15%, to $159.9 million. These deposits consist primarily of business checking accounts and are a key funding component of the companys long term funding strategy and are integral to maintaining a low total cost of funds.
The following table sets forth the extent to which changes in interest rates and changes in the average balances of interest earning assets and interest bearing liabilities affected interest income and expense during the nine months ended September 30, 2005 and September 30, 2004, respectively. For each category of interest earning assets and interest bearing liabilities, information is provided on changes attributable to: (1) volume (change in average portfolio balance multiplied by prior year average rate); (2) interest rate (change in average interest rate multiplied by prior year average balance); and (3) rate and volume (the remaining difference).
AVERAGE BALANCES, INTEREST AND AVERAGE INTEREST RATES