Enterprise Bancorp 10-Q 2006
Washington, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2006
o TRANSITION REPORT UNDER SECTION
13 OR 15(d) OF THE SECURITIES
For the transition period from to
Commission File Number 0-21021
Enterprise Bancorp, Inc.
(Exact name of registrant as specified in its charter)
Registrants telephone number, including area code: (978) 459-9000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
x Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition for accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
o Yes x No
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date: July 31, 2006, Common Stock - Par Value $0.01: 7,686,106 shares outstanding
ENTERPRISE BANCORP, INC.
ENTERPRISE BANCORP, INC.
June 30, 2006 and December 31, 2005
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
Three and six months ended June 30, 2006 and 2005
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
Six months ended June 30, 2006
(1)Stock-based compensation represents vesting of restricted stock awards and stock option grants.
See the accompanying notes to the unaudited consolidated financial statements
ENTERPRISE BANCORP, INC.
Six Months Ended June 30, 2006 and 2005
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, Enterprise Investment Services, LLC, and Enterprise Security Corporation, organized for the purposes of engaging in insurance sales activities, offering non-deposit investment products and services and investing in equity securities on its own behalf and not as a broker, respectively.
(2) Basis of Presentation
The accompanying unaudited consolidated financial statements and these notes should be read in conjunction with the companys December 31, 2005 audited consolidated financial statements and notes thereto contained in the companys 2005 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 15, 2006. 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 2005 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 2005 information has been reclassified to conform to the 2006 presentation.
On May 3, 2006, the company announced a two-for-one stock split in the form of a stock dividend payable to shareholders of record as of June 15, 2006. On June 30, 2006 the company issued 3,842,015 shares related to this dividend. All share and per share amounts have been retroactively adjusted to reflect the stock dividend for all periods presented.
(3) Stock-Based Compensation
The company currently has three individual stock incentive plans (the 1988 plan, the 1998 plan as amended in 2001, and the 2003 plan). No additional options or other rights of any kind may be granted under the 1988 plan. The remaining plans permit the Board of Directors under various terms to grant both incentive and non-qualified stock options, stock appreciation rights and other rights for the purchase of newly issued shares of common stock to officers and other employees, directors and consultants. These plans also allow for the issuance of new shares of common stock with or without restrictions, to officers and other employees, directors and consultants. The plans allow for the issuance of a cumulative total of 2,024,746 new shares of common stock. As of June 30, 2006, 1,590,578 shares, net of forfeited and expired shares, have been granted and 434,168 shares remain available for future grants under these plans.
To date the company has utilized the plans to issue stock option awards and restricted stock awards to officers and other employees, and director stock compensation. No options or other awards of any kind have been granted to consultants. Total stock-based compensation expense related to these plans was $134 thousand and $252 thousand for the three and six months ended June 30, 2006, respectively. The total recognized tax benefit related to stock based compensation expense was $39 thousand and $72 thousand, for the three and six months ended June 30, 2006, respectively.
Stock Option Awards
Prior to January 1, 2006, the company accounted for stock-based compensation plans using the intrinsic value method under which no compensation cost was recorded if, at the grant date, the exercise price of the options was equal to or greater than the fair market value of the companys common stock. However, the company supplementally disclosed pro forma net income and earnings per share amounts as if the fair value based method of accounting had been applied to its stock-based compensation.
On January 1, 2006, the company adopted Financial Accounting Standards No. 123(R) Share-Based Payment (SFAS 123(R)), using the modified version of the prospective application method. Pursuant to this transition method, beginning in 2006 the companys financial statements include (1) stock-based compensation expense for the portion of stock option awards outstanding on January 1, 2006, net of estimated forfeitures, for which the requisite service has been rendered during the period, based on the grant-date fair value estimate of the awards as calculated under the original provisions of SFAS 123 for the pro forma disclosures, and (2) compensation expense for the portion of stock awards issued subsequent to January 1, 2006, net of estimated forfeitures, for which the requisite service has been rendered during the period, based on the grant-date fair value estimate of the awards as calculated under the provisions of SFAS 123(R). The company will recognize the remaining compensation expense for the portion of outstanding awards and compensation expense for any future awards, net of estimated forfeitures, as the requisite service is rendered (i.e., on a straight-line basis over the remaining vesting period of each grant).
As a result of adopting SFAS 123(R), the company recognized stock-based compensation expense related to stock option awards of $70 thousand and $139 thousand for the three and six months ended June 30, 2006, respectively. Accordingly, income before taxes and net income for the three months ended June 30, 2006 were $70 thousand and $57 thousand lower, respectively, and for the six months ended June 30, 2006 were $139 thousand and $114 thousand lower, respectively, than if the company had continued to account for stock-based compensation using the intrinsic value method. The impact on both basic and diluted earnings per share for both the three and six months ended June 30, 2006 was a reduction of $0.01. In addition, prior to the adoption of SFAS 123(R), the company presented the tax benefit of stock option exercises as operating cash flows. Upon the adoption of SFAS 123(R), tax benefits resulting from tax deductions in excess of the compensation cost recognized for those options in the consolidated statement of income are classified as financing cash flows.
As of June 30, 2006, there was $536 thousand of unrecognized stock-based compensation expense, net of estimated forfeitures, related to non-vested stock options. That cost is expected to be recognized over a weighted average period of 2.8 years.
In accordance with the modified prospective transition method, the companys Consolidated Financial Statements for prior periods have not been restated to reflect the impact of SFAS 123(R) or SFAS 123. The pro forma table below reflects net income, basic and diluted earnings per share for the three and six months ended June 30, 2005 had the company determined stock-based compensation expense based on the fair value at the grant date for its options under SFAS 123:
All options that have been granted under the plans generally become exercisable at the rate of 25% a year, in addition options granted since June 2002 provide for full vesting upon attainment of age 62 while remaining employed with the bank. All options granted prior to 1998 expire 10 years from the grant date. Options granted from 1998 through 2004 expire 7 years from the grant date, and options granted in 2005 and 2006 expire 8 years from the grant date.
Under the terms of the plans, incentive stock options may not be granted at less than 100% of the fair market value of the shares on the date of grant and may not have a term of more than ten years. Any shares of common stock reserved for issuance pursuant to options granted under the 1998 and 2003 plans that are returned to the company unexercised shall remain available
for issuance under such plans. For participants owning 10% or more of the companys outstanding common stock (of which there are currently none), incentive stock options may not be granted at less than 110% of the fair market value of the shares on the date of grant.
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 from those that would have been calculated using the Black-Scholes model.
The per share weighted average fair value of stock options granted in 2006 was determined to be $3.79. The weighted average fair value of the options was determined to be 22% of the market value of the stock at the date of grant. The average assumptions used in the model for the 2006 grant for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 4.91%, 16%, 1.66% and 6, respectively. There were no options granted during the six months ended June 30, 2005. Refer to notes 1 and 9 to the consolidated financial statements contained in the companys Annual Report on Form 10-K for the year ended December 31, 2005 for assumptions used to estimate the fair value of options granted prior to 2006.
The expected volatility is the anticipated variability in the companys share price over the expected life of the option. The companys shares began trading on a public exchange in February 2005 and limited trading has occurred. Management determined its expected volatility by reviewing the historical volatility of peer financial institutions and a banking index, in addition to reviewing its own limited history.
The expected life represents the period of time that the option is expected to be outstanding. The company utilized the simplified method and under this method, the expected term equals the vesting term plus the contractual term divided by 2.
The dividend yield is the companys annualized dividend rate divided by its share price.
The risk-free rate is based on the U.S. Treasury rate in effect at the time of grant for a period equivalent to the expected life of the option.
In addition, as SFAS 123(R) requires that the stock-based compensation expense recognized in earnings be based on the amount of awards ultimately expected to vest, a forfeiture assumption should be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to the adoption of SFAS 123(R), the Company was not estimating forfeitures, but was rather adjusting pro forma compensation cost as actual forfeitures occurred, as permitted by SFAS 123. There is no cumulative effect of a change in accounting principle recognized in income at the time of adoption of SFAS 123(R) as the stock-based compensation expense recognized in income prior to adoption was immaterial and therefore the adjustment to reflect estimated forfeitures related to this expense was immaterial. Forfeitures are estimated based on historical experience.
Stock option transactions during the six months ended June 30, 2006 are summarized as follows:
The aggregate intrinsic value in the table above represents the difference between the closing price of the companys common stock on June 30, 2006 and the exercise price, multiplied by the number of options. The intrinsic value of options vested and exercisable represents the total pretax intrinsic value that would have been received by the option holders had all in-the-money vested option holders exercised their options on June 30, 2006. The intrinsic value changes based on the fair market value of the companys stock.
Total intrinsic value of options exercised for the three and six months ended June 30, 2006 was $712 thousand and $792 thousand, respectively. Cash received from option exercises was $188 thousand and $227 thousand for the three and six
months ended June 30, 2006, respectively. Cash received from option exercises for the three and six months ended June 30, 2005 was $318 thousand and $334 thousand, respectively. The actual tax benefit arising during the period for the tax deduction from the disqualifying disposition of shares acquired upon exercise was $3 thousand and $14 thousand for the three and six months ended June 30, 2006, respectively.
Restricted Stock Awards
At June 30, 2006, the company had restrictive stock awards outstanding comprised of 17,500 non-vested shares issued in September 2005. There were no restricted stock awards granted or forfeited during the six months ended June 30, 2006. The shares granted vest twenty percent per year starting on the first anniversary date of the award. The restricted stock award allows for the receipt of dividends, and the voting of all shares, whether or not vested, throughout the vesting period. For the three and six months ended June 30, 2006, compensation expense recognized in association with this restricted stock award amounted to $13 and $25 thousand, respectively. At June 30, 2006 the weighted-average grant date fair value of non-vested restricted stock awards was $14.25 per share. As of June 30, 2006, there was $208 thousand of unrecognized compensation expense related to restricted stock awards. That cost is expected to be recognized over a weighted average period of 4.2 years.
Director Stock Compensation
The members of the companys Board of Directors are offered the choice to receive shares of the companys common stock in lieu of cash compensation for attendance at Board and Board Committee meetings. The issuance of the new shares related to director compensation occurs in December of each year. For the year 2006, Directors will be granted shares of common stock in lieu of cash fees at the per share price of $15.79, which reflects the value of the common stock on January 3, 2006, based on the average of the high and low trade prices of the common stock on the NASDAQ Global Market on that date (split adjusted).
Director compensation expense amounted to $77 thousand for the three months ended June 30, 2006, compared to $80 thousand for the three months ended June 30, 2005. Included in the expense for the three months ended June 30, 2006 were cash fees of $51 thousand, which represented approximately 3,249 shares to be issued at the end of the fiscal year. Included in the expense for the three months ended June 30, 2005 were cash fees of $56 thousand, which represented approximately 3,814 shares that were issued in December 2005.
Director compensation expense amounted to $126 thousand for the six months ended June 30, 2006, compared to $129 thousand for the six months ended June 30, 2005. Included in the expense for the six months ended June 30, 2006 were cash fees of $88 thousand, which represented approximately 5,579 shares to be issued at the end of the fiscal year. Included in the expense for the six months ended June 30, 2005 were cash fees of $92 thousand which represented approximately 6,198 shares that were issued in December 2005.
(4) Supplemental Retirement Plan
The following table illustrates the net periodic benefit cost for the supplemental executive retirement plan as of June 30, 2006:
The plan was established on July 15, 2005. The company anticipates accruing an additional $313 thousand to the plan during the remainder of 2006.
(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 2005 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. Refer to note 1 to the consolidated financial statements contained in the companys 2005 Annual Report on Form 10-K for significant accounting policies.
(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 and six months ended June 30th and the effect of those shares on earnings:
At June 30, 2006, there were 5,000 outstanding stock options, which were excluded from the calculation of diluted earnings per share due to the exercise price exceeding the average market price. These options, which were not dilutive at that date, may potentially dilute earnings per share in the future.
(7) 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 company 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. The estimated fair value of these commitments carried on the balance sheet was $72 thousand and $88 thousand at June 30, 2006 and 2005, respectively. These amounts are amortized to income over the life of the letters of credit, typically one year.
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 June 30, 2006, 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 2005 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 2005 Annual Report on Form 10-K. In applying these accounting policies, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. As discussed in the companys 2005 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 reported second quarter 2006 net income of $2.182 million compared to $1.981 million during the second quarter of 2005, an increase of 10%. Diluted earnings per share were $0.28 for the quarter compared to $0.26 for second quarter 2005, an increase of 8%. All prior period per share amounts have been adjusted to reflect the two-for-one stock split paid on June 30, 2006 in the form of a stock dividend.
Net income for the six months ended June 30, 2006 amounted to $4.238 million compared to $3.832 million for the same period in 2005, an increase of 11%. Diluted earnings per share were $0.54 for the six months ended June 30, 2006 compared to $0.50 for the same period in 2005, an increase of 8%.
The companys earnings are largely dependent on its net interest income, which is the difference between interest income on loans and investments and interest expense on deposits and borrowings. The re-pricing frequency of these assets and liabilities are not identical, and therefore subject the company to the risk of adverse changes in interest rates. This is often referred to as interest rate risk and is reviewed in more detail in Item 3, Quantitative and Qualitative Disclosures About Market Risk.
The companys net income growth continues to result primarily from strong net interest income performance, offset by increases in non-interest expense. Net interest income for the six months ended June 30, 2006 amounted to $20.5 million compared to $18.0 million for the same period in 2005, an increase of 14%. The primary driver of net interest income growth over the period was loan growth, which increased 17% since June 30, 2005. Net interest margin, the spread earned between interest-earning assets and the companys funding sources, primarily deposits, was 4.83% and 4.81% for the three and six months ended June 30, 2006 compared to 4.77% and 4.74% for the same periods in 2005. The slight increase in margin primarily resulted from increases in the market rates on assets, which were mostly offset by increases in funding costs. Although net interest margin was higher than the June 30, 2005 comparable periods, the flat yield curve and a very competitive marketplace continue to pressure margin.
Non-interest expense amounted to $16.5 million for the six months ended June 30, 2006 compared to $14.6 million for the same period in 2005, an increase of 13%, and reflected the strategic and operational costs necessary to support the companys continued growth.
The year-to-date results also included an increase in non-interest income consisting primarily of strong growth in investment advisory fees and other income, and were offset by a reduction in the net gains on the sales of investment securities. Included in other income are $62 thousand of tax credit income and $82 thousand of bank-owned life insurance income that were not present in the prior year period.
The provision for loan losses is also a significant factor in the companys operating results. It directly increases the companys allowance for loan losses, which reflects managements estimate of the reserves necessary to support the credit risk inherent in the loan portfolio. The companys management of credit risk is reviewed in more detail in this Item 2, under the heading Asset Quality and the Allowance for Loan Losses.
Total assets amounted to $982.8 million at June 30, 2006, and grew 7% over December 31, 2005 and 9% over June 30, 2005.
The companys core asset strategy is to grow loans, primarily commercial loans. Total loans at June 30, 2006 amounted to $732.8 million, or 75% of total assets and commercial loans amounted to $626.1 million. The loan portfolio increased 5% since December 31, 2005 and 17% since June 30, 2005.
The investment portfolio is the other key component of the companys earning assets and is primarily used to invest excess funds, provide liquidity and to manage the companys asset-liability position. Total investments amounted to $145.5 million at June 30, 2006, or 15% of total assets. The portfolio declined 7% and 19% since December 31, 2005 and June 30, 2005, respectively. The decline in investments since June 30, 2005 reflects a reduction in excess liquidity due to the funding gap discussed below.
From a funding perspective, managements strategy is to maximize low cost deposit growth, primarily through relationship-based checking and savings accounts. When asset growth exceeds low cost deposit growth, a funding gap occurs. Managements principal options are then to grow higher cost deposits (certificates of deposit and higher cost money market products), raise funds externally through brokered deposits (brokered CDs) or Federal Home Loan Bank of Boston borrowings (FHLB borrowings), sell investment securities, and/or to utilize the ongoing cash flow from the investment portfolio.
Over the past nine months, a funding gap has occurred as loan growth has exceeded low cost deposit growth. Consequently, management has utilized brokered CDs, FHLB borrowings and investment portfolio cash flows. In the fourth quarter of 2005, the company began using brokered CDs as an alternative to FHLB borrowings. At June 30, 2006, FHLB borrowings and brokered CDs outstanding amounted to $3.3 million and $78.5 million, respectively, compared to $6.9 million and $0 million, respectively, at June 30, 2005.
At June 30, 2006, total deposits, which included brokered CDs, amounted to $890.5 million, representing 15% and 11% growth over December 31, 2005 and June 30, 2005, respectively. Total deposits, excluding brokered CDs, amounted to $812.0 million at June 30, 2006 and grew 6% and 1% over the December 31 and June 30, 2005 comparable periods, respectively.
At June 30, 2006, the company has the capacity to borrow approximately $450 million in additional funds. Management believes the company has adequate capacity to fund its business.
Opportunities and Risks
Management believes that the company has established a market presence in the Merrimack Valley and North Central regions of Massachusetts and in South Central 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 banking, investment, and insurance products delivered through prompt and personal service based on managements familiarity and understanding of the banking and other financial service 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. Market competition includes the expanded commercial 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 the products offered by non-bank financial service competitors.
Despite these challenges, the company has continued to maintain strong commercial loan growth. Management believes this achievement is the result of ongoing business development efforts and continued market expansion within existing and into new markets. The company has fourteen branch locations and continues to look for market and branch opportunities that will increase long-term 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 credit, interest rate and operational risk.
Credit risk management is reviewed below in this Item 2 under the heading Asset Quality and the Allowance for Loan Losses.
Interest rate risk management is reviewed under Item 3, Quantitative and Qualitative Disclosures About Market Risk.
Operational risk management is also a key component of the companys risk management process, 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 and an intrusion detection system 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 critical services will be restored.
Total assets increased $64.3 million, or 7%, over December 31, 2005, to $982.8 million at June 30, 2006. The increase was primarily attributable to increases in total loans and short-term investments.
As of June 30, 2006, short-term investments amounted to $32.6 million, or 3% of total assets compared to $5.4 million, or 1% of total assets, at December 31, 2005. The increase in short-term investments resulted from temporary deposit inflows at the end of June. Short-term investments carried as cash equivalents consist of overnight and term federal funds sold and money market mutual funds.
At June 30, 2006, the investment portfolios fair market value was $145.5 million, representing a decline of $11.0 million since December 31, 2005, and a decline of $33.8 million since June 30, 2005. The fair market value of the investment portfolio represented 15%, 17%, and 20% of the total assets at June 30, 2006, December 31, 2005, and June 30, 2005, respectively.
The following table summarizes the fair market value of investments at the dates indicated:
(1) Federal agency obligations include securities issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the FHLB. These securities do not represent obligation of the US government and are not backed by the full faith and credit of the United States Treasury.
(2) The bank is required to purchase FHLB stock in association with outstanding advances from the FHLB; this stock is classified as a restricted investment and carried at cost.
Since June 30, 2005, the investment portfolio had $32.5 million of principal paydowns, calls and maturities. Of these proceeds, $7.2 million was reinvested in the portfolio, with the remainder utilized to fund loan growth.
The net unrealized loss on the portfolio at June 30, 2006 was $2.9 million compared to net unrealized losses of $1.1 million at December 31, 2005 and $1.5 million at June 30, 2005. The decrease in fair market value was primarily due to higher market interest rates in the current period over the prior periods. 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.
Unrealized gains or losses will only be recognized in the statements of income 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 $732.8 million, or 75% of total assets, at June 30, 2006, an increase of $33.0 million, or 5% compared to December 31, 2005 and an increase of $108.2 million, or 17%, compared to June 30, 2005. Year-to-date loan growth has been at a slower rate in 2006 than in the twelve months of 2005 when total loans grew 23%.
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.
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 $341.4 million at June 30, 2006, compared to $327.0 million at December 31, 2005, an increase of $14.4 million or 4%. Commercial real estate loans are typically secured by apartment buildings, office or mixed-use facilities, strip shopping malls or other commercial property.
Commercial and industrial loans totaled $164.1 million at June 30, 2006, compared to $166.0 million at December 31, 2005, a decrease of $1.9 million or 1%. Commercial loans include seasonal revolving lines of credit, 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 $8.4 million at June 30, 2006 and $8.2 million at December 31, 2005.
Commercial construction loans amounted to $120.7 million at June 30, 2006, compared to $108.0 million at December 31, 2005, an increase of $12.6 million or 12%. Commercial 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.
At June 30, 2006 the company had commercial loan balances participated out to various banks amounting to $9.5 million, compared to $9.0 million at December 31, 2005. These balances 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 at the companys pro rata share of ownership and amounted to $15.9 million and $18.8 million at June 30, 2006 and December 31, 2005, respectively. 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 companys credit risk management function focuses 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, as well as 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, 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 $12.5 million, or 1.70% of total loans at June 30, 2006, was adequate to absorb reasonably anticipated losses due to the credit risk associated with the loan portfolio at that date.
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, 2005.
The following table sets forth non-performing assets at the dates indicated:
Total non-performing loans were $2.0 million at June 30, 2006 compared to $1.5 million and $1.8 million at December 31, 2005 and June 30, 2005, respectively. The ratio of non-performing loans to total loans remained relatively consistent at 0.27% as of June 30, 2006, compared to 0.21% and 0.29% at December 31, 2005 and June 30, 2005, respectively. Short-term fluctuations are not uncommon with this ratio and the increase since December 2005 is not considered significant. The classification of a loan as non-performing does not necessarily indicate that loan principal and interest will be ultimately uncollectible. However, management recognizes the greater risk characteristics of these assets and therefore considers the potential risk of loss on assets included in this category in evaluating the adequacy of the allowance for loan losses.
The ratio of delinquent loans 30-89 days past due as a percentage of total loans increased to 0.40% at June 30, 2006, from 0.14% at December 31, 2005 and 0.20% at June 30, 2006. Management does not consider the increase to be significant. The ratio of delinquent loans to total loans will fluctuate due to the timing of customer payments, generally the largest concentration of loans fall into the 30 40 day past due category as was the case at June 30, 2006.
Management closely monitors the credit quality of individual delinquent and 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 was 624.61% at June 30, 2006 compared to 816.40% and 633.24% at December 31, and June 30, 2005, respectively. The ratio is consistent with June 30, 2005 and has decreased since December 31, 2005. The December ratio reflects the low level of non-performing loans at that time.
The following table summarizes the activity in the allowance for loan losses for the periods indicated:
Net loans charged-off during the six months ended June 30, 2006 and 2005 were $81 thousand and $6 thousand, respectively. The provision for loan losses for the six months ended June 30, 2006 and 2005 was $517 thousand and $475 thousand, respectively. The provision reflects managements estimate of loan loss reserves necessary to support the level of credit risk inherent in the portfolio during the period.
Total deposits amounted to $890.5 million at June 30, 2006 compared to $775.4 million at December 31, 2005. The increase of $115.1 million, or 15%, primarily resulted from an increase in brokered CDs of $68.5 million and temporary deposit inflows in June. Total deposits have increased $85.8 million, or 11%, compared to June 30, 2005, primarily due to growth in certificates of deposit, both internally generated and brokered, partially offset by declines in other deposits. Excluding brokered CDs, total deposits grew 6% and 1% through June 30, 2006 compared to December 31 and June 30, 2005, respectively.
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 $4.0 million at June 30, 2006 compared to $58.6 million at December 31, 2005 and $13.0 million at June 30, 2005. The decrease in the balance at June 30, 2006 primarily resulted from the increased use of brokered CDs as an alternative funding source as part of the companys liquidity management strategy.
Accounting Rule Changes
In December 2005, the FASB issued FSP SOP 94-6-1, Terms of Loan Products That May Give Rise to a Concentration of Credit Risk. This FSP was issued in response to inquiries from constituents and discussions with the SEC staff and regulators of financial institutions to address the circumstances in which the terms of loan products give rise to a concentration of credit risk as that term is used in SFAS No. 107 Disclosures about Fair Value of Financial Instruments, and what disclosures apply to entities who deal with loan products whose terms may give rise to a concentration of credit risk. An entity shall provide the disclosures required by SFAS No. 107 for either an individual loan product type or a group of loan products with similar features that are determined to represent a concentration of credit risk in accordance with the guidance of SOP 94-6-1 for all periods presented in financial statements. This SOP is effective for interim and annual periods ending after December 19, 2005. At June 30, 2006, the company did not have either an individual loan product type or a group of loan products with similar features that are determined to represent a concentration of credit risk in accordance with the guidance of SOP 94-6-1.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes An Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. In addition, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. The provisions of FIN 48 are to be applied to all tax positions upon initial adoption of this standard. Only tax positions that meet the more-likely-than-not recognition threshold at the effective date may be recognized or continue to be recognized upon adoption of FIN 48. Management does not anticipate that the adoption of FIN 48 will have a material impact on the companys financial position or results of operation.
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 of the Board of Directors. 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 in the brokered CD market and 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, brokered CDs, FHLB borrowings, repurchase agreements, junior subordinated debentures and earnings. In the fourth quarter of 2005, the company began using brokered CDs as an alternative to FHLB borrowings. The advantage of brokered CD funding is that no collateral is required. A disadvantage is that funding usually takes a week to complete, whereas FHLB borrowings are usually immediately available.
At June 30, 2006, the bank had the capacity to borrow additional funds from the FHLB of up to $82 million, and had the ability to issue up to $368 million in additional brokered CDs through three vendors. Management believes that the company has adequate liquidity to meet its commitments.
Capital Resources and Dividends
As of June 30, 2006, 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 actual capital amounts and ratios are presented as of June 30, 2006 in the table below. The banks capital amounts and ratios do not differ materially from the amounts and ratios presented for the company.
* This requirement does not apply to the company and is reflected in the table merely for informational purposes with respect to the bank. For the bank to qualify as well capitalized, it must also maintain a leverage capital ratio (Tier 1 capital to average assets) of at least 5%.
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.
Prior to 2006, dividends were paid once a year. In 2006, the company began paying quarterly dividends. Quarterly dividends of $0.07 per share were paid in both March and June. Shareholders utilized the DRP to reinvest $471 thousand, of the $1.1 million paid by the company during the six months ended June 30, 2006, into 28,998 shares of the companys common stock.
On July 18, 2006, the company announced a quarterly dividend of $0.07 to be paid on September 1, 2006 to shareholders of record as of August 11, 2006. On an annualized basis, year-to-date dividends represent a 17% increase over the prior years annual dividend.
On June 30, 2006, the company issued 3,842,015 shares in a two-for-one stock split paid in the form of a stock dividend.
Results of Operations
Six Months Ended June 30, 2006 vs. Six Months Ended June 30, 2005
Unless otherwise indicated, the reported results are for the six months ended June 30, 2006 with the comparable period and prior year being the six months ended June 30, 2005.
The company reported net income of $4.238 million compared to $3.832 million in the prior year, an increase of 11%. Diluted earnings per common share were $0.54 for the six months ended June 30, 2006 compared to $0.50 for the prior year, an increase of 8%.
Net Interest Income
The companys net interest income was $20.5 million, an increase of $2.5 million or 14%. Total interest and dividend income for the 2006 period increased by $6.7 million, while total interest expense for the period increased $4.2 million. The increase in net interest income was due primarily to an increase in average loan balances.
Tax equivalent net interest margin increased by seven basis points to 4.81% for the current period, compared to 4.74% for the same period in 2005. The slight increase in margin through June 30, 2006 was primarily due to a 91 basis point increase in the yield on interest earning assets, resulting from rising market rates during the period, particularly the prime lending rate. These yield increases were essentially offset by an increase of 87 basis points in the cost of funds, due to funding through higher cost deposits and borrowed funds, offset by 5% growth in non-interest bearing deposits.
Interest income amounted to $29.0 million, an increase of $6.7 million, or 30%, compared to $22.4 million in the prior year. The increase resulted primarily from a 12% increase in the average balance of interest earning assets and from a 91 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 $129.9 million, or 22%, in average loan balances to $718.4 million. Higher market rates during the period resulted in average loan yields increasing 90 basis points to 7.25%. Interest income on loans amounted to $25.8 million, an increase of $7.3 million over the prior year.
The average balance of investment securities and short-term investments (together investments) decreased $38.2 million, or 19%, to $160.7 million. This decrease was primarily due to maturities and paydowns of investments, which were redeployed to fund loan growth. However, the tax equivalent yield realized on investments increased 23 basis points to 4.59%, due to increases in market interest rates, the maturity of lower yielding securities and slower prepayments. Investment income amounted to $3.2 million, a decrease of $610 thousand compared to the same period in the prior year.
Interest expense amounted to $8.5 million, an increase of $4.2 million compared to $4.4 million in the prior year. The increase resulted primarily from an 87 basis point increase in the average cost of funds on deposits and borrowings, due to increased market rates and a 11% increase in the average balance of deposits and borrowings.
Interest expense on savings, interest checking and money market accounts increased $1.2 million over the prior year, to $3.4 million. This increase resulted from a 58 basis point increase in the average cost of savings, interest checking and money market accounts. This increase in interest expense was partially offset by a slight reduction in the average balance on these accounts.
Interest expense on certificates of deposit increased $2.5 million over the prior year, to $3.9 million. The average balance of certificates of deposit increased $73.9 million, or 54%, to $210.5 million. The increase in the average CD balance primarily resulted from brokered CDs that the company utilized to fund loan growth and to a lesser degree to internally generated CD growth. Brokered CD balances averaged $46.3 million and $0 for the six months ended June 30, 2006 and 2005, respectively. The average cost of CDs also increased 167 basis points over the prior period, due to higher market rates.
Interest expense on borrowed funds, consisting of FHLB borrowings and repurchase agreements, increased $440 thousand over the same period last year. The average balance of borrowed funds, primarily FHLB borrowings, increased $14.8 million to $28.5 million, as the company utilized borrowings as another funding vehicle to support growth in the loan portfolio. The average cost of borrowed funds increased 165 basis points due to an increase in market interest rates.
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 six months ended June 30, 2006 and June 30, 2005, 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