Table of Contents
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2008 — Commission File Number 000-51305
HERITAGE FINANCIAL GROUP
(A United States Corporation)
IRS Employer Identification Number 45-0479535
721 N. Westover Blvd., Albany, GA 31707
229-420-0000
229-420-0000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 and 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yesx Noo
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filero Accelerated filero Non-accelerated filero Smaller reporting companyx
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the exchange Act). Yeso Nox
APPLICABLE ONLY TO CORPORATE ISSUERS
State the number of shares outstanding of each issuer’s classes of common equity, as of the latest practicable date:
At August 11, 2008 there were 10,651,488 shares of issuer’s common stock outstanding.
HERITAGE FINANCIAL GROUP
INDEX
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| Number | ||||||||
| 3 | ||||||||
| 4 | ||||||||
| 5 | ||||||||
| 6 | ||||||||
| 8 | ||||||||
| 10 | ||||||||
| 13 | ||||||||
| 24 | ||||||||
| 25 | ||||||||
| 26 | ||||||||
| 28 | ||||||||
| EX-31.1 Section 302 Certification of the CEO | ||||||||
| EX-31.2 Section 302 Certification of the CFO | ||||||||
| EX-32.1 Section 906 Certification of the CEO & CFO | ||||||||
Table of Contents
HERITAGE FINANCIAL GROUP AND SUBSIDIARY
Consolidated Balance Sheets
June 30, 2008 and December 31, 2007
June 30, 2008 and December 31, 2007
| Unaudited | Audited | |||||||
| June 30, | December 31, | |||||||
| 2008 | 2007 | |||||||
Assets | ||||||||
| Cash and due from banks | $ | 6,318,260 | $ | 8,953,836 | ||||
| Interest-bearing deposits in banks | 441,039 | 379,961 | ||||||
| Federal funds sold | 6,149,000 | 14,505,000 | ||||||
| Securities available for sale, at fair value | 116,756,266 | 107,867,192 | ||||||
| Federal home loan bank stock, at cost | 3,748,300 | 2,969,700 | ||||||
| Other equity securities, at cost | 980,000 | — | ||||||
| Loans | 314,545,560 | 304,673,138 | ||||||
| Less allowance for loan losses | 4,107,864 | 4,415,669 | ||||||
| Loans, net | 310,437,696 | 300,257,469 | ||||||
| Premises and equipment, net | 16,569,834 | 14,815,520 | ||||||
| Accrued interest receivable | 2,267,161 | 2,586,357 | ||||||
| Intangible assets | 1,000,000 | 1,000,000 | ||||||
| Foreclosed assets | 2,408,804 | 364,999 | ||||||
| Cash surrender value of bank owned life insurance | 13,833,466 | 8,640,647 | ||||||
| Other assets | 6,665,146 | 6,331,560 | ||||||
| $ | 487,574,972 | $ | 468,672,241 | |||||
Liabilities and Stockholders’ Equity | ||||||||
| Deposits | ||||||||
| Noninterest-bearing | $ | 18,774,559 | $ | 21,058,567 | ||||
| Interest-bearing | 302,619,220 | 309,570,843 | ||||||
| Total deposits | 321,393,779 | 330,629,410 | ||||||
| Federal funds purchased and securities sold under repurchase agreements | 30,629,407 | 15,288,452 | ||||||
| Other borrowings | 65,000,000 | 50,000,000 | ||||||
| Accrued interest payable | 772,878 | 947,352 | ||||||
| Other liabilities | 6,427,557 | 6,214,877 | ||||||
| Total liabilities | 424,223,621 | 403,080,091 | ||||||
Commitments and contingencies | ||||||||
Stockholders’ equity | ||||||||
| Preferred stock, par value $0.01; 1,000,000 shares authorized; no shares issued | — | — | ||||||
| Common stock, par value $0.01; 25,000,000 shares authorized; 11,453,228 and 11,443,723 issued | 114,532 | 114,437 | ||||||
| Capital surplus | 39,463,944 | 39,009,323 | ||||||
| Retained earnings | 43,269,417 | 42,406,483 | ||||||
| Accumulated other comprehensive loss | (4,791,821 | ) | (3,303,342 | ) | ||||
| Unearned employee stock ownership plan (ESOP) shares, 308,490 and 330,525 shares | (3,084,900 | ) | (3,305,250 | ) | ||||
| 74,971,172 | 74,921,651 | |||||||
| Treasury stock, at cost, 797,534 and 615,934 shares | (11,619,821 | ) | (9,329,501 | ) | ||||
| Total stockholders’ equity | 63,351,351 | 65,592,150 | ||||||
| $ | 487,574,972 | $ | 468,672,241 | |||||
See Notes to Consolidated Financial Statements.
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HERITAGE FINANCIAL GROUP AND SUBSIDIARY
Consolidated Statements of Income (Unaudited)
For the Three and Six Months Ended June 30, 2008 and 2007
For the Three and Six Months Ended June 30, 2008 and 2007
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
Interest income | ||||||||||||||||
| Interest and fees on loans | $ | 5,289,433 | $ | 5,514,001 | $ | 10,766,139 | $ | 10,749,637 | ||||||||
| Interest on taxable securities | 1,205,193 | 1,046,731 | 2,355,082 | 1,978,067 | ||||||||||||
| Interest on nontaxable securities | 298,314 | 281,425 | 624,863 | 466,451 | ||||||||||||
| Interest on federal funds sold | 51,614 | 155,978 | 123,368 | 377,058 | ||||||||||||
| Interest on deposits in other banks | 2,723 | 6,122 | 10,871 | 16,708 | ||||||||||||
| 6,847,277 | 7,004,257 | 13,880,323 | 13,587,921 | |||||||||||||
Interest expense | ||||||||||||||||
| Interest on deposits | 2,129,761 | 2,767,336 | 4,654,366 | 5,379,721 | ||||||||||||
| Interest on other borrowings | 914,860 | 577,863 | 1,733,703 | 1,062,348 | ||||||||||||
| 3,044,621 | 3,345,199 | 6,388,069 | 6,442,069 | |||||||||||||
| Net interest income | 3,802,656 | 3,659,058 | 7,492,254 | 7,145,852 | ||||||||||||
Provision for loan losses | 782,000 | 337,000 | 1,182,000 | 495,000 | ||||||||||||
| Net interest income after provision for loan losses | 3,020,656 | 3,322,058 | 6,310,254 | 6,650,852 | ||||||||||||
Noninterest income | ||||||||||||||||
| Service charges on deposit accounts | 976,140 | 939,384 | 1,903,418 | 1,774,502 | ||||||||||||
| Other service charges, commissions and fees | 331,734 | 259,724 | 658,803 | 616,275 | ||||||||||||
| Brokerage fees | 261,796 | 264,181 | 505,831 | 441,407 | ||||||||||||
| Mortgage origination fees | 116,914 | 92,766 | 205,708 | 194,311 | ||||||||||||
| Bank owned life insurance | 99,384 | 87,260 | 192,839 | 169,056 | ||||||||||||
| Gain (loss) on sale of securities | 7,386 | 287 | 19,745 | (28,395 | ) | |||||||||||
| Other | 205,982 | 65,213 | 278,119 | 129,782 | ||||||||||||
| 1,999,336 | 1,708,815 | 3,764,463 | 3,296,938 | |||||||||||||
Noninterest expense | ||||||||||||||||
| Salaries and employee benefits | 2,224,418 | 2,371,388 | 4,525,375 | 4,654,209 | ||||||||||||
| Equipment | 298,898 | 277,248 | 620,058 | 554,502 | ||||||||||||
| Occupancy | 272,164 | 254,067 | 563,795 | 504,256 | ||||||||||||
| Advertising and marketing | 111,345 | 105,747 | 256,676 | 195,811 | ||||||||||||
| Legal and accounting | 141,972 | 93,091 | 268,803 | 190,899 | ||||||||||||
| Consulting & other professional fees | 85,098 | 174,169 | 178,690 | 287,081 | ||||||||||||
| Directors fees and retirement | 160,263 | 131,202 | 313,197 | 259,404 | ||||||||||||
| Telecommunications | 63,258 | 58,513 | 135,177 | 114,036 | ||||||||||||
| Supplies | 55,008 | 56,461 | 112,852 | 110,711 | ||||||||||||
| Data processing fees | 337,247 | 372,690 | 641,460 | 551,496 | ||||||||||||
| Other operating | 427,275 | 451,923 | 916,377 | 830,106 | ||||||||||||
| 4,176,946 | 4,346,499 | 8,532,460 | 8,252,511 | |||||||||||||
| Income before income taxes | 843,046 | 684,374 | 1,542,257 | 1,695,279 | ||||||||||||
Applicable income taxes | 155,215 | 135,363 | 274,887 | 427,327 | ||||||||||||
| Net income | $ | 687,831 | $ | 549,011 | $ | 1,267,370 | $ | 1,267,952 | ||||||||
Basic earnings per share | $ | 0.07 | $ | 0.05 | $ | 0.12 | $ | 0.12 | ||||||||
Diluted earnings per share | $ | 0.07 | $ | 0.05 | $ | 0.12 | $ | 0.12 | ||||||||
See Notes to Consolidated Financial Statements.
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HERITAGE FINANCIAL GROUP AND SUBSIDIARY
Consolidated Statements of Comprehensive Income (Unaudited)
For the Three and Six Months Ended June 30, 2008 and 2007
For the Three and Six Months Ended June 30, 2008 and 2007
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
Net income | $ | 687,831 | $ | 549,011 | $ | 1,267,370 | $ | 1,267,952 | ||||||||
Other comprehensive income (loss): | ||||||||||||||||
| Net unrealized loss on cash flow hedge arising during the period, net of tax benefit of $125,946 for the quarter and for the year to date | (188,920 | ) | — | (188,920 | ) | — | ||||||||||
| Net realized gain on termination of cash flow hedge during the period, net of tax of $359,490 | — | — | 539,235 | — | ||||||||||||
| Elimination of unrealized gain on cash flow hedge terminated during the period, net of tax of | ||||||||||||||||
| $156,558 | — | — | (234,838 | ) | — | |||||||||||
| Accretion of realized gain on terminated cash flow hedge, net of tax of $19,608 for the quarter and the year to date | (29,412 | ) | — | (29,412 | ) | — | ||||||||||
| Unrealized holding losses arising during the period, net of tax benefit of $1,461,489 and $1,006,221 for the quarter and $1,041,798 and $942,076 for the year to date | (2,192,233 | ) | (1,530,873 | ) | (1,562,697 | ) | (1,433,283 | ) | ||||||||
| Reclassification adjustment for (gains) losses included in net income, net of (tax) benefit of $2,954 and ($114) for the quarter and ($7,898) and $11,261 for the year to date | (4,432 | ) | (173 | ) | (11,847 | ) | 17,134 | |||||||||
Total other comprehensive loss | (2,414,997 | ) | (1,531,046 | ) | (1,488,479 | ) | (1,416,149 | ) | ||||||||
Comprehensive loss | $ | (1,727,166 | ) | $ | (982,035 | ) | $ | (221,109 | ) | $ | (148,197 | ) | ||||
See Notes to Consolidated Financial Statements.
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HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 2008 AND
THE YEAR ENDED DECEMBER 31, 2007
FOR THE SIX MONTHS ENDED JUNE 30, 2008 AND
THE YEAR ENDED DECEMBER 31, 2007
(Unaudited)
| Common Stock | ||||||||||||
| �� | Capital | |||||||||||
| Shares | Par Value | Surplus | ||||||||||
Balance, December 31, 2006 | 11,449,155 | $ | 114,492 | $ | 37,807,784 | |||||||
| Net income | — | — | — | |||||||||
| Cash dividend declared, $0.24 per share | — | — | — | |||||||||
| Stock-based compensation expense | 811,781 | |||||||||||
| Repurchase of 61,106 shares of stock for the treasury | — | — | — | |||||||||
| Issuance of 310 shares of common stock from the treasury | — | — | 432 | |||||||||
| Forfeiture of 14,632 shares of restricted stock | (14,632 | ) | (147 | ) | 147 | |||||||
| Other comprehensive loss | — | — | — | |||||||||
| Excess tax benefit from stock based compensation plans | 64,119 | |||||||||||
| Exercise of stock options | 9,200 | 92 | 115,276 | |||||||||
| ESOP shares earned, 44,070 shares | — | — | 210,106 | |||||||||
Balance, December 31, 2007 | 11,443,723 | 114,437 | 39,009,323 | |||||||||
| Net income | — | — | — | |||||||||
| Cash dividend declared, $0.14 per share | — | — | — | |||||||||
| Repurchase of 181,740 shares of stock for the treasury | — | — | — | |||||||||
| Issuance of 140 shares of treasury stock | — | — | (299 | ) | ||||||||
| Other comprehensive loss | — | — | — | |||||||||
| Stock-based compensation expense | — | — | 405,872 | |||||||||
| Issuance of restricted stock | 9,505 | 95 | (95 | ) | ||||||||
| ESOP shares earned, 22,035 shares | — | — | 49,143 | |||||||||
Balance, June 30, 2008 | 11,453,228 | $ | 114,532 | $ | 39,463,944 | |||||||
See Notes to Consolidated Financial Statements.
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HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 2008 AND
THE YEAR ENDED DECEMBER 31, 2007
(Unaudited)
FOR THE SIX MONTHS ENDED JUNE 30, 2008 AND
THE YEAR ENDED DECEMBER 31, 2007
(Unaudited)
| Accumulated | ||||||||||||||||
| Unearned | Other | |||||||||||||||
| Retained | ESOP | Treasury | Comprehensive | |||||||||||||
| Earnings | Shares | Stock | (Loss) | Total | ||||||||||||
| $40,248,349 | $ | (3,745,950 | $ | (8,518,017 | ) | $ | (3,097,880 | ) | $ | 62,808,778 | ||||||
| 2,921,105 | — | — | — | 2,921,105 | ||||||||||||
| (762,971) | — | — | — | (762,971 | ) | |||||||||||
| — | — | — | — | 811,781 | ||||||||||||
| (816,227 | ) | (816,227 | ) | |||||||||||||
| 4,743 | 4,853 | |||||||||||||||
| — | — | — | — | — | ||||||||||||
| — | — | — | (205,462 | ) | (205,462 | ) | ||||||||||
| — | — | — | — | 64,119 | ||||||||||||
| — | — | — | — | 115,368 | ||||||||||||
| — | 440,700 | — | — | 650,806 | ||||||||||||
| 42,406,483 | (3,305,250 | ) | (9,329,501 | ) | (3,303,342 | ) | 65,592,150 | |||||||||
| 1,267,370 | — | — | — | 1,267,370 | ||||||||||||
| (404,436) | — | — | — | (404,436 | ) | |||||||||||
| — | (2,292,365 | ) | — | (2,292,365 | ) | |||||||||||
| — | — | 2,045 | — | 1,746 | ||||||||||||
| — | — | — | (1,488,479 | ) | (1,488,479 | ) | ||||||||||
| — | — | — | — | 405,872 | ||||||||||||
| — | — | — | — | — | ||||||||||||
| — | 220,350 | — | — | 269,493 | ||||||||||||
| $43,269,417 | $ | (3,084,900 | ) | $ | (11,619,821 | ) | $ | (4,791,821 | ) | $ | 63,351,351 | |||||
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HERITAGE FINANCIAL GROUP AND SUBSIDIARY
Consolidated Statements of Cash Flows (Unaudited)
For the Six Months Ended June 30, 2008 and 2007
For the Six Months Ended June 30, 2008 and 2007
| Six Months Ended June 30, | ||||||||
| 2008 | 2007 | |||||||
OPERATING ACTIVITIES | ||||||||
| Net income | $ | 1,267,370 | $ | 1,267,952 | ||||
| Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
| Depreciation and amortization | 502,548 | 490,412 | ||||||
| Provision for loan losses | 1,182,000 | 495,000 | ||||||
| ESOP compensation expense | 269,493 | 355,900 | ||||||
| Stock-based compensation expense | 405,872 | 429,051 | ||||||
| Net (gain) loss on sale of securities available for sale | (19,745 | ) | 28,395 | |||||
| Net gain on termination of cash flow hedge | 898,725 | — | ||||||
| Accretion of gain on termination of cash flow hedge | (49,020 | ) | — | |||||
| Net (increase) decrease in foreclosed assets | (2,043,805 | ) | 4,163 | |||||
| Increase in bank owned life insurance | (5,192,819 | ) | (169,057 | ) | ||||
| (Increase) decrease in interest receivable | 319,196 | (129,362 | ) | |||||
| Increase (decrease) in interest payable | (174,474 | ) | 319,419 | |||||
| Increase (decrease) in taxes payable | 274,887 | (218,030 | ) | |||||
| Net other operating activities | (1,089,738 | ) | 823,194 | |||||
| Total adjustments | (283,120 | ) | 2,429,085 | |||||
| Net cash provided by operating activities | 1,550,490 | 3,668,929 | ||||||
INVESTING ACTIVITIES | ||||||||
| (Increase) decrease in interest-bearing deposits in banks | (61,078 | ) | 1,769,025 | |||||
| Purchases of securities available for sale | (40,561,986 | ) | (34,150,575 | ) | ||||
| Proceeds from maturities of securities available for sale | 8,616,448 | 3,932,915 | ||||||
| Proceeds from sale of securities available for sale | 20,451,970 | 3,970,820 | ||||||
| Purchase of bank owned life insurance | 5,000,000 | — | ||||||
| Net change in Federal home loan bank stock | (778,600 | ) | (20,300 | ) | ||||
| Decrease in federal funds sold | 8,356,000 | 7,880,000 | ||||||
| Increase in loans, net | (11,362,227 | ) | (18,200,490 | ) | ||||
| Purchase of premises and equipment | (2,256,862 | ) | (788,086 | ) | ||||
| Net cash used in investing activities | (22,596,335 | ) | (35,606,691 | ) | ||||
FINANCING ACTIVITIES | ||||||||
| Increase (decrease) in deposits | (9,235,631 | ) | 28,577,784 | |||||
| Increase in federal funds purchased and securities sold under agreement to repurchase | 15,340,955 | 4,962,585 | ||||||
| Proceeds from other borrowings | 15,000,000 | — | ||||||
| Purchase of treasury stock, net | (2,290,619 | ) | (99,284 | ) | ||||
| Dividends paid to stockholders | (404,436 | ) | (364,564 | ) | ||||
| Net cash provided by financing activities | 18,410,269 | 33,076,521 | ||||||
| Net increase (decrease) in cash and due from banks | (2,635,576 | ) | 1,166,867 | |||||
| Cash and due from banks at beginning of period | 8,953,836 | 9,781,232 | ||||||
| Cash and due from banks at end of period | $ | 6,318,260 | $ | 10,948,099 | ||||
See Notes to Consolidated Financial Statements.
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HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS
ENDED JUNE 30, 2008 AND 2007
(Unaudited)
FOR THE SIX MONTHS
ENDED JUNE 30, 2008 AND 2007
(Unaudited)
| Six Months Ended March 31, | ||||||||
| 2008 | 2007 | |||||||
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION | ||||||||
| Cash paid during the period for: | ||||||||
| Interest | $ | 6,562,543 | $ | 6,122,650 | ||||
| Taxes | — | 907,873 | ||||||
NONCASH TRANSACTIONS | ||||||||
| Increase in unrealized losses on securities available for sale | $ | 2,624,239 | $ | 2,358,277 | ||||
| Decrease in unrealized gain on termination of cash flow hedges | 391,396 | — | ||||||
| Increase in unrealized losses on cash flow hedges | 314,866 | — | ||||||
See Notes to Consolidated Financial Statements.
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HERITAGE FINANCIAL GROUP AND SUBSIDIARY
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 — BASIS OF PRESENTATION AND ACCOUNTING ESTIMATES
The accompanying consolidated financial information of the Company is unaudited; however, such information reflects all adjustments (consisting of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of the financial position and results of operations. The results of operations for the three and six months ended June 30, 2008, are not necessarily indicative of the results that may be expected for the full year. These statements should be read in conjunction with the consolidated financial statements and related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
The consolidated financial statements include the accounts of the Company and its subsidiary. Significant intercompany transactions and balances have been eliminated in consolidation.
In preparing the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, contingent assets and liabilities and deferred tax assets.
NOTE 2 — EARNINGS PER SHARE
Basic earnings per share represent income available to common shareholders divided by the weighted-average number of common shares outstanding during the period, excluding unallocated shares of the Employee Stock Ownership Plan. The table below sets forth our earnings per share for the periods indicated:
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||
| 2008 | 2007 | 2008 | 2007 | |||||||||||||
| Basic earnings per share: | ||||||||||||||||
| Net income | $ | 687,831 | $ | 549,011 | $ | 1,267,370 | $ | 1,267,952 | ||||||||
| Weighted average common shares outstanding | 10,210,936 | 10,324,625 | 10,246,912 | 10,321,290 | ||||||||||||
| Total basic earnings per common share | $ | 0.07 | $ | 0.05 | $ | 0.12 | $ | 0.12 | ||||||||
| Diluted earnings per share: | ||||||||||||||||
| Net income | $ | 687,831 | $ | 549,011 | $ | 1,267,370 | $ | 1,267,952 | ||||||||
| Weighted average common shares outstanding | 10,210,936 | 10,324,625 | 10,246,912 | 10,321,290 | ||||||||||||
| Effect of dilutive stock options and restricted stock | 1,799 | 92,932 | 1,988 | 54,675 | ||||||||||||
| Weighted average dilutive common shares outstanding | 10,212,735 | 10,417,557 | 10,248,900 | 10,375,965 | ||||||||||||
| Total diluted earnings per common share | $ | 0.07 | $ | 0.05 | $ | 0.12 | $ | 0.12 | ||||||||
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NOTE 3 — SHARE BASED COMPENSATION
On May 17, 2006, our stockholders approved the 2006 Equity Incentive Plan (the “Plan”). The purpose of the Plan is to promote the long-term growth and profitability of Heritage Financial Group, to provide directors, advisory directors, officers and employees of Heritage Financial Group and its affiliates with an incentive to achieve corporate objectives, to attract and retain individuals of outstanding competence and to provide such individuals with an equity interest in Heritage Financial Group. Under the Plan, the Compensation Committee of the Board of Directors has discretion to award up to 771,149 shares, of which 550,281 were available as stock options or stock appreciation rights and 220,328 shares were available as restricted stock awards. During 2006, the Compensation Committee of the Board of Directors granted stock options and tandem stock appreciation rights totaling 520,605 shares and granted restricted stock awards totaling 207,905 shares. During the first quarter of 2008, an additional 19,750 of tandem stock option and stock appreciation rights, and 9,505 of restricted stock awards were granted to employees. All stock options, stock appreciation rights and restricted stock awards vest over a period of five years.
The Company granted restricted awards that may not be sold or otherwise transferred until certain restrictions have lapsed. The share based expense for these awards was determined based on the market price of our stock at the date of grant applied to the total number of shares that were anticipated to fully vest, amortized over the vesting period. As of June 30, 2008, there was approximately $1,508,000 of unrecognized compensation associated with these awards. For the three and six months ended June 30, 2008, we recognized compensation expense of approximately $125,000 and $250,000, respectively.
We recognized compensation expense related to stock options of approximately $78,000 for the three months and $156,000 for the six months ended June 30, 2008. At June 30, 2008, there was approximately $936,000 of unrecognized compensation related to stock options.
NOTE 4 — DERIVATIVE FINANCIAL INSTRUMENTS
In October and November of 2007, the Company entered into three, 5-year interest rate swap agreements totaling $20 million in notional amount to hedge against interest rate risk in a declining rate environment. On March 17, 2008, the Company terminated its three interest rate swap agreements with its counterparty for a total gain of $898,725. This gain will be deferred and recognized as a component of interest and fees on loans on a straight-line basis over the next fifty-four months, which was the remaining term on the interest rate swap agreements.
In May of 2008, the Company entered into two, 3-year interest rate swap agreements totaling $20 million in notional amount to hedge against interest rate risk in a flat or declining interest rate environment. As a cash flow hedge, the portion of the change in the fair value of the derivative that has been deemed highly effective is recognized in other comprehensive income until the related cash flows from the hedged item are recognized in earnings.
As of June 30, 2008, the Company recognized interest income of approximately $112,000 year to date and $73,000 quarter to date on derivative financial instruments. There were no derivative financial instruments outstanding as of June 30, 2007.
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NOTE 5 — FAIR VALUE MEASUREMENTS
On January 1, 2008, the Company adopted FASB No. 157, Fair Value Measurements. FASB No. 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. FASB No. 157 applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements; accordingly, the standard does not require any new fair value measurements of reported balances.
FASB No. 157 emphasizes that fair value is market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, FASB No. 157 establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Level 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).
Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs may include quoted prices for similar assets and liabilities in active markets, as well as inputs that are observable for the asset or liability (other than quoted prices), such as interest rates, foreign exchange rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liabilities, which are typically based on an entity’s own assumptions, as there is little, if any, related market activity. In instances where the determination of the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.
The table below presents the Company’s assets and liabilities measured at fair value on a recurring basis as of June 30, 2008, aggregated by the level in the fair value hierarchy within which those measurements fall.
| Quoted Prices | Significant | |||||||||||||||
| in Active | Other | Significant | ||||||||||||||
| Markets for | Observable | Unobservable | ||||||||||||||
| Identical Assets | Inputs | Inputs | ||||||||||||||
| (Level 1) | (Level 2) | (Level 3) | Total | |||||||||||||
Assets | ||||||||||||||||
| Available for sale investment securities | $ | — | $ | 116,756,266 | $ | — | $ | 116,756,266 | ||||||||
| Total assets at fair value | $ | — | $ | 116,756,266 | $ | — | $ | 116,756,266 | ||||||||
Liabilities | ||||||||||||||||
| Derivative financial instruments | $ | — | $ | 314,866 | $ | — | $ | 314,866 | ||||||||
| Total liabilities at fair value | $ | — | $ | 314,866 | $ | — | $ | 314,866 | ||||||||
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| ITEM 2. | MANAGEMENT’S DISCUSSION AND ANALYSIS |
Forward-Looking Statements.
This report contains certain ‘forward-looking statements’ that may be identified by the use of such words as “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated” with respect to our financial condition. Results of operations and business are subject to various factors that could cause actual results to differ materially from these estimates and most other statements that are not historical in nature. These factors include, but are not limited to, general and local economic conditions, changes in interest rates, deposit flows, demand for mortgage, consumer and other loans, real estate values, competition, changes in accounting principles, policies or guidelines, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting our operations, pricing, products and services.
General
Heritage Financial Group (“the Company”) is the parent holding company of HeritageBank of the South (“the Bank”). The Company is in a mutual holding company structure and 74% of its outstanding common stock is owned by Heritage, MHC (“MHC”), a federal mutual holding company.
The principal business of the Company is operating our wholly owned subsidiary, the Bank. Our results of operations depend primarily on our net interest income. Net interest income is the difference between the interest income we earn on our interest-earning assets, consisting primarily of loans and investments, and the interest we pay on our interest-bearing liabilities, consisting of savings and checking accounts, money market accounts, time deposits, federal funds purchased and securities sold under agreements to repurchase and other borrowings. Our results of operations also are affected by our provisions for loan losses, noninterest income and noninterest expense. Noninterest income consists primarily of service charges on deposit accounts, mortgage origination fees, transaction fees, bank-owned life insurance, and commissions from investment services. Noninterest expense consists primarily of salaries and employee benefits, occupancy, equipment and data processing, advertising, professional fees and other costs. Our results of operations also may be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.
Evolution of Business Strategy
We originally were chartered as a federal credit union in 1955. In 1998, we became a community chartered credit union. We accepted deposits and made loans to members who lived, worked or worshiped in the approved counties for the credit union charter. In 2001, we converted to a mutual thrift charter in order to better serve our customers and communities through a broader lending ability and an expanded customer base beyond the field of membership permitted for our credit union. The mutual holding company structure was established in 2002, and we converted from a thrift charter to a state savings bank charter in 2005. We feel this structure best suits our continued efforts to grow and expand our commercial business.
The Company completed an initial public stock offering on June 29, 2005. We sold 3,372,375 shares of common stock in that offering for $10.00 per share. The Company’s employee stock ownership plan (the “ESOP”) purchased 440,700 shares with the proceeds of a loan from the Company. The Company received net proceeds of $32.4 million in the public offering, 50% of which was contributed to the Bank and $4.4 million of which was loaned to the ESOP for its purchase of shares in the offering. The Company also issued an additional 7,867,875 shares of common stock to MHC, so that MHC would own 70% of the outstanding common stock at the close of the offering.
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Evolution of Business Strategy (Continued)
Our current business strategy is to operate a well-capitalized and profitable commercial and retail financial institution dedicated to serving the needs of our customers. We strive to be the primary financial institution in the market areas we serve. We offer a broad range of products and services, while stressing personalized and efficient customer service and convenient access to these products and services. We intend to continue to operate as a commercial and consumer lender. We have structured operations around a branch system that is staffed with knowledgeable and well-trained employees. Subject to capital requirements and our ability to grow in a reasonable and prudent manner, we may open additional branches as opportunities arise. In addition to our branch system, we continue to expand electronic services for our customers. We attempt to differentiate ourselves from our competitors by providing a higher level of customer service.
We continue to implement our business strategy, as set forth in our Form 10-K, which was filed with the Securities and Exchange Commission on March 31, 2008. A critical component of this strategy includes increasing our commercial loan portfolio. During the first six months of 2008, our commercial real estate, business and multifamily loans increased $6.0 million or 3.9% to $161.0 million at June 30, 2008. Our ability to continue to grow our commercial loan portfolio is an important element of our long-term business strategy.
Another key component of our business strategy is the expansion of our operations outside of the Southwest Georgia market. In January of 2008, we opened our second branch in Ocala, Florida. As of June 30, 2008, we had total loans of $34.2 million and total deposits of $27.4 million at our Ocala, Florida branches. We are currently operating two permanent branches in Ocala.
Operating a branch outside of the Southwest Georgia market subjects us to additional risk factors. These risk factors include, but are not limited to the following: management of employees from a distance, lack of knowledge of the local market, additional credit risks, logistical operational issues, and time constraints of management. These risk factors, as well as others we have not identified, may affect our ability to successfully operate outside of our current market area.
For more information on risk factors please see Item IA under Part II of this 10-Q.
Critical Accounting Policies
We have not changed any of our critical accounting policies since those disclosed in our Form 10-K, which was filed with the Securities and Exchange Commission on March 31, 2008. Those accounting policies relate to the judgments and estimates used in the preparation of our financial statements in the calculation of the allowance for loan losses, the accounting for impaired loans and the provision for income taxes.
Off Balance Sheet Liabilities
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit and standby letters of credit. We use the same credit policies in making these commitments as we do for on-balance sheet instruments. A summary of the Company’s commitments as of June 30, 2008, is as follows:
| (In thousands) | ||||
| Commitments to extend credit | $ | 43,473 | ||
| Financial stand-by letters of credit | 4,986 | |||
| $ | 48,459 | |||
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Comparison of Financial Condition at June 30, 2008 and December 31, 2007
Total assets increased $18.9 million or 4.0% to $487.6 million at June 30, 2008, from $468.7 million at December 31, 2007. Total interest earning assets increased $10.5 million or 2.5% to $437.9 million at June 30, 2008, from $427.4 million at December 31, 2007. Total loans increased $9.9 million or 3.2% to $314.5 million at June 30, 2008. Approximately $8.9 million of the loans booked during the first half of 2008 were related to our investment in the Chattahoochee Bank of Georgia (in organization) (“Chattahoochee”). We expect the majority of these loans to be paid off when Chattahoochee commences operations sometime late in the third quarter or early fourth quarter of this year. During the first half of 2008, loans outstanding in the North Central Florida region increased by $7.6 million to $34.2 million. Loans outstanding in the Southwest Georgia region decreased by $6.7 million during the first half of 2008. This decrease in loans was approximately evenly divided between commercial and retail loans. The weakened economic environment in the country, the Southeastern United States, and in our markets is resulting in very limited loan demand. In addition, as economic factors have deteriorated, we have tightened our credit standards. Therefore, we expect loan volume to be very limited for the remainder of 2008 unless economic trends improve significantly.
Securities increased $8.9 million at June 30, 2008 as compared to December 31, 2007. During the first half of the year, we took advantage of a steepened yield curve to prefund some investments that will mature over the next twelve months. Other earning assets decreased $8.3 million during the first half of 2008, primarily due to a decrease in federal funds sold. The decrease in federal funds sold of $8.4 million was due to our deposit pricing strategy. During the first half of 2008, we saw many of our competitors offering abnormally high deposit rates, despite the drop in rates from the Federal Reserve. We sought to pay more reasonable rates of interest on federal funds purchased and other borrowings during the first half of the year, and only paid market rates of interest on deposit accounts of select customers who had their primary banking relationship with us. This caused federal funds sold to decrease and other borrowings to increase, while certificates of deposits decreased.
Other equity securities increased to $980,000 as we funded our investment in Chattahoochee during the second quarter of 2008.
Premises and equipment increased by $1.8 million, primarily due to the construction of our second permanent location in Ocala. This branch opened in July of this year.
Foreclosed assets increased $2.0 million to $2.4 million. The majority of this increase was the foreclosure of a residential development in the Florida panhandle. This loan was a participation purchased by the Bank’s commercial lending division in Albany.
Cash surrender value of bank owned life insurance (“BOLI”) increased by $5.2 million, primarily due to the purchase of $5 million of additional BOLI in June of this year. This purchase was made due to an advantageous interest rate environment compared to other investment alternatives. In addition, this purchase allowed us to cover many new officers of the Bank that were not covered under existing BOLI policies which were purchased in 2001.
Total liabilities increased $21.1 million or 5.3% to $424.2 million at June 30, 2008 compared with $403.1 million at December 31, 2007. The increase was due to an increase of $15.0 million in other borrowings and $15.3 million in federal funds purchased and repurchase agreements, while deposits decreased by $9.2 million. The total amount of other borrowings increased to $65.0 million during the first half of 2008. Federal funds purchased and repurchase agreements increased to $30.6 million at June 30, 2008 from $15.3 million in December 31, 2007. Deposits decreased $9.2 million or 2.8% to $321.4 million compared with $330.6 at December 31, 2007. The majority of the decrease in deposits is due to a decrease in interest bearing deposits. During the year, we have faced tremendous competitive pressures on deposit rates. As we have seen this pressure increase, we have implemented policies to only give our highest deposit rates to relationship customers. Due to this policy, we have eliminated a number of single service customers whose only product with the Bank was a certificate of deposit. Although this has caused our deposits to decrease, we feel that the
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positive impact it has had on our net interest margin outweigh the decline in deposit balances. As deposit rates continue to remain extremely competitive, we will likely begin to offer higher rates to single product customers. This could have a negative impact on our net interest margin.
Total equity decreased $2.3 million to $63.3 million at June 30, 2008, compared with $65.6 million at December 31, 2007. Net income of $1.2 million for the first six months of 2008, net derivatives transactions of $86,000 and the allocation of $220,000 in ESOP shares increased equity, which was offset by dividends of $404,000, an increase in unrealized losses on available for sale securities of $1.5 million, and the purchase of treasury stock for $2.3 million.
Comparison of Operating Results
General
For the three months ended June 30, 2008 and 2007
During the quarter ended June 30, 2008, our net income increased $139,000 or 25.3% to $688,000 compared to $549,000 for the quarter ended June 30, 2007. The increase was due primarily to an increase in net interest income and noninterest income, which was offset by a higher provision and noninterest expense during the period.
For the six months ended June 30, 2008 and 2007
During the first half of 2008, income remained level at $1.3 million compared to $1.3 million for the first half of 2007. Higher net interest income and noninterest income was offset by a significant increase in the provision for loan losses, and higher noninterest expense.
Interest Income
For the three months ended June 30, 2008 and 2007
Total interest income for the three months ended June 30, 2008, decreased $157,000 or 2.2% to $6.8 million, compared to $7.0 million during the second quarter of 2007. The decrease was the result of a 69 basis points decrease in yield on average earning assets to 6.32% during the second quarter of 2008 as compared to the yield of 7.01% earned during the same period in 2007. This decrease was due to an overall fall in interest rates. We expect the yield on our earning assets to decrease slightly or remain flat during the remainder of 2008 as we continue to see the effects of the Federal Reserve rate cuts from late 2007 and early 2008. Average interest earning assets increased $35.3 million for the quarter ending June 30, 2008, compared with the same period in 2007.
For the six months ended June 30, 2008 and 2007
Total interest income for the six months ended June 30, 2008, increased $292,000 or 2.2% to $13.9 million, compared to $13.6 million during the second quarter of 2007. The increase was the result of an increase in average interest earning assets of $38.5 million for the first half of 2008 when compared to the same period in 2007. The yield on earning assets decreased 47 basis points to 6.50% during the six months ended June 30, 2008 from 6.97% during the 2007 period.
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Interest Expense
For the three months ended June 30, 2008 and 2007
Total interest expense decreased $301,000 or 9.0% to $3.0 million for the quarter ended June 30, 2008, compared to $3.3 million during the same period in 2007. The average cost of funds decreased 80 basis points 3.76% during the second quarter of 2008 compared with 4.56% during the same period in 2007. The average balance of interest bearing liabilities was $395.8 million at June 30, 2008, an increase of $41.8 million or 11.8% compared to $354.1 million at June 30, 2007.
For the six months ended June 30, 2008 and 2007
Total interest expense decreased $54,000 or 0.8% to $6.4 million for the six months ended June 30, 2008. The average cost of funds decreased 44 basis points to 3.30% during the first half of 2008 compared with 3.74% during the same period in 2007. The average balance of interest bearing liabilities was $389.0 million at June 30, 2008, an increase of $42.0 million or 12.1% compared to $347.0 million at June 30, 2007. We expect to see our yield on interest bearing liabilities to remain flat or decrease slightly during the remainder of 2008. However, as previously mentioned, the market for deposit products is extremely competitive, and if it remains at this competitive level for the remainder of 2008, without a corresponding rise in Federal funds rates, it could have a negative impact on the cost of our interest bearing liabilities.
Net Interest Income
For the three months ended June 30, 2008 and 2007
Net interest income of $3.8 million was an increase from the $3.7 million shown during the same period in 2007. The net interest spread increased 1 basis point for the second quarter of 2008 to 3.24% compared with 3.23% during the same period in 2007. The net interest margin fell 16 basis points to 3.57% for the three months ended June 30, 2008 compared to the same period in 2007.
For the six months ended June 30, 2008 and 2007
Net interest income of $7.5 million was a increase from the $7.1 million shown during the same period in 2007. The net interest spread decreased 2 basis points for the first half of 2008 to 3.21% compared to 3.23% during the same period in 2007. The net interest margin fell 14 basis points to 3.57% for the six months ended June 30, 2008 compared to 3.72% during the first half of 2007.
General Comments on Interest Rates
During the first quarter of 2008, we saw dramatic drops in interest rates as the Federal Reserve lowered the federal funds target rate three times for a total of 200 basis points. On April 30, 2008, the Federal Reserve lowered rates an additional 25 basis points and modified their bias from weakness to cautious. These reductions in rates have put extreme downward pressure on our margins, as our loans tend to reprice more quickly than our deposit products. Our asset-liability management policy seeks to mitigate interest rate risk by making our balance sheet as neutral as possible to changes in interest rates. Although our goal is to be neutral to changes in rates, we will never achieve this without taking undue risk. Therefore, we remain exposed to further reductions in interest rates. For more information on the effect of changes in interest rates, see Item 3 of this Form 10-Q.
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Provision for Loan Losses
For the three months and six months ended June 30, 2008 and 2007
During the quarter ended June 30, 2008, we recorded a $782,000 provision for loan losses, which was a significant increase compared to the $337,000 provision during the same period in 2007. For the year to date period, we recorded a $1,182,000 provision for loan losses, which was $687,000 higher than the $495,000 of provision expense we incurred for the first half of 2007. As general economic treads have declined, we have experienced increases in internally criticized and classified loans, as well as increases in nonperforming and past due loans.
Annualized net charge-offs to average outstanding loans increased to 1.77% for the three months ending June 30, 2008 compared to 0.01% during the same period of 2007. Annualized net charge-offs to average outstanding loans increased to 0.96% for the six months ending June 30, 2008 compared to 0.04% during the same period of 2007.
Nonperforming loans increased $1.3 million to $1.8 million at June 30, 2008 compared to $546,000 at June 30, 2007. Nonperforming loans to total loans increased to 0.58% at June 30, 2008 from 0.19% at June 30, 2007. Nonperforming assets increased $3.4 million to $4.2 million at June 30, 2008 compared to $865,000 at June 30, 2007. Nonperforming assets to total assets increased to 0.87% at June 30, 2008 as compared to 0.19% in 2007. The allowance for loan losses as a percentage of total loans decreased to 1.31% for June 30, 2008 compared with 1.53% at June 30, 2007. This decrease in the percentage of the allowance for loan losses to total loans is due to the high level of charge-offs that have occurred during the first half of 2008.
Loans past due 30 days and still accruing totaled $2.2 million, or 0.71% of total loans at June 30, 2008. This compares to $1.9 million at December 31, 2007, or 0.65% of loans. At June 30, 2007, past due loans totaled $542,000 or 0.18% of loans.
Our internally criticized and classified assets totaled $19.3 million at June 30, 2008, compared to $13.4 million at December 31, 2007 and $13.7 million at June 30, 2007. These balances include the aforementioned nonperforming loans, other real estate, and repossessed assets. Our internal loan review processes strive to identify weaknesses in loans prior to performance issues. However, our processes do not always provide sufficient time to work out plans with borrowers that would avoid foreclosure and/or losses.
We continue to see weakness in our loan portfolio, and as economic conditions remain difficult, we expect this trend to continue until we see improvement in the overall economy. We have taken actions to prevent losses in our current portfolio, including a weekly meeting of members of management and lenders to discuss the status and action plan on each problem loan. We have also taken steps to better evaluate the capital and liquidity positions of our commercial loan guarantors, particularly those involved in commercial real estate construction and development.
We establish provisions for loan losses, which are charged to operations, at a level we believe will reflect probable credit losses based on historical loss trends and an evaluation of specific credits in the loan portfolio. In evaluating the level of the allowance for loan losses, we consider the types of loans and the amount of loans in the loan portfolio, historical loss experience, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions, and past due status and trends.
We assess the allowance for loan losses on a quarterly basis and make provisions for loan losses as necessary in order to maintain the proper level of allowance. While we use available information to recognize losses on loans, future loan loss provisions may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the allowance for loan losses and may require us to recognize additional provisions based on their judgment of information available to them at the time of their examination. The allowance for loan losses is maintained at a level that represents management’s best estimate of inherent losses in the loan portfolio, and such losses were both probable and reasonably estimable. The level of the allowance is based on estimates and the ultimate losses may vary from the estimates.
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Noninterest Income
A summary of noninterest income follows:
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||||||||||||||||||
| 2008 | 2007 | $ Chg | % Chg | 2008 | 2007 | $ Chg | % Chg | |||||||||||||||||||||||||
| Service charges on deposit accounts | $ | 976,140 | $ | 939,384 | $ | 36,756 | 3.91 | % | $ | 1,903,418 | $ | 1,774,502 | $ | 128,916 | 7.26 | % | ||||||||||||||||
| Other service charges, commissions and fees | 331,734 | 259,724 | 72,010 | 27.73 | % | 658,803 | 616,275 | 42,528 | 6.90 | % | ||||||||||||||||||||||
| Brokerage fees | 261,796 | 264,181 | (2,385 | ) | -0.90 | % | 505,831 | 441,407 | 64,424 | 14.60 | % | |||||||||||||||||||||
| Mortgage origination fees | 116,914 | 92,766 | 24,148 | 26.03 | % | 205,708 | 194,311 | 11,397 | 5.87 | % | ||||||||||||||||||||||
| Bank owned life insurance | 99,384 | 87,260 | 12,124 | 13.89 | % | 192,839 | 169,056 | 23,783 | 14.07 | % | ||||||||||||||||||||||
| Gain (loss) on sale of securities | 7,386 | 287 | 7,099 | 2473.52 | % | 19,745 | (28,395 | ) | 48,140 | -169.54 | % | |||||||||||||||||||||
| Other | 205,982 | 65,213 | 140,769 | 215.86 | % | 278,119 | 129,782 | 148,337 | 114.30 | % | ||||||||||||||||||||||
| Total noninterest income | $ | 1,999,336 | $ | 1,708,815 | $ | 290,521 | 17.00 | % | $ | 3,764,463 | $ | 3,296,938 | $ | 467,525 | 14.18 | % | ||||||||||||||||
| Noninterest income as a percentage of average assets (annualized) | 1.64 | % | 1.54 | % | 1.57 | % | 1.52 | % | ||||||||||||||||||||||||
We have continued to see an increase in service charges on deposit accounts. This increase was made up primarily of a $137,000 increase in non-sufficient fund charges. This increase is due to our implementation of a program that allows customers to receive cash ATM withdrawals and make debit card purchases on overdrawn accounts within defined limits for a fee. This product is increasing overdraft fees, which is responsible for the increase in our service charges on deposit accounts in the current quarter and for the year. The increase in other service charges, commissions and fees was due primarily to an increase in fees from debit and ATM transactions of $69,000 for the quarter and $130,000 for the year to date. We expect to continue to see strong income from debit and ATM transactions as our customers are increasing debit and ATM usage compared with traditional check writing. In addition, we saw a significant decrease in check printing commissions in the first half of 2008 when compared to the same period in 2007. This decrease was due entirely to a one time payment from our vendor on renegotiation of our check printing contract in 2007.
The increase in brokerage fees was due to an increased level of assets under management. In addition, we have benefited from enhanced product offerings with our new third party broker/dealer.
Mortgage fees have increased despite an increase in long term rates, credit tightening in the overall secondary mortgage market due to the collapse of sub-prime lending programs and a general slow down in the housing market. Although we did not participate in sub-prime mortgage lending, we do believe the tightening of the secondary market for these loans will have a negative impact on the overall housing market, and thus cause us to see mortgage activity below normal levels. However, we do believe we are benefiting from a decrease in the number of competing mortgage brokers in the markets we serve.
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The increase in earnings on bank owned life insurance is due to an increased level of interest on our policies, due to a rise in longer term interest rates and exchanges we have made into higher yielding policies.
The gain on sales of securities for the year to date is due to portfolio adjustments we have made to increase yield and better position our balance sheet for potential changes in interest rates. We may take additional gains or losses during the year to increase yields and for asset-liability management purposes.
The majority of the increase in other noninterest income is a gain of approximately $100,000 on the sale of a1/2 interest in a partnership which owns an office building located in the same office as our main office. This interest was sold to a related party.
Noninterest Expense
A summary of noninterest expense follows:
| Three Months Ended June 30, | Six Months Ended June 30, | |||||||||||||||||||||||||||||||
| 2008 | 2007 | $ Chg | % Chg | 2008 | 2007 | $ Chg | % Chg | |||||||||||||||||||||||||
| Salaries and employee benefits | $ | 2,224,418 | $ | 2,371,388 | $ | (146,970 | ) | -6.20 | % | $ | 4,525,375 | $ | 4,654,209 | $ | (128,834 | ) | -2.77 | % | ||||||||||||||
| Equipment | 298,898 | 277,248 | 21,650 | 7.81 | % | 620,058 | 554,502 | 65,556 | 11.82 | % | ||||||||||||||||||||||
| Occupancy | 272,164 | 254,067 | 18,097 | 7.12 | % | 563,795 | 504,256 | 59,539 | 11.81 | % | ||||||||||||||||||||||
| Advertising and marketing | 111,345 | 105,747 | 5,598 | 5.29 | % | 256,676 | 195,811 | 60,865 | 31.08 | % | ||||||||||||||||||||||
| Legal and accounting | 141,972 | 93,091 | 48,881 | 52.51 | % | 268,803 | 190,899 | 77,904 | 40.81 | % | ||||||||||||||||||||||
| Consulting & other professional fees | 85,098 | 174,169 | (89,071 | ) | -51.14 | % | 178,690 | 287,081 | (108,391 | ) | -37.76 | % | ||||||||||||||||||||
| Directors fees and retirement | 160,263 | 131,202 | 29,061 | 22.15 | % | 313,197 | 259,404 | 53,793 | 20.74 | % | ||||||||||||||||||||||
| Telecommunications | 63,258 | 58,513 | 4,745 | 8.11 | % | 135,177 | 114,036 | 21,141 | 18.54 | % | ||||||||||||||||||||||
| Supplies | 55,008 | 56,461 | (1,453 | ) | -2.57 | % | 112,852 | 110,711 | 2,141 | 1.93 | % | |||||||||||||||||||||
| Data processing fees | 337,247 | 372,690 | (35,443 | ) | -9.51 | % | 641,460 | 551,496 | 89,964 | 16.31 | % | |||||||||||||||||||||
| Other operating | 427,275 | 451,923 | (24,648 | ) | -5.45 | % | 916,377 | 830,106 | 86,271 | 10.39 | % | |||||||||||||||||||||
| Total noninterest expenses | $ | 4,176,946 | $ | 4,346,499 | $ | (169,553 | ) | -3.90 | % | $ | 8,532,460 | $ | 8,252,511 | $ | 279,949 | 3.39 | % | |||||||||||||||
| Noninterest expenses as a percentage of average assets (annualized) | 3.43 | % | 3.91 | % | 3.56 | % | 3.80 | % | ||||||||||||||||||||||||
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Salaries and employee benefits declined despite cost of living increases and the addition of new staff for our first permanent branch in Ocala. The efficiency project we undertook in the first half of 2007 has allowed us to reduce our branch and back office staff through attrition. In addition, our ESOP expense has been reduced because of our lower stock price. Expenses under our senior executive retirement plans have also been eliminated for 2008 due to the acceleration of vesting that took place in the third quarter of 2007.
Equipment and occupancy expenses increased primarily because of the permanent branch we opened in Ocala in January of 2008. This will increase during the second half of 2008 as we begin to operate our second permanent location in Ocala.
The increase in advertising and marketing is due to additional marketing expenses incurred with our expansion into Ocala and the implementation of a branding campaign in our Albany market.
The increase in legal and accounting fees was primarily due to increased legal fees associated with our investment in the Chattahoochee Bank of Georgia (in organization).
Consulting and other professional fees decreased due to the elimination of consulting fees incurred from our efficiency project that was undertaken during the first two quarters of 2007.
Directors fees and retirement fees increased primarily due to an increase in directors compensation for directors of the Bank who have served on the board for more than one year.
The increase in telecommunications expenses is related to the addition of the new branch in Ocala.
Supplies remained relatively flat as we have implemented better internal controls related to the purchase of supplies, and we have also renegotiated our supply contract with a major vendor.
Data processing fees increased for the year due to two factors. First, as debit card usage and ATM fees have increased, the cost of facilitating these transactions has also increased. These fees are more than offset by the income we receive on these transactions. Also, during the first quarter of 2007, we resolved a billing dispute with our core processing provider, which resulted in lower than normal processing fees. During 2008, those fees returned to normal levels.
The increase in other operating expenses for the year was due primarily to increases in regulatory fees and expenses related to foreclosures and other real estate.
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Income Tax Expense.
Income tax expense was $20,000 greater during the three months ended June 30, 2008, when compared to the three months ended June 30, 2007, as a result of the increase in net income before taxes. The effective tax rate was 18.4% for the 2008 quarter, compared to 19.8% for the 2007 quarter. For the six months ended June 30, 2008, income tax expense was $152,000 lower than the 2007 period. The effective tax rate was 17.8% for the first six months of 2008, compared to 25.2% for the first six months of 2007.
The lower tax rate for 2008 is due primarily to a significant increase in the amount of tax exempt income the Company receives from the purchase of municipal securities and BOLI.
Liquidity and Capital Resources
Liquidity management involves the matching of cash flow requirements of customers, who may be either depositors desiring to withdraw funds or borrowers needing assurance that sufficient funds will be available to meet their credit needs and the ability of the Company to manage those requirements. The Company strives to maintain an adequate liquidity position by managing the balances and maturities of interest earning assets and interest bearing liabilities so that the balance it has in short-term investments at any given time will adequately cover any reasonably anticipated immediate need for funds. Additionally, the Bank maintains relationships with correspondent banks, which could provide funds on short-term notice if needed.
The liquidity and capital resources of the Company are monitored continuously by the Company’s Board-authorized Asset Liability Management Committee and on a periodic basis by state and federal regulatory authorities. As determined under guidelines established by these regulatory authorities, the Company’s and the Bank’s liquidity ratios at June 30, 2008, were considered satisfactory. At that date, the Bank’s short-term investments were adequate to cover any reasonably immediate need for funds. The Company is aware of no events or trends likely to result in a material change in liquidity.
The consolidated statement of cash flows for the six months ended June 30, 2008 and 2007, detail cash flows from operating, investing and financing activities. For the six months ended June 30, 2008, net provided by operating activities was $1.6 million while investing activities used $22.6 million, primarily due to the purchase of securities, BOLI and to fund loan growth, and financing activities provided $18.4 million primarily from an increase in other borrowings and repurchase agreements, resulting in a net decrease in cash during the six month period of $2.6 million.
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Regulatory Capital Ratios for HeritageBank of the South at June 30, 2008
The Company’s and the Bank’s regulatory capital levels exceed the minimums required by state and federal authorities. The following table reflects the Bank’s compliance at June 30, 2008, with regulatory capital requirements. These calculations are based on total risk weighted assets of $384.9 million as of June 30, 2008, and average total assets of $478.3 million for the six months ended June 30, 2008.
| Minimum Required to | ||||||||||||||||||||||||
| Be Well Capitalized | ||||||||||||||||||||||||
| For Capital | Under Prompt | |||||||||||||||||||||||
| Adequacy | Corrective Action | |||||||||||||||||||||||
| Actual | Purposes | Provisions | ||||||||||||||||||||||
| Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||||||||
| (Dollars in thousands) | ||||||||||||||||||||||||
| Total Capital to Risk Weighted Assets | $ | 61,848 | 16.1 | % | $ | 30,789 | 8.0 | % | $ | 38,486 | 10.0 | % | ||||||||||||
| Tier I Capital to Risk Weighted Assets | 57,740 | 15.0 | 15,394 | 4.0 | 23,092 | 6.0 | ||||||||||||||||||
| Tier I Capital to Average Total Assets | 57,740 | 12.0 | 19,174 | 4.0 | 23,967 | 5.0 | ||||||||||||||||||
Heritage Financial Group is subject to Georgia capital requirements for bank holding companies. At June 30, 2008, Heritage Financial Group had total equity of $63.3 million or 13.0% of total assets as of that date. Under Georgia capital requirements for holding companies, Heritage Financial Group had Tier I leverage capital of $67.0 million or 14.0%, which was $47.8 million above the 4.0% requirement.
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| ITEM 3. | QUANTITAVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
The Company is exposed only to U.S. dollar interest rate changes, and, accordingly, the Company manages exposure by considering the possible changes in the net interest margin. The Company does not have any trading instruments nor does it classify any portion of the investment portfolio as held for trading. The Company monitors its sensitivity to changes in interest rates and may use derivative instruments to hedge this risk. The Company does not enter into derivatives or other financial instruments for trading or speculative purposes. Finally, the Company has no exposure to foreign currency exchange rate risk and commodity price risk.
Interest rates play a major part in the net interest income of a financial institution. The sensitivity to rate changes is known as “interest rate risk”. The repricing of interest earning assets and interest bearing liabilities can influence the changes in net interest income.
The Company uses simulation analysis to monitor changes in net interest income due to changes in market interest rates. The simulation of rising, declining and flat interest rate scenarios allows management to monitor and adjust interest rate sensitivity to minimize the impact of market interest rate swings. The analysis of the impact on net interest income over a twelve-month period is subjected to 100, 200 and 300 basis point increases and decreases in market rates on net interest income and is monitored on a quarterly basis.
The Company’s strategy is to mitigate interest risk to the greatest extent possible. Based on our analysis of the Company’s overall risk to changes in interest rates, we structure investment and funding transactions to reduce this risk. In addition, we may enter into off-balance sheet transactions to mitigate this risk. These strategies aim to achieve neutrality to interest rate risk. Although we strive to have our net interest income neutral to changes in rates, due to the inherent nature of our business, we will never be completely neutral to changes in rates.
The Company maintains a Risk Management Committee which monitors and analyzes interest rate risk. This Committee is comprised of members of senior management and outside directors. This Committee meets on a monthly basis and reviews the simulations listed above, as well as other interest rate risk reports.
The following table shows the results of our projections for net interest income expressed as a percentage change over net interest income in a flat rate scenario for an immediate change or “shock” in market interest rates over a twelve month period.
| Effect | ||||
| Market | on Net | |||
| Rate | Interest | |||
| Change | Income | |||
| +300 | 12.28 | % | ||
| +200 | 10.87 | % | ||
| +100 | 6.60 | % | ||
| -100 | -7.25 | % | ||
| -200 | -13.05 | % | ||
| -300 | -15.85 | % | ||
Additional information required by Item 305 of Regulation S-K is set forth under Item 2 of this report.
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| ITEM 4. | CONTROLS AND PROCEDURES |
An evaluation of the Company’s disclosure controls and procedures as defined in Rule 13a -15(e) under the Securities Exchange Act of 1934 (the “Act”) as of June 30, 2008, was carried out under the supervision and with the participation of the Company’s Chief Executive Officer, Chief Financial Officer and several other members of the Company’s senior management. The Chief Executive Officer and Chief Financial Officer concluded that, as of June 30, 2008, the Company’s disclosure controls and procedures were effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Act is: (i) accumulated and communicated to the Company’s management (including the Chief Executive Officer and the Chief Financial Officer) in a timely manner, and (ii) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. There were no changes in our internal control over financial reporting (as defined in Rule 13a - 15(f) under the Act) that occurred during the quarter ended June 30, 2008, that has materially affected, or is likely to materially affect our internal control over financial reporting.
The Company does not expect that its disclosure controls and procedures will prevent all error and all fraud. A control procedure, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control procedure are met. Because of the inherent limitations in all control procedures, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any control procedure is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies and procedures may deteriorate. Because of the inherent limitations in a cost-effective control procedure, misstatements due to error or fraud may occur and not be detected.
The Company intends to continually review and evaluate the design and effectiveness of its disclosure controls and procedures and to improve its controls and procedures over time and to correct any deficiencies that it may discover in the future. The goal is to ensure that senior management has timely access to all material financial and non-financial information concerning the Company’s business. While the Company believes the present design of its disclosure controls and procedures is effective to achieve its goal, future events affecting its business may cause the Company to modify its disclosure controls and procedures.
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PART II — OTHER INFORMATION
| ITEM 1. | LEGAL PROCEEDINGS |
In the normal course of business, the Company occasionally becomes involved in various legal proceedings. In our opinion, any liability from such proceedings would not have a material adverse effect on the business or financial condition of the Company.
ITEM 1A. RISK FACTORS
There has not been any material change in the risk factors disclosure from that contained in the Company’s 2007 Annual Report on Form 10-K for the fiscal year ended December 31, 2007.
| ITEM 2. | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES |
There were no unregistered sales of equity securities during the quarter ended June 30, 2008.
Below is a summary of issuer purchases of equity securities during the quarter ended June 30, 2008.
| Number of | Maximum | |||||||||||||||
| Total | Shares Purchased | Number of Shares | ||||||||||||||
| Number | as Part of | that may yet be | ||||||||||||||
| of Shares | Average Price | Publicly Announced | Purchased Under the | |||||||||||||
| Purchased | Paid Per Share | Plans or Programs | Plans or Programs | |||||||||||||
| April | — | $ | — | — | 87,154 | |||||||||||
| May | 30,000 | 12.30 | 30,000 | 57,154 | ||||||||||||
| June | — | — | — | — | ||||||||||||
| Total | 30,000 | $ | 12.30 | 30,000 | 57,154 | |||||||||||
| ITEM 3. | DEFAULTS UPON SENIOR SECURITIES |
None.
ITEM 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of the Shareholders of the Company was held on May 21, 2008. At this meeting, proxies were solicited pursuant to Regulation 14A under the Exchange Act. Total shares outstanding amounted to 10,719,354. A total of 9,952,296 shares (92.8% of total shares outstanding) were represented by shareholders in attendance at the meeting or by proxy.
The following director nominees were elected to serve as directors for terms to expire in 2011:
Joseph C. Burger, Jr., 9881,740 votes for, 70,556 votes withheld, representing 99.3% in favor. There were no broker non-votes.
Carol W. Slappey, 9,877,515 votes for, 74,781 votes withheld, representing 99.2% in favor. There were no broker non-votes.
Ratification of the appointment of Mauldin & Jenkins, Certified Public Accountants and Consultants, LLC, as the Company’s independent registered public accounting firm for the fiscal year ended December 31, 2007: by 9,906,988 votes for, 44,058 votes against, and 1,250 abstentions, representing 99.5% in favor. There were no broker non-votes.
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ITEM 5.OTHER INFORMATION
None.
ITEM 6.EXHIBITS
| Reference to | ||||||
| Prior Filing | ||||||
| Regulation S-K | or Exhibit Number | |||||
| Exhibit Number | Document | Attached Hereto | ||||
| 31 | Rule 13a-14(a)/15d-14(a) Certifications | 31 | ||||
| 32 | Section 1350 Certifications | 32 | ||||
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| HERITAGE FINANCIAL GROUP | ||||
| Date: August 14, 2008 | By: | /s/ O. Leonard Dorminey | ||
| O. Leonard Dorminey | ||||
| President and Chief Executive Officer | ||||
| Date: August 14, 2008 | By: | /s/ T. Heath Fountain | ||
| T. Heath Fountain | ||||
| Senior Vice President and Chief Financial Officer | ||||
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