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First Community Bancorp 10-Q 2005
UNITED STATES Washington, D.C. 20549 FORM 10-Q x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2005 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 00-30747 FIRST COMMUNITY BANCORP (Exact name of registrant as specified in its charter)
(858) 756-3023 (Registrant’s 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 x No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No o As of August 1, 2005 there were 16,047,452 shares of the registrant’s common stock outstanding, excluding 414,831 shares of unvested restricted stock.
2 ITEM 1. Unaudited Consolidated Financial Statements UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
See “Notes to Unaudited Condensed Consolidated Financial Statements.” 3 UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS
See “Notes to Unaudited Condensed Consolidated Financial Statements.” 4 UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
See “Notes to Unaudited Condensed Consolidated Financial Statements.” 5 UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See “Notes to Unaudited Condensed Consolidated Financial Statements.” 6 NOTES TO UNAUDITED
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS We are a bank holding company registered under the Bank Holding Company Act of 1956, as amended. Our principal business is to serve as a holding company for our banking subsidiaries. As of June 30, 2005, those subsidiaries were First National Bank, which we refer to as First National, and Pacific Western National Bank, or Pacific Western. We refer to Pacific Western and First National herein as the “Banks” and when we say “we”, “our” or the “Company”, we mean the Company on a consolidated basis with the Banks. When we refer to “First Community” or to the holding company, we are referring to the parent company on a stand-alone basis. We have completed thirteen acquisitions since May 2000. This includes the merger whereby the former Rancho Santa Fe National Bank and First Community Bank of the Desert became wholly-owned subsidiaries of the Company in a pooling-of-interests transaction. The other acquisitions have been accounted for using the purchase method of accounting and, accordingly, their operating results have been included in the consolidated financial statements from their respective dates of acquisition. On May 16, 2005, we filed a registration statement with the SEC regarding the sale of up to 3,400,000 shares of our common stock, no par value per share, which we may offer and sell, from time to time, in amounts, at prices and on terms that we will determine at the time of any particular offering. We expect to use the net proceeds from the sale of our securities to fund future acquisitions of banks and other financial institutions, including First American Bank, as well as for general corporate purposes. (a) Basis of Presentation The accounting and reporting policies of the Company are in accordance with U.S. generally accepted accounting principles. All significant intercompany balances and transactions have been eliminated. Our financial statements reflect all adjustments which are, in the opinion of management, necessary to present a fair statement of the results for the interim periods presented. Certain information and note disclosures normally included in consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission. The interim operating results are not necessarily indicative of operating results for the full year. (b) Use of Estimates Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period to prepare these consolidated financial statements in conformity with U.S. generally accepted accounting principles. Actual results could differ from those estimates. Material estimates subject to change in the near term include, among other items, the allowance for credit losses, the carrying values of intangible assets and the realization of deferred tax assets. (c) Reclassifications Certain prior period amounts have been reclassified to conform to the current year’s presentation. 7 Since January 1, 2004, we have completed the following two acquisitions using the purchase method of accounting, and accordingly, the operating results of the acquired entities have been included in the consolidated financial statements from their respective dates of acquisition:
First Community Financial Corporation. On March 1, 2004, we acquired First Community Financial Corporation, or FC Financial, a privately-held commercial finance company based in Phoenix, Arizona. We paid $40.0 million in cash for all of the outstanding shares of common stock and options of FC Financial. At the time of the acquisition FC Financial became a wholly-owned subsidiary of First National. Harbor National Bank. On April 16, 2004, we acquired Harbor National Bank, or Harbor National, based in Newport Beach, California. We paid $35.7 million in cash for all the outstanding shares of common stock and options of Harbor National. At the time of the merger, Harbor National was merged into Pacific Western. Merger Related Liabilities. All of the acquisitions consummated after December 31, 2000 were completed using the purchase method of accounting. Accordingly, we recorded the estimated merger-related charges associated with each acquisition as a liability at closing when allocating the related purchase price. For each acquisition we developed an integration plan for the consolidated Company which addressed, among other things, requirements for staffing, systems platforms, branch locations and other facilities. The established plans are evaluated regularly during the integration process and modified as required. Merger and integration expenses are summarized in the following primary categories: (i) severance and employee-related charges; (ii) system conversion and integration costs, including contract 8 NOTE 2—ACQUISITIONS (Continued) termination charges; (iii) asset write-downs, lease termination costs for abandoned space and other facilities-related costs; and (iv) other charges. Other charges include investment banking fees, legal fees, other professional fees relating to due diligence activities and shareholder expenses associated with preparation of securities filings, as appropriate. These costs were included in the allocation of the purchase price at the acquisition date based on our formal integration plans. The following table presents the activity in the merger-related liability account for the six months ended June 30, 2005:
On April 28, 2005, we announced that we had entered into a definitive agreement to acquire all of the outstanding common stock and options of First American Bank for $62.3 million in cash. First American Bank had $238.6 million in assets at June 30, 2005. On June 9, 2005, we announced that we had entered into a definitive agreement to acquire all of the outstanding common stock and options of Pacific Liberty Bank for an aggregate of $41.8 million, consisting of First Community common stock and cash delivered to the Pacific Liberty Bank option holders. Pacific Liberty Bank had $151.2 million in assets at June 30, 2005. Both mergers are subject to shareholder and regulatory approval. The First American Bank acquisition is currently expected to close on August 12, 2005, and the Pacific Liberty Bank acquisition is currently expected to close early in the fourth quarter of 2005. NOTE 3—GOODWILL AND OTHER INTANGIBLE ASSETS Goodwill and intangible assets arise from purchase business combinations. Goodwill and other intangible assets deemed to have indefinite lives generated from purchase business combinations are tested for impairment no less than annually. During 2005 no impairment of goodwill and other intangible assets has been recognized. Intangible assets with definite lives are amortized over their respective estimated useful lives to their estimated residual values and reviewed for impairment annually. The amortization expense represents the estimated decline in the value of the underlying deposits or loan customers acquired. We estimate the expense related to the intangible assets will range from $2.6 million to $3.3 million per year for the next five years. The carrying amount of goodwill was $234.0 million at June 30, 2005 and $234.4 million at December 31, 2004. The reduction of goodwill relates to the determination that certain estimated accrued merger costs and related deferred tax assets were no longer required. 9 NOTE 3—GOODWILL AND OTHER INTANGIBLE ASSETS (Continued) The following table presents the changes in the gross amounts of core deposit and customer relationship intangibles and the related accumulated amortization for quarters ended June 30, 2005 and 2004.
The amortized cost, gross unrealized gains and losses and fair value of securities available-for-sale as of June 30, 2005 are as follows:
The maturity distribution based on amortized cost and fair value as of June 30, 2005, by contractual maturity, is shown below. Mortgage-backed securities have contractual terms to maturity, but require periodic payments to reduce principal. In addition, expected maturities may differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
10 NOTE 4—INVESTMENT SECURITIES (Continued) The following table presents the fair value and the unrealized loss on securities that were temporarily impaired as of June 30, 2005.
The temporary impairment is a result of the level of market interest rates and is not a result of the underlying issuers’ ability to repay. Accordingly, we have not recognized the temporary impairment in our consolidated statement of earnings. The following is a summary of the calculation of basic and diluted net earnings per share for the quarters and six months ended June 30, 2005 and 2004.
Diluted earnings per share does not include all potentially dilutive shares that may result from outstanding stock options and restricted and performance stock awards which may eventually vest. The number of common shares underlying stock options and shares of restricted and performance stock which were outstanding but not included in the calculation of diluted net earnings per share were 686,730 and 1,076,958 for the quarters ended June 30, 2005 and 2004 and 663,243 and 1,056,592 for the six months ended June 30, 2005 and 2004. Stock Options. We adopted the fair value method of accounting for stock options effective January 1, 2003, using the prospective method of transition specified in Statement of Financial Accounting Standard (“SFAS”) No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure—an amendment of FASB Statement No. 123. The cost of all stock options granted on or after January 1, 2003, is based on their fair value and is included as a component of compensation expense over the vesting period for such options. 11 NOTE 6—STOCK COMPENSATION (Continued) For stock options granted prior to January 1, 2003, we continue to apply the intrinsic value-based method of accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, under which compensation cost is recognized only when the option exercise price is less than the fair market value of the underlying stock on the date of grant. Had we determined compensation expense based on the fair value method at the grant date for all of our stock options granted, our net earnings and related earnings per share would have been reduced to the pro forma amounts indicated in the table below.
Restricted and Performance Stock. At June 30, 2005, there were 338,012 shares of unvested restricted common stock and 115,000 shares of unvested performance common stock outstanding. The granted shares of restricted common stock vest over a service period of three to four years from date of the grant. The granted shares of performance common stock vest in full or in part on the date the Compensation, Nominating and Governance (“CNG”) Committee of the Board of Directors, as Administrator of the Company’s 2003 Stock Incentive Plan (the “Plan”), determines that the Company achieved certain financial goals established by the CNG Committee and set forth in the grant documents. During the first quarter of 2005, the CNG Committee determined that certain financial goals were met and vested 50% of the granted performance common stock. Although the remaining shares of unvested performance stock expire in July 2010, we expect 57,500 shares to vest in March 2006 and the remaining 57,500 shares to vest in March 2007. Both restricted common stock and performance common stock vest immediately upon a change in control of the Company as defined in the Plan. Compensation expense related to the restricted and performance stock awards approximated $646,000 and $1.3 million during the quarters ended June 30, 2005 and 2004 and $1.6 million and $1.9 million during the six months ended June 30, 2005 and 2004, and is included in compensation expense in the accompanying consolidated statements of earnings. NOTE 7—BORROWINGS AND SUBORDINATED DEBENTURES Borrowings. At June 30, 2005, we had $233.8 million of borrowings outstanding. Borrowings included advances from the Federal Home Loan Bank of San Francisco (the “FHLB”) of $27.1 million in overnight money and $85.0 million of fixed rate advances which begin to mature in December 2005. The weighted average cost of these borrowings was 3.07% at June 30, 2005. Our aggregate remaining secured borrowing capacity from the FHLB was $508.4 million as of June 30, 2005. 12 NOTE 7—BORROWINGS AND SUBORDINATED DEBENTURES (Continued) On August 4, 2005, we amended our revolving lines of credit with U.S. Bank, N.A. and The Northern Trust Company to increase the credit available to the Company. As amended, the Company has a revolving credit line with U.S. Bank for $50 million and with The Northern Trust Company for $20 million. The revolving lines of credit are linked and any draws under the lines are taken from each facility on a pro-rata basis. The revolving credit lines mature on August 3, 2006 and require the Company to maintain certain financial and capital ratios, among other covenants and conditions. Subordinated Debentures. The Company had an aggregate of $121.7 million of subordinated debentures outstanding with a weighted average cost of 6.90% at June 30, 2005. The subordinated debentures were issued in seven separate series. Each issuance has a maturity of thirty years from its date of issue. The subordinated debentures were issued to trusts established by us, which in turn issued trust preferred securities. The proceeds from the issuance of the securities were used primarily to fund several of our acquisitions. Generally and with certain limitations, we are permitted to call the debentures in the first five years if the prepayment election relates to one of the following three events: (i) a change in the tax treatment of the debentures stemming from a change in the IRS laws; (ii) a change in the regulatory treatment of the underlying trust preferred securities as Tier 1 capital; and (iii) a requirement to register the underlying trust as a registered investment company. Under certain of our series of issuances, redemption in the first five years may be subject to a prepayment penalty. Trust I may not be called for 10 years from the date of issuance unless one of the three events described above has occurred and then a prepayment penalty applies. In addition, there is a prepayment penalty if the Trust I debentures are called 10 to 20 years from the date of its issuance, although they may be called at par after 20 years. The following table summarizes the terms of each issuance.
* As described above, certain issuances may be called earlier without penalty upon the occurrence of certain events. ** As of July 28, 2005. As previously mentioned, the subordinated debentures were issued to trusts established by us, which in turn issued $118 million of trust preferred securities. These securities are currently included in our Tier I capital for purposes of determining the Company’s Tier I and total risk-based capital ratios. The Board of Governors of the Federal Reserve System, which is the holding company’s banking regulator, has promulgated a modification of the capital regulations affecting trust preferred securities. Under this modification, beginning March 31, 2009, the Company will be required to use a more restrictive formula to determine the amount of trust preferred securities that can be included in regulatory Tier I capital. At that time, the Company will be allowed to include in Tier I capital an amount of trust preferred securities equal to no more than 25% of the sum of all core capital elements, which is generally defined as shareholders’ equity, less goodwill net of any related deferred income tax liability. The regulations currently in effect 13 NOTE 7—BORROWINGS AND SUBORDINATED DEBENTURES (Continued) through December 31, 2008, limit the amount of trust preferred securities that can be included in Tier I capital to 25% of the sum of core capital elements without a deduction for goodwill. We have determined that our Tier I capital ratios would remain above the well-capitalized level had the modification of the capital regulations been in effect at June 30, 2005. We expect that our Tier I capital ratios will be at or above the existing well capitalized levels on March 31, 2009, the first date on which the modified capital regulations must be applied. NOTE 8—COMMITMENTS AND CONTINGENCES Lending Commitments. The Banks are party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of their customers. Such financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets. The contract or notional amounts of such instruments reflect the extent of involvement the Company has in particular classes of financial instruments. Commitments to extend credit amounting to $924.6 million and $849.6 million were outstanding as of June 30, 2005 and December 31, 2004. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit and financial guarantees amounting to $60.3 million and $63.0 million were outstanding as of June 30, 2005 and December 31, 2004. Standby letters of credit and financial guarantees are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support private borrowing arrangements. Most guarantees expire within one year from the date of issuance. The Company generally requires collateral or other security to support financial instruments with credit risk. Management does not anticipate that any material loss will result from the outstanding commitments to extend credit, standby letters of credit or financial guarantees. Legal Matters. On June 8, 2004, the Company was served with an amended complaint naming First Community and Pacific Western as defendants in a class action lawsuit filed in Los Angeles Superior Court pending as Case No. BC310846. We are named as defendants in our capacity as alleged successors to First Charter Bank, N.A. (“First Charter”), which the Company acquired in October 2001. A former officer of First Charter, who left First Charter in May of 1997, is also named as a defendant. On April 18, 2005, the plaintiffs filed the second amended class action complaint. The second amended complaint alleges that a former officer of First Charter who later became a principal of Four Star Financial Services, LLC (“Four Star”), an affiliate of 900 Capital Services, Inc. (“900 Capital”), improperly induced several First Charter customers to invest in 900 Capital or affiliates of 900 Capital and further alleges that Four Star, 900 Capital and some of their affiliated entities perpetuated their fraud upon investors through various First Charter accounts with First Charter’s purported knowing participation in and/or willful ignorance of the scheme. The key allegations against First Charter in the second amended complaint date back to the mid-1990s and the second amended complaint alleges several counts for relief including aiding and abetting, conspiracy, fraud, breach of fiduciary duty, relief pursuant to the California 14 NOTE 8—COMMITMENTS AND CONTINGENCES (Continued) Business and Professions Code, negligence and relief under the California Securities Act stemming from an alleged fraudulent scheme and sale of securities issued by 900 Capital and Four Star. In disclosures provided to the parties, plaintiffs have asserted that the named plaintiffs have suffered losses well in excess of $3.85 million, and plaintiffs have asserted that “losses to the class total many tens of millions of dollars.” While we understand that the plaintiffs intend to seek to certify a class for purposes of pursuing a class action, a class has not yet been certified and no motion for class certification has been filed. At this stage of litigation, we do not believe it is feasible to accurately assess the likely outcome, the timing of its resolution, or whether it will have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows. We intend to vigorously defend the lawsuit. In the ordinary course of our business, we are party to various other legal actions, which we believe are incidental to the operation of our business. Although the ultimate outcome and amount of liability, if any, with respect to these other legal actions to which we are currently a party cannot presently be ascertained with certainty, in the opinion of management, based upon information currently available to us, any resulting liability is not likely to have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows. NOTE 9—REGULATORY MATTERS On June 14, 2005, the Office of the Comptroller of the Currency (the “OCC”), informed the Company’s subsidiary First National that, as of June 13, 2005, the OCC had terminated the Memorandum of Understanding (the “MOU”) between the OCC and First National, dated April 8, 2004, relating to Bank Secrecy Act/Anti-Money Laundering (“BSA/AML”) matters. The MOU required us to evaluate and strengthen our BSA/AML program and processes and was limited in scope to BSA/AML issues. The OCC stated that it had determined that First National had complied with its obligations under the terms of the MOU. NOTE 10—DIVIDEND APPROVAL On July 27, 2005, our Board of Directors declared a quarterly cash dividend of $0.25 per common share payable on August 31, 2005 to shareholders of record at the close of business on August 16, 2005. NOTE 11—IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS On April 14, 2005, the Securities and Exchange Commission announced the adoption of a new rule that amends the compliance dates for Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payments, a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123R was to be effective for us on July 1, 2005. The new rule permits public companies to delay adoption of SFAS No. 123R to the beginning of their next fiscal period beginning after June 15, 2005, which for us would be as of January 1, 2006. SFAS No. 123R addresses the accounting for transactions in which an entity exchanges its equity instruments for goods and services. SFAS No. 123R eliminates the ability to account for share-based compensation transactions under the intrinsic-value method utilizing Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires that such transactions be accounted for using the fair-value method. We will adopt SFAS 123R on January 1, 2006, and are presently reviewing the standard to determine what effect, if any, it will have on our financial condition and results of operations. 15 ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Quarterly Report on Form 10-Q contains certain forward-looking information about the Company and its subsidiaries, which statements are intended to be covered by the safe harbor for “forward-looking statements” provided by the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical fact are forward-looking statements. Such statements involve inherent risks and uncertainties, many of which are difficult to predict and are generally beyond the control of the Company. We caution readers that a number of important factors could cause actual results to differ materially from those expressed in, implied or projected by, such forward-looking statements. Risks and uncertainties include, but are not limited to: · planned acquisitions and related cost savings cannot be realized or realized within the expected time frame; · revenues are lower than expected; · credit quality deterioration which could cause an increase in the provision for credit losses; · competitive pressure among depository institutions increases significantly; · the Company’s ability to complete planned acquisitions, to successfully integrate acquired entities, or to achieve expected synergies and operating efficiencies within expected time-frames or at all; · the integration of acquired businesses costs more, takes longer or is less successful than expected; · the possibility that personnel changes will not proceed as planned; · the cost of additional capital is more than expected; · a change in the interest rate environment reduces interest margins; · asset/liability repricing risks and liquidity risks; · pending legal matters may take longer or cost more to resolve or may be resolved adversely to the Company; · general economic conditions, either nationally or in the market areas in which the Company does or anticipates doing business, are less favorable than expected; · the economic and regulatory effects of the continuing war on terrorism and other events of war, including the war in Iraq; · legislative or regulatory requirements or changes adversely affecting the Company’s business; · changes in the securities markets; and · regulatory approvals for announced or future acquisitions cannot be obtained on the terms expected or on the anticipated schedule. If any of these risks or uncertainties materializes, or if any of the assumptions underlying such forward-looking statements proves to be incorrect, our results could differ materially from those expressed in, implied or projected by, such forward-looking statements. The Company assumes no obligation to update such forward-looking statements. 16 Overview We are a bank holding company registered under the Bank Holding Company Act of 1956, as amended. Our principal business is to serve as the holding company for our subsidiary banks, First National Bank and Pacific Western National Bank, which we refer to as the Banks. Through the holding company structure, First Community creates operating efficiencies for the Banks by consolidating core administrative, operational and financial functions that serve both of the Banks. The Banks reimburse the holding company for the services performed on their behalf, pursuant to an expense allocation agreement. The Banks are full-service community banks offering a broad range of banking products and services including: accepting time and demand deposits; originating commercial loans, including asset-based lending and factoring, real estate and construction loans, Small Business Administration guaranteed loans, or SBA loans, consumer loans, mortgage loans and international loans for trade finance; providing tax free real estate exchange accommodation services; and providing other business-oriented products. At June 30, 2005, our gross loans totaled $2,169.6 million of which 32% consisted of commercial loans, 66% consisted of commercial real estate loans, including construction loans, and 2% consisted of consumer and other loans. Our portfolio’s value and credit quality is affected in large part by real estate trends in Southern California. These percentages also include some foreign loans, primarily to individuals or entities with business in Mexico, representing approximately 5% of total loans. The Banks compete actively for deposits, and we tend to solicit noninterest-bearing deposits. In managing the top line of our business, we focus on loan growth and loan yield, deposit cost, and net interest margin, as net interest income, on a year-to-date basis, accounts for 91% of our net revenues (net interest income plus noninterest income). Among other factors, our operating results depend generally on the following: The Level of Our Net Interest Income Net interest income is the excess of interest earned on our interest-earning assets over the interest paid on our interest-bearing liabilities. Our primary interest-earning assets are loans and investment securities. Our primary interest-bearing liabilities are interest-bearing deposits, borrowings, and subordinated debentures. We attempt to increase our net interest income by maintaining a high level of noninterest-bearing deposits to total deposits. At June 30, 2005, approximately 48% of our deposits were noninterest-bearing. Our general policy is to price our deposits in the bottom half or third-quartile of our competitive peer group, resulting in deposit products that bear interest rates at somewhat lower yields. While our deposit balances will fluctuate depending on deposit holders’ perceptions of alternative yields available in the market, we attempt to minimize these variances by attracting noninterest-bearing deposits, which have no expectation of yield. In recent periods we have used the Banks’ secured credit lines with the Federal Home Loan Bank of San Francisco (the “FHLB”) to match-fund the asset based loan portfolio acquired in the FC Financial acquisition and to fund loan demand in the absence of sufficient deposit growth. Loan Growth We generally seek new lending opportunities in the $500,000 to $5 million range, try to limit loan maturities for commercial loans to one year, for construction loans up to 18 months, and for commercial real estate loans up to ten years, and price loan products so as to preserve our interest spread and net interest margin. We sometimes encounter strong competition in pursuing lending opportunities such that potential borrowers obtain loans elsewhere at rates lower than those we offer. 17 The Magnitude of Credit Losses We maintain an allowance for credit losses. Our allowance for credit losses is the sum of our allowance for loan losses and our reserve for unfunded commitments. Provisions for credit losses are charged to operations as and when needed for both on and off balance sheet credit exposure. Loans which are deemed uncollectible are charged off and deducted from the allowance for loan losses. Recoveries on loans previously charged off are added to the allowance for loan losses. We emphasize credit quality in originating and monitoring the loans we make and measure our success by the level of our nonperforming assets. Through focusing on credit quality, the loan portfolio of the Company is generally better than the quality of the loan portfolios we have acquired. Following acquisitions, we work to remove problem loans from the portfolio or allow lower credit quality loans to mature, and seek to replace such loans with obligations from borrowers with higher quality credit. Changes in economic conditions, however, such as increases in the general level of interest rates, could negatively impact our customers and lead to increased provisions for credit losses. The Level of Our Noninterest Expense Our noninterest expense includes fixed and controllable overhead, the major components of which are compensation, occupancy, data processing, professional services and communications. We measure success in controlling such costs through monitoring our efficiency ratio. We calculate the efficiency ratio by dividing noninterest expense by the sum of net interest income and noninterest income. The consolidated efficiency ratios have been as follows:
(1) Excludes securities gains and losses and gain on sale of an acquired charged-off loan. Additionally, our operating results have been influenced significantly by acquisitions; the two acquisitions we completed since January 1, 2004, added approximately $304.3 million in assets. Our assets at June 30, 2005, total approximately $2.8 billion. While the total amount of noninterest expense has increased from the first quarter of 2004, the efficiency ratio decreased when compared to the same period. The Company’s accounting policies are fundamental to understanding management’s discussion and analysis of results of operations and financial condition. The Company has identified several policies as being critical because they require management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain and because of the likelihood that materially different amounts would be reported under different conditions or using different assumptions. These policies relate to the allowance for credit losses, the fair value of financial instruments, and the carrying values of goodwill, other intangible assets and deferred income tax assets. For further information, refer to our Annual Report on Form 10-K for the year ended December 31, 2004. 18 Earnings Performance We analyze our performance based on net earnings determined in accordance with accounting principles generally accepted in the United States. The comparability of financial information is affected by our acquisitions. Operating results include the operations of acquired entities from the dates of acquisition. The following table presents net earnings and summarizes per share data and key financial ratios.
(1) Our quarterly results include FC Financial subsequent to March 1, 2004, and Harbor National subsequent to April 16, 2004. The improvement in net earnings in the second quarter of 2005 compared to the same period of 2004 resulted from increased net interest margin and average loan growth. The increase in average loans was due to organic loan growth and loans added to the portfolio from the Harbor National acquisition. Our net interest margin increased 58 basis points to 6.19% for the second quarter of 2005 compared to 5.61% for the same period in 2004. This increase was due to the positive impact the increases in market interest rates have had on our asset-sensitive balance sheet. The decrease in noninterest income for the second quarter of 2005 compared to the same period in 2004 is attributable to lower service fees on deposit accounts. The decrease in noninterest expense for the second quarter of 2005 over the same period of 2004 is largely the result of lower occupancy and professional services costs offset slightly by higher compensation costs. 19 Net Interest Income. Net interest income, which is our principal source of revenue, represents the difference between interest earned on assets and interest paid on liabilities. Net interest margin is net interest income expressed as a percentage of average interest-earning assets. Net interest income is affected by changes in both interest rates and the volume of average interest-earning assets and interest-bearing liabilities. The following table presents, for the periods indicated, the distribution of average assets, liabilities and shareholders’ equity, as well as interest income and yields earned on average interest-earning assets and interest expense and costs on average interest-bearing liabilities.
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