Enterprise Bancorp 10-Q 2005
WASHINGTON, D.C. 20549
For the quarterly period ended March 31, 2005
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)
(Issuers 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 Exchange Act Rule 12b-2).
Yes ý No o
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date:
April 29, 2005, Common Stock - Par Value $0.01: 3,691,610 shares outstanding
ENTERPRISE BANCORP, INC.
ENTERPRISE BANCORP, INC.
March 31, 2005 and December 31, 2004
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
Three months ended March 31, 2005 and 2004
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
Three months ended March 31, 2005
See the accompanying notes to the unaudited consolidated financial statements
ENTERPRISE BANCORP, INC.
Three Months Ended March 31, 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 on February 29, 1996, 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 organized in 1989, has two wholly owned subsidiaries, Enterprise Insurance Services LLC and Enterprise Investment Services LLC, organized for the purpose of engaging in insurance sales activities and offering non-deposit investment products and related securities brokerage services to its customers.
(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 Options
The company measures compensation cost for stock-based compensation plans 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 no options granted for the three months ended March 31, 2005. There were 104,440 options granted during the three months ended March 31, 2004. For options granted in 2004, the per share weighted average fair value of stock options was determined to be $3.01, or 12% of the market value of the stock at the date of grant. The value was determined by using a binomial distribution model. The assumptions used in the model for the 2004 grants for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 3.68%, 15.00%, 1.65% and 6, respectively.
ENTERPRISE BANCORP, INC.
Notes to Unaudited Consolidated Financial Statements
(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 June 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 provides 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. It also delayed the effective date of EITF No. 03-1 for debt securities that are impaired because of interest rate and/or sector spread increases until a final consensus could be reached.
In December 2004, the FASB announced that it will reconsider in its entirety the EITFs and all other guidance on disclosing, measuring, and recognizing other-than-temporary impairments of debt and equity securities. Until the new guidance is issued, companies must continue to comply with the disclosure requirements of EITF 03-1 and all relevant measurement and recognition requirements in other accounting literature.
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 Options, 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.
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.
ENTERPRISE BANCORP, INC.
Notes to Unaudited Consolidated Financial Statements
(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 reflects 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 three months ended March 31st and the effect of those shares on earnings:
(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.
(8) Guarantees and Commitments
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 March 31, 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 March 31, 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; (vii) changes in technology could adversely impact the companys operations and increase technology-related expenditures; (viii) increases in employee compensation and benefit expenses could adversely affect the companys financial results; (ix) 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 (x) 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 $1.851 million compared to $1.715 million for the three months ended March 31, 2005 (the current period) compared to the same period for 2004, an increase of 8%.
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 total short-term investments) and the cost of interest bearing liabilities (deposits and borrowings). The companys earnings are, therefore, subject to the risks associated with changes in the interest rate environment.
Net interest income, which is the margin or spread in dollar terms (i.e., interest income less interest expense) amounted to $8.7 million or 85% of the companys revenue (net interest income plus non-interest income) for the current period.
The increase in net interest income was $1.2 million or 16% through March 31, 2005 compared to the same period in 2004, and was primarily attributed to a $76.9 million, or 16%, increase in the average balance on loans.
The companys net interest margin increased by 16 basis points to 4.71% for the current period, compared to 4.55% for the same period in 2004. The increase in margin through March 31, 2005 was primarily due to a 17 basis point increase in yield on interest earning assets with an offsetting 2 basis points increase in the yield on total deposits and borrowings.
The increase in asset yields was primarily driven by higher market rates, directly resulting from the 175 basis point increase in the Prime Lending Rate since June 2004. Conversely, increases in market deposit and borrowing rates through March 31, 2005 have not directly resulted in a significant increase in the companys cost of funds. Interest bearing liability costs increased 6 basis points in the current period compared to the same period in 2004. In addition the companys average non-interest bearing deposits, a key component of net interest margin, increased $25.6 million or 20%.
The provision for loan losses was $200,000 for the three months ended March 31, 2005 and reflects managements estimate of loan loss reserves necessary to support the level of credit risk inherent in the portfolio. The provision for the same period in 2004 was $750,000 and resulted from approximately $0.4 million in net charge-offs during the quarter and the related effect on managements assessment of the credit risk inherent in the portfolio. The provision for the remaining three quarters of 2004 was $900,000. Management further discusses the provision for loan losses and its assessment of the allowance at March 31, 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, gains 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 $1.5 million and $2.2 million for the three months ended March 31, 2005 and 2004, respectively. The decrease in 2005 was primarily due to reductions in gains on sales of investment securities and decreases in deposit service fees.
The effective management of operating expenses is also a key component of the companys financial results. Non-interest expense amounted to $7.1 million and $6.2 million for the three months ended March 31, 2005 and 2004, respectively. The 15% increase primarily related to the cost of staffing and infrastructure necessary to support the companys continued growth and expansion.
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 $19.7 million, or 2%, since December 31, 2004, and amounted to $867.9 million at March 31, 2005. The balance at December 31, 2004 was partially impacted by an increase in short-term investments, which resulted from a $32 million demand deposit made in late December and withdrawn in early January 2005.
Total loans increased by $20.1 million, or 4%, over December 31, 2004. The growth was primarily in the commercial real estate and commercial and industrial portfolios. The companys growth reflects a continued commitment to developing strong commercial lending relationships with growing businesses, corporations, non-profits, professionals and individuals.
Investments, consisting of investment securities and short-term investments, decreased by $3.4 million or 1% since December 31, 2004.
Deposits decreased by $14.4 million, or 2%, since December 31, 2004. The December 31, 2004 balance was partially impacted by the previously mentioned $32 million demand deposit.
Borrowed funds increased $32.5 million since December 31, 2004. The balance increase primarily resulted from short-term balance fluctuations, with $28 million of the advances anticipated to payoff in less than 30 days.
Opportunities and Risks
Notwithstanding the substantial competition the company faces to attract deposits and to generate loans within its market area, management believes that the company has established a market niche in the Merrimack Valley and North Central regions of Massachusetts.
Management believes that it continually differentiates the company from competitors by providing innovative commercial and consumer banking, investment, and insurance products to our customers, composed principally of growing and privately held businesses, professionals, and consumers, delivered through prompt and personal service based on managements familiarity and understanding of such customers banking needs.
Management believes that the companys market position has been enhanced by the ongoing consolidation within the banking industry, and in particular in Massachusetts. Additionally, management actively seeks to improve its market position by pursuing opportunities in neighboring markets. During 2004, the company opened two new branches, located in Andover, Massachusetts and in Salem, New Hampshire. The company will open its fourteenth office, to be located in Tewksbury, Massachusetts, in mid-2005.
The company has added four branches over the last three years and the continued branch expansion is expected to increase the companys operating expenses, primarily in salaries, marketing, and occupancy expenses, before the growth benefits are fully achieved. Through business development and focused marketing efforts, management expects to continue penetration into existing markets, and to position itself to increase market share as the industry consolidation by larger regional banking companies continues.
The companys interest rate risk management process involves evaluating various interest rate scenarios, competitive dynamics and market opportunities. Currently, management considers the companys primary interest rate risk exposure to be from margin compression due to declining interest rates or a flattening yield curve.
Generally, under the declining rate scenario, longer term asset yields re-price lower, while shorter term liability yields, including non-interest bearing deposits, have minimal ability to decline. Such a scenario has been prevalent in the banking industry over the past couple of years. Significant margin contraction occurred as average interest rates approached historic lows, earning assets continued to re-price downward and interest bearing liabilities had little room to move significantly lower. In addition, as market rates declined prepayments of loans and mortgage backed investment securities accelerated, forcing the company to reinvest those proceeds at the lower market rates. However, in 2004 the downward trend in net interest margin appeared to have stabilized and short-term market rates began to move upward.
Under a flattening yield curve scenario, short-term rates would move near or to the levels of longer term rates, also resulting in margin compression. Under such a scenario, shorter-term liability costs would increase, either from market movements or competitive pressures, while longer term asset yields would remain relatively stable. The risk of a flattening yield curve is somewhat mitigated by the companys product mix. Approximately 35% of loans are indexed to the prime lending rate, a short term rate, and approximately 43% of the companys deposits consist of low cost checking accounts, which are considered unlikely to incur significant interest rate increases.
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 inherent in the loan portfolio is quantified through the allowance for loan losses, which is primarily increased through the provision for loan losses, which is a direct charge to earnings. Management determined that the allowance for loan losses of $11.1 million, or 1.89% of total loans at March 31, 2005, was adequate to absorb reasonably anticipated losses due to the credit risk associated with the loan portfolio at that date. In order to determine the adequacy of its allowance for loan losses management regularly monitors the level of credit risk 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. Management further discusses its assessment of the allowance at March 31, 2005 under the heading Asset Quality and the Allowance for Loan Losses in the Financial Condition section of this Item 2 below.
In addition to the critical nature of effectively managing the companys credit and interest rate risk, 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 an outside party to perform a broad scope of both internal and external security assessments on a regular basis. The third party tests the companys security controls and network configuration, and assesses internal policies, 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 Technology Steering 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.
Management views the current banking landscape as an opportunistic period. Management believes that the combination of its focused business strategy, industry consolidation, branch expansion and continued market penetration has positioned the company well to achieve success in the coming years. The effective management of credit, interest rate and operational risk along with excelling in a very competitive landscape are the significant challenges for the company.
As of March 31, 2005, total short-term investments amounted to $35.1 million or 4% of total assets compared to $40.3 million, or 5% of total assets, at December 31, 2004. Short-term investments carried 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.
At March 31, 2005, all of the companys investment securities were classified as available-for-sale and carried at fair value. At March 31, 2005, the investment portfolios fair market value was $189.4 million, representing 22% of total assets, and consisted of $185.5 million in fixed income securities and $3.9 million in professionally managed equity securities.
During the three months ended March 31, 2005 the company sold $1.04 million of securities, recognizing $200,000 in net gains. Principal paydowns, calls and maturities totaled $4.8 million during the period, and were primarily comprised of principal payments in the mortgage backed securities portfolio. The proceeds from these sales and principal payments were partially utilized to purchase $10.4 million of securities.
The net unrealized loss on the portfolio at March 31, 2005 was $303,000 compared to an unrealized gain of $2.6 million at December 31, 2004. The decrease was primarily due to higher market interest rates at March 31, 2005 as compared to December 31, 2004, leading to lower fixed income security prices and an unrealized loss.
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 value of the portfolio declines, and as rates fall the value of the portfolio rises. The unrealized gains or losses will only be realized if the securities are sold.
The net unrealized gains/losses in the companys equities portfolio fluctuate based on the performance of the individual equities that comprise the portfolio.
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 $590.6 million, or 68% of total assets, at March 31, 2005, an increase of $20.1 million or 4% compared to December 31, 2004 and an increase of $84.9 million or 17% compared to March 31, 2004.
The following table sets forth the loan balances by certain loan categories at the dates indicated and the percentage of each category to total loans, excluding deferred fees.
Commercial real estate loans were $271.8 million at March 31, 2005, compared to $257.7 million at December 31, 2004, an increase of $14.1 million, or 5%. Commercial real estate loans are typically secured by apartment buildings, office facilities, shopping malls, or other commercial property.
Commercial and industrial loans totaled $150.8 at March 31, 2005, compared to $142.9 million at December 31, 2004, an increase of $7.9 million or 6%. Commercial 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 $9.8 million at March 31, 2005 and $10.0 million at December 31, 2004.
Management views commercial construction lending as a market with the potential for continued growth. Over the past twelve months commercial construction lending grew by $20.0 million or 34%. The company attributes this growth to an experienced team of lenders focused on this market segment, coupled with the companys expansion into new geographic markets. The decline of $2.7 million from December 31, 2004 to March 31, 2005 reflected normal paydown activity.
At March 31, 2005, the company had commercial and construction loan balances participated out to various banks amounting to $21.0 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. Loans originated by other banks in which the company is the participating institution are carried on the balance sheet and amounted to $18.9 million at March 31, 2005, compared to $19.1 million at December 31, 2004. The companys participation in these loans range from 5% to 100% of the total loan commitment, with no single participation exceeding $5.0 million.
Asset Quality and the Allowance for Loan Losses
The following table sets forth non-performing assets at the dates indicated:
Total non-performing loans were $2.0 million at March 31, 2005 compared to $2.1 million and $2.9 million at December 31, 2004 and March 31, 2004, respectively. There were no significant changes since December 2004. The change since March 2004 reflects both credit quality improvement and commercial charge-offs during the period.
Management continues to closely monitor the credit quality of individual non-performing relationships as well as the loan portfolio in general, industry concentrations, the local real estate market and current economic conditions. Management believes that the current level of non-performing assets and delinquent loans are reasonable given the historical growth in the loan portfolio and the substantial commercial composition of the portfolio, and are comparable with peer commercial banks.
The level of 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 following tables summarize the activity in the allowance for loan losses for the periods indicated:
The allowance for loan losses to total loan ratio decreased to 1.89% at March 31, 2005 compared to 1.91% and 2.04% at December 31 and March 31, 2004, respectively. The reduction in the ratio, especially compared to March 2004, reflects the continued marginal improvement in managements assessment of the credit risk inherent in the portfolio, determined through managements ongoing evaluation of individual commercial relationships and the current economy.
The allowance for loan losses to non-performing loan ratio increased to 547.59% at March 31, 2005 compared to 510.42% and 359.64% at December 31 and March 31, 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.
Total deposits amounted to $754.2 million at March 31, 2005 compared to $768.6 million at December 31, 2004. The $14.4 million decrease primarily resulted from a $32 million short-term demand deposit received late in December 2004 and withdrawn early in January 2005. Since March 31, 2004 total deposits have increased $65.7 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 $36.2 million at March 31, 2005 compared to $3.7 million at December 31, 2004. The balance increase at March 31, 2005 primarily resulted from short-term balance fluctuations, with $28 million of the advances anticipated to payoff in less than 30 days.
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 March 31, 2005, the bank had the capacity to borrow additional funds from the FHLB of up to $100.7 million, and had the ability to issue up to $113 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 March 31, 2005. Management believes that the company has adequate liquidity to meet its commitments.
As of March 31, 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 March 31, 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
Three Months Ended March 31, 2005 vs. Three Months Ended March 31, 2004
Unless otherwise indicated, the reported results are for the three months ended March 31, 2005 with the comparable period and prior year being the three months ended March 31, 2004.
The company reported net income of $1.851 million compared to $1.715 million in the prior year. The company had basic earnings per common share of $0.50 and $0.48, and diluted earnings per common share of $0.48 and $0.45 for the three months ended March 31, 2005 and March 31, 2004, respectively.
Net Interest Income
The companys net interest income was $8.7 million, an increase of $1.2 million or 16%. Total interest and dividend income for the 2005 period increased by $1.4 million, while total interest expense for the period increased $0.2 million.
Net interest margin increased to 4.71% from 4.55%. The increase primarily resulted from a 17 basis point increase in yield on interest earning assets coupled with only a 2 basis point increase in the total cost of deposits and borrowings.
Interest income amounted to $10.7 million, an increase of $1.4 million or 15%, compared to $9.3 million in the prior year. The increase resulted primarily from a 17 basis point increase in the average tax equivalent yield on interest earning assets and from a 12% increase in average interest earnings assets.
The average loan balance increased $76.9 million or 16% to $571.8 million and the yield earned increased 13 basis points to 6.27%.
Regarding investment securities and short-term investments (together investments), the average balance increased $7.4 million or 4% to $195.7 million and the tax equivalent yield realized increased 14 basis points to 4.40%.
The increase in interest earning asset yields was primarily derived from higher market rates, especially on loans tied to the Prime Lending Rate, which has increased 175 basis points since June 2004.
Interest expense amounted to $2.1 million, an increase of $234,000 or 13%, compared to $1.8 million in the prior year. The increase resulted primarily from a 2 basis point increase in the average yield on deposits and borrowings and from an 11% increase in average deposits and borrowings.
Savings, Personal Interest Checking, and Money Market Demand Accounts comprise 59% of average total deposits and borrowings. The average balance on these accounts increased $58.7 million or 15% to $445.2 million and the yield increased 11 basis points to 0.92%. The increase in yield primarily results from higher market rates and competitive pricing.
Time deposits, borrowed funds and subordinated debentures collectively decreased $8.9 million or 5% to $156.4 million, while the average yield increased 16 basis points to 2.68% from 2.52%. The change in yield was led primarily by borrowed funds, which increased to 2.72% from 1.61%. These funds generally are short-term, priced at current market rates and, therefore, adjust rapidly to changing interest rates. For the period ended March 31, 2005, the average borrowed funds balance only comprised 2% of total deposits and borrowings.
Lastly, average non-interest bearing deposits, which comprise 20% of total deposits and borrowings, increased $25.6 million or 20% to $151.0 million. These deposits consist primarily of business checking accounts and are a key component of the companys long term funding strategy.
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 three months ended March 31, 2005 and March 31, 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