UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
(Mark One)
þ Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year endedDecember 31, 2006
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 000-24503
Washington Banking Company
(Exact name of registrant as specified in its charter)
| | | |
| Washington | | 91-1725825 |
| (State or other jurisdiction of | | (I.R.S. Employer |
| incorporation or organization) | | Identification Number) |
450 SW Bayshore Drive
Oak Harbor, Washington 98277
(Address of principal executive offices) (Zip Code)
Registrant’s telephone number, Including Area Code:(360) 679-3121
Securities Registered Pursuant to Section 12(b) of the Act:None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, No Par Value
(Title of Class)
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
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 and 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (17 C.F.R. 229.405) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy of information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. o
Indicate by check mark if the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o Accelerated filer þ Non-Accelerated filer o
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 aggregate market value of Common Stock held by non-affiliates of registrant at June 30, 2006 was approximately $151,778,208 based upon the closing price of the registrant’s common stock as quoted on the Nasdaq National Market on June 30, 2006 of $17.66.
The number of shares of registrant’s Common Stock outstanding at March 05, 2007 was 9,442,698.
Documents Incorporated by Reference
Portions of the Washington Banking Company definitive Proxy Statement for the 2007 annual meeting of shareholders of are incorporated by reference into Part III of this Form 10-K.
Table of Contents
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Note Regarding Forward-Looking Statements: This Annual Report on Form 10-K 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 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, including the possible impact of international conflict or further terrorist events, are less favorable than expected or have a more direct and pronounced effect than expected on the Company and adversely affect the Company’s ability to continue its internal growth at historical rates and maintain the quality of its earning assets; (2) changes in interest rates reduce interest margins more than expected or negatively affect liquidity; (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) Washington Banking Company’s ability to realize the efficiencies it expects to derive from its investment in personnel and infrastructure. However, you should be aware that these factors are not an exhaustive list, and you should not assume that these are the only factors that may cause actual results to differ from expectations. In addition, you should note that we do not intend to update any of the forward-looking statements or the uncertainties that may adversely impact those statements.
PART I
Item 1. Business
General
Washington Banking Company (the “Company”) was formed on April 30, 1996 and is a registered bank holding company whose primary business is conducted by its wholly-owned subsidiary, Whidbey Island Bank (the “Bank”). 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 Company and the Bank have formed several subsidiaries for various purposes as follows:
Whidbey Island Bank is a Washington state-chartered bank that conducts a full-service community commercial banking business. The Bank also offers nondeposit managed investment products and services, which are not Federal Deposit Insurance Corporation (“FDIC”) insured. These programs are provided through the investment advisory companies Elliott Cove Capital Management LLC and DFC Services & DFC Insurance Services. Another nondeposit product offered through the Bank, which is not FDIC insured, is a sweep investment option available through a brokerage account.
Washington Banking Capital Trust I (“The Trust”) is a wholly-owned subsidiary of the Company. The Trust was formed in June 2002 for the exclusive purpose of issuing trust preferred securities to acquire junior subordinated debentures issued by the Company. Those debentures are the sole assets of the Trust and payments on the debt are the sole revenues of the Trust. The Company has fully and unconditionally guaranteed all obligations of the Trust.
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Washington Funding Group (“The Group”) was a wholly-owned subsidiary of the Company. The Company discontinued operations of the Group effective June 30, 2004. The Group was formed in January 2003 for the purpose of expanding the Bank’s wholesale mortgage real estate lending platform. During the second quarter of 2004, the Company elected to concentrate corporate resources toward the Bank’s retail operations and closed the Group’s operations. Although the Group’s income from the sale of loans enhanced the Company’s total revenues during 2003 and 2004, the operation of those offices did not provide a satisfactory financial return in either year.
Rural One, LLC (“Rural One”) is a majority-owned subsidiary of the Bank and is certified as a Community Development Entity by the Community Development Financial Institutions Fund of the United Stated Department of Treasury. Rural One was formed in September 2006, for the exclusive purpose of an investment in Federal tax credits related to the New Markets Tax Credit program.
At December 31, 2006, the Company had total assets of $794.5 million, total deposits of $703.8 million and shareholders’ equity of $66.4 million. A more thorough discussion of the Company’s financial performance appears in Item 7 -Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The Company’s website address iswww.wibank.com.Exchange Act reports are available free of charge from the Company’s website. The reports can also be obtained through the Securities and Exchange Commission’s (the “SEC”) EDGAR database athttp://www.sec.gov.The contents of the Company’s Internet website are not incorporated into this report or into any other communication delivered to security holders or furnished to the SEC.
Growth Strategy
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.
The Company’s geographical expansion to date has primarily been concentrated along the I-5 corridor from Snohomish to Whatcom Counties; however, additional areas will be considered if they meet the Company’s criteria. Acquisition of banks or branches may also be used as a means of expansion if appropriate opportunities are presented. The primary factors considered in determining the areas of geographic expansion are the availability of knowledgeable personnel, such as managers and lending officers with experience in their fields of expertise, longstanding community presence and extensive banking relationships, customer demand and perceived market potential.
Management believes that increasing the success of current branches and expanding into appropriate market places while managing up-front costs is an excellent way to build franchise value and increase business. The Company’s strategy is to support its employees in providing a high level of personal service to its customers while expanding the loan, deposit and investment products and other services that the Company offers. Maintenance of asset quality will be emphasized by controlling nonperforming assets and adhering to prudent underwriting standards. In addition, management will maintain its focus on improving operating efficiencies and internal operating systems to further manage noninterest expense.
Growth requires expenditures of substantial sums to purchase or lease real property and equipment and to hire experienced personnel. New branch offices are often not profitable for a period of time after opening and management expects that earnings may be negatively affected in the short term.
Market Areas
The Company’s primary market area currently consists of Island, Skagit, Whatcom, Snohomish and San Juan counties in northwest Washington State. Although the Pacific Northwest is typically associated with
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industries such as computer technology, aerospace and coffee, the Company’s market encompasses distinct economies that are somewhat removed from the Seattle metropolitan region.
Island County’s largest population center, Oak Harbor, is dominated by a large military presence with naval operations at Naval Air Station (“NAS”) Whidbey Island. The jobs generated by NAS Whidbey contribute significantly to the county’s economy. Other primary industries providing employment for county residents are: education; health and social services; retail trade; and manufacturing. Due to its natural beauty, the county attracts tourism and has a number of retirement communities.
The economy of Skagit County is primarily comprised of agriculture, fishing, wood products, tourism, international trade, and specialized manufacturing. With its accessible ports and refineries, Skagit County is the center of the state’s petroleum industry.
Whatcom County, which borders Canada, has an economy with a prominent manufacturing base, as well as a significant academic-research and vocational-technical base, as it is the home of Western Washington University, one of Washington’s largest four-year academic centers. The United States Customs and Border Patrol and municipal, county and state governments give Whatcom County an additional employment base.
Snohomish County is one of the fastest growing areas in the state. Industrial sectors include aerospace, biotechnology, and electronics, as well as a military naval base and large retail influences.
The economy of San Juan County is predominantly comprised of retail trade, tourism, finance and insurance, and real estate services. The county is known for its beautiful locale, which attracts many visitors, and serves as a second home to an affluent sector of the population.
Washington State’s economy has rebounded from the low employment levels experienced in 2001 – 2003, with recent employment growth being the strongest in years. Home-building related employment was one of the fastest growing industries statewide over the past two years. Even as mortgage rates drift higher, they are still relatively low by historical standards, and Washington State population continues to increase. The large military bases located in the Company’s region continue to have a positive economic impact.
Competition
The Company operates in a highly competitive banking environment, competing for deposits, loans and other financial services with a number of larger and well-established commercial banks, savings banks, savings and loan associations, credit unions and other institutions, including nonbanking financial services companies.
Some of the Bank’s competitors are not subject to the same regulations as the Bank; they may have substantially higher lending limits, and may offer certain services that the Bank does not provide. Federal law allows mergers or other combinations, relocations of a bank’s main office and branching across state lines. Recent amendments to the federal banking laws to eliminate certain barriers between banking and commercial firms are expected to result in even greater competition in the future. Although the Company has been able to compete effectively in its market areas to date, there can be no assurance that the Company’s competitive efforts will continue to be successful.
Executive Officers of the Company
The following table sets forth certain information about the executive officers of the Company:
| | | | | | | | | | | |
| | | | | | | Has served as an |
| | | | | | | executive officer |
| | | | | | | of the Company or |
| Name | | Age | | Position | | Bank since |
| | | | | | | |
| Michal D. Cann | | | 58 | | | President and Chief Executive Officer | | | 1992 | |
| Joseph W. Niemer | | | 55 | | | Executive Vice President and Chief Credit Officer | | | 2005 | |
| Richard A. Shields | | | 47 | | | Executive Vice President and Chief Financial Officer | | | 2004 | |
| John L. Wagner | | | 63 | | | Executive Vice President and Chief Operating Officer | | | 2004 | |
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Michal D. Cann. Mr. Cann, 58, has been the President and Chief Executive Officer of the Company since its inception in 1996, the President and Chief Executive Officer of the Bank since 1993, and a director of the Bank since 1992. Mr. Cann has over 30 years of banking experience, previously having served as the President of Valley Bank, Mount Vernon, Washington, and in other senior management positions in other banks and a bank holding company.
Joseph W. Niemer. Mr. Niemer, 55, is the Executive Vice President and Chief Credit Officer of the Bank. Mr. Niemer has over 30 years of experience in various credit-related positions with Pacific Northwest-based banks. Most recently, he was the Senior Vice President and Chief Credit Officer for Washington Mutual Bank’s Commercial Group, where he oversaw commercial and commercial real estate credit decisions.
Richard A. Shields. Mr. Shields, 47, is the Executive Vice President and Chief Financial Officer of the Company and the Bank. Mr. Shields joined the Bank in 2004 and has over 20 years of experience in various accounting-related positions with Pacific Northwest-based banks. Most recently, he was the Vice President and Controller at Umpqua Bank that has grown substantially both organically and through multiple acquisitions.
John L. Wagner. Mr. Wagner, 63, is the Executive Vice President and Chief Operating Officer of the Bank. He joined the Bank in 1999 as Senior Vice President and Regional Manager in Whatcom County. In 2002, Mr. Wagner was selected to oversee branch administration and was promoted to COO in 2004. Mr. Wagner has an extensive background in banking and international finance as well as comprehensive administrative experience as former President of Bank of Washington in Bellingham, Washington.
Employees
The Company had 324 full time equivalent employees at December 31, 2006. None of the Company’s employees are covered by a collective bargaining agreement or represented by a collective bargaining group. Management considers its relations with employees to be good.
The Bank, provides services through twenty bank branches in five counties located in northwestern Washington. In addition to the President, the Bank has an established management team of senior executives who are fully involved and responsible for theday-to-day business of the Bank.
Supervision and Regulation
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 (“BHC Act”) registered with and subject to examination by the Federal Reserve Board (“FRB”). The Bank is a Washington state-chartered commercial bank and is subject to examination, supervision and regulation by the Washington State Department of Financial Institutions – Division of Banks (“Division”). FDIC insures the Bank’s deposits and in that capacity also regulates the Bank.
The Company’s earnings and activities are affected by legislation, by actions of the FRB, the Division, the FDIC and other regulators, by local legislative and administrative bodies, and by decisions of courts in Washington State. These include limitations on the ability of the Bank to pay dividends to the Company, and numerous federal and state consumer protection laws imposing requirements on the making, enforcement, and collection of consumer loans, and restrictions by regulators on the sale of mutual funds and other uninsured investment products to customers.
Gramm-Leach-Bliley Financial Services Modernization Act. Congress enacted major federal financial institution reform legislation in 1999. Title I of the Gramm-Leach-Bliley Act (the “GLB Act”), which became effective March 11, 2000, allows bank holding companies to elect to become financial holding companies. In addition to activities previously permitted bank holding companies, financial holding companies may engage in nonbanking activities that are financial in nature, such as securities, insurance and merchant banking activities, subject to certain limitations.
The activities of bank holding companies, such as the Company that are not financial holding companies, are generally limited to managing or controlling banks. A bank holding company is required to obtain the prior
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approval of the FRB for the acquisition of more than 5% of the outstanding shares of any class of voting securities or substantially all of the assets of any bank or bank holding company. Nonbank acquisitions by bank holding companies such as the Company are generally limited to 5% of voting shares of a company and activities previously determined by the FRB by regulation or order to be so closely related to banking as to be a proper incident to banking or managing or controlling banks.
The GLB Act also included the most extensive consumer privacy provisions ever enacted by Congress. These provisions, among other things, require full disclosure of the Company’s privacy policy to consumers and mandate offering the consumer the ability to “opt out” of having non-public personal information disclosed to third parties. Pursuant to these provisions, the federal banking regulators have adopted privacy regulations. In addition, the states are permitted to adopt more extensive privacy protections through legislation or regulation. The Company does not disclose any nonpublic personal information about its customers or former customers to anyone, except as permitted by law.
Additional legislation may be enacted or regulations imposed to further regulate banking and financial services or to limit finance charges or other fees or charges earned in such activities. There can be no assurance whether any such legislation or regulation will place additional limitations on the Company’s operations or adversely affect its earnings.
There are various legal restrictions on transactions between the Company and any nonbank subsidiaries, and between the Company and the Bank. With certain exceptions, federal law also imposes limitations on, and requires collateral for, extensions of credit by insured depository institutions, such as the Bank, to their nonbank affiliates, such as the Company.
Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (“Interstate Act”) permits nationwide interstate banking and branching under certain circumstances. Subject to certain limitations and restrictions, a bank holding company, with prior approval of the FRB, may acquire anout-of-state bank. Banks in states that do not prohibitout-of-state mergers may merge with the approval of the appropriate federal banking agency. A state bank may establish a de novo branch out of state if such branching is expressly permitted by the other state.
Federal and State Bank Regulation. Among other things, applicable federal and state statutes and regulations which govern a bank’s activities relate to minimum capital requirements, required reserves against deposits, investments, loans, legal lending limits, mergers and consolidations, borrowings, issuance of securities, payment of dividends, establishment of branches and other aspects of its operations. The Division and the FDIC also have authority to prohibit banks under their supervision from engaging in what they consider to be unsafe and unsound practices.
Specifically with regard to the payment of dividends, there are certain limitations on the ability of the Company to pay dividends to its shareholders. It is the policy of the FRB that bank holding companies should pay cash dividends on common stock only out of income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries.
Various federal and state statutory provisions also limit the amount of dividends that subsidiary banks can pay to their holding companies without regulatory approval. Additionally, depending upon the circumstances, the FDIC or the Division could take the position that paying a dividend would constitute an unsafe or unsound banking practice.
Under longstanding FRB policy, a bank holding company is expected to act as a source of financial strength for its subsidiary banks and to commit resources to support such banks. The Company could be required to commit resources to the Bank in circumstances where it might not do so, absent such policy.
The Bank is required to file periodic reports with the FDIC and the Division and is subject to periodic examinations and evaluations by those regulatory authorities. These examinations must be conducted every
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12 months. The FDIC and the Division may each accept the results of an examination by the other in lieu of conducting an independent examination.
In the liquidation or other resolution of a failed insured depository institution, deposits in offices and certain claims for administrative expenses and employee compensation are afforded a priority over other general unsecured claims, including nondeposit claims, and claims of a parent company such as the Company. Such priority creditors would include the FDIC, which succeeds to the position of insured depositors
Capital Adequacy. The Company and the Bank are subject to risk-based capital and leverage guidelines issued by federal banking agencies for banks and bank holding companies. These agencies are required by law to take specific prompt corrective actions with respect to institutions that do not meet minimum capital standards. As of December 31, 2006, the Company and the Bank exceeded the minimum capital standards.
Sarbanes-Oxley Act of 2002. The Company is also subject to the periodic reporting, information disclosure, proxy solicitation, insider trading restrictions and other requirements of the Securities Exchange Act of 1934, including provisions of the Sarbanes Oxley Act of 2002.
USA Patriot Act of 2001. Under the USA Patriot Act of 2001 (“Patriot Act”), adopted by the U.S. Congress on October 26, 2001 to combat terrorism, FDIC-insured banks and commercial banks are required to increase their due diligence efforts for correspondent accounts and private banking customers. The Patriot Act requires the Bank to engage in additional record keeping or reporting, requiring identification of owners of accounts, or of the customers of foreign banks with accounts, and restricting or prohibiting certain correspondent accounts. While management believes that the Patriot Act may affect recordkeeping and reporting expenses to some degree, it does not believe that it will have a material adverse effect on the Company’s business and operations.
Effects of Governmental Monetary Policies
Profitability in banking depends on interest rate differentials. In general, the difference between the interest earned on a bank’s loans, securities and other interest-earning assets and the interest paid on a bank’s deposits and other interest-bearing liabilities is the major source of a bank’s earnings. Thus, the earnings and growth of the Company are affected not only by general economic conditions, but also by the monetary and fiscal policies of the United States and its agencies, particularly the FRB. The FRB implements national monetary policy for such purposes as controlling inflation and recession by its open market operations in United States government securities, control of the discount rate applicable to borrowing from the FRB and the establishment of reserve requirements against certain deposits. The actions of the FRB in these areas influence growth of bank loans, investments and deposits, and also affect interest rates charged on loans and paid on deposits. The nature and impact of future changes in monetary policies and their impact on the Company are not predictable.
Historical performance may not be indicative of future performance and, as noted elsewhere in this report, the Company has included forward-looking statements about its business, plans and prospects that are subject to change. Forward-looking statements are particularly located in, but not limited to, the sections Item 1 –Businessand Item 7 –Management’s Discussion and Analysis of Financial Condition and Results of Operations. In addition to the other risks or uncertainties contained in this report, the following risks may affect operating results, financial condition and cash flows. If any of these risks occur, either alone or in combination with other factors, the Company’s business, financial condition or operating results could be adversely affected. Moreover, readers should note this is not an exhaustive list; that some risks are unknown or not quantifiable, and other risks that are currently perceived as immaterial may ultimately prove more significant than expected. Statements about plans, predictions or expectations should not be construed to be assurances of performance or promises to take a given course of action.
Adequacy of the Allowance for Loan Losses. The Company has established a reserve for possible losses expected in connection with loans in the credit portfolio. This allowance reflects estimates of the collectibility
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of certain identified loans, as well as an overall risk assessment of total loans outstanding. The determination of the amount of loan loss allowance is subjective; although the method for determining the amount of the allowance uses criteria such as risk ratings and historical loss rates, these factors may not be adequate predictors of future loan performance. Accordingly, the Company cannot offer assurances that these estimates ultimately will prove correct or that the loan loss allowance will be sufficient to protect against losses that ultimately may occur. If the loan loss allowance proves to be inadequate, it may require unexpected charges to income, which would adversely impact results of operations and financial condition. Moreover, bank regulators frequently monitor banks’ loan loss allowances, and if regulators were to determine that the allowance was inadequate, they may require the Company to increase the allowance, which also would adversely impact revenues and financial condition.
Growth and Management. Financial performance and profitability will depend on the Company’s ability to manage recent growth and potential future growth. In addition, any future acquisitions and continued growth may present operating and other problems that could have an adverse effect on the Company’s business, financial condition and results of operations. Accordingly, there can be no assurance that the Company will be able to execute it’s growth strategy or maintain the level of profitability that it has achieved in the past.
Changes in Market Interest Rates. The Company’s earnings are impacted by changing interest rates. Changes in interest rates affect the demand for new loans, the credit profile of existing loans, the rates received on loans and securities, and rates paid on deposits and borrowings. The relationship between the rates received on loans and securities and the rates paid on deposits and borrowings is known as the net interest spread. Based on the Company’s current volume and mix of interest-bearing liabilities and interest-earning assets, net interest spread could be expected to increase during times when interest rates rise in a parallel shift along the yield curve and, conversely, to decline during times of similar falling interest rates. Exposure to interest rate risk is managed by monitoring the re-pricing frequency of rate-sensitive assets and rate-sensitive liabilities over any given period. Although management believes the current level of interest rate sensitivity is reasonable, significant fluctuations in interest rates could potentially have an adverse affect on the Company’s business, financial condition and results of operations.
Liquidity. Liquidity measures the ability to meet loan demand and deposit withdrawals and to service liabilities as they come due. Dramatic fluctuations in loan or deposit balances make it challenging to manage liquidity. A sharp reduction in deposits could force the Company to borrow heavily in the wholesale deposit market. In addition, rapid loan growth during periods of low liquidity could induce the Company to purchase federal funds from correspondent banks, borrow at the Federal Home Loan Bank of Seattle or Federal Reserve discount window, raise deposit interest rates and/or decline loans.
Geographic Concentration. Substantially, all of the Company’s business is derived from a five-county area in northwest Washington State. Employment opportunities within these communities have traditionally been primarily in the areas of military spending, oil and gas industries, tourism and manufacturing. Many of the markets served by the Company have quickly earned a reputation as desirable places for quality of life for families and entrepreneurs. While the Company’s expansion strategy has been built around these growing and diverse geographic markets, the Company’s business is, and will remain, sensitive to economic factors that relate to these industries and to local and regional business conditions. As a result, local or regional economic downturns, or downturns that disproportionately affect one or more of the key industries in the Company’s markets, may have a more pronounced effect upon it’s business than they might on an institution that is more broadly diverse in geographic concentration. The extent of the future impact of these events on economic and business conditions cannot be predicted; however, prolonged or acute fluctuations could have a material and adverse impact upon the Company’s results of operation and financial condition.
Regulation. The Company is subject to government regulation that could limit or restrict it’s activities, which in turn could adversely impact operations. The financial services industry is regulated extensively. Federal and state regulation is designed primarily to protect the deposit insurance funds and consumers, as well as shareholders. These regulations can sometimes impose significant limitations on operations. Moreover, federal and state banking laws and regulations undergo frequent, significant changes. Changes in laws and regulations may affect the cost of doing business, limit permissible activities (including insurance and
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securities activities), or the Company’s competitive position in relation to credit unions, savings associations and other financial institutions. These changes could also reduce federal deposit insurance coverage, broaden the powers or geographic range of financial holding companies, alter the taxation of financial institutions and change the structure and jurisdiction of various regulatory agencies.
Federal monetary policy, particularly as implemented through the Federal Reserve System, can significantly affect credit availability. Other federal legislation such as the Sarbanes-Oxley Act can dramatically shift resources and costs to ensure adequate compliance.
Competition. Competition may adversely affect the Company’s performance. The financial services business is becoming increasingly competitive due to changes in regulation, technological advances, and the accelerating pace of consolidation among financial services providers. The Company faces competition both in attracting deposits and in originating loans. Competition for loan’s principally through the pricing of interest rates and loan fees, and the efficiency and quality of services. Increasing levels of competition in the banking and financial services industries may reduce market share or cause the prices charged for services to fall. Results may differ in future periods depending upon the nature or level of competition.
Credit Risk. A source of risk arises from the possibility that losses will be sustained if a significant number of borrowers, guarantors and related parties fail to perform in accordance with the terms of their loans. The Company has adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for credit losses, which management believes are appropriate to minimize risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying the credit portfolio. These policies and procedures, however, may not prevent unexpected losses that could materially affect results of operations.
Item 1B. Unresolved Staff Comments
The Company had no unresolved staff comments from the Securities and Exchange Commission.
Item 2. Properties
The executive offices of the Company are located at 450 Southwest Bayshore Drive in Oak Harbor, WA in a building that is owned by the Company on leased land. The building also houses the Bank’s Oak Harbor branch. At December 31, 2006, the Bank conducted business at 20 branch locations, thirteen of which are owned by the Bank, including the main office in Coupeville, WA, and seven are leased under various agreements. The Company owns two additional facilities for administrative purposes.
The Company purchased property in the Smokey Point/ Arlington, WA area with plans to relocate the Smokey Point branch, which is currently leased. Purchase of the property closed during the fourth quarter of 2006. Management anticipates branch construction to begin during the second quarter of 2007.
Item 3. Legal Proceedings
The Company and its subsidiaries are, from time to time, defendants in, and are threatened with, various legal proceedings arising from regular business activities. Management believes that its liability for damages, if any, arising from such claims or contingencies will not have a material adverse effect on the Company’s results of operations, financial conditions or cash flows.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of securities holders of the Company during the quarter ended December 31, 2006.
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PART II
| |
| Item 5. | Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |
The Company’s common stock is traded on the Nasdaq Global Select Market System under the symbol “WBCO.”
The Company is aware that blocks of its stock are held in street name by brokerage firms. As a result, the number of shareholders of record does not include the actual number of beneficial owners of the Company’s stock. As of March 5, 2007, the Company’s common stock was held of record by approximately 335 shareholders, a number which does not include beneficial owners who hold shares in “street name.”
The following are the high and low adjusted closing prices for the Company’s stock as reported by the Nasdaq Global Select Market System and the quarterly cash dividends paid by the Company to its shareholders on a per share basis during 2006 and 2005, as adjusted for stock dividends and splits:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | 2006 | | 2005 |
| | | | | |
| | | High | | Low | | Dividend | | High | | Low | | Dividend |
| | | | | | | | | | | | | |
| First quarter | | $ | 15.52 | | | $ | 14.21 | | | $ | 0.050 | | | $ | 11.97 | | | $ | 10.65 | | | $ | 0.045 | |
| Second quarter | | | 17.97 | | | | 14.42 | | | | 0.050 | | | | 12.12 | | | | 10.20 | | | | 0.045 | |
| Third quarter | | | 18.39 | | | | 15.20 | | | | 0.050 | | | | 15.79 | | | | 12.20 | | | | 0.045 | |
| Fourth quarter | | | 18.09 | | | | 16.13 | | | | 0.050 | | | | 14.80 | | | | 13.60 | | | | 0.045 | |
The Company’s dividend policy requires the Board of Directors to review the Company’s financial performance, capital adequacy, cash resources, regulatory restrictions, economic conditions and other factors, and if such review is favorable, the Board may declare and pay dividends. For 1997 and prior years, cash dividends were paid on an annual basis. After completion of the initial public offering in 1998, the Company has paid cash dividends on a quarterly basis. On October 24, 2002, the Company distributed a 10% stock dividend, and on February 26, 2004, the Company distributed a 15% stock dividend. In addition, the Company declared a4-for-3 stock split, which was distributed on May 17, 2005 and a5-for-4 stock split, which was distributed on September 6, 2006. The ability of the Company to pay dividends will depend on the profitability of the Bank, the need to retain or increase capital, and the dividend restrictions imposed upon the Bank by applicable banking law. Although the Company anticipates payment of a regular quarterly cash dividend, future dividends are subject to these limitations and to the discretion of the Board of Directors, and could be reduced or eliminated.
Sales of Unregistered Securities
The Company had no sales of unregistered securities during the fourth quarter of 2006.
Purchases of Equity Securities
The Company had no purchases of its equity securities during the fourth quarter of 2006.
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Five-Year Stock Performance Graph
The following chart compares the yearly percentage change in the cumulative shareholder return on the Company’s common stock during the five years ended December 31, 2006, with (1) the Total Return for the NASDAQ Stock Market Index (which is a broad nationally recognized index of stock performance by companies traded on the NASDAQ Market System and the NASDAQ Small Cap Market) (2) the Total Return Index for SNL Bank NASDAQ (comprised of banks listed on the NASDAQ National Market System) and (3) Total Return for SNL Securities $500M to $1 Billion Bank Index (comprised of publicly-traded banks located in the U.S. with total assets between $500 million and $1 billion).
The graph assumes $100.00 was invested on December 31, 2001, in the Company’s common stock and the comparison groups and assumes the reinvestment of all cash dividends prior to any tax effect and retention of all stock dividends.
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Period Ending |
| | | |
| Index | | 12/31/01 | | 12/31/02 | | 12/31/03 | | 12/31/04 | | 12/31/05 | | 12/31/06 |
| |
| Washington Banking Company | | | 100.00 | | | | 140.71 | | | | 196.19 | | | | 256.30 | | | | 348.28 | | | | 405.95 | |
| NASDAQ Composite | | | 100.00 | | | | 68.76 | | | | 103.67 | | | | 113.16 | | | | 115.57 | | | | 127.58 | |
| SNL Bank NASDAQ | | | 100.00 | | | | 102.85 | | | | 132.76 | | | | 152.16 | | | | 147.52 | | | | 165.62 | |
| SNL Bank $500M-$1B | | | 100.00 | | | | 127.67 | | | | 184.09 | | | | 208.62 | | | | 217.57 | | | | 247.44 | |
Source: SNL Financial LC,
Charlottesville, VA (434) 977-1600© 2006
10
| |
| Item 6. | Selected Financial Data |
Consolidated Five-Year Statements of Operations and Selected Financial Data
The following table sets forth selected audited consolidated financial information and certain financial ratios for the Company. This information is derived in part from the audited consolidated financial statements and notes thereto of the Company set forth in Item 8 –Financial Statements and Supplementary Dataand should be read in conjunction with the Company’s financial statements and the management discussion set forth in Item 7 –Management’s Discussion and Analysis of Financial Condition and Results of Operations.
| | | | | | | | | | | | | | | | | | | | | | | | |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | | | 2003 | | 2002 |
| | | | | | | 2004 | | | | |
| | | | | | | | | | | |
| (Dollars in thousands, except per share amounts) | | |
Operating data: | | | | | | | | | | | | | | | | | | | | |
| | Total interest income | | $ | 55,443 | | | $ | 45,790 | | | $ | 38,464 | | | $ | 35,913 | | | $ | 34,785 | |
| | Total interest expense | | | 18,441 | | | | 11,566 | | | | 8,837 | | | | 8,737 | | | | 10,657 | |
| | | | | | | | | | | | | | | | | | | | | |
| | | Net interest income | | | 37,002 | | | | 34,224 | | | | 29,627 | | | | 27,176 | | | | 24,128 | |
| | Provision for loan losses | | | (2,675 | ) | | | (2,250 | ) | | | (3,500 | ) | | | (3,200 | ) | | | (3,866 | ) |
| | | | | | | | | | | | | | | | | | | | | |
| | | Net interest income after provision | | | 34,327 | | | | 31,974 | | | | 26,127 | | | | 23,976 | | | | 20,262 | |
| | Service charges on deposits | | | 3,296 | | | | 3,150 | | | | 2,986 | | | | 2,127 | | | | 1,801 | |
| | Other noninterest income | | | 3,696 | | | | 4,149 | | | | 3,685 | | | | 3,732 | | | | 3,224 | |
| | | | | | | | | | | | | | | | | | | | | |
| | | Total noninterest income | | | 6,992 | | | | 7,299 | | | | 6,671 | | | | 5,859 | | | | 5,025 | |
| | Noninterest expense | | | 27,530 | | | | 25,225 | | | | 23,267 | | | | 21,014 | | | | 17,231 | |
| | | | | | | | | | | | | | | | | | | | | |
| | | Income before income taxes | | | 13,789 | | | | 14,048 | | | | 9,531 | | | | 8,821 | | | | 8,056 | |
| | Provision for income taxes | | | 4,298 | | | | 4,580 | | | | 2,985 | | | | 2,798 | | | | 2,719 | |
| | | | | | | | | | | | | | | | | | | | | |
| | Loss from discontinued operations, net of tax | | | — | | | | — | | | | (370 | ) | | | (56 | ) | | | — | |
| | | | | | | | | | | | | | | | | | | | | |
| | | | Net income | | $ | 9,491 | | | $ | 9,468 | | | $ | 6,176 | | | $ | 5,967 | | | $ | 5,337 | |
| | | | | | | | | | | | | | | | | | | | | |
| Average number of shares outstanding, basic | | | 9,217,000 | | | | 9,098,000 | | | | 9,012,000 | | | | 8,902,000 | | | | 8,589,000 | |
| Average number of shares outstanding, diluted | | | 9,490,000 | | | | 9,428,000 | | | | 9,326,000 | | | | 9,248,000 | | | | 9,069,000 | |
Per share data(1): | | | | | | | | | | | | | | | | | | | | |
| | Net income per share, basic | | $ | 1.03 | | | $ | 1.04 | | | $ | 0.69 | | | $ | 0.67 | | | $ | 0.62 | |
| | Net income per share, diluted | | | 1.00 | | | | 1.00 | | | | 0.66 | | | | 0.65 | | | | 0.59 | |
| | Book value | | | 7.07 | | | | 6.27 | | | | 5.48 | | | | 4.97 | | | | 4.53 | |
| | Dividends | | | 0.20 | | | | 0.18 | | | | 0.18 | | | | 0.14 | | | | 0.13 | |
Balance sheet data: | | | | | | | | | | | | | | | | | | | | |
| | Total assets | | $ | 794,545 | | | $ | 725,976 | | | $ | 657,724 | | | $ | 581,741 | | | $ | 535,412 | |
| | Loans receivable | | | 719,580 | | | | 630,258 | | | | 579,980 | | | | 499,919 | | | | 430,074 | |
| | Allowance for loan losses | | | 10,048 | | | | 8,810 | | | | 7,903 | | | | 6,116 | | | | 5,514 | |
| | Other real estate owned | | | 363 | | | | — | | | | 1,222 | | | | 504 | | | | 592 | |
| | Federal funds sold | | | — | | | | 21,095 | | | | — | | | | 4,795 | | | | 23,000 | |
| | Deposits | | | 703,767 | | | | 637,489 | | | | 563,001 | | | | 501,497 | | | | 462,995 | |
| | Other borrowed funds | | | — | | | | 10,000 | | | | 5,000 | | | | 12,500 | | | | 15,000 | |
| | Junior subordinated debentures | | | 15,007 | | | | 15,007 | | | | 15,007 | | | | — | | | | — | |
| | Trust preferred securities | | | — | | | | — | | | | — | | | | 15,000 | | | | 15,000 | |
| | Shareholders’ equity | | | 66,393 | | | | 57,849 | | | | 49,591 | | | | 44,360 | | | | 39,432 | |
| |
| (1) | Per share data adjusted for the 5-for-4 stock split distributed on September 6, 2006, 4-for-3 stock split distributed on May 17, 2005, 15% stock dividend distributed February 26, 2004 and 10% stock dividend distributed October 24, 2002. |
11
(Continued)
| | | | | | | | | | | | | | | | | | | | | | |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 | | 2003 | | 2002 |
| | | | | | | | | | | |
Selected performance ratios: | | | | | | | | | | | | | | | | | | | | |
| | Return on average assets | | | 1.25% | | | | 1.37% | | | | 0.98% | | | | 1.06% | | | | 1.09% | |
| | Return on average equity | | | 15.36% | | | | 17.87% | | | | 13.37% | | | | 14.43% | | | | 14.41% | |
| | Net interest margin (fully tax-equivalent) | | | 5.29% | | | | 5.36% | | | | 5.15% | | | | 5.22% | | | | 5.36% | |
| | Net interest spread | | | 4.77% | | | | 5.02% | | | | 4.89% | | | | 4.92% | | | | 4.99% | |
| | Noninterest expense to average assets | | | 3.64% | | | | 3.64% | | | | 3.71% | | | | 3.73% | | | | 3.52% | |
| | Efficiency ratio (fully tax-equivalent) | | | 62.07% | | | | 60.37% | | | | 63.55% | | | | 62.96% | | | | 58.39% | |
| | Dividend payout ratio | | | 19.58% | | | | 16.97% | | | | 23.24% | | | | 21.63% | | | | 20.37% | |
Asset quality ratios: | | | | | | | | | | | | | | | | | | | | |
| | Nonperforming loans to period-end loans | | | 0.51% | | | | 0.34% | | | | 0.48% | | | | 0.83% | | | | 0.75% | |
| | Allowance for loan losses to period-end loans | | | 1.40% | | | | 1.40% | | | | 1.36% | | | | 1.22% | | | | 1.28% | |
| | Allowance for loan losses to nonperforming loans | | | 276.19% | | | | 408.06% | | | | 281.05% | | | | 147.09% | | | | 171.14% | |
| | Nonperforming assets to total assets | | | 0.50% | | | | 0.30% | | | | 0.61% | | | | 0.80% | | | | 0.71% | |
| | Net loan charge-offs to average loans outstanding | | | 0.21% | | | | 0.22% | | | | 0.32% | | | | 0.56% | | | | 0.64% | |
| | Capital ratios: | | | | | | | | | | | | | | | | | | | | |
| | Total risk-based capital | | | 11.52% | | | | 11.52% | | | | 11.40% | | | | 12.01% | | | | 12.80% | |
| | Tier 1 risk-based capital | | | 10.27% | | | | 10.28% | | | | 10.15% | | | | 10.85% | | | | 11.22% | |
| | Leverage ratio | | | 10.24% | | | | 10.26% | | | | 9.87% | | | | 10.17% | | | | 9.89% | |
| | Average equity to average assets | | | 8.17% | | | | 7.65% | | | | 7.36% | | | | 7.33% | | | | 7.57% | |
| | Other data: | | | | | | | | | | | | | | | | | | | | |
| | Number of banking offices | | | 20 | | | | 19 | | | | 18 | | | | 17 | | | | 17 | |
| | Number of full time equivalent employees | | | 324 | | | | 296 | | | | 289 | | | | 300 | | | | 247 | |
| |
| (1) | Per share data adjusted for the 5-for-4 stock split distributed on September 6, 2006, 4-for-3 stock split distributed on May 17, 2005, 15% stock dividend distributed February 26, 2004 and 10% stock dividend distributed October 24, 2002. |
Summary of Quarterly Financial Information
See Item 8 –Financial Statements and Supplementary Data, Note 21 – Selected Quarterly Financial Data (Unaudited).
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with Item 8 –Financial Statements and Supplementary Data.
Executive Overview
For the year ended December 31, 2006, the Company reported total assets of $794.5 million, total loans of $719.6 million, total deposits of $703.8 million and shareholders’ equity of $66.4 million. 2006 saw many achievements, some of which were not necessarily reflected in the operating results. Events in 2006 included:
| |
| • | Double-digit organic loan and deposit growth. For 2006 loan growth was 14% and deposit growth was 10%. |
| |
| • | Maintained strong credit quality standards, with net charge-offs of only 0.21% of average loans for 2006. The ratio of nonperforming assets to total assets at December 31, 2006 was 0.50%. |
| |
| • | Increased cash dividend by 14% to $0.05 per quarter. |
| |
| • | A 5-for-4 stock split distributed on September 6, 2006. |
| |
| • | Opened 20th branch; located in Bellingham, Washington. |
The Company also dealt with some challenges in the past year including:
| |
| • | Diluted earnings per share was flat at $1.00 for the years ended 2006 and 2005. During the fourth quarter of 2006, the Company took steps to address noninterest expense by restructuring backroom operations and reducing the workforce by twenty employees. The Company incurred a one-time restructuring charge of approximately $575,000 during the fourth quarter of 2006. |
12
| |
| • | The Company’s net interest margin compressed during 2006 due to increasing deposit costs, the inverted yield curve (where short-term interest rates were higher than longer term rates) and the structure of the Company’s balance sheet. The fully tax-equivalent net interest margin for 2006 was 5.29%, down 7 basis points from 2005. The Company expects continued net interest margin compression during 2007. |
Summary of Critical Accounting Policies
Significant accounting policies are described in Item 8 –Financial Statements and Supplementary Data, Note 1 – Summary of Significant Accounting Policies. 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: The allowance for loan losses is established to absorb known and inherent losses attributable to loans outstanding. The adequacy of the allowance is monitored on a regular basis and is based on management’s evaluation of numerous factors. These factors include the quality of the current loan portfolio; the trend in the loan portfolio’s risk ratings; current economic conditions; loan growth rates; past-due and nonperforming trends; historical charge-offs and recovery experience; and other pertinent information.
Stock-based Compensation: Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R,Share-Based Payment, a revision to the previously issued guidance on accounting for stock options and other forms of equity-based compensation.
Results of Operations Overview
Net income for the year 2006 was $9.5 million, compared with $9.5 million in 2005, and $6.2 million in 2004. Diluted earnings per share for the years ended 2006, 2005 and 2004 were $1.00, $1.00 and $0.66, respectively. Return on average equity decreased to 15.36% in 2006, compared with 17.87% in 2005. Return on average equity in 2004 was 13.37%.
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 volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities; |
| |
| • | The volume of free funds (consisting of noninterest-bearing deposits and other liabilities and shareholders’ equity); |
| |
| • | The volume of noninterest-earning assets; |
| |
| • | Market interest rate fluctuations; and |
| |
| • | Asset quality. |
13
The following tables set forth various components of the balance sheet that affect interest income and expense, and their respective yields or rates:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Net Interest Income Analysis as of: |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| | | Average | | Interest | | Average | | Average | | Interest | | Average | | Average | | Interest | | Average |
| (Dollars in thousands) | | balance | | earned/paid | | yield | | balance | | earned/paid | | yield | | balance | | earned/paid | | yield |
| | | | | | | |
Assets | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Loans(1)(2) | | $ | 682,939 | | | $ | 54,707 | | | | 8.01% | | | $ | 608,998 | | | $ | 44,707 | | | | 7.34% | | | $ | 547,462 | | | $ | 37,509 | | | | 6.85% | |
| Federal funds sold | | | 2,686 | | | | 135 | | | | 5.03% | | | | 12,365 | | | | 440 | | | | 3.56% | | | | 8,103 | | | | 111 | | | | 1.37% | |
| Interest-bearing cash | | | 844 | | | | 86 | | | | 10.19% | | | | 897 | | | | 28 | | | | 3.12% | | | | 699 | | | | 9 | | | | 1.29% | |
| Investments: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Taxable | | | 12,618 | | | | 414 | | | | 3.28% | | | | 14,158 | | | | 399 | | | | 2.82% | | | | 14,473 | | | | 434 | | | | 3.00% | |
| | Non-taxable(2) | | | 7,306 | | | | 459 | | | | 6.28% | | | | 6,810 | | | | 477 | | | | 7.00% | | | | 10,798 | | | | 715 | | | | 6.62% | |
| | | | | | | |
| Interest-earning assets | | | 706,393 | | | | 55,801 | | | | 7.90% | | | | 643,228 | | | | 46,051 | | | | 7.16% | | | | 581,535 | | | | 38,778 | | | | 6.67% | |
| Noninterest-earning assets | | | 50,384 | | | | | | | | | | | | 49,832 | | | | | | | | | | | | 45,819 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Total assets | | $ | 756,777 | | | | | | | | | | | $ | 693,060 | | | | | | | | | | | $ | 627,354 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Liabilities and Shareholders’ Equity | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Deposits: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Interest-bearing demand and money market | | $ | 231,316 | | | $ | 4,521 | | | | 1.95% | | | $ | 227,588 | | | $ | 2,485 | | | | 1.09% | | | $ | 212,519 | | | $ | 1,610 | | | | 0.76% | |
| | Saving deposits | | | 55,139 | | | | 432 | | | | 0.78% | | | | 57,131 | | | | 448 | | | | 0.78% | | | | 48,270 | | | | 381 | | | | 0.79% | |
| | Time deposits | | | 276,211 | | | | 11,604 | | | | 4.20% | | | | 224,002 | | | | 7,024 | | | | 3.14% | | | | 208,991 | | | | 5,632 | | | | 2.69% | |
| Interest-bearing deposits | | | 562,666 | | | | 16,557 | | | | 2.94% | | | | 508,721 | | | | 9,957 | | | | 1.96% | | | | 469,780 | | | | 7,623 | | | | 1.62% | |
| Fed funds purchased | | | 6,850 | | | | 362 | | | | 5.28% | | | | 5,740 | | | | 159 | | | | 2.77% | | | | 3,106 | | | | 46 | | | | 1.48% | |
| Junior subordinated debentures | | | 15,007 | | | | 1,337 | | | | 8.91% | | | | 15,007 | | | | 1,071 | | | | 7.14% | | | | 15,007 | | | | 782 | | | | 5.21% | |
| Other interest-bearing liabilities | | | 4,183 | | | | 185 | | | | 4.37% | | | | 9,846 | | | | 379 | | | | 3.85% | | | | 8,919 | | | | 386 | | | | 4.33% | |
| Interest-bearing liabilities | | | 588,706 | | | | 18,441 | | | | 3.13% | | | | 539,314 | | | | 11,566 | | | | 2.14% | | | | 496,812 | | | | 8,837 | | | | 1.78% | |
| Noninterest-bearing deposits | | | 100,267 | | | | | | | | | | | | 96,511 | | | | | | | | | | | | 81,146 | | | | | | | | | |
| Other noninterest-bearing liabilities | | | 6,004 | | | | | | | | | | | | 4,250 | | | | | | | | | | | | 3,193 | | | | | | | | | |
| Total liabilities | | | 694,977 | | | | | | | | | | | | 640,075 | | | | | | | | | | | | 581,151 | | | | | | | | | |
| Shareholders’ equity | | | 61,800 | | | | | | | | | | | | 52,985 | | | | | | | | | | | | 46,203 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Total liabilities and shareholders’ equity | | $ | 756,777 | | | | | | | | | | | $ | 693,060 | | | | | | | | | | | $ | 627,354 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Net interest income(2) | | | | | | $ | 37,362 | | | | | | | | | | | $ | 34,485 | | | | | | | | | | | $ | 29,941 | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Net interest spread | | | | | | | | | | | 4.77% | | | | | | | | | | | | 5.02% | | | | | | | | | | | | 4.89% | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
Net interest margin(2) | | | | | | | | | | | 5.29% | | | | | | | | | | | | 5.36% | | | | | | | | | | | | 5.15% | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| |
| (1) | Of this amount, loan fees accounted for $2,001, $1,003, and $1,342, for the years ended December 31, 2006, 2005 and 2004, respectively. Loan totals include both current and nonaccrual loans. |
| |
| (2) | Interest income on non-taxable assets is presented on a fully tax-equivalent basis using a federal statutory rate of 34.4%, 34.3% and 34%, for the years ended December 31, 2006, 2005 and 2004, respectively. These adjustments were $358, $259, and $316, for the years ended December 31, 2006, 2005 and 2004, respectively. |
Net interest income on a taxable-equivalent basis totaled $37.4 million at December 31, 2006 compared with $34.5 million in 2005. Changes in net interest income during the year were principally caused by an increase in average earning assets due to strong loan growth and higher yields on earning assets. The yields on interest earning assets increased 74 basis points to 7.90% at December 31, 2006. However, the interest rate spread contracted 25 basis points in 2006 to end the year at 4.77%. This contraction in the spread was due to competitive pressure on loan and deposit pricing during 2006. This pricing pressure caused the average cost of interest-bearing liabilities to increase 99 basis points during 2006, which was exacerbated by the change in deposit mix towards higher cost time deposit and money market products. The Company expects continued net interest margin compression during 2007, although not to the same degree as seen in the second half of 2006.
In 2005, net interest income on a tax equivalent basis increased 15% to $34.5 million at December 31, 2005. Changes in net interest income was principally due to an increase in average earning assets due to strong loan
14
growth and higher yields on earning assets. Loans, the largest component of earning assets, increased an average of $61.5 million, compared with 2004. The yield on earning assets increased 49 basis points in 2005 to end the year at 7.16%. This increase was due to repricing of variable rate loans, as well as higher rates on new loan originations in 2005 compared with 2004. Average interest-bearing liabilities increased $42.5 million in 2005 compared with 2004. The cost of interest-bearing liabilities increased 36 basis points during 2005 to end the year at 2.14%. The increase was primarily the result of an increase in the cost of time deposits and to a lesser extent interest-bearing demand and money market accounts. The cost of interest-bearing deposits generally increased during 2005 as a result of increases in short term interest rates. These changes caused the interest rate spread to widen 0.13% to 5.02% in 2005 and the net interest margin widened 0.21 % to 5.36%. The net interest margin widened by more than the spread due to an increase of $15.4 million in average noninterest-bearing sources of funds.
The following table details the effects of the interest changes over the last two years:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Interest Rate & Volume Analysis |
| | | 2006 compared to 2005 | | 2005 compared to 2004 |
| | | | | |
| | | Increase (decrease) due to(2) | | Increase (decrease) due to(2) |
| | | | | |
| | | Volume | | Rate | | Total | | Volume | | Rate | | Total |
| (Dollars in thousands) | | | | | | | | | | | | |
Loans(1)(3) | | $ | 5,711 | | | $ | 4,289 | | | $ | 10,000 | | | $ | 4,400 | | | $ | 2,798 | | | $ | 7,198 | |
| Federal funds sold | | | (645) | | | | 340 | | | | (305) | | | | 81 | | | | 248 | | | | 329 | |
| Interest-earning cash | | | (2) | | | | 60 | | | | 58 | | | | 3 | | | | 16 | | | | 19 | |
Securities(1) | | | 14 | | | | (17) | | | | (3) | | | | (185) | | | | (88) | | | | (273) | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | Total interest income | | $ | 5,078 | | | $ | 4,672 | | | $ | 9,750 | | | $ | 4,299 | | | $ | 2,974 | | | $ | 7,273 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing demand deposits | | $ | 41 | | | $ | 1,995 | | | $ | 2,036 | | | $ | 121 | | | $ | 754 | | | $ | 875 | |
| Savings deposits | | | (16) | | | | — | | | | (16) | | | | 69 | | | | (2) | | | | 67 | |
| Time deposits | | | 1,863 | | | | 2,717 | | | | 4,580 | | | | 425 | | | | 966 | | | | 1,391 | |
| Fed funds purchased | | | 36 | | | | 167 | | | | 203 | | | | 56 | | | | 57 | | | | 113 | |
| Junior subordinated debentures | | | — | | | | 266 | | | | 266 | | | | — | | | | 289 | | | | 289 | |
| Trust preferred securities | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | |
| Other borrowings | | | (257) | | | | 61 | | | | (196) | | | | 144 | | | | (150) | | | | (6) | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | Total interest expense | | $ | 1,667 | | | $ | 5,206 | | | $ | 6,873 | | | $ | 815 | | | $ | 1,914 | | | $ | 2,729 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| |
| (1) | Interest income on non-taxable investments is presented on a fully tax-equivalent basis using the federal statutory rate of 34.4%, 34.3% and 34.0%, for the years ended December 31, 2006, 2005 and 2004, respectively. |
| |
| (2) | The changes attributable to the combined effect of volume and interest rates have been allocated proportionately. |
| |
| (3) | Interest income previously accrued on nonaccrual loans is reversed in the period the loan is placed on nonaccrual status. |
Provision for Loan Losses: The provision for loan losses is highly dependent on the Company’s ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, decline in general economic conditions could increase future provisions for loan loss and materially impact the Company’s net income. For further discussion of the Company’s asset quality see the Credit Risks and Asset Quality section found in Item 7 –Management’s Discussion and Analysis of Financial Condition and Results of Operations.
In 2006, the provision for loan losses increased 19% to $2.7 million, compared with $2.3 million in 2005. Changes in the provision were due to slightly higher net charge-offs of $1.4 million in 2006, compared with $1.3 million in 2005 and continued loan portfolio growth as compared to 2005. During 2006, the allowance for loan losses as a percent of total loans remained the same at 1.40% as compared to 2005.
In 2005, the provision for loan losses declined 36% to $2.3 million, compared with $3.5 million in 2004. Changes in the provision were due lower net charge-offs of $1.3 million in 2005, compared with $1.7 million in 2004 and overall improved credit quality of the loan portfolio. During 2005, the allowance for loan losses as a percent of total loans increased to 1.40%, compared with 1.36% in 2004.
Noninterest Income: Noninterest income remains a key focus of the Company. Since 2004, the Company has focused on diversifying the noninterest income mix. In 2004, 63% of noninterest income consisted of
15
income from sale of loans and service charges, while in 2005, 54% of noninterest income was derived from these products. In 2006, 57% of noninterest income came from income from sale of loans and service charges. The diversification of the noninterest income mix resulted primarily from the introduction of nondeposit investment products consisting primarily of annuity sales, and investment service fees, and income from the Company’s Bank Owned Life Insurance (“BOLI”) product.
In 2006, noninterest income declined 4% to $7.0 million, compared with $7.3 million in 2005. Changes in noninterest income were primarily due to increases in service charges and fees of $146,000 and electronic banking fees of $288,000 as compared to 2005. These increases in noninterest income were offset by a decline in annuity sales commissions of $388,000, Small Business Administration (“SBA”) loan sale premiums of $418,000 and income from the sale of mortgage loans of $64,000 as compared to 2005.
In 2005, noninterest income increased 9% to $7.3 million as compared to $6.7 million in 2004. Changes in noninterest income were primarily attributed to increases in annuity sales of $580,000 (the first year this product was offered), service charges and fees of $164,000, SBA loan sale premiums of $198,000 and electronic banking fees of $152,000 as compared to 2004. The Company’s BOLI product was purchased in July 2004. In 2005, the Bank realized a full year of income from this product, which represented an additional $124,000 of noninterest income as compared to 2004. These increases were offset by a decline in income from the sale of mortgage loans of $410,000.
Noninterest Expense: The Company continues to focus on controlling noninterest expenses and addressing long term operating expenses. As a result of consolidating back office operations and improving operating efficiencies, the Company continued to successfully manage noninterest expense in 2006 and 2005. Due to this focused effort, noninterest expense grew by only $2.3 million, $2.0 million and $2.3 million in 2006, 2005 and 2004, respectively.
The Company’s efficiency ratio increased to 62.07% in 2006 as compared to 60.37% in 2005 and 63.55% in 2004. As detailed in the table below, the 2006 efficiency ratio was directly impacted by a one time restructuring charge of $575,000 and increases in salaries and benefits.
| | | | | | | | | | | | | | | | | | | | | | |
| | | Years Ended December 31 | | | | |
| | | | | Change | | Change |
| | | 2006 | | 2005 | | 2004 | | 2006 vs. 2005 | | 2005 vs. 2004 |
| | | | | | | | | | | |
| (Dollars in thousands) | | | | | | | | | | |
| Salaries and benefits | | $ | 19,757 | | | $ | 18,004 | | | $ | 16,585 | | | $ | 1,753 | | | $ | 1,419 | |
| | Less: loan origination costs | | | (2,950) | | | | (2,918) | | | | (2,841) | | | | (32) | | | | (77) | |
| | | | | | | | | | | | | | | | | | | | | |
| Net salaries and benefits (as reported) | | | 16,807 | | | | 15,086 | | | | 13,744 | | | | 1,721 | | | | 1,342 | |
| Occupancy expense | | | 3,596 | | | | 3,373 | | | | 3,278 | | | | 223 | | | | 95 | |
| Office supplies and printing | | | 640 | | | | 659 | | | | 644 | | | | (19) | | | | 15 | |
| Restructuring Charge | | | 575 | | | | — | | | | — | | | | 575 | | | | — | |
| Data processing | | | 479 | | | | 493 | | | | 490 | | | | (14) | | | | 3 | |
| Consulting and professional fees | | | 769 | | | | 829 | | | | 793 | | | | (60) | | | | 36 | |
| Other | | | 4,664 | | | | 4,785 | | | | 4,318 | | | | (121) | | | | 467 | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total noninterest expense | | $ | 27,530 | | | $ | 25,225 | | | $ | 23,267 | | | $ | 2,305 | | | $ | 1,958 | |
| | | | | | | | | | | | | | | | | | | | | |
The increase in salaries and benefits expense in 2006 was primarily a result of the following items:
| |
| • | The Company recorded $133,000 of pre-tax stock option expense in 2006 under SFAS No. 123R, “Share-Based Payment”, compared to no stock option expense in 2005. Additionally, the Company issued restricted stock awards in 2005 and 2006 which attributed an additional $183,000 of expense in 2006. See Item 8 –Financial Statements and Supplementary Data, Note 12 – Stock Incentive Plans. |
| |
| • | Salaries increased by $1.5 million or 10% compared to 2005. The increase was attributable to general wage increases and commissions paid on sales of nondeposit investment products. The Company’s number of full time equivalent employees increased to 324 from 296 at December 31, 2006 and 2005, respectively. However, in December 2006, the Company eliminated twenty positions within the Bank; this reduction in workforce was primarily in back office operations. The Company recorded a one-time restructuring charge of $575,000 consisting primarily of severance packages and early vesting of stock awards. |
16
| |
| • | Employee benefits paid by the Company increased $139,000 or 9% as compared to 2005. This increase was due primarily to increased costs of health insurance. |
The increase in salaries and benefits expense in 2005 was a result of:
| |
| • | Employee benefits paid by the Company increased $296,000 or 15% as compared to 2004. This increase was due primarily to increased costs of health insurance. Additionally, the Company issued restricted stock awards in March 2005 with related costs of approximately $97,000. See Item 8 –Financial Statements and Supplementary Data, Note 12 – Stock Incentive Plans. |
| |
| • | Salaries increased by $692,000 or 5% compared to 2004. The increase was attributable to general wage increases and commissions paid on sales of nondeposit investment products. The Company’s number of full time equivalent employees remained relatively flat with 296 and 289 at December 31, 2005 and 2004, respectively. |
| |
| • | Bonuses for 2005 increased by $473,000. The increase in bonus expense was consistent with the performance of the Company and the achievement of goals set by senior management for 2005. |
The changes in other categories of noninterest expenses in 2006 and 2005 were related to the following areas:
| |
| • | Occupancy expense was $3.6 million in 2006 compared to $3.4 million and $3.3 million in 2005 and 2004, respectively. The increase in occupancy expense was primarily due to the addition of new locations. |
| |
| • | In 2006, the Company incurred $125,000 of consulting and audit fees related to regulations of Section 404 of the Sarbanes Oxley Act of 2002 (“SOX”) compared to $212,000 in related SOX expense for 2005 and minimal expense in 2004. This change was due to the Company’s required implementation of SOX Section 404 in 2005 and related consulting and audit expenses in ensuring the Company’s compliance. |
| |
| • | The Company had related expenses on several foreclosed properties totaling $43,000, $253,000, and $54,000 in 2006, 2005 and 2004, respectively. These properties were subsequently sold. For further details concerning foreclosed properties, see the Credit Risks and Asset Quality section found in Item 7 –Management’s Discussion and Analysis of Financial Condition and Results of Operations. |
| |
| • | Washington State business and occupation tax (“B&O”) paid in 2005 increased $177,000 compared with the previous year. This increase was consistent with the Company’s increase in gross income for 2005. |
Income Tax: The Company’s consolidated effective tax rate, as a percentage of pre-tax income from continuing operations, decreased to 31.17%, in 2006 compared to an effective tax rate of 31.60% and 31.32% for 2005 and 2004, respectively. The effective tax rate is lower than the federal statutory rate of 35.00% due to nontaxable income generated from investments in BOLI, tax-exempt municipal bonds and loans. Additionally, the Company’s 2006 tax rate reflects a benefit from the New Market Tax Credit Program whereby a subsidiary of the Bank will be 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. Additional information on income taxes is provided in Item 8 –Financial Statements and Supplementary Data,Note 9 – Income Taxes.
Financial Condition Overview
In 2006, the Company continued to focus on growing its loan portfolio and deposit funding base. Loans at December 31, 2006 grew 14% to $719.6 million compared to $630.3 million at December 31, 2005. Deposits at December 31, 2006 grew 10% to $703.7 million compared to $637.5 million at December 31, 2005. Shareholders’ equity increased $8.5 million to $66.4 million, with a book value of $7.07 per share at December 31, 2006. The Company’s ability to sustain continued loan and deposit growth is dependent on many factors, including the effects of competition, economic conditions, retention of key personnel and valued customers, and the Company’s ability to close loans.
Investment Securities: The composition of the Company’s investment portfolio reflects management’s investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of
17
investment income. The investment securities portfolio mitigates interest rate risk inherent in the loan portfolio, while providing a vehicle for the investment of available funds and a source of liquidity.
In 2006, total investment securities decreased $2.3 million compared to 2005. The decrease was a result of the maturity of investment securities that were not replaced due to the low rate environment coupled with an anticipated increase in loan demand. During 2005, the Company’s investment portfolio was relatively unchanged from 2004. In 2005, securities maturing or sold were reinvested in equivalent securities. The Company’s investment portfolio mix, based upon amortized cost, is outlined in the table below:
| | | | | | | | | | | | | | |
| | | Investment Portfolio as of: |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| (Dollars in thousands) | | | | | | |
| U.S. government agency securities | | $ | 9,872 | | | $ | 10,361 | | | $ | 10,842 | |
| Pass-through securities | | | 101 | | | | 127 | | | | 220 | |
| Corporate obligations | | | — | | | | 987 | | | | 987 | |
| Preferred stock | | | — | | | | — | | | | 504 | |
| State & political subdivisions | | | 6,817 | | | | 7,602 | | | | 7,111 | |
| | | | | | | | | | | | | |
| | Total(1) | | $ | 16,790 | | | $ | 19,077 | | | $ | 19,304 | |
| | | | | | | | | | | | | |
| |
| (1) | No investment in aggregate, to a single issuer, exceeds 10% of shareholders’ equity. |
The average life of the Company’s investment portfolio in 2006 increased to 3.9 years from 3.2 years in 2005. The following table further details the Company’s investment portfolio, based upon market value at December 31, 2006. Additional information about the investment portfolio is provided in Item 8 - Financial Statements and Supplementary Data,Note 3-Investment Securities.
| | | | | | | | | | | | | | | | | | | | | | |
| | | Investment Portfolio Maturities and Average Yield |
| | | December 31, 2006 |
| | | |
| | | Within | | | | Over | | |
| | | 1 Year | | 1-5 Years | | 5-10 Years | | 10 Years | | Total |
| (Dollars in thousands) | | | | | | | | | | |
| U.S. government agency securities | | | | | | | | | | | | | | | | | | | | |
| | Balance | | $ | 2,984 | | | $ | 6,888 | | | $ | — | | | $ | — | | | $ | 9,872 | |
| | Weighted average yield | | | 3.90% | | | | 4.79% | | | | — | | | | — | | | | 4.44% | |
| Pass-through securities | | | | | | | | | | | | | | | | | | | | |
| | Balance | | | — | | | | 101 | | | | — | | | | — | | | | 101 | |
| | Weighted average yield | | | — | | | | 5.37% | | | | — | | | | — | | | | 5.37% | |
| State and political subdivisions | | | | | | | | | | | | | | | | | | | | |
| | Balance | | | 1,826 | | | | 2,469 | | | | 2,522 | | | | — | | | | 6,817 | |
| | Weighted average yield | | | 4.44% | | | | 4.10% | | | | 3.87% | | | | — | | | | 4.07% | |
| | | | | | | | | | | | | | | | | | | | | |
| Total balance | | $ | 4,810 | | | $ | 9,458 | | | $ | 2,522 | | | $ | — | | | $ | 16,790 | |
| | | | | | | | | | | | | | | | | | | | | |
| Weighted average yield | | | 4.10% | | | | 4.60% | | | | 3.87% | | | | — | | | | 3.84% | |
Loans: Interest and fees earned on the Company’s loan portfolio is the primary source of revenue. In 2006, loans increased 14% or $89.3 million, compared to 2005. In 2006, commercial real estate and construction segments were the primary source of growth, adding an additional $59.6 million in loans. The Company attempts 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 solid loan growth and a
18
diversified portfolio that is not heavily concentrated in any one industry or in any one community. The following table further details the loan portfolio:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Loan Portfolio Composition as of: |
| | | | | December 31 |
| | | | | |
| | | | | 2006 | | | | 2005 | | | | 2004 | | | | 2003 | | | | 2002 |
| | | | | | | | | | | | | | | | | | | | | |
| | | | | | | % of | | | | | | % of | | | | | | % of | | | | | | % of | | | | | | % of |
| (Dollars in thousands) | | | | Balance | | total | | | | Balance | | total | | | | Balance | | Total | | | | Balance | | Total | | | | Balance | | Total |
| | | | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | | 82,990 | | 11.6% | | $ | | 79,341 | | 12.6% | | $ | | 80,927 | | 14.0% | | $ | | 87,371 | | 17.5% | | $ | | 91,816 | | 21.4% |
| Real estate mortgages: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | One-to-four family residential | | | | 54,509 | | 7.6% | | | | 45,278 | | 7.2% | | | | 46,242 | | 8.0% | | | | 35,209 | | 7.1% | | | | 40,177 | | 9.3% |
| | Commercial | | | | 249,109 | | 34.7% | | | | 218,260 | | 34.7% | | | | 173,280 | | 29.9% | | | | 133,539 | | 26.7% | | | | 94,404 | | 22.0% |
| | | | | | | | | | | | | | | | | | | | | |
| | | Total real estate mortgages | | | | 303,618 | | 42.3% | | | | 263,538 | | 41.9% | | | | 219,522 | | 37.9% | | | | 168,748 | | 33.8% | | | | 134,581 | | 31.3% |
| Real estate construction | | | | 142,436 | | 19.8% | | | | 113,661 | | 18.1% | | | | 105,940 | | 18.3% | | | | 70,974 | | 14.2% | | | | 40,112 | | 9.4% |
| Consumer | | | | 188,535 | | 26.3% | | | | 172,715 | | 27.4% | | | | 172,249 | | 29.8% | | | | 171,734 | | 34.5% | | | | 162,141 | | 37.9% |
| | | | | | | | | | | | | | | | | | | | | |
| | | Subtotal | | | | 717,579 | | 100.0% | | | | 629,255 | | 100.0% | | | | 578,638 | | 100.0% | | | | 498,827 | | 100.0% | | | | 428,650 | | 100.0% |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Less: allowance for loan losses | | | | (10,048) | | | | | | (8,810) | | | | | | (7,903) | | | | | | (6,116) | | | | | | (5,514) | | |
| Deferred loan fees, net | | | | 2,001 | | | | | | 1,003 | | | | | | 1,342 | | | | | | 1,092 | | | | | | 1,424 | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Loans, net | | $ | | 709,532 | | | | $ | | 621,448 | | | | $ | | 572,077 | | | | $ | | 493,803 | | | | $ | | 424,560 | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
The Company’s loan portfolio is comprised of the following loan types:
| |
| • | Commercial Loans: Commercial loans include both secured and unsecured loans for working capital and expansion. Short-term working capital loans generally are secured by accounts receivable, inventory and/or equipment, while longer-term commercial loans are usually secured by equipment. |
| |
| • | Real Estate Mortgage Loans: Real estate loans consist of two types:one-to-four family residential and commercial properties. |
| | |
| | + | One-to-Four Family Residential Loans:One-to-four family residential loans are secured principally by 1st deeds of trust on residential properties principally located within the Company’s market area. |
| |
| | + | Commercial Real Estate Loans: Commercial real estate loans are secured principally by manufacturing facilities, apartment buildings and commercial buildings for office, storage and warehouse space. Loans secured by commercial real estate may involve a greater degree of risk thanone-to-four family residential loans. Payments on such loans are often dependent on successful business management operations. |
| |
| • | Real Estate Construction Loans: Real estate construction loans consist of three types: 1) commercial real estate, 2) one-to-four family residential construction, and 3) speculative construction. |
| | |
| | + | Commercial Real Estate: Commercial real estate construction loans are primarily for owner-occupied properties. |
| |
| | + | One-to-Four Family Residential:One-to-four family residential construction loans are for the construction of custom homes, where the homebuyer is the borrower. |
| |
| | + | Speculative Construction: Speculative construction provides financing to builders for the construction of pre-sold homes and speculative residential construction. With few exceptions, the Company limits the number of unsold homes being built by each builder. The Company lends to qualified builders who are building in markets that management believes it understands and in which it is comfortable with the economic conditions. |
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| |
| • | Consumer Loans: The Company’s consumer loan portfolio consists of automobile loans, boat and recreational vehicle financing, home equity and home improvement loans, and miscellaneous secured and unsecured personal loans. |
| | |
| | + | Direct Consumer Loans: Direct consumer loans consist of automobile loans, boat and recreational vehicle financing, home equity and home improvement loans, and miscellaneous secured and unsecured personal loans originated directly by the Bank’s loan officers. |
| |
| | + | Indirect Consumer Loans: The Company makes loans for new and used automobile and recreational vehicles that are originated indirectly by selected dealers located in the Company’s market areas. The Company has limited its indirect loan purchases primarily to dealerships that are established and well known in their market areas and to applicants that are not classified as sub-prime. |
The Company makes certain loans which are guaranteed by the SBA. The SBA, an independent agency of the federal government, provides loan guarantees to qualifying small and medium sized businesses for up to 85% of the principal loan amount. The Company currently sells the guaranteed portion of each loan to investors in the secondary market. The guaranteed portion of an SBA loan is generally sold at a premium. In 2006, the Company sold total guaranteed portions of SBA loans in the amount of $5.4 million, compared with $8.0 million in 2005. The Company retains the unguaranteed portion of the loan. The retained portion of the SBA loan is classified within the portfolio by loan type.
Specific types of loans within the Company’s portfolio are more sensitive to interest rate changes. Commercial and real estate construction loan interest rates are primarily based upon current market rates plus a basis point spread charged by the Company. To better understand the Company’s risk associated with these loans, the following table sets forth the maturities by loan type:
| | | | | | | | | | | | | | | | | | | |
| | | Maturity and Sensitivity of Loans |
| | | to Changes in Interest Rates |
| | | Maturing |
| | | |
| | | Within 1 Year | | 1-5 Years | | After 5 Years | | Total |
| (Dollars in thousands) | | | | | | | | |
| Commercial | | $ | 31,018 | | | $ | 26,424 | | | $ | 25,548 | | | $ | 82,990 | |
| Real estate construction: | | | | | | | | | | | | | | | | |
| | One-to-four family residential | | | 60,041 | | | | 33,016 | | | | 3,050 | | | | 96,107 | |
| | Commercial | | | 35,296 | | | | 7,172 | | | | 3,861 | | | | 46,329 | |
| | | | | | | | | | | | | | | | | |
| Total real estate construction | | | 95,337 | | | | 40,188 | | | | 6,911 | | | | 142,436 | |
| | | | | | | | | | | | | | | | | |
| | | Total | | $ | 126,355 | | | $ | 66,612 | | | $ | 32,459 | | | $ | 225,426 | |
| | | | | | | | | | | | | | | | | |
| Fixed-rate loans | | $ | 30,265 | | | $ | 29,120 | | | $ | 6,483 | | | $ | 65,868 | |
| Variable-rate loans | | | 96,090 | | | | 37,492 | | | | 25,976 | | | | 159,558 | |
| | | | | | | | | | | | | | | | | |
| | | Total | | $ | 126,355 | | | $ | 66,612 | | | $ | 32,459 | | | $ | 225,426 | |
| | | | | | | | | | | | | | | | | |
20
Credit Risks and Asset Quality
Credit Risks: The extension of credit, in the form of loans or other credit substitutes, to individuals and businesses is a major portion of the Company’s principal business activity. Company policies and applicable laws and regulations require risk analysis as well as ongoing portfolio and credit management.
The Company manages its credit risk through lending limit constraints, credit review, approval policies and extensive, ongoing internal monitoring. Through this monitoring process, nonperforming loans are identified. Nonperforming assets consist of nonaccrual loans, restructured loans, past due loans and other real estate owned. Additional information on nonperforming assets is provided in Item 8 –Financial Statements and Supplementary Data, Note 1 – Significant Accounting Policies. Nonperforming assets are assessed for potential loss exposure on an individual or homogeneous group basis. Further details on the loss analysis are provided below in the Allowance for Loan Losses section. The following table summarizes the Company’s nonperforming assets for the past five years:
| | | | | | | | | | | | | | | | | | | | | | |
| | | Nonperforming Assets as of: |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 | | 2003 | | 2002 |
| (Dollars in thousands) | | | | | | | | | | |
| Nonaccrual loans | | $ | 3,638 | | | $ | 2,159 | | | $ | 2,812 | | | $ | 4,158 | | | $ | 3,222 | |
| Restructured loans | | | — | | | | — | | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total nonperforming loans | | | 3,638 | | | | 2,159 | | | | 2,812 | | | | 4,158 | | | | 3,222 | |
| Other real estate owned | | | 363 | | | | — | | | | 1,222 | | | | 504 | | | | 592 | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total nonperforming assets | | $ | 4,001 | | | $ | 2,159 | | | $ | 4,034 | | | $ | 4,662 | | | $ | 3,814 | |
| | | | | | | | | | | | | | | | | | | | | |
| Impaired loans | | $ | 4,001 | | | $ | 2,159 | | | $ | 3,417 | | | $ | 6,721 | | | $ | 3,222 | |
| Accruing loans past due> 90 days | | | 30 | | | | — | | | | — | | | | — | | | | — | |
| Potential problem loans | | | — | | | | — | | | | 356 | | | | 314 | | | | — | |
| Allowance for loan losses | | | 10,048 | | | | 8,810 | | | | 7,903 | | | | 6,116 | | | | 5,514 | |
| Interest foregone on nonaccrual loans | | | 265 | | | | 185 | | | | 204 | | | | 224 | | | | 220 | |
| Nonperforming loans to loans | | | 0.51% | | | | 0.34% | | | | 0.48% | | | | 0.83% | | | | 0.75% | |
| Allowance for loan losses to loans | | | 1.40% | | | | 1.40% | | | | 1.36% | | | | 1.22% | | | | 1.28% | |
| Allowance for loan losses to nonperforming loans | | | 276.19% | | | | 408.06% | | | | 281.05% | | | | 147.09% | | | | 171.14% | |
| Allowance for loan losses to nonperforming assets | | | 251.13% | | | | 408.06% | | | | 195.91% | | | | 131.19% | | | | 144.57% | |
| Nonperforming assets to total assets | | | 0.50% | | | | 0.30% | | | | 0.61% | | | | 0.80% | | | | 0.71% | |
Allowance for Loan Losses: The allowance for loan 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 Company’s methodology for making such assessments and determining the adequacy of the allowance includes the following key elements:
| |
| • | Specific allowances for identified problem loans and portfolio segments. |
| |
| • | A formula allowance based upon the historical loss experience of the loan portfolio, mix of the portfolio by loan type and the loan grade quality. |
| |
| • | A general unallocated allowance consistent with SFAS No. 5, “Accounting for Contingencies.” |
The evaluation of each element and the overall allowance is based on a continuing assessment of nonperforming assets, recent and historical loss experience, and other factors, including regulatory guidance and economic factors. The allocation of the allowance is based on an evaluation of nonperforming assets, historical ratios of loan losses and other factors that may affect future loan losses in specific categories of loans.
21
The following table shows the allocation of the allowance for loan losses, by loan type, for the past five years:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Allocation of Allowance for Loan Losses as of: |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 | | 2003 | | 2002 |
| | | | | | | | | | | |
| | | | | % of | | | | % of | | | | % of | | | | % of | | | | % of |
| (Dollars in thousands) | | Amount | | total(1) | | Amount | | total(1) | | Amount | | total(1) | | Amount | | total(1) | | Amount | | total(1) |
| | | | | | | | | | | |
| Balance applicable to: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Commercial | | $ | 782 | | | | 11.5% | | | $ | 737 | | | | 12.6% | | | $ | 772 | | | | 14.0% | | | $ | 799 | | | | 17.5% | | | $ | 842 | | | | 21.4% | |
| Real estate mortgage | | | 3,303 | | | | 41.3% | | | | 2,844 | | | | 41.8% | | | | 2,352 | | | | 37.9% | | | | 1,762 | | | | 33.8% | | | | 1,297 | | | | 31.3% | |
| Real estate construction | | | 1,781 | | | | 21.3% | | | | 1,378 | | | | 18.0% | | | | 1,399 | | | | 18.2% | | | | 912 | | | | 14.2% | | | | 450 | | | | 9.3% | |
| Consumer | | | 2,593 | | | | 25.9% | | | | 2,308 | | | | 27.6% | | | | 2,449 | | | | 29.9% | | | | 2,415 | | | | 34.5% | | | | 2,209 | | | | 38.0% | |
| Unallocated | | | 1,589 | | | | N/A | | | | 1,543 | | | | N/A | | | | 931 | | | | N/A | | | | 228 | | | | N/A | | | | 716 | | | | N/A | |
| | | | | | | | | | | |
| | Total | | $ | 10,048 | | | | 100.0% | | | $ | 8,810 | | | | 100.0% | | | $ | 7,903 | | | | 100.0% | | | $ | 6,116 | | | | 100.0% | | | $ | 5,514 | | | | 100.0% | |
| | | | | | | | | | | |
| |
| (1) | Represents the total of outstanding loans in each category as a percent of total loans outstanding. |
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. Based on the assessment of loan quality, the Company believes that the current allowance for loan losses is appropriate under the current circumstances and economic conditions.
Asset Quality: The Company’s asset quality has improved over the past two years. Additionally, increased recoveries of prior charged-off amounts have helped decrease net charge-offs to average loans by 43 basis points since 2002. The following table sets forth historical information regarding the Company’s net charge-offs and average loans for the past five years:
| | | | | | | | | | | | | | | | | | | | | | |
| | | Net Loan Charge-Offs as of: |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 | | 2003 | | 2002 |
| (Dollars in thousands) | | | | | | | | | | |
| Indirect net charge-offs | | $ | (332) | | | $ | (837) | | | $ | (926) | | | $ | (1,055) | | | $ | (749) | |
| Other net charge-offs | | | (1,105) | | | | (506) | | | | (787) | | | | (1,543) | | | | (1,911) | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total net charge-offs | | $ | (1,437) | | | $ | (1,343) | | | $ | (1,713) | | | $ | (2,598) | | | $ | (2,660) | |
| | | | | | | | | | | | | | | | | | | | | |
| Average indirect loans | | $ | 98,889 | | | $ | 95,126 | | | $ | 103,278 | | | $ | 100,684 | | | $ | 86,181 | |
| Average other loans | | | 581,890 | | | | 508,201 | | | | 436,678 | | | | 359,560 | | | | 326,608 | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total average loans | | $ | 680,779 | | | $ | 603,327 | | | $ | 539,956 | | | $ | 460,244 | | | $ | 412,789 | |
| | | | | | | | | | | | | | | | | | | | | |
| Indirect net charge-offs to average indirect loans | | | 0.34% | | | | 0.88% | | | | 0.90% | | | | 1.05% | | | | 0.87% | |
| Other net charge-offs to average other loans | | | 0.25% | | | | 0.10% | | | | 0.18% | | | | 0.43% | | | | 0.59% | |
| Net charge-offs to average loans | | | 0.21% | | | | 0.22% | | | | 0.32% | | | | 0.56% | | | | 0.64% | |
22
The following table sets forth historical information regarding changes in the Company’s allowance for loan losses:
| | | | | | | | | | | | | | | | | | | | | | |
| | | Summary of Loan Loss Experience as of: |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 | | 2003 | | 2002 |
| (Dollars in thousands) | | | | | | | | | | |
| Balance at beginning of period | | $ | 8,810 | | | $ | 7,903 | | | $ | 6,116 | | | $ | 5,514 | | | $ | 4,308 | |
| Charge-offs: | | | | | | | | | | | | | | | | | | | | |
| | Commercial | | | (1,239) | | | | (524) | | | | (467) | | | | (1,293) | | | | (1,689) | |
| | Real estate | | | (86) | | | | (98) | | | | (206) | | | | (177) | | | | (67) | |
| | Consumer and other | | | (1,062) | | | | (1,594) | | | | (1,668) | | | | (1,725) | | | | (1,286) | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total charge-offs | | | 2,387 | | | | (2,216) | | | | (2,341) | | | | (3,195) | | | | (3,042) | |
| | | | | | | | | | | | | | | | | | | | | |
| Recoveries: | | | | | | | | | | | | | | | | | | | | |
| | Commercial | | | 345 | | | | 227 | | | | 184 | | | | 208 | | | | 103 | |
| | Real estate | | | 12 | | | | 143 | | | | 79 | | | | — | | | | — | |
| | Consumer and other: | | | 593 | | | | 503 | | | | 365 | | | | 389 | | | | 279 | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total recoveries | | | 950 | | | | 873 | | | | 628 | | | | 597 | | | | 382 | |
| | | | | | | | | | | | | | | | | | | | | |
| Net charge-offs | | | (1,437) | | | | (1,343) | | | | (1,713) | | | | (2,598) | | | | (2,660) | |
| Provision for loan losses | | | 2,675 | | | | 2,250 | | | | 3,500 | | | | 3,200 | | | | 3,866 | |
| | | | | | | | | | | | | | | | | | | | | |
| Balance at end of period | | $ | 10,048 | | | $ | 8,810 | | | $ | 7,903 | | | $ | 6,116 | | | $ | 5,514 | |
| | | | | | | | | | | | | | | | | | | | | |
Deposits: In 2006, the Company continued its efforts to expand its deposit base through competitive pricing and delivery of quality service. The Company’s efforts were successful with a 10% increase in total deposits over 2005. The Company was particularly successful in growing money market deposits by attracting an additional $17.3 million in 2006. As outlined in the following table, the Company increased average deposit balances during 2006. Additional information regarding deposits is provided in Item 8 –Financial Statements and Supplementary Data, Note 6 – Deposits.
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Average Deposit Balances as of: |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| | | Average | | Average | | Average | | Average | | Average | | Average |
| | | balance | | rate | | balance | | rate | | balance | | rate |
| (Dollars in thousands) | | | | | | | | | | | | |
| Interest-bearing demand and money market deposits | | $ | 231,316 | | | | 1.95% | | | $ | 227,588 | | | | 1.09% | | | $ | 212,519 | | | | 0.76% | |
| Savings deposits | | | 55,139 | | | | .78% | | | | 57,131 | | | | 0.78% | | | | 48,270 | | | | 0.79% | |
| Time deposits | | | 276,211 | | | | 4.20% | | | | 224,002 | | | | 3.14% | | | | 208,991 | | | | 2.72% | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | Total interest-bearing deposits | | | 562,666 | | | | 2.94% | | | | 508,721 | | | | 1.96% | | | | 469,780 | | | | 1.63% | |
| Demand and other noninterest-bearing deposits | | | 100,267 | | | | | | | | 96,511 | | | | | | | | 81,146 | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | Total average deposits | | $ | 662,933 | | | | | | | $ | 605,232 | | | | | | | $ | 550,926 | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
Time deposits were approximately 43% of the total deposit base as of December 31, 2006. In 2006, average time deposits increased 23% or $52.2 million, compared to 2005, due to a shift in consumer demand toward time deposits and more aggressive pricing of time deposits by the Company to support strong loan growth.
Although a significant amount of time deposits will mature and reprice in the next twelve months, the Company expects to retain the majority of such balances. In the short term, time deposits have limited impact on the liquidity of the Company and these deposits can generally be retained and expanded with increases in rates paid which might, however, increase the cost of funds more than anticipated.
23
The following table sets forth the amounts and maturities of time deposits at December 31, 2006:
| | | | | | | | | | | | | | | | | | | | | | |
| | | Maturities of Time Deposits |
| | | Less than | | 3 to 6 | | 6 to 12 | | Over 12 | | |
| | | 3 months | | months | | months | | months | | Total |
| (Dollars in thousands) | | | | | | | | | | |
| Time deposits of $100,000 or more | | $ | 35,827 | | | $ | 41,930 | | | $ | 55,293 | | | $ | 18,676 | | | $ | 151,726 | |
| All other time deposits | | | 24,196 | | | | 60,630 | | | | 42,052 | | | | 24,326 | | | | 151,204 | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total time deposits | | $ | 60,023 | | | $ | 102,560 | | | $ | 97,345 | | | $ | 43,002 | | | $ | 302,930 | |
| | | | | | | | | | | | | | | | | | | | | |
Borrowings: Total borrowings outstanding decreased to $18.1 million at December 31, 2006 compared to $25.0 million in 2005. The change in borrowings is attributable to the repayment of $10.0 million in short term borrowings from the Federal Home Loan Bank (the “FHLB”). The Company’s sources of funds consist of borrowings from correspondent banks, the FHLB and junior subordinated debentures.
FHLB Borrowings: The Company relies upon 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 (principally, securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. At December 31, 2006 the Company had an outstanding $3.1 million in overnight borrowings, with a remaining unused line of credit of $125 million. Additional information regarding FHLB borrowings is provided in Item 8 –Financial Statements and Supplementary Data,Note 7 – FHLB Advances and Stock.
Junior Subordinated Debentures: The Company had $15.0 million of junior subordinated debentures outstanding at December 31, 2006. The entire amount of debentures outstanding have interest rates which adjust on a quarterly basis based on the London Interbank Offered Rate (“LIBOR”) plus 3.65%. Increases in short term interest rates during 2006 resulted in increased interest expense for the debentures. The debentures have a30-year maturity, but are callable at the Company’s option without penalty after June 27, 2007. As of December 31, 2006, the entire amount of debentures outstanding qualified as Tier 1 capital for regulatory capital purposes. Additional information regarding junior subordinated debentures is provided in Item 8 –Financial Statements and Supplementary Data,Note 8 – Trust Preferred Securities and Junior Subordinated Debentures.
Shareholders’ Equity: Shareholders’ equity increased $8.6 million to $66.4 million at December 31, 2006 from $57.8 million at December 31, 2005. The increase in shareholders’ equity was due to the retention of approximately $7.6 million, or 80%, of net income for the year and proceeds from the exercise of stock options of $594,000. The Company paid approximately $1.9 million in cash dividends during 2006. The following table represents the cash dividends declared and dividend payout ratio for the past three years:
| | | | | | | | | | | | | |
| | | Cash Dividends & Payout Ratios |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Dividend declared per share | | $ | 0.20 | | | $ | 0.18 | | | $ | 0.18 | |
| Dividend payout ratio | | | 19.58% | | | | 17.46% | | | | 26.51% | |
Cash dividends are approved by the Board of Directors in connection with its review of the Company’s capital plan. The cash dividend is subject to regulatory limitation as described in Item I –Business, Supervision and Regulation Section. There is no assurance that future cash dividends will be declared or increased. In 2006, the Company declared a 5-for-4 stock split payable on September 6, 2006. Additionally, net restricted stock awards valued at $276,000, with vesting periods ranging from one to five years, were granted in 2006. For further information on shareholders’ equity, see Item 8 –Financial Statements and Supplementary Data, Consolidated Statements of Shareholders’ Equity.
24
Regulatory Capital Requirements: The Company (on a consolidated basis) and the Bank are subject to minimum capital requirements, under which risk percentages are assigned to various categories of assets and off-balance sheet items to calculate a risk-adjusted capital ratio. The Federal Reserve and FDIC regulations set forth the qualifications necessary for bank holding companies and banks to be classified as “well capitalized,” primarily for assignment of insurance premium rates. Failure to qualify as “well capitalized” can: (a) negatively impact a bank’s ability to expand and to engage in certain activities, (b) cause an increase in insurance premium rates, and (c) impact a bank holding company’s ability to utilize certain expedited filing procedures, among other things. The Company’s and Bank’s current capital ratios are located in Item 8 –Financial Statements and Supplementary Data, Note 13- Regulatory Capital Matters.
Whidbey Island Bank: The principal objective of the Bank’s liquidity management program is to maintain the ability to meetday-to-day cash flow requirements of its customers who either wish to withdraw funds or to draw upon credit facilities to meet their cash needs. The Bank monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and the repayment and maturities of loans, the Bank can utilize established lines of credit with correspondent banks, sale of investment securities or borrowings from the FHLB.
Washington Banking Company: The Company is a separate legal entity from the Bank and must provide for its own liquidity. Substantially all of the Company’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that could limit the ability of the Bank to pay dividends to the Company. However, management believes that such restrictions will not have an adverse impact on the ability of the Company to meets its ongoing cash obligations, which consist principally of debt service on the $15.0 million of outstanding junior subordinated debentures, which totaled approximately $1.3 million in 2006. Further information on the Company’s cashflows can be found in Item 8 –Financial Statements and Supplementary Data, Note 15 – Washington Banking Company Information.
Consolidated Cashflows: The consolidated cashflows of the Company and its subsidiary the Bank are disclosed in the Consolidated Statement of Cash Flows found in Item 8 –Financial Statements and Supplementary Data. Net cash provided by operating activities was $12.9 million during 2006. The principal source of cash provided by operating activities was net income from continuing operations. Investing activities used $93.4 million in 2006. The net use of cash was principally for loan growth of $91.2 million. Financing activities provided $58.1 million, primarily through net deposit growth of $66.3 million. This was offset by the payoff of short term borrowings of $10.0 million and cash dividends to shareholders of $1.9 million.
25
Off-Balance Sheet Commitments: Standby letters of credit, commercial letters of credit, and financial guarantees written, are conditional commitments issued by the Company to guarantee the performance of a customer to a third party or payment by a customer to a third party. Those guarantees are primarily issued in international trade or to support public and private borrowing arrangements, including commercial paper, bond financing, and similar transactions. Except for certain long-term guarantees, the majority of 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 amounts to one hundred percent of the commitment amount at December 31, 2006. The Company routinely charges a fee for these credit facilities. The Company has not been required to perform on any financial guarantees. The following table summarizes the Company’s commitments to extend credit:
Commitments to Extend Credit
| | | | | | |
| | | December 31, 2006 |
| (Dollars in thousands) | | |
| Loan commitments | | | | |
| | Fixed rate | | $ | 45,536 | |
| | Variable rate | | | 140,229 | |
| Standby letters of credit | | | 2,014 | |
| | | | | |
| | Total commitments | | $ | 187,779 | |
| | | | | |
Contractual Commitments: The Company is party to many contractual financial obligations, including repayment of borrowings and operating lease payments. The following table summarizes the contractual obligations of the Company as of December 31, 2006:
| | | | | | | | | | | | | | | | | | | | | | |
| | | Future Contractual Obligations |
| | | |
| | | | | Within | | | | Over |
| | | Total | | 1 year | | 1-3 years | | 3-5 years | | 5 years |
| (Dollars in thousands) | | | | | | | | | | |
| Debt | | $ | — | | | $ | — | | | $ | — | | | $ | — | | | $ | — | |
| Operating leases | | | 1,628 | | | | 362 | | | | 372 | | | | 150 | | | | 744 | |
| Junior subordinated debentures | | | 15,007 | | | | — | | | | — | | | | — | | | | 15,007 | |
| | | | | | | | | | | | | | | | | | | | | |
| | Total | | $ | 16,635 | | | $ | 362 | | | $ | 372 | | | $ | 150 | | | $ | 15,751 | |
| | | | | | | | | | | | | | | | | | | | | |
26
| |
| Item 7A. | Quantitative and Qualitative Disclosures about Market Risk |
| |
| Asset/ Liability Management |
The purpose of asset/liability management is to provide stable net interest income by protecting the Company’s earnings from undue interest rate risk that arises from volatile interest rates and changes in the balance sheet mix, and by managing the risk/return relationships between liquidity, interest rate risk, market risk, and capital adequacy. The Company maintains an asset/liability management policy that provides guidelines for controlling exposure to interest rate risk by utilizing the following ratios and trend analyses: liquidity, equity, volatile liability dependence, portfolio maturities, maturing assets and maturing liabilities. The Company’s policy is to control the exposure of its earnings to changing interest rates by generally endeavoring to maintain a position within a narrow range around an “earnings neutral position,” which is defined as the mix of assets and liabilities that generate a net interest margin that is least affected by interest rate changes.
Interest Rate Risk: The Company is exposed to interest rate risk. Interest rate risk is the risk that financial performance will decline over time due to changes in prevailing interest rates and resulting yields on interest-earning assets and costs of interest-bearing liabilities. Generally, there are three sources of interest rate risk as described below:
| |
| • | Re-pricing Risk: Generally, re-pricing risk is the risk of adverse consequences from a change in interest rates that arises because of differences in the timing of when those interest rate changes affect an institution’s assets and liabilities. |
| |
| • | Basis Risk: Basis risk is the risk of adverse consequences resulting from unequal changes in the spread between two or more rates for different instruments with the same maturity. |
| |
| • | Option Risk: In banking, option risks are known as borrower options to prepay loans and depositor options to make deposits, withdrawals, and early redemptions. Option risk arises whenever bank products give customers the right, but not the obligation, to alter the quantity of the timing of cash flows. |
A number of measures are used to monitor and manage interest rate risk, including income simulations and interest sensitivity (gap) analyses. An income simulation model is the primary tool used to assess the direction and magnitude of changes in net interest income resulting from changes in interest rates. Key assumptions in the model include prepayment speeds on fixed rate assets, cash flows and maturities of other investment securities, and loan and deposit volumes and pricing. These assumptions are inherently uncertain and, as a result, the model cannot precisely estimate net interest income or precisely predict the impact of higher or lower interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes and changes in market conditions and management strategies, among other factors.
| | | | | | | | | | | | | | | | | | | | | |
| | | Interest Rate Simulation Impact on Net Interest Income |
| | | | | 2006 | | | | 2005 |
| | | | | | | | | |
| | | | | Change in net interest | | Percentage | | | | Change in net interest | | Percentage |
| Scenario | | | | income from scenario | | change | | | | income from scenario | | change |
| | | | | | | | | |
| Up 100 basis points | | $ | | | 175,000 | | | | 0.5% | | | $ | | | 601,000 | | | | 1.6% | |
| Down 100 basis points | | $ | | | (219,000 | ) | | | (0.6%) | | | $ | | | (715,000 | ) | | | (1.9%) | |
Interest Rate Sensitivity: The analysis of an institution’s interest rate gap (the difference between the repricing of interest-earning assets and interest-bearing liabilities during a given period of time) is another standard tool for the measurement of the exposure to interest rate risk. The Company believes that because interest rate gap analysis does not address all factors that can affect earnings performance, it should be used in conjunction with other methods of evaluating interest rate risk.
27
The following table sets forth the estimated maturity or repricing, and the resulting interest rate gap of the Company’s interest-earning assets and interest-bearing liabilities at December 31, 2006. The interest rate gaps reported in the table arise when assets are funded with liabilities having different repricing intervals. The amounts shown in the following table could be significantly affected by external factors such as changes in prepayment assumptions, early withdrawals of deposits and competition:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Estimated Maturity and Repricing at December 31, 2006 |
| | | | | 0–3 months | | | | 4–12 months | | | | 1–5 years | | | | Over 5 years | | | | Total |
| (Dollars in thousands) | | | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Interest-earning deposits | | $ | | | 761 | | | $ | | | — | | | $ | | | — | | | $ | | | — | | | $ | | | 761 | |
| | Investment securities | | | | | 997 | | | | | | 3,813 | | | | | | 9,357 | | | | | | 2,623 | | | | | | 16,790 | |
| | Investment in subsidiary | | | | | — | | | | | | — | | | | | | — | | | | | | 201 | | | | | | 201 | |
| | FHLB stock | | | | | 1,984 | | | | | | — | | | | | | — | | | | | | — | | | | | | 1,984 | |
| | Loans held for sale | | | | | 2,458 | | | | | | — | | | | | | — | | | | | | — | | | | | | 2,458 | |
| | Loans | | | | | 242,726 | | | | | | 66,156 | | | | | | 298,364 | | | | | | 110,334 | | | | | | 717,580 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Total interest-earning assets | | $ | | | 248,926 | | | $ | | | 69,969 | | | $ | | | 307,721 | | | $ | | | 113,157 | | | $ | | | 739,773 | |
| Percent of interest-earning assets | | | | | 33.65% | | | | | | 9.46% | | | | | | 41.59% | | | | | | 15.30% | | | | | | 100.00% | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Interest-bearing demand deposits | | $ | | | 152,087 | | | $ | | | — | | | $ | | | — | | | $ | | | — | | | $ | | | 152,087 | |
| | Money market deposits | | | | | 101,856 | | | | | | — | | | | | | — | | | | | | — | | | | | | 101,856 | |
| | Savings deposits | | | | | 50,036 | | | | | | — | | | | | | — | | | | | | — | | | | | | 50,036 | |
| | Time deposits | | | | | 66,889 | | | | | | 200,676 | | | | | | 35,365 | | | | | | — | | | | | | 302,930 | |
| | FHLB overnight borrowings | | | | | 3,075 | | | | | | — | | | | | | — | | | | | | — | | | | | | 3,075 | |
| | Junior subordinated debentures | | | | | 15,007 | | | | | | — | | | | | | — | | | | | | — | | | | | | 15,007 | |
| | Other borrowed funds | | | | | — | | | | | | — | | | | | | — | | | | | | — | | | | | | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Total interest-bearing liabilities | | $ | | | 388,951 | | | $ | | | 200,676 | | | $ | | | 35,365 | | | $ | | | — | | | $ | | | 624,992 | |
| Percent of interest-bearing liabilities | | | | | 62.23% | | | | | | 32.11% | | | | | | 5.66% | | | | | | 0.00% | | | | | | 100.00% | |
| Interest sensitivity gap | | $ | | | (140,025 | ) | | $ | | | (130,707 | ) | | $ | | | 272,356 | | | $ | | | 113,157 | | | $ | | | 114,781 | |
| Interest sensitivity gap, as a percentage of total assets | | | | | (17.62% | ) | | | | | (16.45% | ) | | | | | 34.28% | | | | | | 14.24% | | | | | | | |
| Cumulative interest sensitivity gap | | $ | | | (140,025 | ) | | $ | | | (270,732 | ) | | $ | | | 1,624 | | | $ | | | 114,781 | | | | | | | |
| Cumulative interest sensitivity gap, as a percentage of total assets | | | | | (17.62% | ) | | | | | (34.07% | ) | | | | | 0.20% | | | | | | 14.45% | | | | | | | |
| |
| Impact of Inflation and Changing Prices |
The primary impact of inflation on the Company’s operations is increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution’s performance than the effects of general levels of inflation. Although interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services, increases in inflation generally have resulted in increased interest rates.
28
| |
| Item 8. | Financial Statements and Supplementary Data |
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
| | | | | |
| | | Page |
| | | |
| | | 30 | |
| | | 31 | |
| | | 33 | |
| | | 34 | |
| | | 35 | |
| | | 36 | |
| | | 37 | |
| | | 38 | |
29
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Company’s management, including its Chief Executive Officer and its Chief Financial Officer, together with its consolidated subsidiary, is responsible for establishing, maintaining and assessing adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with accounting principals generally accepted in the United States of America.
The Company’s internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principals generally accepted in the United States of America, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the Company’s financial statements.
Management recognizes that there are inherent limitations in the effectiveness of any system of internal control, and accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation and fair presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in theInternal Control-Integrated Framework. Based on this assessment, management believes that, as of December 31, 2006, the Company’s internal control over financial reporting was effective based on those criteria.
The Company’s independent registered public accounting firm has audited management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, as stated in their report, which expresses unqualified opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006.
30
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
Washington Banking Company
We have audited the accompanying consolidated statement of financial condition of Washington Banking Company and subsidiaries (Company) as of December 31, 2006 and 2005, and the related consolidated statements of income, shareholders’ equity, comprehensive income and cash flows for each of the three years in the period ended December 31, 2006. We also have audited management’s assessment included in the accompanying Management’s Report on Internal Control over Financial Reporting that the Company maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and Directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
31
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM- (CONTINUED)
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Washington Banking Company and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and cash flows for each of the three years ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, management’s assessment that Washington Banking Company maintained effective internal control over financial reporting as of December 31, 2006 is fairly stated, in all material respects, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Furthermore, in our opinion, Washington Banking Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Bellingham, Washington
March 12, 2007
32
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Financial Condition
December 31, 2006 and 2005
(Dollars in thousands, except per share data)
| | | | | | | | | | | | | |
| | | 2006 | | 2005 |
| | | | | |
| | | | | Assets | | | | | | | | |
| Cash and due from banks | | $ | 18,984 | | | $ | 19,949 | |
| | ($3,703 and $3,313, respectively, are restricted) | | | | | | | | |
| Interest-bearing deposits | | | 761 | | | | 983 | |
| Federal funds sold | | | — | | | | 21,095 | |
| | | | | | | | | |
| | | | | Total cash, restricted cash, and cash equivalents | | | 19,745 | | | | 42,027 | |
| Investment securities available for sale | | | 16,790 | | | | 19,077 | |
| | | | | | | | | |
| | | | | Total investment securities | | | 16,790 | | | | 19,077 | |
| Federal Home Loan Bank stock | | | 1,984 | | | | 1,984 | |
| Loans held for sale | | | 2,458 | | | | 2,829 | |
| Loans receivable | | | 719,580 | | | | 630,258 | |
| Allowance for loan losses | | | (10,048) | | | | (8,810) | |
| | | | | | | | | |
| | | | | Total loans, net | | | 709,532 | | | | 621,448 | |
| Premises and equipment, net | | | 23,372 | | | | 20,514 | |
| Bank owned life insurance | | | 10,930 | | | | 10,558 | |
| Other assets | | | 9,734 | | | | 7,539 | |
| | | | | | | | | |
| | | | | Total assets | | $ | 794,545 | | | $ | 725,976 | |
| | | | | | | | | |
| | | | | Liabilities and Shareholders’ Equity | | | | | | | | |
| Liabilities: | | | | | | | | |
| | Deposits | | | | | | | | |
| | | | Noninterest-bearing | | $ | 96,858 | | | $ | 105,365 | |
| | | | Interest-bearing | | | 303,979 | | | | 287,214 | |
| | | | Time deposits | | | 302,930 | | | | 244,910 | |
| | | | | | | | | |
| | | | | Total deposits | | | 703,767 | | | | 637,489 | |
| | Other borrowed funds | | | 3,075 | | | | 10,000 | |
| | Junior subordinated debentures | | | 15,007 | | | | 15,007 | |
| | Other liabilities | | | 6,303 | | | | 5,631 | |
| | | | | | | | | |
| | | | | Total liabilities | | | 728,152 | | | | 668,127 | |
| Commitments and contingencies (See Notes 16, 17 and 19) | | | | | | | | |
| Shareholders’ equity: | | | | | | | | |
| | Preferred stock, no par value. Authorized 20,000 shares: | | | | | | | | |
| | | no shares issued or outstanding | | | — | | | | — | |
| | Common stock, no par value. Authorized 13,679,757 shares: | | | | | | | | |
| | | issued and outstanding 9,388,600 and 9,227,763 shares in 2006 and 2005, respectively | | | 33,016 | | | | 32,106 | |
| | Retained earnings | | | 33,422 | | | | 25,789 | |
| | Accumulated other comprehensive income (loss), net | | | (45) | | | | (46) | |
| | | | | | | | | |
| | | | | Total shareholders’ equity | | | 66,393 | | | | 57,849 | |
| | | | | | | | | |
| | | | | Total liabilities and shareholders’ equity | | $ | 794,545 | | | $ | 725,976 | |
| | | | | | | | | |
See accompanying notes to consolidated financial statements.
33
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Income
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands, except per share data)
| | | | | | | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Interest income: | | | | | | | | | | | | |
| | Interest and fees on loans | | $ | 54,498 | | | $ | 44,615 | | | $ | 37,428 | |
| | Interest on taxable investment securities | | | 414 | | | | 357 | | | | 345 | |
| | Interest on tax-exempt investment securities | | | 310 | | | | 310 | | | | 482 | |
| | Other | | | 221 | | | | 508 | | | | 209 | |
| | | | | | | | | | | | | |
| | | Total interest income | | | 55,443 | | | | 45,790 | | | | 38,464 | |
| Interest expense: | | | | | | | | | | | | |
| | Interest on time deposits | | | 11,604 | | | | 7,024 | | | | 5,632 | |
| | Interest on savings and money market deposits | | | 2,919 | | | | 1,995 | | | | 1,369 | |
| | Interest on NOW deposits | | | 2,034 | | | | 938 | | | | 623 | |
| | Interest on other borrowings | | | 547 | | | | 538 | | | | 431 | |
| | Interest on junior subordinated debentures | | | 1,337 | | | | 1,071 | | | | 782 | |
| | Interest on trust preferred securities | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | |
| | | Total interest expense | | | 18,441 | | | | 11,566 | | | | 8,837 | |
| | | | | | | | | | | | | |
| | | | Net interest income | | | 37,002 | | | | 34,224 | | | | 29,627 | |
| Provision for loan losses | | | 2,675 | | | | 2,250 | | | | 3,500 | |
| | | | | | | | | | | | | |
| | | | Net interest income after provision for loan losses | | | 34,327 | | | | 31,974 | | | | 26,127 | |
| Noninterest income: | | | | | | | | | | | | |
| | Service charges and fees | | | 3,296 | | | | 3,150 | | | | 2,986 | |
| | Income from the sale of loans | | | 709 | | | | 773 | | | | 1,183 | |
| | (Loss) Gain on sale of securities | | | — | | | | (50) | | | | 144 | |
| | Electronic banking income | | | 1,052 | | | | 764 | | | | 612 | |
| | SBA premium income | | | 339 | | | | 757 | | | | 559 | |
| | Other | | | 1,596 | | | | 1,905 | | | | 1,187 | |
| | | | | | | | | | | | | |
| | | Total noninterest income | | | 6,992 | | | | 7,299 | | | | 6,671 | |
| | | | | | | | | | | | | |
| Noninterest expense: | | | | | | | | | | | | |
| | Salaries and benefits | | | 16,807 | | | | 15,086 | | | | 13,744 | |
| | Occupancy and equipment | | | 3,596 | | | | 3,373 | | | | 3,278 | |
| | Office supplies and printing | | | 640 | | | | 659 | | | | 644 | |
| | Data processing | | | 479 | | | | 493 | | | | 490 | |
| | Consulting and professional fees | | | 769 | | | | 829 | | | | 793 | |
| | Other | | | 5,239 | | | | 4,785 | | | | 4,318 | |
| | | | | | | | | | | | | |
| | | Total noninterest expense | | | 27,530 | | | | 25,225 | | | | 23,267 | |
| | | | | | | | | | | | | |
| | | Income before income taxes and discontinued operations | | | 13,789 | | | | 14,048 | | | | 9,531 | |
| Provision for income taxes | | | 4,298 | | | | 4,580 | | | | 2,985 | |
| | | | | | | | | | | | | |
| Income from continuing operations | | | 9,491 | | | | 9,468 | | | | 6,546 | |
| Loss from discontinued operations, net of tax, of ($238) | | | — | | | | — | | | | (370) | |
| | | | | | | | | | | | | |
| | | | Net income | | $ | 9,491 | | | $ | 9,468 | | | $ | 6,176 | |
| | | | | | | | | | | | | |
| Earnings (loss) per common share, basic | | | | | | | | | | | | |
| | Continuing operations | | $ | 1.03 | | | $ | 1.04 | | | $ | 0.73 | |
| | Discontinued operations | | | — | | | | — | | | | (0.04) | |
| | | | | | | | | | | | | |
| | | | Net income per share | | $ | 1.03 | | | $ | 1.04 | | | $ | 0.69 | |
| | | | | | | | | | | | | |
| Earnings (loss) per common share, diluted | | | | | | | | | | | | |
| | Continuing operations | | $ | 1.00 | | | $ | 1.00 | | | $ | 0.70 | |
| | Discontinued operations | | | — | | | | — | | | | (0.04) | |
| | | | | | | | | | | | | |
| | | | Net income per share | | $ | 1.00 | | | $ | 1.00 | | | $ | 0.66 | |
| | | | | | | | | | | | | |
| Average number of shares outstanding, basic | | | 9,217,000 | | | | 9,098,000 | | | | 9,012,000 | |
| Average number of shares outstanding, diluted | | | 9,490,000 | | | | 9,428,000 | | | | 9,326,000 | |
See accompanying notes to consolidated financial statements.
34
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Shareholders’ Equity
Years Ended December 31, 2006, 2005 and 2004
(Dollars and shares in thousands, except per share data)
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | Accumulated | | |
| | | Common stock | | | | | | other | | Total |
| | | | | Retained | | Deferred | | comprehensive | | shareholders’ |
| | | Shares | | Amount | | earnings | | compensation | | income | | equity |
| | | | | | | | | | | | | |
Balance at December 31, 2003(1) | | | 8,930 | | | $ | 31,125 | | | $ | 13,273 | | | $ | — | | | $ | (38 | ) | | $ | 44,360 | |
| Net income | | | — | | | | — | | | | 6,176 | | | | | | | | — | | | | 6,176 | |
| Net change in unrealized gain on securities available for sale | | | — | | | | — | | | | — | | | | | | | | 282 | | | | 282 | |
| Less: adjustment for gains included in net income, net of tax of $47 | | | — | | | | — | | | | — | | | | | | | | (97 | ) | | | (97 | ) |
| Tax benefit associated with stock options | | | — | | | | 160 | | | | — | | | | | | | | — | | | | 160 | |
| Cash dividend, $0.22 per share | | | — | | | | — | | | | (1,521 | ) | | | | | | | — | | | | (1,521 | ) |
| Stock option compensation | | | — | | | | 23 | | | | — | | | | | | | | — | | | | 23 | |
| Stock options exercised | | | 119 | | | | 208 | | | | — | | | | | | | | — | | | | 208 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
Balance at December 31, 2004 | | | 9,049 | | | $ | 31,516 | | | $ | 17,928 | | | $ | — | | | $ | 147 | | | $ | 49,591 | |
| Net income | | | — | | | | — | | | | 9,468 | | | | | | | | — | | | | 9,468 | |
| Net change in unrealized (loss) on securities available for sale | | | — | | | | — | | | | — | | | | | | | | (226 | ) | | | (226 | ) |
| Plus adjustment for gains included in net income, net of tax of $17 | | | — | | | | — | | | | — | | | | | | | | 33 | | | | 33 | |
| Tax benefit associated with stock options | | | — | | | | 113 | | | | — | | | | | | | | — | | | | 113 | |
| Cash dividend, $0.22 per share | | | — | | | | — | | | | (1,607 | ) | | | | | | | — | | | | (1,607 | ) |
| Stock option compensation | | | — | | | | 23 | | | | — | | | | | | | | — | | | | 23 | |
| Issuance of restricted stock | | | 44 | | | | 483 | | | | — | | | | (483 | ) | | | — | | | | — | |
| Amortization of restricted stock | | | — | | | | — | | | | — | | | | 97 | | | | — | | | | 97 | |
| Stock options exercised | | | 135 | | | | 357 | | | | — | | | | | | | | — | | | | 357 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
Balance at December 31, 2005 | | | 9,228 | | | $ | 32,492 | | | $ | 25,789 | | | $ | (386 | ) | | $ | (46 | ) | | $ | 57,849 | |
| Net income | | | — | | | | — | | | | 9,491 | | | | | | | | — | | | | 9,491 | |
| Net change in unrealized (loss) on securities available for sale | | | — | | | | — | | | | — | | | | | | | | 1 | | | | 1 | |
| Cash dividend, $0.20 per share | | | — | | | | — | | | | (1,858 | ) | | | | | | | — | | | | (1,858 | ) |
| Stock option compensation | | | — | | | | 133 | | | | — | | | | | | | | — | | | | 133 | |
| Issuance of restricted stock | | | 18 | | | | 276 | | | | — | | | | (276 | ) | | | — | | | | — | |
| Amortization of restricted stock | | | — | | | | — | | | | — | | | | 183 | | | | — | | | | 183 | |
| Stock options exercised | | | 143 | | | | 594 | | | | — | | | | | | | | — | | | | 594 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
Balance at December 31, 2006 | | | 9,389 | | | $ | 33,495 | | | $ | 33,422 | | | $ | (479 | ) | | $ | (45 | ) | | $ | 66,393 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| |
| (1) | Adjusted to reflect a 5-for-4 stock split distributed by the Company on September 6, 2006. |
See accompanying notes to consolidated financial statements.
35
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
| | | | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 |
| Comprehensive Income: | | | | | | |
| Net income | | $ | 9,491 | | | $ | 9,468 | | | $ | 6,176 | |
| Increase in unrealized gain on securities available for sale, net of tax, of $(1) ($85) and ($106), for years ended 2006, 2005 and 2004, respectively | | | 1 | | | | (226 | ) | | | 282 | |
| Less: adjustment for gains (losses) included in net income, net of tax, of $(17) and $47, for years ended 2005 and 2004, respectively | | | — | | | | 33 | | | | (97 | ) |
| | | | | | | | | | | | | |
| Comprehensive income | | $ | 9,492 | | | $ | 9,275 | | | $ | 6,361 | |
| | | | | | | | | | | | | |
See accompanying notes to consolidated financial statements.
36
WASHINGTON BANKING COMPANY
AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands)
| | | | | | | | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Cash flows from operating activities: | | | | | | | | | | | | |
| | Net income from continuing operations | | $ | 9,491 | | | $ | 9,468 | | | $ | 6,546 | |
| | Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | | | | | | |
| | | Federal Home Loan Bank stock dividends | | | — | | | | (8 | ) | | | (64 | ) |
| | | Deferred income tax expense (benefit) | | | (684 | ) | | | 1,440 | | | | (630 | ) |
| | | Amortization of investment premiums, net | | | 11 | | | | 2 | | | | 44 | |
| | | Net (increase) decrease in subsidiary investment | | | 46 | | | | 81 | | | | (288 | ) |
| | | Earnings on bank owned life insurance | | | (372 | ) | | | (341 | ) | | | (217 | ) |
| | | Provision for loan losses | | | 2,675 | | | | 2,250 | | | | 3,500 | |
| | | Net decrease (increase) in loans held for sale | | | 371 | | | | 5,482 | | | | (60 | ) |
| | | Depreciation and amortization of premises and equipment | | | 1,629 | | | | 1,605 | | | | 1,682 | |
| | | Net (gain) loss on sale of securities | | | — | | | | 50 | | | | (144 | ) |
| | | Net (gain) loss on sale of premises and equipment | | | (17 | ) | | | (103 | ) | | | 152 | |
| | | Net loss on sale of other real estate | | | (6 | ) | | | (20 | ) | | | (136 | ) |
| | | Write downs on other real estate | | | 10 | | | | 254 | | | | 34 | |
| | | (Increase) decrease in other assets | | | (1,194 | ) | | | (2,666 | ) | | | 880 | |
| | | Stock option compensation | | | 133 | | | | 23 | | | | 23 | |
| | | Tax benefit associated with stock options | | | — | | | | 113 | | | | 160 | |
| | | Amortization of restricted stock | | | 183 | | | | 97 | | | | — | |
| | | Increase (decrease) in other liabilities | | | 674 | | | | 2,506 | | | | (311 | ) |
| | | | Cash flows from continuing operating activities | | | 12,950 | | | | 20,233 | | | | 11,171 | |
| | | | Loss from discontinued operations, net of tax | | | — | | | | — | | | | (370 | ) |
| | | | | | | | | | | | | |
| | | | | Cash flows from operations | | | 12,950 | | | | 20,233 | | | | 10,801 | |
| | | | | | | | | | | | | |
| Cash flows from investing activities: | | | | | | | | | | | | |
| | Purchases of investment securities available for sale | | | (3,675 | ) | | | (6,110 | ) | | | (1,500 | ) |
| | Maturities/calls/principal payments of investment and mortgage-backed securities available for sale | | | 5,951 | | | | 5,503 | | | | 6,479 | |
| | Sale of investment securities available for sale | | | — | | | | 504 | | | | 5,799 | |
| | Maturities/calls of investment securities held to maturity | | | — | | | | — | | | | 475 | |
| | Purchase of bank owned life insurance | | | — | | | | — | | | | (10,000 | ) |
| | Sale of Federal Home Loan Bank stock | | | — | | | | — | | | | 368 | |
| | Net increase in loans | | | (91,191 | ) | | | (51,681 | ) | | | (83,051 | ) |
| | Purchases of premises and equipment | | | (4,470 | ) | | | (2,112 | ) | | | (3,069 | ) |
| | Proceeds from sale of other real estate owned and premises and equipment | | | 65 | | | | 1,519 | | | | 1,335 | |
| | | | | | | | | | | | | |
| | | | | Cash flows from investing activities | | | (93,320 | ) | | | (52,377 | ) | | | (83,164 | ) |
| | | | | | | | | | | | | |
| Cash flows from financing activities: | | | | | | | | | | | | |
| | Net increase in deposits | | | 66,277 | | | | 74,488 | | | | 61,504 | |
| | Increase (decrease) in other borrowed funds | | | (10,000 | ) | | | 5,000 | | | | (7,500 | ) |
| | Increase (decrease) in overnight borrowings | | | 3,075 | | | | (22,000 | ) | | | 17,000 | |
| | Dividends paid on common stock | | | (1,858 | ) | | | (1,607 | ) | | | (1,521 | ) |
| | Proceeds from stock options exercised | | | 594 | | | | 357 | | | | 208 | |
| | | | | | | | | | | | | |
| | | | | Cash flows from financing activities | | | 58,088 | | | | 56,238 | | | | 69,691 | |
| | | | | | | | | | | | | |
| | | | | Net change in cash and cash equivalents | | | (22,282 | ) | | | 24,094 | | | | (2,672 | ) |
| Cash and cash equivalents at beginning of period | | | 42,027 | | | | 17,933 | | | | 20,605 | |
| | | | | | | | | | | | | |
| Cash and cash equivalents at end of period | | $ | 19,745 | | | $ | 42,027 | | | $ | 17,933 | |
| | | | | | | | | | | | | |
| Supplemental information: | | | | | | | | | | | | |
| | Loans foreclosed and transferred to other real estate owned | | $ | 432 | | | $ | 53 | | | $ | 1,333 | |
| | Loans made on bank-owned property sold | | | — | | | | — | | | | 272 | |
| | Cash paid for interest | | | 17,574 | | | | 11,221 | | | | 8,759 | |
| | Cash paid for income taxes | | | 5,210 | | | | 4,170 | | | | 2,992 | |
| | Transfer of investments from held to maturity to available for sale | | | — | | | | — | | | | 14,267 | |
| | Deconsolidation of trust preferred securities | | | — | | | | — | | | | 15,000 | |
See accompanying notes to consolidated financial statements.
37
NOTES TO 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”) was formed on April 30, 1996 and is a registered bank holding company whose primary business is conducted by its wholly-owned subsidiary, Whidbey Island Bank (the “Bank”). 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 Company and the Bank have formed several subsidiaries for various purposes as follows:
| |
| • | Washington Banking Capital Trust I (the “Trust”) is a wholly-owned subsidiary of the Company. The Trust, was formed in June 2002 for the exclusive purpose of issuing trust preferred securities. In 2003, the Trust subsidiary was consolidated. In 2004, pursuant to Financial Accounting Standards Board (“FASB”) Financial Interpretation No. 46R (“FIN 46R”), the Company deconsolidated the Trust. See Note (8) – Trust Preferred Securities and Junior Subordinated Debentures for further details. |
| |
| • | Washington Funding Group (“the Group”) was a wholly-owned subsidiary of the Company. The Group was formed in January 2003 for the purpose of wholesale mortgage real estate lending. The loans were originated and sold in the name of the Bank. During the second quarter of 2004, the Company decided to concentrate corporate resources toward the Bank’s retail operations and close the Group’s operations effective June 30, 2004. |
| |
| • | Rural One, LLC (“Rural One”) is a majority-owned subsidiary of the Bank and is certified as a Community Development Entity by the Community Development Financial Institutions Fund of the United States Department of Treasury. Rural One was formed in September 2006, for the exclusive purpose of investing in Federal tax credits related to the New Markets Tax Credit program. See Note (9) – Income Taxes for further details. |
(b) Basis of Presentation: The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries as described above. The consolidated financial statements of the Company have been prepared in conformity with accounting principles generally accepted in the United States of America. All significant intercompany balances and transactions have been eliminated in consolidation. In preparing the consolidated financial statements, in conformity with generally accepted accounting principles, management makes estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expense during the reported periods. Actual results could differ from these estimates. Management considers the estimates used in developing the allowance for loan losses to be particularly sensitive estimates that may be subject to revision in the near term.
(c) Segments: Pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 131,Disclosure about Segments of an Enterprise and Related Information, the Company has evaluated the requirements of this standard and had identified two reportable segments: Whidbey Island Bank and the discontinued operations of Washington Funding Group, Inc., both wholly-owned subsidiaries of Washington Banking Company. Due to the discontinuation of the Group in the second quarter of 2004, the Company currently has only one segment, Whidbey Island Bank, and is not required to disclose segment reporting by this standard.
(d) Recent Financial Accounting Pronouncements: In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123R,Shared Based Payment, which is a revision of SFAS No. 123,Accounting for Stock-Based Compensation. Statement No. 123R supersedes Accounting Principles Board Opinion No. 25 (“APB 25”),Accounting for Stock Issued to Employees, and amends SFAS No. 95,Statement of Cash Flows. SFAS No. 123R requires that the costs resulting from all stock-based compensation be measured at fair value and recognized in the Company’s financial statements. Application of the Statement is effective for reporting periods after December 15, 2005. The Company has adopted SFAS No. 123R effective January 1, 2006. For further details on the impact to the Company’s financial statements please refer to Note (12) –Stock-Based Compensation.
38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
In February 2006, FASB issued SFAS No. 155,Accounting for Certain Hybrid Financial Instruments. SFAS No. 155 resolves issues addressed in Statement 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The Company does not expect the adoption of SFAS No. 155 to have a material impact on its financial statements.
In March 2006, FASB issued SFAS No. 156,Accounting for Servicing of Financial Assets, which amended FASB Statement No. 140,Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, with respect to the accounting for separately recognized servicing assets and servicing liabilities. This Statement permits an entity to reclassify certain available-for-sale securities to trading securities, regardless of the restriction in paragraph 15 of Statement No. 115, provided that those available-for-sale securities are identified in some manner as offsetting the entity’s exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently measure at fair value. This Statement is effective at the date an entity adopts the requirements of this Statement. The adoption of SFAS No. 156 had no material impact on the Company’s financial statements.
In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109.” FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that it has taken or expects to take on a tax return. FIN 48 is effective beginning in the first quarter of fiscal year 2007. The Company does not expect that the adoption of FIN 48 to have a material impact on its financial statements.
In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements.This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements. This Statement will be effective for financial statements issued by the Company for the year ended December 31, 2008. The Company is currently evaluating the impact of this statement on the Company.
In September 2006, the FASB issued SFAS No. 158,“Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans” (an amendment of FASB Statements No. 87, 88, 106, and 132R). This Statement requires an employer to recognize in its statement of financial position an asset for a plan’s over funded status or a liability for a plan’s under funded status, measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year (with limited exceptions), and recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. These changes will be reported in comprehensive income and as a separate component of shareholders’ equity. This Statement is effective during the fourth quarter of fiscal year 2006. The Company does not offer any defined benefit retirement plans and therefore believes this new accounting standard had no impact on its financial statements.
(e) Cash and Cash Equivalents: For purposes of reporting cash flows, cash and cash equivalents include cash on hand and due from banks, interest-earning deposits and federal funds sold, all of which have original maturities of three months or less.
(f) Federal Home Loan Bank Stock: The Bank’s investment in FHLB stock is carried at par value, which approximates its fair value. As a member of the FHLB system, the Bank is required to maintain a minimum level of investment in FHLB stock based on specific percentages of the Bank’s outstanding mortgages, total assets or FHLB advances. At December 31, 2006, the Bank’s minimum required investment was approximately $681. Amounts in excess of the required minimum for FHLB membership may be redeemed at par at FHLB’s discretion, which is subject to their capital plan, bank policies, and regulatory requirements, which may be amended or revised periodically.
39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(g) Investment Securities: Investment securities available for sale include securities that management intends to use as part of its overall asset/liability management strategy and that may be sold in response to changes in interest rates and resultant prepayment risk and other related factors. Securities available for sale are carried at market value, and unrealized gains and losses (net of related tax effects) are excluded from net income but are included as a separate component of comprehensive income. Upon realization, such gains and losses will be included in net income using the specific identification method.
Investment securities held to maturity are comprised of debt securities for which the Company has positive intent and ability to hold to maturity and are carried at cost, adjusted for amortization of premiums and accretion of discounts using the interest method over the estimated lives of the securities.
Management determines the appropriate classification of investment securities at the purchase date in accordance with SFAS No. 115,Accounting for Certain Investments in Debt and Equity Securities.
(h) Loans Held for Sale: Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Net unrealized losses are recognized through a valuation allowance by charges to income. When a loan is sold, the gain is recognized in the consolidated statement of income as the proceeds less the book value of the loan including unamortized fees and capitalized direct costs.
(i) Loans Receivable, Net: Loans receivable, net, are stated at the unpaid principal balance, net of: premiums, unearned discounts, net deferred loan origination fees and costs, and the allowance for loan losses.
Interest on loans is calculated using the simple interest method based on the daily balance of the principal amount outstanding and is credited to income as earned.
Loans are placed on nonaccrual status when collection of principal or interest is considered doubtful (generally, loans 90 days or more past due).
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.
Interest income previously accrued on nonaccrual loans, but not yet received, is reversed in the period the loan is placed on nonaccrual status. Payments received are generally applied to principal. However, based on management’s assessment of the ultimate collectibility of an impaired or nonaccrual loan, interest income may be recognized on a cash basis. Nonaccrual loans are returned to an accrual status when management determines the circumstances have improved to the extent that there has been a sustained period of repayment performance and both principal and interest are deemed collectible.
Loan fees and certain direct loan origination costs are deferred and the net fee or cost is recognized in interest income using the interest method over the estimated life of the individual loans, adjusted for actual prepayments.
(j) Allowance for Loan Losses: The allowance for loan losses is based upon the Company’s estimates. The Company determines the adequacy of the allowance for loan losses based on evaluations of the loan portfolio, recent loss experience and other factors, including economic and market conditions. The Company determines the amount of the allowance for loan losses required for certain sectors based on relative risk characteristics of the loan portfolio. Actual losses may vary from current estimates. These estimates are reviewed periodically and as adjustments become necessary, are reported in earnings in the periods in which they become known. The allowance for loan losses is increased by expensing to the provisions for loan losses. Losses are charged to the allowance and recoveries are credited to the allowance.
40
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(k) Premises and Equipment: Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are computed using the straight-line method over the estimated useful lives of the assets. The estimated useful lives used to compute depreciation and amortization include buildings and building improvements, 15 to 40 years; land improvements, 15 to 25 years; furniture, fixtures and equipment, 3 to 7 years; and leasehold improvements, lesser of useful life or life of the lease.
(l) Bank Owned Life Insurance: During the second quarter of 2004, the Bank made a $10,000 investment in bank owned life insurance (“BOLI”). These policies insure the lives of officers of the Bank, and name the Bank as beneficiary. Noninterest income is generated tax-free (subject to certain limitations) from the increase in the policies’ underlying investments made by the insurance company. The Bank is capitalizing on the ability to partially offset costs associated with employee compensation and benefit programs with the BOLI.
(m) Other Real Estate Owned: Other real estate owned includes properties acquired through foreclosure. These properties are recorded at the lower of cost or estimated fair value. Losses arising from the acquisition of property, in full or partial satisfaction of loans, are charged to the allowance for loan losses.
Subsequent to the transfer to other real estate owned, these assets continue to be recorded at the lower of cost or fair value (less estimated cost to sell), based on periodic evaluations. Generally, legal and professional fees associated with foreclosures are expensed as incurred. However, in no event are recorded costs allowed to exceed fair value. Subsequent gains, losses or expenses recognized on the sale of these properties are included in noninterest income or expense.
(n) Federal Income Taxes: The Company files a consolidated federal income tax return. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the periods in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rate is recognized in income in the period that includes the enactment date.
(o) Stock-Based Compensation: Prior to January 1, 2006, the Company accounted for stock-based compensation under the intrinsic value method of accounting prescribed by APB 25, Accounting for Stock Issued to Employeesand FASB Interpretation No. 44 (“FIN 44”),Accounting for Certain Transactions Involving Stock Compensation. At January 1, 2006, the Company began recognizing compensation expense for stock-based compensation with the adoption of SFAS No. 123R,Share Based Payments. For further details on the impact to the Company’s financial statements please refer to Note (12) –Stock-Based Compensation.
(p) Reclassifications: Certain amounts in previous years may have been reclassified to conform to the 2006 financial statement presentation.
| |
| (2) | Restrictions on Cash Balance |
The Company is required to maintain an average reserve balance with the Federal Reserve Bank or maintain such reserve balance in the form of cash. The amount of the required reserve balance on December 31, 2006 and 2005 was $3,703 and $3,313, respectively, and was met by holding cash with the Federal Reserve Bank.
41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
| |
| (3) | Investment Securities |
The amortized costs and market values of investment securities at December 31, 2006 and 2005 were as summarized:
| | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | Gross | | Gross | | |
| | | | | | | unrealized | | unrealized | | |
| | | | | Gross | | losses | | losses | | |
| | | Amortized | | unrealized | | less than | | greater than | | Market |
| | | Cost | | gains | | 12 Months | | 12 Months | | Value |
| December 31, 2006: | | | | | | | | | | |
| | | | | | | | | | | |
| Investments available for sale: | | | | | | | | | | | | | | | | | | | | |
| | U.S. government agency securities | | $ | 9,941 | | | $ | 2 | | | $ | — | | | $ | (71) | | | $ | 9,872 | |
| | Pass-through securities | | | 101 | | | | — | | | | — | | | | — | | | | 101 | |
| | Corporate obligations | | | — | | | | — | | | | — | | | | — | | | | — | |
| | State and political subdivisions | | | 6,819 | | | | 27 | | | | (8) | | | | (21) | | | | 6,817 | |
| | | | | | | | | | | | | | | | | | | | | |
| | | Total investment securities available for sale | | $ | 16,861 | | | $ | 29 | | | $ | (8) | | | $ | (92) | | | $ | 16,790 | |
| | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | Gross | | Gross | | |
| | | | | | | unrealized | | unrealized | | |
| | | | | Gross | | losses | | losses | | |
| | | Amortized | | unrealized | | less than | | greater than | | Market |
| | | Cost | | gains | | 12 Months | | 12 Months | | Value |
| December 31, 2005: | | | | | | | | | | |
| | | | | | | | | | | |
| Investments available for sale: | | | | | | | | | | | | | | | | | | | | |
| | U.S. government agency securities | | $ | 10,494 | | | $ | — | | | $ | (43) | | | $ | (90) | | | $ | 10,361 | |
| | Pass-through securities | | | 126 | | | | 1 | | | | — | | | | — | | | | 127 | |
| | Corporate obligations | | | 999 | | | | — | | | | (12) | | | | — | | | | 987 | |
| | State and political subdivisions | | | 7,529 | | | | 81 | | | | — | | | | (8) | | | | 7,602 | |
| | | | | | | | | | | | | | | | | | | | | |
| | | Total investment securities available for sale | | $ | 19,148 | | | $ | 82 | | | $ | (55) | | | $ | (98) | | | $ | 19,077 | |
| | | | | | | | | | | | | | | | | | | | | |
Certain investment securities shown in the preceding table currently have fair values less than amortized cost and therefore contain unrealized losses. As of December 31, 2006 and 2005, the Company had 22 and 12 investment securities that were in an unrealized loss position. The Company has evaluated these securities and has determined that the decline in value is temporary and is related to the change in market interest rates since purchase. The decline in value is not related to any company or industry specific event.
In 2005, the Company sold $504 available for sale securities. The gross realized loss was ($50).
The amortized cost and market value of investment securities by contractual maturity at December 31, 2006 are as follows:
| | | | | | | | | | | | | | | | | | | | | | | | |
| | | Dates of Maturities |
| | | |
| | | Under | | 1-5 | | 5-10 | | Over | | |
| | | 1 year | | years | | years | | 10 years | | Total |
| | | | | | | | | | | |
| Investments available for sale: | | | | | | | | | | | | | | | | | | | | |
| | U.S. government agency securities: | | | | | | | | | | | | | | | | | | | | |
| | | Amortized cost | | $ | 3,004 | | | $ | 6,937 | | | $ | — | | | $ | — | | | $ | 9,941 | |
| | | Market value | | | 2,984 | | | | 6,888 | | | | — | | | | — | | | | 9,872 | |
| | Pass-through securities: | | | | | | | | | | | | | | | | | | | | |
| | | Amortized cost | | | — | | | | 101 | | | | — | | | | — | | | | 101 | |
| | | Market value | | | — | | | | 101 | | | | — | | | | — | | | | 101 | |
| | State and political subdivisions: | | | | | | | | | | | | | | | | | | | | |
| | | Amortized cost | | | 1,816 | | | | 2,466 | | | | 2,537 | | | | — | | | | 6,819 | |
| | | Market value | | | 1,826 | | | | 2,469 | | | | 2,522 | | | | — | | | | 6,817 | |
| | | | | | | | | | | | | | | | | | | | | |
| | | | Total amortized cost | | | 4,820 | | | | 9,503 | | | | 2,537 | | | | — | | | | 16,861 | |
| | | | Total market value | | $ | 4,810 | | | $ | 9,458 | | | $ | 2,522 | | | $ | — | | | $ | 16,790 | |
| | | | | | | | | | | | | | | | | | | | | |
At December 31, 2006 and 2005, investment securities with recorded values of $6,397 and $5,910, respectively, were pledged to secure public deposits and for other purposes as required or permitted by law.
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
| |
| (4) | Loans and Allowance for Loan Losses |
The loan portfolio composition, based upon the purpose and primary source of repayment of the loans, was as follows:
| | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 |
| | | | | |
| Commercial loans | | $ | 82,990 | | | $ | 79,341 | |
| Real estate mortgages | | | 303,618 | | | | 263,538 | |
| Real estate construction loans | | | 142,436 | | | | 113,661 | |
| Consumer loans | | | 188,535 | | | | 172,715 | |
| | | | | | | | | |
| | Subtotal | | | 717,579 | | | | 629,255 | |
| Less: | | | | | | | | |
| Allowance for loan losses | | | (10,048) | | | | (8,810) | |
| Deferred loan fees, net | | | 2,001 | | | | 1,003 | |
| | | | | | | | | |
| | Net loans | | $ | 709,532 | | | $ | 621,448 | |
| | | | | | | | | |
The following is an analysis of the changes in the allowance for loan losses:
| | | | | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Beginning balance | | $ | 8,810 | | | $ | 7,903 | | | $ | 6,116 | |
| Provision for loan losses | | | 2,675 | | | | 2,250 | | | | 3,500 | |
| Recoveries | | | 950 | | | | 873 | | | | 628 | |
| Charge-offs | | | (2,387) | | | | (2,216) | | | | (2,341) | |
| | | | | | | | | | | | | |
| | Ending balance | | $ | 10,048 | | | $ | 8,810 | | | $ | 7,903 | |
| | | | | | | | | | | | | |
The Company had impaired loans which consisted of nonaccrual and accrual loans. As of December 31, 2006, the Company had no commitments to extend additional credit on these impaired loans. Impaired loans and their related reserve for loan losses were as follows:
| | | | | | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Impaired loans | | | | | | | | | | | | |
| | Nonaccrual loans | | $ | 3,638 | | | $ | 2,159 | | | $ | 2,812 | |
| | Accrual loans | | | 30 | | | | — | | | | 605 | |
| | | | | | | | | | | | | |
| | | Total impaired loans | | $ | 3,668 | | | $ | 2,159 | | | $ | 3,417 | |
| | | | | | | | | | | | | |
| Reserve for impaired loans | | | | | | | | | | | | |
| | Nonaccrual loans | | $ | 551 | | | $ | 239 | | | $ | 477 | |
| | Accrual loans | | | 30 | | | | — | | | | 394 | |
| | | | | | | | | | | | | |
| | | Total reserve for loan losses | | $ | 581 | | | $ | 239 | | | $ | 871 | |
| | | | | | | | | | | | | |
The average balance on impaired loans was as follows:
| | | | | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Average balance impaired loans | | | | | | | | | | | | |
| Nonaccrual loans | | $ | 2,518 | | | $ | 2,521 | | | $ | 3,902 | |
| Accrual loans | | | 14 | | | | — | | | | 135 | |
| | | | | | | | | | | | | |
| | Ending balance | | $ | 2,532 | | | $ | 2,521 | | | $ | 4,037 | |
| | | | | | | | | | | | | |
43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The following table details the interest income which would have been recognized if the loans had accrued interest, in accordance with their original terms, and the interest actually recognized.
| | | | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Interest income not recognized on impaired loans | | $ | 265 | | | $ | 185 | | | $ | 204 | |
| Interest income recognized on impaired loans | | $ | 189 | | | $ | 38 | | | $ | 42 | |
(5) Premises and Equipment
Premises and equipment consisted of the following:
| | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 |
| | | | | |
| Land and buildings | | $ | 20,432 | | | $ | 17,513 | |
| Furniture and equipment | | | 9,242 | | | | 8,547 | |
| Land improvements | | | 2,212 | | | | 2,101 | |
| Computer software | | | 2,110 | | | | 1,743 | |
| Construction in progress | | | 650 | | | | 257 | |
| | | | | | | | | |
| | Subtotal | | | 34,646 | | | | 30,161 | |
| Less: accumulated depreciation | | | (11,274) | | | | (9,647) | |
| | | | | | | | | |
| | Total | | $ | 23,372 | | | $ | 20,514 | |
| | | | | | | | | |
(6) Deposits
Deposits are summarized as follows:
| | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 |
| | | | | |
| Time deposits | | $ | 302,930 | | | $ | 244,910 | |
| Savings | | | 50,036 | | | | 59,635 | |
| Money market | | | 101,856 | | | | 84,537 | |
| Negotiable orders of withdrawal (“NOWs”) | | | 152,087 | | | | 143,042 | |
| Noninterest-bearing demand | | | 96,858 | | | | 105,365 | |
| | | | | | | | | |
| | Total | | $ | 703,767 | | | $ | 637,489 | |
| | | | | | | | | |
Time deposits mature as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31, 2006 |
| | | |
| | | Less than | | |
| | | 1 Year | | 1-2 Years | | 2-3 Years | | 3-4 Years | | 4-5 Years | | Over 5 Years | | Total |
| | | | | | | | | | | | | | | |
| Time deposits of $100,000 or more | | $ | 133,051 | | | $ | 13,320 | | | $ | 4,025 | | | $ | 1,330 | | | $ | — | | | $ | — | | | $ | 151,726 | |
| All other Time deposits | | | 126,879 | | | | 14,750 | | | | 8,671 | | | | 790 | | | | 114 | | | | — | | | | 151,204 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | Total | | $ | 259,930 | | | $ | 28,070 | | | $ | 12,696 | | | $ | 2,120 | | | $ | 114 | | | $ | — | | | $ | 302,930 | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| |
| (7) | FHLB Advances and Stock |
The Bank is required to maintain an investment in the stock of FHLB. The requirement is based on the following components:
| | |
| | • | 3.5% of the average daily balance of advances outstanding during the most recent quarter; plus |
| |
| | • | the greater of $500 or 0.75% of mortgage loans and pass-through securities; or |
| |
| | • | 5.0% of the outstanding balance of loans sold to the FHLB minus the membership requirement. |
44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
During 2005, the FHLB suspended payment of dividends. The Company evaluated this suspension and has determined that the suspension of dividends is temporary and that the stock is not considered impaired as of December 31, 2006.
A credit line has been established by the FHLB for Whidbey Island Bank. At December 31, 2006, the line of credit available to the Bank was $124,785. The Bank may borrow from the FHLB in amounts up to 15% of its total assets. Advances on the line are collateralized by securities pledged and held in safekeeping by the FHLB, as well as supported by eligible real estate loans. As of December 31, 2006, collateral consisted entirely of eligible real estate loans in the amount of $189,920. At December 31, 2006 the Bank had $2,000 of overnight borrowings and $1,075 of Federal Funds purchased outstanding. The Bank had no overnight borrowings outstanding as of December 31, 2005. The Bank’s FHLB advances mature as follows:
| | | | | | | | | | | | | | | | | | | |
| | | December 31, 2006 | | December 31, 2005 |
| | | | | |
| | | | | Weighted | | | | Weighted |
| | | | | average interest | | | | average interest |
| Date of maturity | | Amount | | rate | | Amount | | rate |
| | | | | | | | | |
| | 2006 | | | | — | | | | — | | | | 10,000 | | | | 3.76% | |
| | | | | | | | | | | | | | | | | | | |
| | Total | | | $ | — | | | | | | | $ | 10,000 | | | | | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 |
| | | | | |
| Average balance | | $ | 6,780 | | | $ | 5,586 | |
| Maximum amount outstanding at any month end | | | 18,000 | | | | 30,000 | |
| |
| (8) | Trust Preferred Securities and Junior Subordinated Debentures |
Washington Banking Capital Trust I, a statutory business trust, is a wholly-owned subsidiary of the Company created for the exclusive purposes of issuing and selling capital securities and utilizing sale proceeds to acquire junior subordinated debt issued by the Company. On June 27, 2002, the Trust issued $15,000 of trust preferred securities with a30-year maturity, callable after the fifth year by Washington Banking Company. The rate adjusts quarterly based on Three-Month LIBOR plus 3.65%. On December 31, 2006 the rate was 9.02%. These securities, within certain limitations, are considered Tier I capital for the purposes of regulatory capital requirements.
The junior subordinated debentures are the sole assets of the Trust, and payments under the junior subordinated debentures are the sole revenues of the Trust. All of the common securities of the Trust are owned 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.
Pursuant to FIN 46R, the Company deconsolidated the trust beginning first quarter of 2004 and began to report the junior subordinated debentures within the liabilities section of the statement of financial condition. Prior to deconsolidation, the Trust and the related trust preferred securities were included within borrowings as a separate line item in the Company’s statement of financial condition
45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(9) Income Taxes
Income tax expense (benefit) consisted of the following:
| | | | | | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Federal: | | | | | | | | | | | | |
| | Current tax expense | | $ | 4,982 | | | $ | 3,140 | | | $ | 3,615 | |
| | Deferred tax expense (benefit) | | | (684) | | | | 1,440 | | | | (630) | |
| State current tax expense | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | |
| | | Total | | $ | 4,298 | | | $ | 4,580 | | | $ | 2,985 | |
| | | | | | | | | | | | | |
The following table presents major components of the net deferred federal income tax asset resulting from differences between financial reporting and tax basis:
| | | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 |
| | | | | |
| Deferred tax assets: | | | | | | | | |
| | Allowance for loan loss | | $ | 3,517 | | | $ | 3,022 | |
| | Deferred compensation | | | 404 | | | | 310 | |
| | Other | | | 20 | | | | 61 | |
| | Market value adjustment of investment securities available for sale | | | 25 | | | | 25 | |
| | | | | | | | | |
| | | | Total deferred tax assets | | | 3,966 | | | | 3,418 | |
| Deferred tax liabilities: | | | | | | | | |
| | | Deferred loan fees | | | 1,552 | | | | 1,799 | |
| | | Premises and equipment | | | 433 | | | | 505 | |
| | | FHLB stock dividend | | | 152 | | | | 149 | |
| | | Investment in partnership | | | 140 | | | | — | |
| | | Prepaid expenses | | | 111 | | | | 111 | |
| | | Other | | | 23 | | | | — | |
| | | | | | | | | |
| | | | Total deferred tax liabilities | | | 2,411 | | | | 2,564 | |
| | | | | | | | | |
| | | | Deferred tax assets, net | | $ | 1,555 | | | $ | 854 | |
| | | | | | | | | |
Reconciliation between the statutory federal income tax rate and the effective tax rate is as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| | | | | | | |
| Income tax expense at federal statutory rate | | $ | 4,744 | | | | 34.4% | | | $ | 4,857 | | | | 34.3% | | | $ | 3,241 | | | | 34% | |
| Federal tax credits | | | (400) | | | | (2.9%) | | | | — | | | | — | | | | — | | | | — | |
| Interest income on tax-exempt securities | | | (305) | | | | (2.2%) | | | | (285) | | | | (1.7%) | | | | (297) | | | | (3%) | |
| Other liabilities | | | 259 | | | | 1.9% | | | | 8 | | | | — | | | | 41 | | | | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | Total | | $ | 4,298 | | | | 31.2% | | | $ | 4,580 | | | | 32.6% | | | $ | 2,985 | | | | 31% | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
There was no valuation allowance for deferred tax assets as of December 31, 2006 or 2005. The Company has determined that it is not required to establish a valuation allowance for the deferred tax assets as management believes it is more likely than not that the deferred tax asset will be realized in the normal course of business.
46
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The following illustrates the reconciliation of the numerators and denominators of the basic and diluted earnings per share (“EPS”) computations:
| | | | | | | | | | | | | |
| | | Year Ended December 31, 2006 |
| | | |
| | | Income | | Weighted average shares | | Per share amount |
| | | | | | | |
Basic EPS | | | | | | | | | | | | |
| Income available to common shareholders | | $ | 9,491 | | | | 9,217,000 | | | $ | 1.03 | |
| Effect of dilutive securities: stock options | | | — | | | | 273,000 | | | | (0.03) | |
| | | | | | | | | | | | | |
Diluted EPS | | $ | 9,491 | | | | 9,490,000 | | | $ | 1.00 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| | | Year Ended December 31, 2005 |
| | | |
| | | Income | | Weighted average shares | | Per share amount |
| | | | | | | |
Basic EPS | | | | | | | | | | | | |
| Income available to common shareholders | | $ | 9,468 | | | | 9,098,000 | | | $ | 1.04 | |
| Effect of dilutive securities: stock options | | | — | | | | 330,000 | | | | (.04) | |
| | | | | | | | | | | | | |
Diluted EPS | | $ | 9,468 | | | | 9,428,000 | | | $ | 1.00 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| | | Year Ended December 31, 2004 |
| | | |
| | | Income | | Weighted average shares | | Per share amount |
| | | | | | | |
Basic EPS | | | | | | | | | | | | |
| Income available to common shareholders | | $ | 6,176 | | | | 9,012,000 | | | $ | 0.69 | |
| Effect of dilutive securities: stock options | | | — | | | | 314,000 | | | | (0.03) | |
| | | | | | | | | | | | | |
Diluted EPS | | $ | 6,176 | | | | 9,326,000 | | | $ | 0.66 | |
| | | | | | | | | | | | | |
On September 6, 2006, the Company issued a 5-for-4 stock split to shareholders of record as of August 21, 2006. On May 17, 2005, the Board of Directors issued a 4-for-3 stock split to shareholders of record as of May 2, 2005. On February 26, 2004, the Board of Directors issued a 15% stock dividend to shareholders of record as of February 10, 2004. All periods presented have been restated to reflect the stock splits and dividend.
| |
| (11) | Employee Benefit Plans |
(a) 401(k) and Profit Sharing Plan: During 1993, the Board of Directors approved a defined contribution plan (“the Plan”). The Plan covers substantially all full-time employees and many part-time employees once they meet the age and length of service requirements. The Plan allows for a voluntary salary reduction, under which eligible employees are permitted to defer a portion of their salaries, with the Company contributing a percentage of the employee’s contribution to the employee’s account. Employees are fully vested in their elected and employer matching contributions at all times. At the discretion of the Board of Directors, an annual profit sharing contribution may be made to eligible employees. Profit sharing contributions vest over a six-year period.
The Company’s contributions for the years ended December 31, 2006, 2005 and 2004 under the employee matching feature of the plan were $228, $215 and $196, respectively. This represents a match of the participating employees’ salary deferral of 50% of the first 5% of the compensation deferred. There were no contributions under the profit sharing portion of the plan for the years presented.
(b) Deferred Compensation Plan: In December 2000, the Bank approved the adoption of an Executive Deferred Compensation Plan (“Comp Plan”) to take effect January 2001, under which select participants
47
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
may elect to defer receipt of a portion of eligible compensation. The following is a summary of the principal provisions of the Compensation Plan:
| |
| | Purpose: The purpose of the Comp Plan is to (1) provide a deferred compensation arrangement for a select group of management or highly compensated employees within the meaning of Sections 201(2) and 301(a)(3) of ERISA and directors of the Bank, and (2) attract and retain the best available personnel for positions of responsibility with the Bank and its subsidiaries. The Comp Plan is intended to be an unfunded deferred compensation agreement. Participation in the Comp Plan is voluntary. |
| |
| | Source of Benefits: Benefits under the Comp Plan are payable solely by the Bank. To enable the Bank to meet its financial commitment under the Comp Plan, assets may be set aside in a corporate-owned vehicle. These assets are available to all general creditors of the Bank in the event of the Bank’s insolvency. Participants of the Comp Plan are unsecured general creditors of the Bank with respect to the Comp Plan benefits. Deferrals under the Comp Plan may reduce compensation used to calculate benefits under the Bank’s 401(k) Plan. |
(c) Bank Owned Life Insurance: During the second quarter of 2004, the Bank made a $10,000 investment in BOLI. These policies insure the lives of officers of the Bank, and name the Bank as beneficiary. Noninterest income is generated tax-free (subject to certain limitation) from the increase in the policies’ underlying investments made by the insurance company.
(12) Stock-Based Compensation
The Company adopted the 2005 Stock Incentive Plan (“2005 Plan”) following stockholder’s approval at the 2005 Annual Meeting of Stockholders. Subsequent to the adoption of the 2005 Plan, no additional grants may be issued under the prior plan.
The 2005 Plan provides grants of up to 833,333 shares, which includes any remaining shares subject to stock awards under the prior plans for future awards, or which have been forfeited, cancelled or expire. Grants from the 2005 Plan may take any of the following forms: incentive stock options, nonqualified stock options, restricted stock, restricted unit, performance shares, performance units, stock appreciation rights or dividend equivalent rights. As of December 31, 2006, the Company had 778,809 shares available for grant.
(a) Stock Options: Under the terms of the 2005 Plan, the exercise price of each incentive stock option must be greater than or equal to the market price of the Company’s stock on the date of the grant. The plan further provides that no stock option granted to a single grantee may exceed $100 in aggregate fair market value in a single calendar year. Stock options vest over a period of no greater than five years from the date of grant. Additionally, the right to exercise the option terminates ten years from the date of grant.
On January 1, 2006, the Company adopted the provisions of SFAS 123R,Share Based Payment, requiring the Company to recognize expense related to the fair value of stock option awards. The Company elected to use the modified prospective transition method as permitted by SFAS 123R and therefore has not restated the financial results for prior periods. Under this transition method, stock option compensation expense for the nine months ended September 30, 2006 includes compensation expense for all stock option compensation awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Stock option compensation expense for all stock option compensation awards granted subsequent to January 1, 2006 was based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. The Company recognizes compensation expense for stock option awards on a straight-line basis over the requisite service period of the award.
Prior to the adoption of SFAS 123R, the Company applied SFAS No. 123, amended by SFAS No. 148,“Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS 148”), which allowed companies to apply the existing accounting rules under APB 25 and related Interpretations. In general, as the exercise price of options granted under these plans was equal to the market price of the underlying common
48
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
stock on the grant date, no stock-option employee compensation cost was recognized in the Company’s net income. As required by SFAS 148 prior to the adoption of SFAS 123R, the Company provided pro forma net income and pro forma net income per common share disclosures for stock-option awards, as if the fair-value-based method defined in SFAS 123 had been applied. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation during the 2005 and 2004:
| | | | | | | | | |
| | | Years Ended December 31 |
| | | |
| | | 2005 | | 2004 |
| | | | | |
Basic earnings per share: | | | | | | | | |
| As reported | | | | | | | | |
| Income from continuing operations | | $ | 1.04 | | | $ | 0.73 | |
| Loss from discontinued operations | | | — | | | | (0.04) | |
| | | | | | | | | |
| Net income | | $ | 1.04 | | | $ | 0.69 | |
| | | | | | | | | |
| Pro forma | | | | | | | | |
| Income from continuing operations | | $ | 1.04 | | | $ | 0.73 | |
| Loss from discontinued operations | | | — | | | | (0.04) | |
| | | | | | | | | |
| Net income | | $ | 1.04 | | | $ | 0.69 | |
| | | | | | | | | |
Diluted earnings per share: | | | | | | | | |
| As reported | | | | | | | | |
| Income from continuing operations | | $ | 1.00 | | | $ | 0.70 | |
| Loss from discontinued operations | | | — | | | | (0.04) | |
| | | | | | | | | |
| Net income | | $ | 1.00 | | | $ | 0.66 | |
| | | | | | | | | |
| Pro forma | | | | | | | | |
| Income from continuing operations | | $ | 1.00 | | | $ | 0.70 | |
| Loss from discontinued operations | | | — | | | | (0.04) | |
| | | | | | | | | |
| Net income | | $ | 1.00 | | | $ | 0.66 | |
| | | | | | | | | |
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 grant date fair value of options granted during 2006 was $6.10 per share. There were no stock options issued during 2005 or 2004. The following assumptions were used in arriving at the fair value of options granted in 2006:
| | | | | |
| | | 2006 |
| | | |
| Risk-free interest rate | | | 4.32% to 4.95% | |
| Dividend yield rate | | | 1.20% to 1.40% | |
| Price volatility | | | 38.13% | |
| Expected life of options | | | 7 years | |
49
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The following table summarizes information about stock options outstanding at December 31, 2006:
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | Outstanding | | Exercisable |
| | | | | |
| | | | | Weighted | | | | | | Weighted | | |
| | | | | average | | | | | | average | | |
| | | | | exercise | | Average | | | | exercise | | Average |
| Exercise Price Range | | Shares | | price | | life(1) | | Shares | | price | | life(1) |
| | | | | | | | | | | | | |
| $4.39 to 5.00 | | | 180,437 | | | $ | 4.45 | | | | 3.05 | | | | 159,065 | | | $ | 4.44 | | | | 3.05 | |
| 5.01 to 8.50 | | | 117,255 | | | | 6.05 | | | | 4.35 | | | | 86,999 | | | | 6.05 | | | | 4.35 | |
| 8.51 to 12.00 | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | |
| 12.01 to 15.50 | | | 30,653 | | | | 14.59 | | | | 9.29 | | | | — | | | | — | | | | — | |
| 15.51 to 17.35 | | | 2,800 | | | | 17.35 | | | | 9.88 | | | | — | | | | — | | | | — | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | 331,145 | | | $ | 6.06 | | | | 4.15 | | | | 246,064 | | | $ | 4.98 | | | | 3.12 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| |
| (1) | Average contractual life remaining in years. |
The following table summarizes information on stock option activity during 2006:
| | | | | | | | | | | | | | | | | |
| | | | | Weighted | | | | |
| | | | | average | | | | Aggregate |
| | | | | exercise | | Average | | intrinsic |
| | | Shares | | price | | life(1) | | value |
| | | | | | | | | |
| Outstanding at January 1, 2006 | | | 441,624 | | | $ | 4.79 | | | | | | | | | |
| Granted | | | 33,900 | | | | 14.82 | | | | | | | | | |
| Exercised | | | (142,822 | ) | | | 4.17 | | | | | | | $ | 1,709 | |
| Forfeited, expired or cancelled | | | (1,557 | ) | | | 8.58 | | | | | | | | | |
| | | | | | | | | | | | | | | | | |
| Outstanding at December 31, 2006 | | | 331,145 | | | $ | 6.06 | | | | 4.15 | | | $ | 3,534 | |
| | | | | | | | | | | | | | | | | |
| Exercisable at December 31, 2006 | | | 246,064 | | | $ | 4.98 | | | | 3.12 | | | $ | 2,907 | |
| | | | | | | | | | | | | | | | | |
| |
| (1) | Average contractual life remaining in years. |
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 December 31, 2006 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 December 31, 2006. This amount changes based upon the fair market value of the Company’s stock.
The total intrinsic value of options exercised for the years ended December 31, 2006, 2005 and 2004 was $1,709, $1,398 and $948, respectively.
For the year ended December 31, 2006 the Company recognized $110, in stock option compensation expense as a component of salaries and benefits. As of December 31, 2006 there was approximately $212 of total unrecognized compensation cost related to nonvested options.
(b) Restricted Stock Awards: The Company grants restricted stock periodically for the benefit of employees. Recipients of restricted stock 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. Restrictions are based on continuous service.
The following table summarizes information on restricted stock activity during 2006:
| | | | | | | | | | | | | |
| | | | | Weighted | | Weighted average |
| | | | | average | | remaining |
| | | | | grant price per | | contractual |
| | | Shares | | share | | terms (in years) |
| | | | | | | |
| Outstanding at January 1, 2006 | | | 43,707 | | | $ | 11.03 | | | | | |
| Granted | | | 19,374 | | | | 14.98 | | | | | |
| Vested | | | (12,159 | ) | | | 11.02 | | | | | |
| Forfeited, expired or cancelled | | | (1,105 | ) | | | 12.34 | | | | | |
| | | | | | | | | | | | | |
| Outstanding at December 31, 2006 | | | 49,817 | | | $ | 12.53 | | | | 2.99 | |
| | | | | | | | | | | | | |
50
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
The total intrinsic value of restricted stock vested for the years ended December 31, 2006 was $204. No restricted stock vested for the years ended December 31, 2005 and 2004.
For years ended December 31, 2006 and 2005 the Company recognized $183 and $96 respectively, in restricted stock compensation expense as a component of salaries and benefits. As of December 31, 2006 there was $479 of total unrecognized compensation costs related to non-vested restricted stock.
(13) Regulatory Capital Matters
The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about risk components, asset risk weighting and other factors.
Risk-based capital guidelines issued by the FDIC establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures for banks. The Bank’s Tier 1 capital is comprised primarily of common equity and trust preferred securities, and excludes the equity impact of adjusting available-for-sale securities to fair value. Total capital also includes a portion of the allowance for loan losses, as defined according to regulatory guidelines.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital to risk-weighted assets (as defined in the regulations), and of Tier 1 capital to average assets (as defined in the regulations). As of December 31, 2006, the Bank met the minimum capital requirements to which it is subject and is considered to be “well-capitalized.”
The following tables describe the Company’s and Bank’s regulatory capital and threshold requirements for the 2006 and 2005 periods:
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | To be well-capitalized |
| | | | | For capital | | under prompt corrective |
| | | Actual | | adequacy purposes | | action provisions |
| | | | | | | |
| | | | | | | Minimum | | | | Minimum |
| | | Amount | | Ratio | | Amount | | ratio | | Amount | | ratio |
| | | | | | | |
December 31, 2006: | | | | | | | | | | | | | | | | | | | | | | | | |
Total risk-based capital
(to risk-weighted assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| | Consolidated | | $ | 91,331 | | | | 11.52% | | | $ | 63,453 | | | | 8.00% | | | $ | N/A | | | | | |
| | Whidbey Island Bank | | | 88,522 | | | | 11.19% | | | | 63,299 | | | | 8.00% | | | | 79,123 | | | | 10.00% | |
| Tier 1 capital (to risk-weighted assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| | Consolidated | | | 81,416 | | | | 10.27% | | | | 31,727 | | | | 4.00% | | | | N/A | | | | | |
| | Whidbey Island Bank | | | 78,630 | | | | 9.94% | | | | 31,649 | | | | 4.00% | | | | 47,474 | | | | 6.00% | |
| Tier 1 capital (to average assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| | Consolidated | | | 81,416 | | | | 10.24% | | | | 31,796 | | | | 4.00% | | | | N/A | | | | | |
| | Whidbey Island Bank | | | 78,630 | | | | 9.92% | | | | 31,711 | | | | 4.00% | | | | 39,637 | | | | 5.00% | |
51
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
| | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | To be well-capitalized |
| | | | | For capital | | under prompt corrective |
| | | Actual | | adequacy purposes | | action provisions |
| | | | | | | |
| | | | | | | Minimum | | | | Minimum |
| | | Amount | | Ratio | | Amount | | ratio | | Amount | | ratio |
| | | | | | | |
December 31, 2005: | | | | | | | | | | | | | | | | | | | | | | | | |
Total risk-based capital
(to risk-weighted assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| | Consolidated | | $ | 81,689 | | | | 11.52% | | | $ | 56,722 | | | | 8.00% | | | $ | N/A | | | | | |
| | Whidbey Island Bank | | | 79,277 | | | | 11.21% | | | | 56,591 | | | | 8.00% | | | | 70,739 | | | | 10.00% | |
| Tier 1 capital (to risk-weighted assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| | Consolidated | | | 72,879 | | | | 10.28% | | | | 28,361 | | | | 4.00% | | | | N/A | | | | | |
| | Whidbey Island Bank | | | 70,467 | | | | 9.96% | | | | 28,296 | | | | 4.00% | | | | 42,444 | | | | 6.00% | |
| Tier 1 capital (to average assets) | | | | | | | | | | | | | | | | | | | | | | | | |
| | Consolidated | | | 72,879 | | | | 10.26% | | | | 28,423 | | | | 4.00% | | | | N/A | | | | | |
| | Whidbey Island Bank | | | 70,467 | | | | 9.93% | | | | 28,375 | | | | 4.00% | | | | 35,469 | | | | 5.00% | |
In addition, under Washington State banking regulations, the Bank is limited as to the ability to declare or pay dividends to the Company up to the amount of the Bank’s retained earnings then on hand.
| |
| (14) | Fair Value of Financial Instruments |
Because broadly traded markets do not exist for most of the Company’s financial instruments, the fair value calculations attempt to incorporate the effect of current market conditions at a specific time. Fair valuations are management’s estimates of values. These calculations are subjective in nature, involve uncertainties and matters of significant judgment and do not include tax ramifications, therefore, the results cannot be determined with precision, substantiated by comparison to independent markets and may not be realized in an actual sale or immediate settlement of the instruments. There may be inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, which could significantly affect the results. For all of these reasons, the aggregation of the fair value calculations presented herein do not represent, and should not be construed to represent, the underlying value of the Company.
When possible, quoted market prices are used to determine fair value. In cases where a quoted market price is not available, the fair value of financial instruments is estimated using the present value of future cash flows or other valuation methods.
(a) Cash and Cash Equivalents: The carrying value of cash and cash equivalent instruments approximates fair value.
(b) Interest-earning Deposits: The carrying values of interest-earning deposits maturing within ninety days approximate their fair values. Fair values of other interest-earning deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.
(c) Federal Funds Sold: The carrying value of federal funds sold approximates fair value.
(d) Securities: The fair value of all investment securities, excluding FHLB stock, is based upon quoted market prices. FHLB stock is not publicly traded, however, it may be redeemed on a dollar-for-dollar basis for any amount the Bank is not required to hold. The fair value is therefore equal to the carrying value.
(e) Loans: The loan portfolio is composed of commercial, consumer, real estate construction and real estate loans. The carrying value of variable rate loans approximates their fair value. The fair value of fixed rate loans is estimated by discounting the estimated future cash flows of loans, sorted by type and security, by the weighted average rate of such loans and rising rates currently offered by the Bank for similar loans.
52
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(f) Deposits: For deposits with no contractual maturity such as checking accounts, money market accounts and savings accounts, fair values approximate book values. The fair value of certificates of deposit are based on discounted cash flows using the difference between the actual deposit rate and an alternative cost of funds rate, currently offered by the Bank for similar types of deposits.
(g) Trust Preferred Securities/ Junior Subordinated Debentures: The fair value of trust preferred securities is estimated at their recorded value due to the cost of the instrument re-pricing on a quarterly basis.
(h) Other Borrowed Funds: Other borrowed funds consist of FHLB advances. The carrying amount of FHLB advances is estimated using discounted cash flow analyses based on the Company’s current incremental borrowing rates of similar types of borrowing arrangements.
(i) Off-Balance Sheet Items: Commitments to extend credit represent the principal category of off-balance sheet financial instruments (see Note 16). The fair value of these commitments is not material since they are for relatively short periods of time and are subject to customary credit terms, which would not include terms that would expose the Company to significant gains or losses.
The table below presents the carrying value amount of the Company’s financial instruments and their corresponding fair values:
| | | | | | | | | | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 |
| | | | | |
| | | Carrying | | Fair | | Carrying | | Fair |
| | | value | | value | | value | | value |
| | | | | | | | | |
| Financial assets: | | | | | | | | | | | | | | | | |
| | Cash and cash equivalents | | $ | 18,984 | | | $ | 18,984 | | | $ | 19,949 | | | $ | 19,949 | |
| | Interest-earning deposits | | | 761 | | | | 761 | | | | 983 | | | | 983 | |
| | Federal funds sold | | | — | | | | — | | | | 21,095 | | | | 21,095 | |
| | FHLB stock | | | 1,984 | | | | 1,984 | | | | 1,984 | | | | 1,984 | |
| | Investment securities: | | | | | | | | | | | | | | | | |
| | | Available for sale | | | 16,790 | | | | 16,790 | | | | 19,077 | | | | 19,077 | |
| | Loans held for sale | | | 2,458 | | | | 2,458 | | | | 2,829 | | | | 2,829 | |
| | Loans | | | 719,580 | | | | 713,543 | | | | 630,258 | | | | 623,698 | |
| Financial liabilities: | | | | | | | | | | | | | | | | |
| | Deposits | | | 703,767 | | | | 702,971 | | | | 637,489 | | | | 636,676 | |
| | FHLB overnight borrowings | | | 3,075 | | | | 3,075 | | | | — | | | | — | |
| | Junior subordinated debentures | | | 15,007 | | | | 17,827 | | | | 15,007 | | | | 15,007 | |
| | Other borrowed funds | | | — | | | | — | | | | 10,000 | | | | 10,000 | |
53
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
| |
| (15) | Washington Banking Company Information |
The summarized condensed financial statements for Washington Banking Company (parent company only) are presented in the following table:
| | | | | | | | | | | |
| | | December 31 |
| | | |
| | | 2006 | | 2005 |
| Condensed Balance Sheets | | | | |
| Assets: | | | | | | | | |
| | Cash and cash equivalents | | $ | 1,124 | | | $ | 895 | |
| | Other assets | | | 1,468 | | | | 1,277 | |
| | Investment in subsidiaries | | | 78,808 | | | | 70,684 | |
| | | | | | | | | |
| | | Total assets | | $ | 81,400 | | | $ | 72,856 | |
| | | | | | | | | |
| Liabilities: | | | | | | | | |
| | Junior subordinated debentures | | $ | 15,007 | | | $ | 15,007 | |
| Shareholders’ equity: | | | | | | | | |
| | Common stock | | | 33,016 | | | | 32,106 | |
| | Retained earnings | | | 33,422 | | | | 25,789 | |
| | Accumulated other comprehensive income, net | | | (45 | ) | | | (46 | ) |
| | | | | | | | | |
| | | Total shareholders’ equity | | | 66,393 | | | | 57,849 | |
| | | | | | | | | |
| | | Total liabilities and shareholders’ equity | | $ | 81,400 | | | $ | 72,856 | |
| | | | | | | | | |
54
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
| | | | | | | | | | | | | | | |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| Condensed Statements of Income | | | | | | |
| Interest income: | | | | | | | | | | | | |
| | Interest-earning deposits | | $ | 26 | | | $ | 18 | | | $ | 5 | |
| | Common securities | | | 41 | | | | 33 | | | | 24 | |
| | | | | | | | | | | | | |
| | | Total interest income | | | 67 | | | | 51 | | | | 29 | |
| Interest expense: | | | | | | | | | | | | |
| | Junior subordinated debentures | | | 1,337 | | | | 1,071 | | | | 782 | |
| | | | | | | | | | | | | |
| | | Net interest income (loss) | | | (1,270) | | | | (1,020) | | | | (753) | |
| | Noninterest expense | | | 482 | | | | 600 | | | | 503 | |
| | | | | | | | | | | | | |
| Loss before income tax benefit and undistributed earnings of subsidiaries | | | (1,752) | | | | (1,620) | | | | (1,256) | |
| Income tax benefit | | | 603 | | | | 556 | | | | 479 | |
| | | | | | | | | | | | | |
| Loss before undistributed earnings of subsidiaries | | | (1,149) | | | | (1,064) | | | | (777) | |
| Undistributed earnings of subsidiaries | | | 7,790 | | | | 8,182 | | | | 4,173 | |
| Dividend income from the Bank | | | 2,850 | | | | 2,350 | | | | 3,150 | |
| Loss from discontinued operations | | | — | | | | — | | | | (370) | |
| | | | | | | | | | | | | |
| | | Net income | | $ | 9,491 | | | $ | 9,468 | | | $ | 6,176 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | |
| | | Years Ended December 31 |
| | | |
| | | 2006 | | 2005 | | 2004 |
| Condensed Statements of Cash Flows | | | | | | |
| Operating activities: | | | | | | | | | | | | |
| | Net income from continuing operations | | $ | 9,491 | | | $ | 9,468 | | | $ | 6,546 | |
| | Adjustments to reconcile net income to net cash used in operating activities: | | | | | | | | | | | | |
| | Equity in undistributed earnings of subsidiaries | | | (7,790) | | | | (8,182) | | | | (4,173) | |
| | Stock option compensation | | | 23 | | | | 24 | | | | 23 | |
| | Other assets | | | (191) | | | | (801) | | | | 375 | |
| | | | | | | | | | | | | |
| | | Cash flows provided by operating activities | | | 1,533 | | | | 509 | | | | 2,771 | |
| | | | | | | | | | | | | |
| Investing activities: | | | | | | | | | | | | |
| | Investment in subsidiaries | | | (41) | | | | (293) | | | | (247) | |
| Financing activities: | | | | | | | | | | | | |
| | Dividends paid to shareholders | | | (1,858) | | | | (1,607) | | | | (1,521) | |
| | Proceeds from exercise of stock options and stock issuances | | | 594 | | | | 357 | | | | 208 | |
| | | | | | | | | | | | | |
| | | Cash flows used in financing activities | | | (1,264) | | | | (1,250) | | | | (1,313) | |
| | | | | | | | | | | | | |
| | | Net increase (decrease) in cash and cash equivalents | | | 228 | | | | (488) | | | | 1,211 | |
| Cash and cash equivalents at beginning of year | | | 895 | | | | 1,343 | | | | 132 | |
| | | | | | | | | | | | | |
| Cash and cash equivalents at end of year | | $ | 1,123 | | | $ | 895 | | | $ | 1,343 | |
| | | | | | | | | | | | | |
(a) Leasing Arrangements: The Company is obligated under a number of noncancelable operating leases for land and buildings. The majority of these leases have renewal options. In addition, some of the leases contain escalation clauses tied to the consumer price index with caps.
At December 31, 2006 the Company’s future minimum rental payments required under land, buildings and equipment operating leases that have initial or remaining noncancelable lease terms of one year or more are as follows:
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| | | 2007 | | 2008 | | 2009 | | 2010 | | 2011 | | Thereafter | | Total |
| | | | | | | | | | | | | | | |
| Minimum Payments | | $ | 362 | | | $ | 228 | | | $ | 144 | | | $ | 72 | | | $ | 78 | | | $ | 744 | | | $ | 1,628 | |
Rent expense applicable to operating leases for the years ended December 31, 2006, 2005 and 2004 was $408, $345, and $336, respectively.
(b) Commitments to Extend Credit: 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
55
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained, if it is deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies, but may include: property, plant and equipment; accounts receivable; inventory; and income-producing commercial properties.
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, the majority of 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 amounts to one hundred percent of the commitment amount at December 31, 2006.
The Bank has not been required to perform on any financial guarantees and did not incur any losses on its commitments in 2006 and 2005.
Commitments to extend credit were as follows:
| | | | | | | |
| | | December 31, 2006 |
| | | |
| Loan commitments | | | | |
| | Fixed rate | | $ | 45,536 | |
| | Variable rate | | | 140,229 | |
| Standby letters of credit | | | 2,014 | |
| | | | | |
| | | Total commitments | | | 187,779 | |
| | | | | |
(17) Mortgage Loan Commitments and Loans Held for Sale
The Company was exposed to market risk on outstanding mortgage loan commitments and unsold residential mortgage loans held-for-sale during the first six months of 2004. As part of its risk management processes, the Company executed a program to limit portions of this risk through the use of derivative financial instruments, principally forward sales of mortgage-backed securities, and mandatory delivery contracts. The Company held open forward contracts to deliver Fannie Mae and Ginnie Mae mortgage-backed securities at a future date which, in conjunction with uncommitted mortgage loans held-for-sale, eliminated a portion of the market risk for a specified price. Pursuant to the requirements of SFAS No. 133, the estimated value of these derivative contracts were recognized in the accompanying financial statements at their estimated fair value. The Company did not use hedge accounting for this program because the estimated benefits from applying hedge accounting were not significant. Since the discontinuation of the Group in the second quarter of 2004, the Company has not used derivitive financial instruments as a hedge against market risk on outstanding mortgage loan commitments nor unsold residential mortgage loans held-for-sale.
(18) Related Party Transactions
As of December 31, 2006 and 2005, the Bank had loans to persons serving as directors and executive officers, and to entities related to such individuals aggregating $3,314 and $6,141, respectively. All loans were made on essentially the same terms and conditions as comparable transactions with other persons, and do not involve more than the normal risk of collectibility. During the year ended December 31, 2006, total principal additions were $14,141 and total principal payments were $15,023.
Deposits from related parties held by the Bank at December 31, 2006 and 2005 totaled $7,080 and $5,635, respectively.
56
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(19) Contingencies
The Company and its subsidiaries are from time to time defendants in and are threatened with various legal proceedings arising from regular business activities. Management believes the ultimate liability, if any, arising from such claims or contingencies will not have a material adverse effect on the Company’s results of operations or financial condition.
(20) Subsequent Events
On January 25, 2007, the Board of Directors declared a cash dividend of $0.05 per share to shareholders of record as of February 12, 2007, payable on February 27, 2007.
57
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(Dollars in thousands, except per share data)
(21) Selected Quarterly Financial Data (Unaudited)
Results of operations on a quarterly basis were as follows:
| | | | | | | | | | | | | | | | | | |
| | | Year Ended December 31, 2006 |
| | | |
| | | First | | Second | | Third | | Fourth |
| | | quarter | | quarter | | quarter | | quarter |
| | | | | | | | | |
| Interest income | | $ | 12,649 | | | $ | 13,518 | | | $ | 14,435 | | | $ | 14,840 | |
| Interest expense | | | 3,554 | | | | 4,283 | | | | 5,010 | | | | 5,594 | |
| | | | | | | | | | | | | | | | | |
| | Net interest income | | | 9,095 | | | | 9,235 | | | | 9,425 | | | | 9,246 | |
| Provision for loan losses | | | 500 | | | | 800 | | | | 750 | | | | 625 | |
| | | | | | | | | | | | | | | | | |
| | Net interest income after provision for loan losses | | | 8,595 | | | | 8,435 | | | | 8,675 | | | | 8,621 | |
| Noninterest income | | | 1,883 | | | | 1,680 | | | | 1,725 | | | | 1,704 | |
| Noninterest expense | | | 6,683 | | | | 6,393 | | | | 6,755 | | | | 7,698 | |
| | | | | | | | | | | | | | | | | |
| | Income before provision for income taxes | | | 3,796 | | | | 3,722 | | | | 3,645 | | | | 2,627 | |
| | | | | | | | | | | | | | | | | |
| Provision for income taxes | | | 1,244 | | | | 1,236 | | | | 1,003 | | | | 816 | |
| | | | | | | | | | | | | | | | | |
| | Net income | | $ | 2,552 | | | $ | 2,486 | | | $ | 2,642 | | | $ | 1,811 | |
| | | | | | | | | | | | | | | | | |
| Basic earnings per share | | $ | 0.28 | | | $ | 0.27 | | | $ | 0.29 | | | $ | 0.20 | |
| Diluted earnings per share | | $ | 0.27 | | | $ | 0.26 | | | $ | 0.28 | | | $ | 0.19 | |
| Cash dividends declared per share | | $ | 0.05 | | | $ | 0.05 | | | $ | 0.05 | | | $ | 0.05 | |
| | | | | | | | | | | | | | | | | | |
| | | Year Ended December 31, 2005 |
| | | |
| | | First | | Second | | Third | | Fourth |
| | | quarter | | quarter | | quarter | | quarter |
| | | | | | | | | |
| Interest income | | $ | 10,293 | | | $ | 11,137 | | | $ | 11,788 | | | $ | 12,572 | |
| Interest expense | | | 2,513 | | | | 2,796 | | | | 2,975 | | | | 3,282 | |
| | | | | | | | | | | | | | | | | |
| | Net interest income | | | 7,780 | | | | 8,341 | | | | 8,813 | | | | 9,290 | |
| Provision for loan losses | | | 425 | | | | 525 | | | | 550 | | | | 750 | |
| | | | | | | | | | | | | | | | | |
| | Net interest income after provision for loan losses | | | 7,355 | | | | 7,816 | | | | 8,263 | | | | 8,540 | |
| Noninterest income | | | 1,651 | | | | 1,892 | | | | 1,991 | | | | 1,765 | |
| Noninterest expense | | | 5,987 | | | | 6,159 | | | | 6,336 | | | | 6,743 | |
| | | | | | | | | | | | | | | | | |
| | Income before provision for income taxes | | | 3,019 | | | | 3,549 | | | | 3,918 | | | | 3,562 | |
| | | | | | | | | | | | | | | | | |
| Provision for income taxes | | | 976 | | | | 1,200 | | | | 1,239 | | | | 1,165 | |
| | | | | | | | | | | | | | | | | |
| | Net income | | $ | 2,043 | | | $ | 2,349 | | | $ | 2,679 | | | $ | 2,397 | |
| | | | | | | | | | | | | | | | | |
| Basic earnings per share | | $ | 0.22 | | | $ | 0.26 | | | $ | 0.30 | | | $ | 0.26 | |
| Diluted earnings per share | | $ | 0.21 | | | $ | 0.25 | | | $ | 0.28 | | | $ | 0.26 | |
| Cash dividends declared per share | | $ | 0.045 | | | $ | 0.045 | | | $ | 0.045 | | | $ | 0.045 | |
58
| |
| Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |
None
| |
| Item 9A. | Controls and Procedures |
As of the end of the fiscal period covered by this report, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures. The principal executive and financial officers supervised and participated in this evaluation. Based on this evaluation, the principal executive and financial officers 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. In addition, there have been no significant changes in the internal controls or in other factors known to management that could significantly affect the internal controls subsequent to the most recent evaluation. Management found no facts that would require the Company to take any corrective actions with regard to significant deficiencies or material weaknesses.
Management’s Report on Internal Control Over Financial Reporting
See “Management’s Report on Internal Control Over Financial Reporting” set forth in Item 8 –Financial Statements and Supplementary Data, immediately preceding the financial statement audit report of Moss Adams LLP.
Item 9B. Other Information
None
PART III
| |
| Item 10. | Directors and Executive Officers of the Registrant |
Information concerning directors of the Company is incorporated herein by reference to the section entitled “Election of Directors” in the Company’s definitive Proxy Statement dated March 23, 2007 (the “Proxy Statement”) for the annual meeting of shareholders to be held April 27, 2007.
The required information with respect to the executive officers of the Company is included under the caption “Executive Officers of the Company” in Part I of this report. Part I of this report is incorporated herein by reference.
The required information with respect to compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to the section entitled “Beneficial Ownership and Section 16(a) Reporting Compliance,” of the Proxy Statement.
| |
| Item 11. | Executive Compensation |
For information concerning executive compensation see “Executive Compensation” of the Proxy Statement, which is incorporated herein by reference. The Report of the Compensation Committee on Executive Compensation which is contained in the Proxy Statement is not incorporated by this reference.
| |
| Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
For information concerning security ownership of certain beneficial owners and management see “Security Ownership of Certain Beneficial Owners and Management” of the Proxy Statement, which is incorporated herein by reference.
59
| |
| Item 13. | Certain Relationships and Related Transactions |
For information concerning certain relationships and related transactions, see “Interest of Management in Certain Transactions” of the Proxy Statement, which is incorporated herein by reference.
| |
| Item 14. | Principal Accounting Fees and Services |
For information concerning principal accounting fees and services, see “Relationship with Independent Public Accountants” of the Proxy Statement, which is incorporated herein by reference.
PART IV
| |
| Item 15. | Exhibits, Financial Statement Schedules |
(a) (1) Financial Statements: The financial statements and related documents listed in the index set forth in Item 8 of this report are filed as part of this report.
(2) Financial Statement Schedules: All other schedules to the consolidated financial statements are omitted because they are no applicable or not material or because the information is included in the consolidated financial statements or related notes in Item 8 of this report.
(3) Exhibits: The exhibits filed as part of this report and exhibits incorporated herein by reference to other documents are listed in the Index of Exhibits to this annual report.
60
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on the 15th of March, 2007.
| |
| | WASHINGTON BANKING COMPANY |
| | (Registrant) |
| |
| | |
| | Michal D. Cann |
| | President and |
| | Chief Executive Officer |
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated, on the 15th of March, 2007.
| |
| | Principal Executive Officer: |
| |
| | |
| | Michal D. Cann |
| | President and |
| | Chief Executive Officer |
| |
| | Principal Financial and |
| | Accounting Officer: |
| | |
| | By | /s/ Richard A. Shields |
| |
| | |
| | Richard A. Shields |
| | Senior Vice President and |
| | Chief Financial Officer |
61
Michal D. Cann, pursuant to a power of attorney which is being filed with this Annual Report on Form 10-K, has signed this report on March 15, 2007, asattorney-in-fact for the following directors who constitute a majority of the board of directors.
Jay T. Lien
Robert B. Olson
Anthony B. Pickering
Edward J. Wallgren
| |
| | By /s/ Michal D. Cann |
| | |
| | Michal D. Cann |
| | Attorney-in-fact |
| | March 15, 2007 |
62
| | | | | |
| Exhibit No. | | Exhibit Description |
| | 3.1 | | | Articles of Amendment to Articles of Incorporation of the Company(1) |
| | 3.2 | | | Amended and Restated Articles of Incorporation of the Company(1) |
| |
| | 3.3 | | | Articles of Amendment to the Amended and Restated Articles of Incorporation of the Company(6) |
| |
| | 3.4 | | | Bylaws of the Company(1) |
| |
| | 4.1 | | | Form of Common Stock Certificate(1) |
| |
| | 4.2 | | | Stock Repurchase Plan(3) |
| |
| | 4.3 | | | Pursuant to Section 601(b)(4)(iii)(A) of Regulation S-K, copies of instruments defining the rights of holders of long-term debt and preferred securities are not filed. The Company agrees to furnish a copy thereof to the Securities and Exchange Commission upon request. |
| | 10.1 | | | 1992 Employee Stock Option Plan(1) |
| |
| | 10.2 | | | 1993 Director Stock Option Plan(1) |
| |
| | 10.3 | | | 1998 Stock Option and Restricted Stock Award Plan(2) |
| |
| | 10.4 | | | Form of Severance Agreement(1) |
| |
| | 10.5 | | | Executive Employment Agreement between the Company and Mr. Cann(4) |
| |
| | 10.8 | | | 2005 Stock Incentive Plan(5) |
| |
| | 21 | | | Subsidiaries of the Registrant |
| |
| | 23 | | | Consent of Moss Adams LLP |
| |
| | 24 | | | Power of Attorney |
| | 31.1 | | | Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002 |
| | 31.2 | | | Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(a) and Section 302 of the Sarbanes Oxley Act of 2002 |
| | 32.1 | | | Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350 |
| | 32.2 | | | Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes Oxley Act of 2002, 18 U.S.C. Section 1350 |
| |
| (1) | Incorporated by reference to the Form SB-2 (Registration No. 333-49925) previously filed by the Company, declared effective on June 22, 1998. |
| |
| (2) | Incorporated by reference to the definitive proxy statement dated August 19, 1998 for the Annual Meeting of Shareholders held September 24, 1998. |
| |
| (3) | Incorporated by reference to the Form 8-K dated April 30, 1999, previously filed by the Company. |
| |
| (4) | Incorporated by reference to Forms 8-K dated May 12, 2005 and September 30, 2005, previously filed by the Company. |
| |
| (5) | Incorporated by reference to Form S-8 dated November 10, 2005, previously filed by the Company. |
| |
| (6) | Incorporated by reference to Form 8-K dated July 14, 2005, and Form 8-K dated August 24, 2006, previously filed by the Company. |
63
