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Washington Banking Company 10-Q 2008 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2008
For the transition period from to
Commission File Number 000-24503
WASHINGTON BANKING COMPANY
(Exact name of registrant as specified in its charter)
450 SW Bayshore Drive
Oak Harbor, Washington 98277 (Address of principal executive offices) (Zip Code) (360) 679-3121
(Registrant’s telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for
such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days.
Yes þ No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer,
a non-accelerated filer, or a smaller reporting company.
See the definitions of “large
accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark if the registrant is a shell company as defined in Rule 12b-2 under the
Securities Exchange Act of 1934, as amended. Yes o No þ
The number of shares of the issuer’s Common Stock outstanding at August 1, 2008 was 9,487,560.
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PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES Condensed Consolidated Statements of Financial Condition (unaudited)
(Dollars in thousands, except per share data)
See accompanying notes to condensed consolidated financial statements.
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WASHINGTON BANKING COMPANY
AND SUBSIDIARY Condensed Consolidated Statements of Income (unaudited)
(Dollars in thousands, except per share data)
See accompanying notes to condensed consolidated financial statements.
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WASHINGTON BANKING COMPANY
AND SUBSIDIARY Condensed Consolidated Statements of Shareholders’ Equity and
Comprehensive Income (unaudited)
(Dollars in thousands, except per share data)
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WASHINGTON BANKING COMPANY
AND SUBSIDIARY Condensed Consolidated Statements of Cashflows (unaudited)
(Dollars in thousands)
See accompanying notes to condensed consolidated financial statements.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
(1) Description of Business and Summary of Significant Accounting Policies
(a) Description of Business: Washington Banking Company (the “Company” or “WBCO”) is a registered
bank holding company formed on April 30, 1996. At June 30, 2008 WBCO had two wholly owned
subsidiaries — Whidbey Island Bank (“WIB” or the “Bank”), the Company’s principal subsidiary, and
Washington Banking Master Trust (the “Trust”). The business of the Bank, which is focused in the
northern area of Western Washington, consists primarily of attracting deposits from the general
public and originating loans. The region’s economy has evolved from one that was once heavily
dependent upon forestry, fishing and farming to an economy with a much more diverse blend of
industries including retail trade, services, manufacturing, tourism and a large military base
presence. Although the Bank has a diversified loan portfolio, a substantial portion of its
borrowers’ ability to repay their loans is dependent upon the economic conditions affecting this
area.
(b) Basis of Presentation: The accompanying interim condensed consolidated financial statements
include the accounts of WBCO and its subsidiaries described above. The accompanying interim
condensed consolidated financial statements have been prepared, without audit, pursuant to the
rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, they do not
include all of the information and footnotes required by generally accepted accounting principles
in the United States of America for complete financial statements. These condensed consolidated
financial statements should be read in conjunction with the December 31, 2007 audited consolidated
financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed
with the SEC. In management’s opinion, all adjustments (consisting of normal recurring adjustments)
considered necessary for a fair presentation have been included. Operating results for the six
months ended June 30, 2008 are not necessarily indicative of the results that may be expected for
the year ending December 31, 2008. In preparing the condensed consolidated financial statements,
estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and
expenses are required. Actual results could differ from those estimates.
(c) Reclassifications: Certain amounts in prior year’s financial statements may have been
reclassified to conform to the 2008 presentation. These reclassifications had no significant impact
on the Company’s financial position or results of operations.
(2) Recent Financial Accounting Pronouncements
In March 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 161,
Disclosures about Derivative Instruments and Hedging Activities — an Amendment of FASB Statement
133. Statement No. 161 enhances required disclosures regarding derivatives and hedging activities,
including enhanced disclosures regarding how: (a) an entity uses derivative instruments; (b)
derivative instruments and related hedged items are accounted for under FASB Statement No. 133,
Accounting for Derivative Instruments and Hedging Activities; and (c) derivative instruments and
related hedged items affect an entity’s financial position, financial performance, and cash flows.
Specifically, Statement 161 requires:
Statement No. 161 is effective for fiscal years and interim periods beginning after November 15,
2008. The Company does not expect the standard to have a material impact on its financial
statements.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
(2) Recent Financial Accounting Pronouncements- (Continued)
In May 2008, the Financial Accounting Standards Board (“FASB”) issued FASB Statement No. 162, The
Hierarchy of Generally Accepted Accounting Principles. Statement No. 162 identifies the sources of
accounting principles and the framework for selecting the principles to be used in the preparation
of financial statements of nongovernmental entities that are presented in conformity with generally
accepted accounting principles (GAAP) in the United States (the GAAP hierarchy).
Statement No. 162 is effective 60 days following the SEC’s approval of the Public Company
Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles. The Company does not expect the standard
to have any impact on its financial statements.
In May 2008, FASB issued Statement No. 163, Accounting for Financial Guarantee Insurance Contracts:
An interpretation of FASB Statement No. 60. Statement No. 163 requires that an insurance enterprise
to recognize a claim liability prior to an event of default when there is evidence that credit
deterioration has occurred in an insured financial obligation.
Statement No. 163 is effective for financial statements issued for fiscal years beginning after
December 15, 2008, and all interim periods within those fiscal years. The Company does not expect
the standard to have any impact on its financial statements.
(3) Earnings Per Share
Basic earnings per share is computed by dividing net income available to common shareholders by the
weighted average number shares of common stock outstanding during the period. Diluted earnings per
share is computed in the same manner as basic earnings per share except that the denominator is
increased to include the number of additional common shares that would have been outstanding if
certain shares issueable upon exercise of options and non-vested restricted stock were included.
The following table reconciles the denominator of the basic and diluted earnings per share
computation:
At June 30, 2008 and 2007, the following stock awards were antidilutive and therefore not included
in the computation of diluted net income per share.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
(4) Stock-Based Compensation
(a) Stock Options: The Company measures the fair value of each stock option grant at the date of
the grant, using the Black Scholes option pricing model. The weighted average fair value per share
of options granted during the six months ended June 30, 2008 and 2007 was $2.82 and $5.11 per
share, respectively. The following assumptions were used in arriving at the fair value of options
granted:
The Company recognizes compensation expense for stock option awards on a straight-line basis over
the requisite service period of the award. For the six months ended June 30, 2008 and 2007 the
Company recognized $64 and $45, respectively, in stock based compensation expense as a component of
salaries and benefits. As of June 30, 2008 there was approximately $625 of total unrecognized
compensation cost related to nonvested stock awards.
The following table summarizes information on stock option activity during 2008:
The aggregate intrinsic value in the table above represents the total pretax intrinsic value (i.e.,
the difference between the Company’s closing stock price on June 30, 2008 and the exercise price,
times the number of shares) that would have been received by the option holders had all the option
holders exercised their options on June 30, 2008. This amount changes based upon the fair market
value of the Company’s stock.
(b) Restricted Stock Awards: The Company grants restricted stock awards (“RSA”) and restricted
stock units (“RSU”) periodically for the benefit of employees and directors. Recipients of RSA
awards do not pay any cash consideration to the Company for the shares and receive all dividends
with respect to such shares, whether or not the shares have vested. Recipients of RSU awards do not
pay any cash consideration to the Company for the shares. Restrictions for both awards are based on
continuous service requirements with the Company.
The following table summarizes information on restricted stock activity during 2008:
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
For the six months ended June 30, 2008 and 2007 the Company recognized $79 and $110, respectively,
in restricted stock compensation expense as a component of salaries and benefits. As of June 30,
2008 there was $205 of total unrecognized compensation costs related to nonvested restricted stock.
(c) Restricted Stock Units: The Company grants restricted stock units periodically for the benefit
of employees and directors. Recipients of restricted stock units receive shares of the Company’s
stock upon the lapse of their related restrictions and do not pay any cash consideration to the
Company for the shares. Restrictions are based on continuous service.
The following table summarizes information on restricted stock unit activity during the six months
ended June 30, 2008:
For the six months ended June 30, 2008 the Company recognized $47 in restricted stock units
compensation expense as a component of salaries and benefits; there was no compensation expense in
the prior year. As of June 30, 2008, there was $391 of total unrecognized compensation costs
related to nonvested restricted stock units.
(5) Fair Value Measurements
Effective January 1, 2008, the Company adopted FASB Statement No.157, Fair Value Measurements, for
all financial instruments and non-financial instruments accounted for at fair value on a recurring
basis. Statement No. 157 establishes a new framework for measuring fair value and expands related
disclosures. Broadly, Statement No. 157 framework requires fair value to be determined based on the
exchange price that would be received for an asset or paid to transfer a liability (an exit price)
in the principal or most advantageous market for the asset or liability in an orderly transaction
between market participants. Statement No. 157 establishes market or observable inputs as the
preferred source of values, followed by assumptions based on hypothetical transactions in the
absence of market inputs.
The valuation techniques required by Statement No. 157 are based upon observable and unobservable
inputs. Observable inputs reflect market data obtained from independent sources, while unobservable
inputs reflect our market assumptions. These two types of inputs create the following fair value
hierarchy:
The following section describes the valuation methodologies the Company uses to measure different
financial instruments at fair value.
Investments in debt and equity securities: When available, the Company uses quoted market prices to
determine the fair value of investment securities. These investments are included in Level 1. When
quoted market prices are unobservable, the Company uses quotes from independent pricing vendors
based on recent trading activity and other relevant information including market interest rate
curves, referenced credit spreads and estimated prepayment rates where applicable. These
investments are included in Level 2 and comprise the Company’s portfolio of U.S. agency securities,
municipal bonds and one mortgage-backed security.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
Impaired loans: A loan is considered impaired when, based upon currently known information, it is
deemed probable that the Company will be unable to collect all amounts due as scheduled according
to the original terms of the agreement. Impaired loans are measured based on the present value of
expected future cash flows discounted at the loan’s effective interest rate or, as a practical
expedient, based on the loan’s observable market price or the fair value of collateral, if the loan
is collateral dependent. Impaired loans, which are collateral dependent, are included in the
nonrecurring basis table below.
Other real estate owned: Other real estate owned (“OREO”) includes properties acquired through
foreclosure. These properties are recorded at the lower of cost or estimated fair value (less
estimated cost to sell), based on periodic evaluations. Other real estate owned, which has been
recorded at estimated fair value are included in the nonrecurring basis table below
The following table presents the Company’s assets measured at fair value on a recurring basis at
June 30, 2008:
The following table presents the Company’s assets measured at fair value on a nonrecurring basis at
June 30, 2008:
In accordance with FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan,
impaired loans, with carrying amounts of $2,500 had specific valuation allowances totaling $292,
which were included in the allowance for loan losses.
In accordance with FASB Statement No.144, Accounting for the Impairment or Disposal of Long-Lived
Assets, OREO properties with a total carrying amount of $1,066 were written down to their fair
value of $932. The write down of OREO properties totaling $134, was included in other
noninterest expense.
(6) Subsequent Events
On July 24, 2008, the Company announced that its Board of Directors declared a cash dividend of
$0.065 per share to shareholders of record as of August 5, 2008, payable on August 20, 2008.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Dollars In Thousands, Except Per Share Data)
(7) Commitments and Guarantees
Standby letters of credit are conditional commitments issued by the Bank to guarantee the
performance of a customer to a third party. Those guarantees are primarily issued to support public
and private borrowing arrangements, including commercial paper, bond financing and similar
transactions. Except for certain long-term guarantees, most guarantees expire in one year. The
credit risk involved in issuing letters of credit is essentially the same as that involved in
extending loan facilities to customers. Collateral supporting those commitments, for which
collateral is deemed necessary, generally amounted to one hundred percent of the commitment amount
at June 30, 2008. The Company routinely charges a fee for these credit facilities. Such fees are
amortized into income over the life of the agreement, and unamortized amounts were not significant
as of June 30, 2008. As of June 30, 2008 the commitments under these agreements were $2,201.
At June 30, 2008, the Company was the guarantor of trust preferred securities. The Company has
issued junior subordinated debentures to a wholly owned special purpose trust, which has issued
trust preferred securities. The sole assets of the special purpose trust are the junior
subordinated debentures issued by the Company. Washington Banking Company has fully and
unconditionally guaranteed the capital securities along with all obligations of the Trust under the
trust agreements. The maximum amount of future payments the Company will be required to make under
these agreements is the principal and interest of the trust preferred securities, the principal of
which totaled $25,774 at June 30, 2008.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Note Regarding Forward-Looking Statements: This Quarterly Report on Form 10-Q includes
forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of
1934, as amended (the “Exchange Act”). These forward-looking statements describe Washington
Banking Company’s (the “Company”) management’s expectations regarding future events and developments such as future
operating results, growth in loans and deposits, continued success of the Company’s business plan
and the strength of the local economy. The words “will,” “believe,” “expect,” “should,”
“anticipate” and words of similar construction are intended in part to help identify
forward-looking statements. Future events are difficult to predict, and the expectations described
below are necessarily subject to risk and uncertainty that may cause actual results to differ
materially and adversely. In addition to discussions about risks and uncertainties set forth from
time to time in the Company’s filings with the SEC, factors that may cause actual results to differ
materially from those contemplated in such forward-looking statements include, among others, the
following possibilities: (1) local and national general and economic conditions, (2) changes in interest
rates and their impact on net interest margins; (3) projected business increases following strategic
expansion or opening or acquiring new branches are lower than expected; (4) greater than expected
costs or difficulties related to the integration of acquisitions; (5) increased competitive
pressure among financial institutions; (6) legislation or regulatory requirements or changes that
adversely affect the banking and financial services sector; and (7) the Company’s
ability to realize efficiencies from investment in personnel and
infrastructure. However, the reader should be aware that these factors are not an exhaustive list,
and should not assume that these are the only factors that may cause actual results to differ from
expectations. In addition, it should be noted that the Company does not intend to
update any of the forward-looking statements or the uncertainties that may adversely impact those
statements.
The following discussion and analysis should be read in conjunction with the financial statements
and notes thereto presented elsewhere in this report.
Overview
Washington Banking Company (referred to in this report as the “Company”) is a registered bank
holding company with two wholly-owned subsidiaries: Whidbey Island Bank (the “Bank”), the Company’s
principal subsidiary and Washington Banking Master Trust (the “Trust”). Headquartered in Oak
Harbor, the Company’s market area is primarily northwestern Washington. The market area encompasses
distinct economies, and none are particularly dependent upon a single industrial or occupational
source. The economies within the market areas have evolved from being heavily dependent upon
forestry, fishing and farming to a more diverse blend of industries including retail trade,
services, manufacturing, tourism and a large military presence.
The Company’s strategy is one of value-added growth. Management believes that qualitative and
sustainable growth of the Company, coupled with maintaining profitability, is currently the most
appropriate path to providing good value for its shareholders. To date, the Company’s growth has
been achieved organically and it attributes its reputation for focusing on customer service and
satisfaction as one of the cornerstones to the Company’s success. The Company’s primary objectives
are to improve profitability and operating efficiencies, increase market penetration in areas
currently served, and to continue an expansion strategy in appropriate market areas.
Summary of Critical Accounting Policies
Significant accounting policies are described in Note (1) of the Notes to Consolidated Financial
Statements for the year ended December 31, 2007 as filed in Form 10-K. Not all of these accounting
policies require management to make difficult, subjective or complex judgments or estimates.
Management believes that the following accounting policies could be considered critical under the
SEC’s definition.
Allowance for Loan Losses: There have been no material changes in the accounting policy relating to
allowance for loan losses as compared to that contained in Note (1) of the Notes to Consolidated
Financial Statements for the year ended December 31, 2007 as filed in Form 10-K.
Stock-based Compensation: There have been no material changes in the accounting policy relating to
stock-based compensation as compared to that contained in Note (1) of the Notes to Consolidated
Financial Statements for the year ended December 31, 2007 as filed in Form 10-K.
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Results of Operations Overview
The Company’s net income was stable at $2.4 million, or $0.25 per diluted share, in the second
quarter of 2008, compared with $2.5 million or $0.26 per diluted share in the second quarter of
2007. Return on average equity decreased to 12.74% in the second quarter of 2008, compared with
14.43% in the corresponding quarter of 2007. Return on average assets decreased to 1.09% in the
second quarter of 2008, compared with 1.19% in second quarter of 2007.
For the first six months of 2008, net income was $4.8 million and diluted earnings per share was
$0.50, compared to $4.7 million or $0.50 per diluted share for the same period last year. Return on
average equity decreased to 12.68% for the first six months of 2008, compared with 14.07% last
year.
Net Interest Income: One of the Company’s key sources of earnings is net interest income. To make
it easier to compare results among several periods and the yields on various types of earning
assets (some of which are taxable and others which are not), net interest income is presented in
this discussion on a “taxable-equivalent basis” (i.e., as if it were all taxable at the same rate).
There are several factors that affect net interest income including:
The following tables set forth various components of the balance sheet that affect interest income
and expense, and their respective yields or rates:
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Taxable-equivalent net interest income was $9.5 million in the second quarter of 2008 and 2007.
There were significant changes in the mix of interest-earning assets and interest-bearing
liabilities and their related volumes and rates during the second quarter. Average interest-earning
assets increased $66.3 million to $838.1 million, due to strong loan growth, as compared to $771.8
million for the second quarter of 2007. However, the yields on interest-earning assets decreased
110 basis points to 7.02% in the second quarter of 2008 from 8.12% in the same period in 2007. This
decrease was primarily attributed to a 325 basis point decrease in the prime rate charged on
variable rate loans, which occurred between August 2007 and April 2008. Average interest-bearing
liabilities increased $66.1 million to $717.9 million as compared to $651.8 million in the second
quarter of 2007, with interest-bearing deposits increasing $27.8 million and the remaining $38.3
million increase in the second quarter of 2007 made up of various other borrowing sources. The
average cost of interest-bearing
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liabilities decreased 85 basis points to 2.90% in the second quarter of 2008 from 3.75% in the same
period in 2007. These changes in loan and deposit volumes and rates caused the net interest margin
to decrease 41 basis points in the second quarter of 2008 to 4.54% from 4.95% in the same period
last year.
Taxable-equivalent net interest income was $19.1 million in the first six months of 2008 compared
to $18.7 million in the same period in 2007. There were significant changes in the mix of
interest-earning assets and interest-bearing liabilities and their related volumes and rates in the
first six months of 2008. Average interest-earning assets increased $73.7 million to $832.4
million, due to strong loan growth, compared to $758.7 million for the same period last year.
However, the yields on interest-earning assets decreased 78 basis points to 7.31% in the first six
months of 2008 from 8.09% in the same period in 2007. This decrease was primarily attributed to a
325 basis point decrease in the prime rate charged on variable rate loans, which occurred between
August 2007 and April 2008. Average interest-bearing liabilities increased $74.0 million to $714.0
million compared to $640.0 million in the first six months of 2007, with interest-bearing deposits
increasing $33.6 million and the remaining $40.4 million increase in the first six months of 2008
made up of various other borrowing sources. The average cost of interest-bearing liabilities
decreased 58 basis points to 3.14% in the first six months of 2008 from 3.72% in the same period in
2007. These changes in loan and deposit volumes and rates caused the net interest margin to
decrease 34 basis points in the first six months of 2008 to 4.62% from 4.96% in the same period
last year.
The following table shows how changes in yields or rates and average balances affected net interest
income for the second quarters of 2008 and 2007:
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Provision for Loan Losses: During the second quarter of 2008, the Company recorded a $1.1 million
provision for loan losses compared to $850,000 for the second quarter in 2007. Net charge-offs for
second quarter of 2008 were $869,000, a $333,000 increase over the second quarter of 2007.
Increases in net charge-offs were due to an increase in real estate and indirect consumer loan
charge-offs.
During the first six months of 2008, the Company recorded a $2.1 million provision for loan losses
compared to $1.4 million in the same period in 2007. The increase in the provision for loan and
lease losses is primarily due to loan portfolio growth and the level of net charge-offs. Net
charge-offs for the first six months of 2008 were $1.6 million, compared with $922,000 in the same
period last year.
The provision for loan losses is based on management’s evaluation of inherent risk in the loan
portfolio and a corresponding analysis of the allowance for loan and lease losses. Additional
discussion on loan quality and the allowance for loan and lease losses is provided under the
Allowance for Loan Losses and Nonperforming Assets section of this report.
Noninterest Income: Noninterest income in the second quarter of 2008 decreased 16% to $1.6 million
compared to $2.0 million in the corresponding quarter of 2007. Service charges and fees decreased
$86,000 due to a decline in the number of deposit accounts. Additional changes in noninterest
income were primarily due to decreases: in income from the sale of loans of $160,000; SBA premiums
of $78,000; and a $62,000 decline in sales of investment products.
Noninterest income of $3.4 million for the first six months of 2008 decreased 9%, compared with
$3.8 million in the same period last year. Service charges and fees decreased $177,000 due to a
decline in the number of deposit accounts Additional changes in noninterest income in the first six
months of 2008 were primarily due to decreases in income from the sale of loans of $225,000. The
decrease in income from sale of loans, SBA premiums and investment product income are principally
related to the decreased volume and operations associated with the
proposed merger with Frontier
Financial Corporation that was terminated in May 2008. The Company anticipates that noninterest income in these areas will increase
through the remainder of 2008.
Noninterest Expense: Noninterest expense in the second quarter of 2008 decreased 8% to $6.3 million
compared to $6.9 million for the second quarter of 2007. Salaries and benefits decreased $334,000,
due to reduction in full time equivalent employees (“FTE’s”). Advertising for the second quarter of
2008 decreased $114,000.
Noninterest expense for the first six months of
2008 was $13.2 million, a 4% decrease over last
year. The decrease was principally due to a decrease in salaries and benefits of $755,000 due to a
reduction in FTEs. The number of FTEs decreased to 251 at June 30, 2008 from 305 at June 30, 2007.
This decrease in the number of FTE’s was offset by an $134,000 increase in write-downs of several
other real estate owned properties, and a $138,000 increase in merger related expenses associated
with the terminated merger with Frontier Financial Corporation. Additionally, FDIC premiums in the
first six months of 2008 increased $221,000 as compared to the same period in 2007. In 2007, the
Bank received a credit from the FDIC which reduced the expense by $100,000.
Income Taxes: The Company’s consolidated effective
tax rates for the second quarters of 2008 and
2007 were 32.9% and 31.5%, respectively. The effective tax rates for the first six months of 2008
and 2007 were 32.2% and 31.4%, respectively. The quarterly and year to date effective tax rates are
below the federal statutory rate of 35% principally due to nontaxable income generated from
investments in bank owned life insurance, tax-exempt municipal bonds and loans. Additionally, the
Company’s year to date and quarterly 2008 tax rates reflect a benefit from the New Market Tax
Credit Program, whereby a subsidiary of Whidbey Island Bank has been awarded approximately $3.1
million in future federal tax credits. The tax benefits related to these credits will be recognized
in the same periods that the credits are recognized on the Company’s income tax returns over the
next seven years.
Financial Condition Overview
Total assets were $903.9 million at June 30, 2008, an increase of $21.6 million from December 31,
2007. Loans at June 30, 2008 grew 2% to $824.6 million compared to $805.9 million at December 31,
2007. Deposits at June 30, 2008 decreased 3% to $732.9 million, compared to $758.4 million at
December 31, 2007. Shareholders’ equity increased $4.0 million to $77.5 million, with a book value
of $8.17 per share at June 30, 2008.
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Loans: Total loans outstanding as of June 30, 2008 were $824.6 million, an increase of $18.7
million from December 31, 2007. Loan portfolio growth during 2008 was primarily in the commercial
real estate loans, which was offset by decreases in commercial loans and consumer loans. The
Company has attempted to balance the diversity of its portfolio, believing that this provides a good
means of minimizing risk due to loss and interest rate sensitivity. Active portfolio management has
resulted in a diversified portfolio that is not heavily concentrated in any one industry or
community.
The following table further details the major components of the loan portfolio:
Allowance for Loan Losses: The allowance for loan losses at June 30, 2008 was $11.6 million or
1.40% of total loans and 460.64% of total nonperforming loans. This compares with an allowance of
$11.1 million or 1.38% of total loans and 395.41% of total non-performing loans at December 31,
2007.
The allowance for loan and losses is maintained at a level considered adequate by management to
provide for loan losses inherent in the portfolio. The Company assesses the allowance on a
quarterly basis. The evaluation of the allowance is based on an assessment of
non-performing loans, recent and historical loss experience, and other factors, including regulatory guidance and economic factors. While the Company believes that it uses the best information available to determine the allowance for loan losses, unforeseen market conditions could result in adjustments to the allowance for loan losses, and net income could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. The Company anticipates that normal growth of the loan portfolio will require continued increases in the allowance for loan losses. The following table details the activity of the allowance for loan losses:
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The changes in the allocation of the allowance for loan losses in the first six months of 2008 were
due primarily to changes in the loan portfolio and its mix, changes in the risk grading of loans,
and charge-off and recovery activity.
The table below details the Company’s allocation of the allowance for loan losses by loan type and
remaining unallocated allowances:
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Nonperforming Assets and Other Real Estate Owned Properties (“OREO”): Nonperforming assets include
nonaccrual loans, restructured loans and OREO. At June 30, 2008 nonperforming assets were $3.7
million, or 0.41% of total assets, compared to $4.3 million or 0.49% at December 31, 2007.
Loans are classified as non-accrual when collection of principal or interest is doubtful.
Additionally, loans that are “impaired” in accordance with SFAS No. 114 Accounting by Creditors for
the Impairment of a Loan, are considered for non-accrual status. These loans will typically remain
on nonaccrual status until all principal and interest payments are brought current and the
prospects for future payments in accordance with the loan agreement appear relatively certain.
Foreclosed properties held as OREO are recorded at the lower of the recorded investment in the loan
or market value of the property less estimated selling costs.
The table below shows the composition of the Company’s nonperforming assets:
Changes in the nonaccrual loans for the first six months of 2008 consisted primarily of one
relationship totaling $600,000, which was transferred to OREO and subsequently sold during the
second quarter of 2008. At June 30, 2008 OREO consisted of four properties. Changes in OREO for the
first six months of 2008 consisted of the sale of two properties totaling $708,000 for a gain of
$88,000. Additionally, the fair value of three OREO properties fair values were written down a
total of $134,000.
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Deposits: Total deposits in the first six months of 2008 decreased $25.5 million to $732.9 million
at June 30, 2008. The Decrease in deposits was primarily associated with the proposed merger with
Frontier Financial Corporation. The Company anticipates deposit balances to increase through the
remainder of 2008. Information on average deposit balances and average rates paid is included under
the Net Interest Income section of this report.
The following table further details the major components of the deposit portfolio:
The Company has $10.0 million in brokered time deposits outstanding as of June 30, 2008 and
December 31, 2007. All $10.0 million mature in August 2008; the Company does not intend to renew
these deposits.
Borrowings: Total borrowings outstanding in the first six months of 2008 increased $43.5 million to
$89.8 million at June 30, 2008. The change in borrowings is attributable to increases in short-term
and overnight borrowings with the Federal Home Loan Bank (“FHLB”).
FHLB Overnight Borrowings and Other Borrowed Funds: The Company utilizes advances from the
FHLB to supplement funding needs. The FHLB provides credit for member financial institutions in the
form of overnight borrowings, short-term and long-term advances. As a member, the Bank is required
to own capital stock in the FHLB and is authorized to apply for advances on the pledge of certain
of its mortgage loans and other assets.
During the first quarter the Company entered into a short term borrowing agreement with the FHLB
for a total of $30.0 million. The advances are as follows:
Capital
Shareholders’ Equity: Total shareholders’ equity increased $4.0 million to $77.5 million at June
30, 2008 from $73.6 million at December 31, 2007. Increases in shareholders’ equity were
principally due to $4.8 million of net income for the first six months of 2008, and proceeds from
the exercise of stock awards of $172,000. These increases were offset by the payment of cash
dividends of $1.2 million during the first and second Quarters
of 2008.
Regulatory Capital Requirements: Banking regulations require bank holding companies and banks to
maintain a minimum leverage ratio of core capital to adjusted average total assets of at least 4%.
In addition, banking regulators have adopted risk-based capital guidelines, under which risk
percentages are assigned to various categories of assets and off-balance sheet items to calculate a
risk-adjusted capital ratio. Tier I capital generally consists of common shareholders’ equity
(which does not include unrealized gains and losses on securities), less goodwill and certain
identifiable intangible assets, while Tier II capital includes the allowance for loan losses and
subordinated debt, both subject to certain limitations.
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The FDIC established the qualifications necessary to be classified as a “well-capitalized” bank,
primarily for assignment of FDIC insurance premium rates. As the following table indicates, the
Company and Bank qualified as “well-capitalized” at June 30, 2008 and December 31, 2007:
There can be no assurance that additional capital will not be required in the future due to
greater-than-expected growth, unforeseen expenses or revenue shortfalls.
Liquidity and Cash Flows
Liquidity: The principal objective of the liquidity management program is to maintain the Bank’s
ability to meet the day to day cash flow requirements of its customers who either wish to withdraw
funds or draw upon credit facilities to meet their needs.
Management monitors the sources and uses of funds on a daily basis to maintain an acceptable
liquidity position. The Company’s sources of funds are customer deposits, loan repayments, current
earnings, cash and demand balances due from other banks, federal funds, short-term investments,
investment securities available for sale and trust preferred securities. The Company’s strategy
includes maintaining a “well-capitalized” status for regulatory purposes, while maintaining a
favorable liquidity position and proper asset/liability mix. With this strategy in mind,
management anticipates that the Bank will rely primarily upon customer deposits to provide
liquidity in 2008. These funds will be used for loan originations and deposit withdrawals, to
satisfy other financial commitments and to support continuing operations. Additional funds are
available through established FHLB and correspondent bank lines of credit, which the Bank may use
to supplement funding sources.
Consolidated Cash Flows: As disclosed in the Condensed Consolidated Statements of Cash Flows, net
cash provided by operating activities was $9.4 million for the first six months of 2008. The
principal source of cash provided by operating activities was net income from continuing
operations. Net investing activities used $19.0 million in the first six months of 2008. $21.0
million was used to fund net loan growth. Net cash provided by financing activities was $17.0
million for the first six months of 2008. The principal sources of cash were a $30.0 million net
increase in other borrowings, and $13.5 million in overnight borrowings. Principal uses of cash
were the payment of a $1.2 million cash dividend and the net decrease of $25.5 million in deposits.
Capital Resources:
Off-Balance Sheet Items: The Company is a party to financial instruments with off-balance sheet
risk. Among the off-balance sheet items entered into in the ordinary course of business are
commitments to extend credit and the issuance of letters of credit. These instruments involve, to
varying degrees, elements of credit and interest rate risk in excess of the amounts recognized on
the balance sheet. Certain commitments are collateralized. As of June 30, 2008 and December 31,
2007, the Company’s commitments under letters of credit and financial guarantees amounted to $2.2
million and $1.2 million, respectively. Since many of the commitments are expected to expire
without being drawn upon, these total commitment amounts do not necessarily represent future cash
requirements.
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Item 3. Quantitative and Qualitative Disclosures about Market Risk
At June 30, 2008, based on the measures used to monitor and manage interest rate risk, there had
not been a material change in the Company’s interest rate risk since December 31, 2007. Should
rates increase, the Company may, or may not be positively impacted due to its current slightly
asset sensitive position. For additional information, refer to the Company’s Form 10-K for year
ended December 31, 2007 filed with the SEC.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, management evaluated the effectiveness of the
design and operation of its disclosure controls and procedures. The principal executive and
financial officers supervised and participated in this evaluation. Based on this evaluation, the
chief executive and financial officer each concluded that the Company’s disclosure controls and
procedures are effective in timely alerting them to material information required to be included in
the periodic reports to the SEC. The design of any system of controls is based in part upon
various assumptions about the likelihood of future events, and there can be no assurance that any
of the Company’s plans, products, services or procedures will succeed in achieving their intended
goals under future conditions. Management found no facts that would require the Company to take any
corrective actions with regard to significant deficiencies or material weaknesses.
Changes in Internal Control over Disclosure and Reporting
There was no change in the Company’s internal control over financial reporting that occurred during
the quarterly period ended June 30, 2008 that has materially affected, or is reasonably likely to
materially affect, the internal control over financial reporting.
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PART II — OTHER INFORMATION
Item 1. Legal Proceedings
The Company may be involved in legal proceedings in the regular course of business. At this time,
management does not believe that there is pending litigation resulting in an unfavorable outcome of
which would result in a material adverse change to the Company’s financial condition, results of
operations or cash flows.
Item 1A. Risk Factors
For information regarding risk factors, please refer to Part I, Item 1A in the Company’s Annual
Report on Form 10-K for the year ended December 31, 2007. There have been no material changes in
the Company’s risk factors from those disclosed in the 2007 Annual Report on Form 10-K.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(a) - (c) None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
Item 6. Exhibits
Exhibits
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused
this report to be signed on its behalf by the undersigned, thereunto duly authorized.
WASHINGTON BANKING COMPANY
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