All issued and outstanding shares, weighted-average shares and per share amounts in the accompanying condensed consolidated financial statements have been adjusted to retroactively reflect a three-for-two stock split declared in May 2002 and a 20% stock split declared in May 2001. 8. Adoption of New Accounting Standards In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 discontinues the practice of amortizing goodwill and requires that goodwill be continually evaluated for impairment and be written-down when appropriate. SFAS No. 142 also requires that other intangible assets that have been separately identified and accounted for continue to be amortized over a determinable useful life. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 142 did not have a material effect on the Company’s financial condition or results of operations. In June 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations.” SFAS No. 143 addresses financial accounting and reporting obligations associated with the retirement of long-lived assets and the associated asset retirement costs. SFAS No. 143 is effective for fiscal years beginning after June 15, 2002. Management does not expect that the adoption of SFAS No. 143 will have a material effect on the Company’s consolidated financial statements. In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of,” and provides guidance on the classification and accounting for such assets when held for sale or abandonment. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The adoption of SFAS No. 144 did not have a material effect on the Company’s consolidated financial statements. 11
Management’s Discussion and Analysis
of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Company’s unaudited condensed consolidated financial statements and the notes thereto for the nine month and three month periods ended September 30, 2002 and 2001, included in this report. When used in the following discussion, the word “expects,” “believes,” “anticipates” and other similar expressions are intended to identify forward-looking statements, which are made pursuant to the safe harbor provisions of the private securities litigation reform act of 1995. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those projected. Specific risks and uncertainties include, but are not limited to, general business and economic conditions, and other factors listed from time to time in the Company’s SEC reports. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to publish revised forward-looking statements to reflect the occurrence of unanticipated events or circumstances after the date hereof. HIGHLIGHTS FOR THE QUARTER AND YEAR-TO-DATE(All per share amounts have been retroactively adjusted for the three-for-two stock split declared in May 2002) The Company continued its long term growth trends with net loans of $469.5 million at September 30, 2002, an increase of 13.1% since year-end 2001 and up 17.8% compared to a year ago. Similarly, deposits have also grown steadily for the quarter and year to date in both checking and money market accounts. Deposits were particularly strong during the third quarter because of seasonal tourism, continued in-migration, and strong escrow deposits relating to real estate purchase activity and mortgage refinancing business. Strong seasonal deposit flows in the summer months are consistent with the historical pattern of the Company. Deposits ended the quarter at $502.2 million, up 18.1% from year-end 2001 and up 18.4% compared to a year earlier. Average deposits for the quarter were $462.1 million up 11.0% from the year ago quarter. At quarter end, 95.6% of deposits were “core” in nature (demand, interest bearing demand, savings and time deposits less than $100,000). Net income for the quarter ended September 30, 2002 increased 35.8% to $3,124,000, or $.24 diluted net income per common share, as compared to net income of approximately $2,300,000, or $.18 diluted net income per common share, for the same period in 2001. For the nine months ended September 30, 2002, net income was up 35.1% to $8,473,000 or $.66 diluted net income per common share, up from net income of approximately $6,270,000, or $.50 diluted net income per common share, for the same period in 2001. Stronger earnings during the periods were primarily due to higher net interest income resulting from growth in the Company’s loan and deposit portfolios. In addition, net income benefited from a lower provision for loan losses of $450,000 for the quarter, down from an average run rate of $900,000 for the prior several quarters, and $1,100,000 compared to the third quarter of 2001. The reduced provision was the result of the Company’s ongoing analytic and evaluative assessment of the adequacy of the loan loss reserve. This assessment reflects a continued sound credit quality profile, lower delinquent loans, reduced net loan charge-offs and stable non-performing assets. In addition, the provision requirement was lower because of the modest loan growth during the third quarter. Noninterest income was up 24.3% on a year to date basis owing to strong mortgage origination fees and gains in service charge revenue. The mortgage banking related income for the current quarter was relatively flat compared to the year ago quarter as growth in volume was largely offset by a charge to adjust the value of mortgage servicing rights (MSRs) to fair value. The third quarter charge to MSRs was $350,000 and adjusted the carrying value of MSRs to estimated fair value of .89% of serviced loans. This compares to fair value estimate of 1.03% of serviced loans a year earlier (See Note 5; Mortgage Servicing Rights located on page 10). As has been the case all year, mortgage origination volumes and related fees have continued strong due to the low interest rate climate. At the same time, service charge income has grown 40.0% and 29.4% for the year-to-date and quarter, respectively, due to higher transaction activity levels, customer growth, and product line enhancements. RESULTS OF OPERATIONS –Nine months and Three months ended September 30, 2002 and 2001Net Interest Income Net interest income increased 13.6% for the nine months and increased 10.4% for the quarter ended September 30, 2002 as compared to the same periods in 2001. The net interest margin (NIM) was at 6.70% for the third quarter ended September 30, 2002, compared to the year ago margin of 7.12%, and the preceding quarter’s margin of 6.89%. The easing of the NIM is the result of the continued low interest rate climate, causing yields to compress against an already low cost of funds base. The third quarter yield on earning assets was 7.61% compared to 7.90% in the prior quarter, while overall cost of funds declined to .95% compared to 1.04% for the preceding quarter, well below the 1.90% from a year earlier. On November 6, 2002, prior to the filing of this report, the Federal Reserve lowered the federal funds rate an additional .50% to 1.25%. It is anticipated that this rate change will continue to pressure the NIM as loan yields compress against an already low cost of funds. Assuming interest rates remain at this new benchmark level or increase only modestly in the second half of 2003, management would expect the margin to moderate toward the 6.15% to 6.40% range by late 2003. Should the federal funds rate fall to 1.00% the NIM would likely fall an additional .10% to .20% in 2003. See the “Interest rate risk” section of the Company’s 2002 Form 10K for a more exhaustive discussion of interest rate risk profile. Because of the volatility of market rates, competitor behavior, event risk, possible model or assumption error and other uncertainties, there can be no assurance that any prediction of NIM will be realized. In addition, this projection does not encompass all possible paths of future market rates, in terms of absolute change or rate of change, or changes in the shape of the yield curve. Nor do model forecasts anticipate changes in credit conditions that could affect results, or consider unforeseen changes in loan and deposit volumes, pricing or portfolio management tactics. 12
Total interest income decreased approximately $715,600 (or 2.5%) for the nine months and decreased approximately $53,300 (or 0.5%) for the quarter ended September 30, 2002 as compared to the same periods in 2001, as a result of the low rate environment. For the same reason, total interest expense decreased approximately $3,648,000 (or 50.1%) for the nine months and decreased approximately $863,200 (or 42.4%) for the quarter ended September 30, 2002 as compared to the same periods in 2001. All categories of interest expense have decreased over the periods presented, with the exception of borrowings expense which increased slightly in the third quarter of 2002 as compared to the prior year quarter due to the FHLB term advances booked in the current period. Loan Loss Provision At September 30, 2002, the reserve for loan losses was 1.57% of total loans, consistent with the 1.55% at December 31, 2001 and up from 1.49% at September 30, 2001. Year to date, the loan loss provision was $2,280,000 compared to $2,815,000 for the comparable period in 2001. The provision decreased to $450,000 for the quarter ended September 30, 2002 as compared to $1,100,000 for the third quarter 2001. This reduction in provision was the result of the Company’s ongoing analytic and evaluative assessment of the adequacy of the loan loss reserve. This assessment reflects a continued sound credit quality profile, lower delinquent loans, reduced net loan charge-offs and stable non-performing assets. In addition, the provision requirement was lower because of modest loan growth during the third quarter. Management believes the estimated reserve for loan losses is at an appropriate level consistent with the known and inherent risks within the loan portfolio. Noninterest Income Total noninterest income increased 24.3% for the nine months, but was up only a modest 2.7% for the quarter ended September 30, 2002 as compared to the same periods in 2001. Service charges on deposit accounts increased 40.0% in the nine months and 29.4% for the quarter ended September 30, 2002, as compared to the year earlier periods. These increases primarily resulted from improvements in pricing and processing of overdraft transactions, including customers’ increased use of Bounce Protection on checking accounts. Home purchase and refinance activity benefited the Company’s mortgage banking activity with mortgage revenue (net of loan servicing fees) increasing approximately $237,800 (or 14.1%) for the nine months but decreased $243,300 (or 35.2%) for the quarter ended September 30, 2002, as compared to the same periods a year ago. The increase for the nine-month period was primarily attributable to mortgage origination volumes of $149.9 million for the nine months ended September 30, 2002, up from $130.0 million in the same period a year ago, augmented by improved margins on sales of loans. As discussed above, the decrease in the third quarter net mortgage revenue resulted from a $350,000 pre-tax valuation charge related to mortgage servicing rights that brought the carrying value of MSRs to estimated fair value. Noninterest Expense Total noninterest expense increased 8.6% for the nine months and 3.2% for the quarter ended September 30, 2002 as compared to the same periods in 2001. With most categories of noninterest expense increasing over the periods presented due to growth in business volumes, the increase was primarily centered in personnel, occupancy and equipment expenses. For the third quarter 2002, the category Other Expense was modestly lower due to a decrease in costs associated with several third party escrow service agreements. 13
Income Taxes Income tax expense increased between the periods presented primarily as a result of higher pre-tax income. The Company’s combined Federal and State effective income tax rate for both the third quarter and year to date 2002 was 39.0% compared to 38.9% for both the quarter and year-to-date in 2001 FINANCIAL CONDITION Asset growth was strong in the third quarter of 2002 with total assets increasing 20.3% to $588.1 million at September 30, 2002 compared to $488.8 million at December 31, 2001. This year-to-date increase was primarily due to growth in the loan portfolio and a higher level of overnight federal funds sold. Total loans outstanding (net of deferred loan fees) increased 13.1 % to $477.0 million at September 30, 2002 as compared to $421.7 million at December 31, 2001. The growth was primarily concentrated in the commercial loan and commercial real estate loan portfolios, up $25.9 million and $20.2 million, respectively, consistent with the nature of economic growth in the markets served by the Company. Overnight federal funds sold increased to $36 million as period end liquidity was seasonally strong. The investment securities portfolio grew $5 million from year end 2001 to meet collateral needs. This asset growth was funded by the increased deposits and higher borrowings. Deposits increased 18.1% to $502.2 million at September 30, 2002 compared to $425.3 million at December 31, 2001. All categories of deposits increased, with the exception of time deposits, which decreased slightly while the largest deposit increases were in demand and money market accounts. Average deposits for the quarter were up 11.0% compared to a year earlier. The increase in average deposits is lower than period end comparisons because escrow balances were particularly high on September 30, 2002 as discussed in the “Highlights” section. The Company borrowed $18 million in term advances from FHLB during the quarter to match fund and protect the margin on a portion of its adjustable rate loan portfolio (see “Liquidity” section). Non-performing assets decreased at September 30, 2002 to .26% of total assets compared to .51% at year-end 2001. The Company had no off balance sheet derivative financial instruments as of September 30, 2002 and December 31, 2001. CAPITAL RESOURCES The Company’s total stockholders’ equity at September 30, 2002 was $48.7 million, an increase of $7.0 million from December 31, 2001. The increase was the net result of earnings of $8.5 million for the nine months ended September 30, 2002, less cash dividends to shareholders of $2.4 million during the nine months ended September 30, 2002. In addition, at September 30, 2002 the Company had a net unrealized gain on available for sale securities of approximately $.7 million. At September 30, 2002, the Company’s Tier 1 and total risked-based capital ratios under the Federal Reserve Board’s (“FRB”) risk-based capital guidelines were 9.70% and 11.00%, respectively. The FRB’s minimum risk-based capital ratio guidelines for Tier 1 and total capital are 4% and 8%, respectively. LIQUIDITY It is the Company’s liquidity goal to have sufficient available funds to meet depositor withdrawals as well as to fund borrowing needs of its customers. The Bank’s stable deposit base is the foundation of its long-term liquidity since these funds are not subject to significant volatility as a result of changing interest rates and other economic factors. A further source of liquidity is the Bank’s ability to borrow funds from a variety of reliable counterparties. The Bank may pledge its portfolio of investment securities and certain real estate and business loans to provide collateral to support its borrowing needs. During the quarter, the Company borrowed $18 million in term funding from the Federal Home Loan Bank (FHLB) to match fund and protect the interest margin on a portion of its adjustable rate loans. These advances averaged 3.5 years to maturity at a 3.25% weighted interest rate. In the event the Company required short-term liquidity, correspondent banks have approved unsecured lines of credit totaling $21.0 million as of September 30, 2002. Additionally the FHLB provides a secured line of credit of $88.2 million (or approximately 15% of total assets) that may be accessed for short or long-term borrowings given sufficient qualifying collateral. At September 30, 2002 the Bank had sufficient collateral to support aggregate borrowings up to $63.0 million from FHLB. The Bank has a total of $10.1 million short term borrowing availability from the Federal Reserve Bank (FRB) limited by specific qualifying collateral. In addition, during the first quarter of 2002, the Bank changed its Treasury Tax & Loan (TT&L) election from a collector to investor designation, enabling Federal tax receipts to be held at the Bank within $12.9 million collateral limits and subject to periodic call by the Treasury. Borrowing capacity may be augmented by the State of Oregon community bank CD program, whereby the State places CDs in community banks that qualify under the program (limited to 5% of deposits or approximately $25 million). At September 30, 2002 deposits include a $5.0 million State of Oregon Certificate of Deposit with a maturity of October 16, 2002 bearing an interest rate of 1.79% under this program. At September 30, 2002 the Bank had outstanding short-term and long term borrowings of $13.0 million and $18.0 million respectively, with aggregate remaining borrowings capacity of $101.2 million, given sufficient collateral availability. At that date, the Company had collateral to support approximately $86.0 million in borrowings. The Company continues to have ample available funding sources from reliable counterparties. 14
Consistent with the year earlier period, at September 30, 2002 the Bank had approximately $143.7 million in outstanding commitments to extend credit. Based on historical experience, management anticipates that a significant portion of the commitments will expire or terminate without funding. Approximately 28% of total commitments pertain to various construction projects. Under the terms of such construction commitments and the Company’s loan policies, completion of specified project benchmarks are to be certified by borrower and builder and approved by the Company before funds may be drawn. Management believes that the Bank’s available resources will be sufficient to fund its commitments in the normal course of business. MARKET RISK Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises principally from interest rate risk in its lending, deposit and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Management considers interest rate risk to be a significant market risk, which could have the largest material effect on the Company’s financial condition and results of operations. The Company originates and sells residential mortgage loans, an activity which may involve commitments to originate mortgages at a specific interest rate to a customer in the future (a rate lock), or the Company may commit to sell a mortgage at a specific price in the future to FannieMae or other mortgage investors. The Company makes commitments on a loan by loan “flow” basis. Such commitments could be subject to market price risk should mortgage market prices move adversely and the Company fails to deliver a mortgage loan into the commitment. The Company does not hedge the possible market risk of these commitments but does not believe the exposure to be material. (See Note 5 “Mortgage Servicing Rights” for discussion of fair value impairment risk that may approximate market price risk). The Company also evaluates other risks that may tangentially affect the valuation of its assets such as in credit quality, concentration, and liquidity risks. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company’s business activities. The Company did not experience a material change in market risk at September 30, 2002 as compared to December 31, 2001. CONTROLS AND PROCEDURESEvaluation of Disclosure Controls and Procedures Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended) as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”). Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company required to be included in our reports filed or submitted under the Securities Exchange Act of 1934, as amended. Changes in Internal Controls Since the Evaluation Date, there have not been any significant changes in our internal controls or in other factors that could significantly affect such controls. 15
PART II —OTHER INFORMATIONItem 6. Exhibits and Reports on Form 8-K |
