Page 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For Quarter Ended June 30, 2004 Commission File Number: 001-9383 WESTAMERICA BANCORPORATION (Exact Name of Registrant as Specified in its Charter) CALIFORNIA 94-2156203 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1108 Fifth Avenue, San Rafael, California 94901 (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, including Area Code (707) 863-6000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [ x ] No [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ x ] No [ ] Indicate the number of shares outstanding of each of the registrant classes of common stock, as of the latest practicable date: Title of Class Shares outstanding as of August 4, 2004 Common Stock, 31,715,545 No Par Value Page 2 TABLE OF CONTENTS Page ------------- Forward Looking Statements 2 PART I - FINANCIAL INFORMATION Item 1 - Financial Statements 3 Notes to Unaudited Condensed Consolidated Financial Statements 7 Financial Summary 9 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3 - Quantitative and Qualitative Disclosures about Market Risk 24 Item 4 - Controls and Procedures 24 PART II - OTHER INFORMATION Item 1 - Legal Proceedings 25 Item 2 - Changes in Securities, Use of Proceeds and Issuer Purchases Equity Securities 25 Item 3 - Defaults upon Senior Securities 25 Item 4 - Submission of Matters to a Vote of Security Holders 25 Item 5 - Other Information 26 Item 6 - Exhibits and Reports on Form 8-K 26 (a) - Exhibits Exhibit 11 - Computation of Earnings Per Share 28 Exhibit 31.1 - Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-(14)(a) 29 Exhibit 31.2 - Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-(14)(a) 30 Exhibit 32.1 - Certification Required by 18 U.S.C. Section 1350 31 Exhibit 32.2 - Certification Required by 18 U.S.C. Section 1350 32 (b) - Reports on Form 8-K 26 FORWARD-LOOKING STATEMENTS This report on Form 10-Q contains forward-looking statements about Westamerica Bancorporation for which it claims the protection of the safe harbor provisions contained in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on Management's current knowledge and belief and include information concerning the Company's possible or assumed future financial condition and results of operations. A number of factors, some of which are beyond the Company's ability to predict or control, could cause future results to differ materially from those contemplated. These factors include but are not limited to (1) a slowdown in the national and California economies; (2) economic uncertainty created by terrorist threats and attacks on the United States and the actions taken in response; (3) the prospect of additional terrorist attacks in the United States and the uncertain effect of these events on the national and regional economies; (4) changes in the interest rate environment; (5) changes in the regulatory environment; (6) significantly increasing competitive pressure in the banking industry; (7) operational risks including data processing system failures or fraud; (8) the effect of acquisitions and integration of acquired businesses; (9) volatility of rate sensitive deposits and assets; (10) asset/liability matching risks and liquidity risks; and (11) changes in the securities markets. The reader is directed to the Company's annual report on Form 10-K for the year ended December 31, 2003, for further discussion of factors which could affect the Company's business and cause actual results to differ materially from those expressed in any forward-looking statement made in this report. The Company undertakes no obligation to update any forward-looking statements in this report. Page 3 Part I. FINANCIAL INFORMATION Item 1. Financial Statements WESTAMERICA BANCORPORATION CONSOLIDATED BALANCE SHEETS (In thousands) (unaudited) At June 30, At --------------------------December 31, 2004 2003 2003 --------------------------------------- Assets: Cash and cash equivalents $185,522 $201,560 $189,628 Money market assets 534 633 534 Investment securities available for sale 1,024,798 1,251,341 1,413,911 Investment securities held to maturity, with market values of: $949,257 at June 30, 2004 960,522 $599,484 at June 30, 2003 588,231 $542,729 at December 31, 2003 535,377 Loans, gross 2,319,255 2,406,889 2,323,330 Allowance for loan losses (53,949) (54,159) (53,910) --------------------------------------- Loans, net of allowance for loan losses 2,265,306 2,352,730 2,269,420 Repossessed collateral 0 1,888 90 Premises and equipment, net 35,343 36,408 35,748 Interest receivable and other assets 139,786 131,901 131,677 --------------------------------------- Total Assets $4,611,811 $4,564,692 $4,576,385 ======================================= Liabilities: Deposits: Noninterest bearing $1,272,278 $1,194,847 $1,240,379 Interest bearing: Transaction 569,575 554,568 561,696 Savings 1,072,701 962,967 1,058,082 Time 590,875 741,249 603,834 --------------------------------------- Total deposits 3,505,429 3,453,631 3,463,991 Short-term borrowed funds 712,553 393,287 590,646 Federal Home Loan Bank advance 0 170,000 105,000 Notes payable 21,429 21,393 24,643 Liability for interest, taxes and other expenses 42,605 169,070 51,734 --------------------------------------- Total Liabilities 4,282,016 4,207,381 4,236,014 --------------------------------------- Shareholders' Equity: Authorized - 150,000 shares of common stock Issued and outstanding: 31,784 at June 30, 2004 221,896 32,937 at June 30, 2003 217,236 32,287 at December 31, 2003 218,461 Deferred compensation 2,146 1,824 1,824 Accumulated other comprehensive income: Unrealized (loss) gain on securities available for sale, net (1,416) 26,001 13,191 Retained earnings 107,169 112,250 106,895 --------------------------------------- Total Shareholders' Equity 329,795 357,311 340,371 --------------------------------------- Total Liabilities and Shareholders' Equity $4,611,811 $4,564,692 $4,576,385 ======================================= See accompanying notes to unaudited condensed consolidated financial statements. Page 4 WESTAMERICA BANCORPORATION CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (In thousands, except per share data) (unaudited) Three months ended Six months ended June 30, June 30, 2004 2003 2004 2003 ---------------------------------------------------- Interest Income: Loans $33,403 $39,419 $67,425 $79,832 Money market assets and funds sold 0 2 1 5 Investment securities available for sale Taxable 8,035 8,521 19,410 16,544 Tax-exempt 3,644 3,915 7,518 7,686 Investment securities held to maturity Taxable 3,833 1,345 4,600 3,537 Tax-exempt 4,356 3,397 8,728 6,119 ---------------------------------------------------- Total interest income 53,271 56,599 107,682 113,723 ---------------------------------------------------- Interest Expense: Transaction deposits 124 211 236 453 Savings deposits 992 1,562 2,102 3,271 Time deposits 1,878 2,697 3,808 5,654 Short-term borrowed funds 1,285 962 2,416 1,812 Federal Home Loan Bank advance 2 1,592 897 3,167 Debt financing and notes payable 316 385 652 789 ---------------------------------------------------- Total interest expense 4,597 7,409 10,111 15,146 ---------------------------------------------------- Net Interest Income 48,674 49,190 97,571 98,577 ---------------------------------------------------- Provision for loan losses 750 900 1,500 1,800 ---------------------------------------------------- Net Interest Income After Provision For Loan Losses 47,924 48,290 96,071 96,777 ---------------------------------------------------- Noninterest Income: Service charges on deposit accounts 7,360 6,648 14,228 13,073 Merchant credit card 909 900 1,735 1,762 Financial services commissions 360 210 547 418 Trust income 258 277 508 516 Mortgage banking 131 301 263 527 Securities gains 395 277 2,183 293 Loss on extinguishment of debt (390) 0 (2,204) 0 Other 2,638 2,423 5,266 4,822 ---------------------------------------------------- Total Noninterest Income 11,661 11,036 22,526 21,411 ---------------------------------------------------- Noninterest Expense: Salaries and related benefits 13,332 13,598 26,858 27,297 Occupancy 2,944 3,044 5,892 6,039 Data processing 1,521 1,518 3,038 3,077 Equipment 1,273 1,381 2,435 2,755 Courier service 888 926 1,772 1,855 Professional fees 511 457 921 870 Other 4,521 4,552 9,066 9,118 ---------------------------------------------------- Total Noninterest Expense 24,990 25,476 49,982 51,011 ---------------------------------------------------- Income Before Income Taxes 34,595 33,850 68,615 67,177 ---------------------------------------------------- Provision for income taxes 9,951 10,179 19,657 20,494 ---------------------------------------------------- Net Income $24,644 $23,671 $48,958 $46,683 ==================================================== Other Comprehensive Income: Change in unrealized (loss) gain on securities available for sale, net (22,629) 5,591 (14,607) 6,849 ---------------------------------------------------- Other Comprehensive Income $2,015 $29,262 $34,351 $53,532 ==================================================== Average Shares Outstanding 31,760 33,000 31,906 33,054 Diluted Average Shares Outstanding 32,343 33,492 32,502 33,528 Per Share Data: Basic Earnings $0.78 $0.72 $1.53 $1.41 Diluted Earnings 0.76 0.71 1.51 1.39 Dividends Paid 0.28 0.24 0.54 0.48 See accompanying notes to unaudited condensed consolidated financial statements. Page 5 WESTAMERICA BANCORPORATION CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY (In thousands) (unaudited) Accumulated Compre- Common Deferred hensive Retained Shares Stock Compensation Income/loss Earnings Total ------------------------------------------------------------------------------ Balance, December 31, 2002 33,411 $215,926 $1,272 $19,152 $105,149 $341,499 Net income for the period 46,683 46,683 Stock issued for stock options 191 3,450 3,450 Stock option tax benefits 1,887 1,887 Restricted stock activity 24 407 552 959 Purchase and retirement of stock (689) (4,434) (23,695) (28,129) Dividends (15,887) (15,887) Unrealized gain on securities available for sale, net 6,849 6,849 ------------------------------------------------------------------------------ Balance, June 30, 2003 32,937 $217,236 $1,824 $26,001 $112,250 $357,311 ============================================================================== Balance, December 31, 2003 32,287 $218,461 $1,824 $13,191 $106,895 $340,371 Net income for the period 48,958 48,958 Stock issued for stock options 214 6,166 6,166 Stock option tax benefits 1,826 1,826 Restricted stock activity 16 467 322 789 Purchase and retirement of stock (733) (5,024) (31,399) (36,423) Dividends (17,285) (17,285) Unrealized loss on securities available for sale, net (14,607) (14,607) ------------------------------------------------------------------------------ Balance, June 30, 2004 31,784 $221,896 $2,146 ($1,416) $107,169 $329,795 ============================================================================== See accompanying notes to unaudited condensed consolidated financial statements. Page 6 WESTAMERICA BANCORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (unaudited) For the six months ended June 30, -------------------------- 2004 2003 -------------------------- Operating Activities: Net income $48,958 $46,683 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation of fixed assets 1,917 2,139 Amortization of intangibles and other assets 1,148 1,014 Loan loss provision 1,500 1,800 Amortization of deferred net loan fees 21 117 Decrease in interest income receivable 2,401 362 (Increase) decrease in other assets (4,391) 57,823 Increase (decrease) in income taxes payable 694 2,978 Decrease in interest expense payable (462) (382) Increase (decrease) in other liabilities 3,115 (53,321) Gain on sales of investment securities (2,183) (293) Loss on extinguishment of debt 2,204 0 Writedown of equipment 9 102 Originations of loans for resale (3,562) (5,257) Proceeds from sale of loans originated for resale 3,534 5,007 Net gain on sale of other real estate owned in satisfaction of debt (231) (9) -------------------------- Net Cash Provided by Operating Activities 54,672 58,763 -------------------------- Investing Activities: Net repayments of loans 2,618 84,213 Purchases of investment securities available for sale (76,027) (499,669) Purchases of investment securities held to maturity (494,618) (243,158) Purchases of property, plant and equipment (1,521) (1,750) Proceeds from maturity of securities available for sale 243,046 257,382 Proceeds from maturity of securities held to maturity 63,021 93,912 Proceeds from sale of securities available for sale 199,185 69,305 Proceeds from sale of property and equipment 0 498 Proceeds from sale of other real estate owned 321 293 -------------------------- Net Cash Used in Investing Activities (63,975) (238,974) -------------------------- Financing Activities: Net increase in deposits 41,438 159,565 Net increase in short-term borrowings 121,906 43,551 Repayments to the FHLB (107,204) 0 Repayments of notes payable (3,214) (3,214) Exercise of stock options 5,979 3,308 Repurchases/retirement of stock (36,423) (28,129) Dividends paid (17,285) (15,887) -------------------------- Net Cash Provided by Financing Activities 5,197 159,194 -------------------------- Net Decrease In Cash and Cash Equivalents (4,106) (21,017) -------------------------- Cash and Cash Equivalents at Beginning of Period 189,628 222,577 -------------------------- Cash and Cash Equivalents at End of Period $185,522 $201,560 ========================== Supplemental Disclosure of Noncash Activities: Loans transferred to other repossessed collateral $0 $1,800 Supplemental Disclosure of Cash Flow Activity: Unrealized (loss) gain on securities available for sale, net ($14,607) 6,849 Interest paid for the period 9,649 14,764 Income tax payments for the period 18,850 18,461 Income tax benefit from stock option exercises 1,826 1,887 See accompanying notes to unaudited condensed consolidated financial statements. Page 7 NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1: Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission. The results of operations reflect interim adjustments, all of which are of a normal recurring nature and which, in the opinion of Management, are necessary for a fair presentation of the results for the interim periods presented. The interim results for the six months ended June 30, 2004 and 2003 are not necessarily indicative of the results expected for the full year. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes as well as other information included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. Note 2: Significant Accounting Policies. Certain accounting policies underlying the preparation of these financial statements require Management to make estimates and judgments. These estimates and judgments may affect reported amounts of assets and liabilities, revenues and expenses, and disclosures of contingent assets and liabilities. The most significant of these involve the Allowance for Loan Losses, which is discussed in Note 1 to the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the year ended December 31, 2003. Note 3: Goodwill and Other Intangible Assets The Company has recorded goodwill and core deposit intangibles associated with purchase business combinations and, effective January 1, 2002, accounts for them in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets. Accordingly, goodwill is no longer amortized, but is periodically evaluated for impairment. During 2004, no impairment of goodwill has been recorded. Core deposit intangibles are amortized to their estimated residual values over their expected useful lives; such lives and residual values are also periodically reassessed to determine if any amortization period adjustments are indicated. During the second quarter of 2004, no such adjustments were recorded. The following table summarizes the Company's goodwill and core deposit intangible assets, which are included with Interest receivable and other assets in the Consolidated Balance Sheets, as of January 1, 2004 and June 30, 2004 (dollars in thousands). At At January 1, June 30, 2004 Additions Reductions 2004 ---------------------------------------------------- Goodwill $22,968 $0 $0 $22,968 Accumulated Amortization (3,972) 0 0 (3,972) ---------------------------------------------------- Net $18,996 $0 $0 $18,996 ==================================================== Core Deposit Intangibles $7,783 $0 $0 $7,783 Accumulated Amortization (4,345) 0 (272) (4,617) ---------------------------------------------------- Net $3,438 $0 ($272) $3,166 ==================================================== At June 30, 2004, the estimated aggregate amortization of core deposit intangibles, in thousands of dollars, for the remainder of 2004 and annually through 2009 is $272, $469, $427, $427, $427, and $427, respectively. The weighted average amortization period for core deposit intangibles is 7.6 years. Page 8 Note 4: Stock Options In accordance with SFAS No. 123 "Accounting for Stock-Based Compensation", the Company accounts for its stock option plans using the intrinsic value method. Accordingly, compensation expense is recorded on the grant date only if the current price of the underlying stock exceeds the exercise price of the option. Had compensation cost been determined based on the fair value method established by SFAS 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below: Three months ended Six months ended June 30, June 30, ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- (In thousands, except per share data) Compensation cost based on fair value method, net of tax effect $526 $589 $1,052 $1,178 Net income: As reported $24,644 $23,671 $48,958 $46,683 Pro forma $24,118 $23,082 $47,906 $45,505 Basic earnings per share: As reported $0.78 $0.72 $1.53 $1.41 Pro forma 0.76 0.70 1.50 1.38 Diluted earnings per share: As reported $0.76 $0.71 $1.51 $1.39 Pro forma 0.75 0.69 1.47 1.36 Note 5: Post Retirement Benefits The Company uses an actuarial-based accrual method of accounting for post-retirement benefits. The Company offers a continuation of group insurance coverage to employees electing early retirement until age 65. The Company pays a portion of these early retirees' insurance premium which are determined at their date of retirement. Beginning in 2004, the Company reimburses 50 percent of Medicare Part B premiums for all retirees and spouses over 65. In accordance with SFAS No.132 "Employers' Disclosures about Pensions and Other Post-Retirement Benefits", the Company provides the following interim disclosure related to its post-retirement benefit plan. The following table sets forth the net periodic post retirement benefit costs for the quarter ended June 30. For the six months ended June 30, --------------------------------------- 2004 2003 2002 --------------------------------------- (In thousands) Service cost $93 $7 $104 Interest cost 86 85 86 Amortization of unrecognized transition obligation 31 31 31 --------------------------------------- Net periodic cost $210 $123 $221 ======================================= Page 9 WESTAMERICA BANCORPORATION Financial Summary (In thousands, except per share data) Three months ended Six months ended June 30, June 30, ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- Net Interest Income (FTE)** $54,271 $54,324 $108,877 $108,386 Provision for loan losses (750) (900) (1,500) (1,800) Noninterest income: 11,661 11,036 22,526 21,411 Noninterest expense (24,990) (25,476) (49,982) (51,011) Provision for income taxes (FTE)** (15,548) (15,313) (30,963) (30,303) ---------------------------------------------------- Net income $24,644 $23,671 $48,958 $46,683 ==================================================== Average shares outstanding 31,760 33,000 31,906 33,054 Diluted average shares outstanding 32,343 33,492 32,502 33,528 Shares outstanding at period end 31,784 32,937 31,784 32,937 As Reported: Basic earnings per share $0.78 $0.72 $1.53 $1.41 Diluted earnings per share $0.76 $0.71 $1.51 $1.39 Return on assets 2.21% 2.21% 2.20% 2.21% Return on equity 31.11% 29.27% 30.82% 29.44% Net interest margin 5.21% 5.43% 5.24% 5.51% Net loan losses to average loans 0.11% 0.15% 0.13% 0.16% Efficiency ratio* 37.9% 39.0% 38.0% 39.3% Average Balances: Total assets $4,482,261 $4,304,387 $4,466,967 $4,253,125 Earning assets 4,177,358 4,007,049 4,167,210 3,956,535 Total loans 2,268,989 2,375,491 2,275,444 2,399,754 Total deposits 3,489,250 3,370,433 3,463,399 3,338,681 Shareholders' equity 318,560 324,350 319,475 319,741 Balances at Period End: Total assets $4,611,811 $4,564,692 Earning assets 4,311,562 4,247,094 Total loans 2,319,255 2,406,889 Total deposits 3,505,429 3,453,631 Shareholders' equity 329,795 357,311 Financial Ratios at Period End: Allowance for loan losses to loans 2.33% 2.25% Book value per share $10.38 $10.85 Equity to assets 7.15% 7.83% Total capital to risk assets 11.78% 11.32% Dividends Paid Per Share $0.28 $0.24 $0.54 $0.48 Dividend Payout Ratio 37% 34% 36% 34% The above financial summary has been derived from the Company's unaudited consolidated financial statements. This information should be read in conjunction with those statements, notes and the other information included elsewhere herein. *The efficiency ratio is defined as noninterest expense divided by total revenue (net interest income on a tax-equivalent basis and noninterest income). **Fully taxable equivalent Page 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Westamerica Bancorporation and subsidiaries (the "Company") reported net income of $24.6 million or diluted earnings per share of $0.76 for the second quarter of 2004. These results compare with net income of $23.7 million or $0.71 per share for the same period of 2003. On a year-to-date basis, the Company reported net income for the six months ended June 30, 2004 of $49.0 million or diluted earnings per share of $1.51, compared with $46.7 million or $1.39 per share for the same period of 2003. Following is a summary of the components of net income for the periods indicated (In thousands except per share data and ratios): Three months ended Six months ended June 30, June 30, ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- Net interest income (FTE) $54,271 $54,324 $108,877 $108,386 Provision for loan losses (750) (900) (1,500) (1,800) Noninterest income 11,661 11,036 22,526 21,411 Noninterest expense (24,990) (25,476) (49,982) (51,011) Provision for income taxes (FTE) (15,548) (15,313) (30,963) (30,303) ---------------------------------------------------- Net income $24,644 $23,671 $48,958 $46,683 ==================================================== Average diluted shares 32,343 33,492 32,502 33,528 Diluted earnings per share $0.76 $0.71 $1.51 $1.39 Average total assets 4,482,261 4,304,387 4,466,967 4,253,125 Net income (annualized) to average total assets 2.21% 2.21% 2.20% 2.21% Net income for the second quarter of 2004 was $973 thousand or 4.1% more than the same quarter of 2003. Net interest income (FTE) declined by $53 thousand or 0.1%, primarily the net result of declining yields on average earning assets, lower interest expense, and the effect of higher average earning assets. The loan loss provision declined $150 thousand or 16.7%, reflecting management's assessment of the quality of the loan portfolio. The increase of $625 thousand or 5.7% in noninterest income and a $486 thousand or 1.9% reduction of noninterest expense contributed to growth in net income for the period. The provision for income taxes (FTE) increased $235 thousand or 1.53%. Comparing the first six months of 2004 to the prior year, net income rose $2.3 million or 4.9%. A $491 thousand or 0.5% increase in net interest income was mainly attributable to a lower cost of funding and the effect of growth of earning assets, partially offset by declining yields on those assets. The provision for loan losses decreased $300 thousand or 16.7%. Noninterest income rose $1.1 million or 5.2% and noninterest expense dropped $1.0 million or 2.0%. The income tax provision (FTE) increased $660 thousand or 2.2%. Net Interest Income Following is a summary of the components of net interest income for the periods indicated (dollars in thousands): Three months ended Six months ended June 30, June 30, ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- Interest and fee income $53,271 $56,599 $107,682 $113,723 Interest expense (4,597) (7,409) (10,111) (15,146) FTE adjustment 5,597 5,134 11,306 9,809 ---------------------------------------------------- Net interest income (FTE) $54,271 $54,324 $108,877 $108,386 ==================================================== Average earning assets $4,177,358 $4,007,049 $4,167,210 $3,956,535 Net interest margin (FTE) 5.21% 5.43% 5.24% 5.51% The Company's primary source of revenue is net interest income, or the difference between interest income earned on earning assets and interest expense paid on interest-bearing liabilities. Net interest income (FTE) during the second quarter of 2004 decreased $53 thousand or 0.1% to $54.3 million from the same period in 2003. The decrease was mainly attributable to the effect of the lower margin earned on those assets (the rate component). The margin decrease was the net effect of a 52 bp drop in the average earning asset yield, partially offset by a 41 bp decline in the cost of funds. Offsetting the decline was the effect of an increase in average earning assets (the volume component), which grew $170.3 million or 4.3%. Comparing the first six months of 2004 with the prior year, net interest income (FTE) increased $491 thousand or 0.5%. The increase was caused by higher earning assets (up $210.7 million or 5.3%), partially offset by the lower margin earned on earning assets. The margin reduction was the result of a 55 bp decrease in the average asset yield combined with a 39 bp decline in the cost of funds. Page 11 Interest and Fee Income Interest & fee income (FTE) for the second quarter of 2004 decreased $2.9 million or 4.6% from the same period in 2003. The decline was the net effect of higher average earning assets in 2004, more than offset by lower yields earned on those assets. Average earning assets grew $170.3 million (4.3%) due to expansion in the investment portfolio of $276.8 million as follows: mortgage backed securities and collateralized mortgage obligations (up $206.4 million), municipal securities (up $99.1 million) and U.S. Agency obligations (up $31.7 million). Partially offsetting the increases was a $50.0 million decline in other securities. Loans declined $106.5 million, including commercial real estate loans (down $136.4 million) and direct consumer loans (down $8.9 million). The declines were mitigated by increases in residential real estate loans (up $22.6 million) and commercial loans (up $16.1 million). The average yield on the Company's earning assets decreased for the quarter from 6.17% in 2003 to 5.65%, down 52 bp, in 2004. This downward trend in yields was reflective of continuing maturities and payoffs and funding of new earning assets at lower interest rates during 2003 and into 2004, as evident in indirect consumer loans (96 bp decline), commercial real estate loans (50 bp decline), residential real estate loans (84 bp decline), commercial loans (36 bp decline) and personal credit lines (56 bp decline). As a result, the loan portfolio yield decreased 70 bp. The investment portfolio yield declined 11 bp, primarily the net result of declines in yields of municipal securities (down 43 bp) and U.S. Agency obligations (down 51 bp), and a 101 bp increase in mortgage backed securities and collateralized mortgage obligations. Comparing the first half of 2004 to 2003, interest and fee income (FTE) decreased by $4.5 million or 3.7%. The decline was due to the combined effect of a higher volume of earning assets, the impact of lower yields and lower loan fee income. The positive volume was attributable to a $210.7 million (5.3%) increase in average earning assets, including mortgage backed securities and collateralized mortgage obligations (up $233.7 million), municipal securities (up $131.4 million), U.S. obligations (up $43.0 million), residential real estate loans (up $19.7 million) and commercial loans (up $11.0 million). The growth was countered by declines in commercial real estate loans (down $138.6 million), direct consumer loans (down 10.4 million), construction loans (down $8.2 million), other securities (down $61.0 million) and U.S. Treasury securities (down $12.1 million). The average yield on earning assets for the first six months of 2004 was 5.73% compared to 6.28% in 2003. All earning asset yields fell except for a 131 bp increase in other securities and a 50 bp increase in mortgage backed securities and collateralized mortgage obligations. The investment portfolio yield decreased 13 bp, affected primarily by lower yields on U.S. Agency obligations (down 61 bp) and municipal securities (down 44 bp). The yield on dealer loans was down 98 bp, commercial real estate loans was down 55 bp, residential real estate loans was down 89 bp, commercial loans yield also declined 31 bp and the yield on personal credit lines decreased 52 bp. As a result, the composite loan yield declined 70 bp. Interest Expense Interest expense decreased $2.8 million or 38.0% in the second quarter of 2004 compared to the year-ago period. The decrease resulted from a drop in the average rate paid on interest-bearing liabilities and a shift to lower-rate liabilities. The average rate paid on interest-bearing liabilities fell from 1.05% in 2003 to 0.64% in 2004. The average rate on bankers money fund balances dropped 29 bp, rates on federal funds purchased decreased 23 bp, rates on CDs over $100 thousand declined an average of 29 bp, rates on money market savings accounts were lowered 31 bp, and rates on regular savings declined 13 bp. Average interest-bearing liabilities grew $54.7 million or 1.9% in the second quarter of 2004 from a year ago. Short-term borrowings rose by $231.4 million mainly due to increases in repurchase agreements and federal funds purchased. Federal Home Loan Bank ("FHLB") advances, which carried higher interest rates than short-term borrowings, decreased from $170 million to none. Interest bearing deposits rose by $118.8 million; however, a change in mix to lower-rate categories, resulted in a rate-related decrease in interest expense. Money market savings gained $57.7 million, reduced by a $51.0 million decrease in CDs over $100 thousand. During the first half of 2004, interest expense decreased $5.0 million or 33.2% from 2003, again due to a lower average rate paid on interest-bearing liabilities and growth of lower-rate interest-bearing liabilities. The average rate paid on interest-bearing liabilities declined to 0.70% in the first half of 2004 compared with 1.10% in 2003. Average rates on all deposit categories declined including money market savings (from 0.85% in the first six months of 2003 to 0.52% in the same period of 2004), CDs over $100 thousand (from 1.52% to 1.09%) and retail CDs with maturities varying from 1 month to over 3 years (from 1.84% to 1.42%). Interest rates on short-term borrowings declined from 1.00% to 0.84%. Total average interest-bearing liabilities grew $102.5 million or 3.7% for the six months ended June 30, 2004. The growth in lower-rate liabilities caused a decrease in interest expense. Short-term borrowings and money market savings increased $208.0 million and $61.0 million, respectively. Federal Home Loan Bank advances and CDs over $100 thousand declined $121.7 million and $29.7 million, respectively. Page 12 In all periods, the Company has attempted to continue to reduce high-rate time deposits while increasing the balances of more profitable, lower-cost transaction accounts in order to minimize the cost of funds. Net Interest Margin (FTE) The following summarizes the components of the Company's net interest margin for the periods indicated: Three months ended Six months ended June 30, June 30, ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- Yield on earning assets 5.65% 6.17% 5.73% 6.28% Rate paid on interest-bearing liabilities 0.64% 1.05% 0.70% 1.10% ---------------------------------------------------- Net interest spread 5.01% 5.12% 5.03% 5.18% Impact of all other net noninterest bearing funds 0.20% 0.31% 0.21% 0.33% ---------------------------------------------------- Net interest margin 5.21% 5.43% 5.24% 5.51% ==================================================== During the second quarter of 2004, the net interest margin fell 22 bp compared to the same period in 2003, as yields on earnings assets declined faster than rates paid on interest-bearing liabilities. The unfavorable impact of lower rates earned on loans and the investment portfolio, triggered by maturities and repricings in a low-rate interest environment, was partially mitigated by decreases in rates paid on deposits and short-term funds. The decline in the net interest spread of 11 bp was narrower due to a greater reliance on noninterest bearing funding sources. The average balance of these sources increased $127.9 million or 16.6%. Similarly, on a year-to-date basis, the net interest margin decreased 27 bp when compared to the same period in 2003. Earning asset yields decreased 55 bp and the cost of interest-bearing liabilities fell by 40 bp, resulting in a 15 bp decline in the interest spread. Noninterest bearing funding sources increased $105.9 million or 13.8%, with their value decreasing to 21 bp. Page 13 Summary of Average Balances, Yields/Rates and Interest Differential The following tables present, for the periods indicated, information regarding the Company's consolidated average assets, liabilities and shareholders' equity, the amount of interest income from average earning assets and the resulting yields, and the amount of interest expense paid on interest-bearing liabilities. Average loan balances include nonperforming loans. Interest income includes proceeds from loans on nonaccrual status only to the extent cash payments have been received and applied as interest income. Yields on securities and certain loans have been adjusted upward to reflect the effect of income which is exempt from federal income taxation at the current statutory tax rate (dollars in thousands). For the three months ended June 30, 2004 --------------------------------------- Interest Rates Average Income/ Earned/ Balance Expense Paid --------------------------------------- Assets: Money market assets and funds sold $534 $0 0.00% Investment securities: Available for sale Taxable 796,597 8,035 4.03% Tax-exempt 295,698 5,435 7.35% Held to maturity Taxable 404,923 3,833 3.79% Tax-exempt 410,617 6,794 6.62% Loans: Commercial Taxable 352,119 4,778 5.46% Tax-exempt 234,780 3,958 6.78% Commercial real estate 779,408 14,709 7.59% Real estate construction 36,789 601 6.57% Real estate residential 361,069 3,996 4.43% Consumer 504,824 6,729 5.36% -------------------------- Total loans 2,268,989 34,771 6.16% -------------------------- Total earning assets 4,177,358 58,868 5.65% Other assets 304,903 ------------- Total assets $4,482,261 ============= Liabilities and shareholders' equity Deposits: Noninterest bearing demand $1,256,128 $-- -- Savings and interest-bearing transaction 1,619,797 1,116 0.28% Time less than $100,000 273,552 956 1.41% Time $100,000 or more 339,773 922 1.09% -------------------------- Total interest-bearing deposits 2,233,122 2,994 0.54% Short-term borrowed funds 614,065 1,285 0.83% Federal Home Loan Bank advance 0 2 N/A Debt financing and notes payable 21,428 316 5.90% -------------------------- Total interest-bearing liabilities 2,868,615 4,597 0.64% Other liabilities 38,958 Shareholders' equity 318,560 ------------- Total liabilities and shareholders' equity $4,482,261 ============= Net interest spread (1) 5.01% Net interest income and interest margin (2) $54,271 5.21% ========================== (1) Net interest spread represents the average yield earned on earning assets minus the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by calculating the difference between interest income and expense (annualized), divided by the average balance of earning assets. Page 14 For the three months ended June 30, 2003 --------------------------------------- Interest Rates Average Income/ Earned/ Balance Expense Paid --------------------------------------- Assets: Money market assets and funds sold $633 $2 1.26% Investment securities: Available for sale Taxable 794,228 8,521 4.29% Tax-exempt 306,094 5,900 7.71% Held to maturity Taxable 237,012 1,345 2.27% Tax-exempt 293,591 5,300 7.22% Loans: Commercial Taxable 367,588 5,366 5.86% Tax-exempt 203,231 3,635 7.17% Commercial real estate 915,817 18,419 8.07% Real estate construction 42,243 791 7.51% Real estate residential 338,462 4,458 5.27% Consumer 508,150 7,996 6.31% -------------------------- Total loans 2,375,491 40,665 6.86% -------------------------- Total earning assets 4,007,049 61,733 6.17% Other assets 297,338 ------------- Total assets $4,304,387 ============= Liabilities and shareholders' equity Deposits: Noninterest bearing demand $1,130,608 $-- -- Savings and interest-bearing transaction 1,537,163 1,773 0.46% Time less than $100,000 311,932 1,343 1.73% Time $100,000 or more 390,730 1,354 1.38% -------------------------- Total interest-bearing deposits 2,239,825 4,470 0.80% Short-term borrowed funds 382,677 962 1.00% Federal Home Loan Bank advance 170,000 1,592 3.71% Debt financing and notes payable 21,393 385 7.19% -------------------------- Total interest-bearing liabilities 2,813,895 7,409 1.05% Other liabilities 35,534 Shareholders' equity 324,350 ------------- Total liabilities and shareholders' equity $4,304,387 ============= Net interest spread (1) 5.12% Net interest income and interest margin (2) $54,324 5.43% ========================== Page 15 For the six months ended June 30, 2004 --------------------------------------- Interest Rates Average Income/ Earned/ Balance Expense Paid --------------------------------------- Assets: Money market assets and funds sold $534 $1 0.37% Investment securities: Available for sale Taxable 922,406 19,410 4.21% Tax-exempt 302,290 11,249 7.44% Held to maturity Taxable 257,603 4,600 3.57% Tax-exempt 408,933 13,569 6.64% Loans: Commercial Taxable 348,940 9,603 5.53% Tax-exempt 233,181 7,927 6.84% Commercial real estate 792,414 29,565 7.50% Real estate construction 37,778 1,286 6.85% Real estate residential 353,975 7,976 4.51% Consumer 509,156 13,802 5.45% -------------------------- Total loans 2,275,444 70,159 6.20% -------------------------- Total earning assets 4,167,210 118,988 5.73% Other assets 299,757 ------------- Total assets $4,466,967 ============= Liabilities and shareholders' equity: Deposits: Noninterest bearing demand $1,232,714 $-- -- Savings and interest-bearing transaction 1,612,498 2,338 0.29% Time less than $100,000 278,099 1,959 1.42% Time $100,000 or more 340,088 1,849 1.09% -------------------------- Total interest-bearing deposits 2,230,685 6,146 0.55% Short-term borrowed funds 573,612 2,416 0.84% Federal Home Loan Bank advance 48,306 898 3.67% Debt financing and notes payable 21,983 651 5.93% -------------------------- Total interest-bearing liabilities 2,874,586 10,111 0.70% Other liabilities 40,192 Shareholders' equity 319,475 ------------- Total liabilities and shareholders' equity $4,466,967 ============= Net interest spread (1) 5.03% Net interest income and interest margin (2) $108,877 5.24% ========================== Page 16 For the six months ended June 30, 2003 --------------------------------------- Interest Rates Average Income/ Earned/ Balance Expense Paid --------------------------------------- Assets: Money market assets and funds sold $633 $5 1.58% Investment securities: Available for sale Taxable 745,824 16,544 4.44% Tax-exempt 305,084 11,606 7.61% Held to maturity Taxable 245,021 3,537 2.89% Tax-exempt 260,219 9,469 7.28% Loans: Commercial Taxable 368,184 10,588 5.80% Tax-exempt 202,912 7,405 7.36% Commercial real estate 931,046 37,156 8.05% Real estate construction 45,999 1,677 7.35% Real estate residential 334,253 9,028 5.40% Consumer 517,360 16,517 6.44% -------------------------- Total loans 2,399,754 82,371 6.92% -------------------------- Total earning assets 3,956,535 123,532 6.28% Other assets 296,590 ------------- Total assets $4,253,125 ============= Liabilities and shareholders' equity: Deposits: Noninterest bearing demand $1,124,087 $-- -- Savings and interest-bearing transaction 1,529,851 3,724 0.49% Time less than $100,000 314,988 2,869 1.84% Time $100,000 or more 369,755 2,785 1.52% -------------------------- Total interest-bearing deposits 2,214,594 9,378 0.85% Short-term borrowed funds 365,578 1,812 1.00% Federal Home Loan Bank advance 170,000 3,167 3.76% Debt financing and notes payable 21,911 789 7.26% -------------------------- Total interest-bearing liabilities 2,772,083 15,146 1.10% Other liabilities 37,214 Shareholders' equity 319,741 ------------- Total liabilities and shareholders' equity $4,253,125 ============= Net interest spread (1) 5.18% Net interest income and interest margin (2) $108,386 5.51% ========================== (1) Net interest spread represents the average yield earned on earning assets minus the average rate paid on interest-bearing liabilities. (2) Net interest margin is computed by calculating the difference between interest income and expense (annualized), divided by the average balance of earning assets. Page 17 Summary of Changes in Interest Income and Expense due to Changes in Average Asset & Liability Balances and Yields Earned & Rates Paid The following tables set forth a summary of the changes in interest income and interest expense due to changes in average asset and liability balances (volume) and changes in average interest rates for the periods indicated. Changes not solely attributable to volume or rates have been allocated in proportion to the respective volume and rate components (dollars in thousands). Three months ended June 30, 2004 compared with three months ended June 30, 2003 --------------------------------------- Volume Rate Total --------------------------------------- Interest and fee income: Money market assets and funds sold ($0) (2) ($2) Investment securities: Available for sale Taxable 24 (510) (486) Tax-exempt ($197) (268) (465) Held to maturity Taxable $1,278 1,210 2,488 Tax-exempt $1,964 (470) 1,494 Loans: Commercial Taxable ($225) (363) (588) Tax-exempt $533 (210) 323 Commercial real estate ($2,658) (1,052) (3,710) Real estate construction (97) (93) (190) Real estate residential 282 (744) (462) Consumer (53) (1,214) (1,267) --------------------------------------- Total loans (2,218) (3,676) (5,894) --------------------------------------- Total earning assets 851 (3,716) (2,865) --------------------------------------- Interest expense: Deposits: Savings and interest-bearing transaction 90 (747) (657) Time less than $100,000 (154) (233) (387) Time $100,000 or more (163) (269) (432) --------------------------------------- Total interest-bearing deposits (227) (1,249) (1,476) --------------------------------------- Short-term borrowed funds 503 (180) 323 Federal Home Loan Bank advance 0 (1,590) (1,590) Debt financing and notes payable 1 (70) (69) --------------------------------------- Total interest-bearing liabilities 277 (3,089) (2,812) --------------------------------------- Increase in Net Interest Income $574 ($627) ($53) ======================================= Page 18 Six months ended June 30, 2004 compared with six months ended June 30, 2003 --------------------------------------- Volume Rate Total --------------------------------------- Interest and fee income: Money market assets and funds sold (1) (3) ($4) Investment securities: Available for sale Taxable 3,809 (943) 2,866 Tax-exempt (68) (289) (357) Held to maturity Taxable 212 851 1,063 Tax-exempt 4,998 (898) 4,100 Loans: Commercial Taxable (500) (485) (985) Tax-exempt 1,081 (559) 522 Commercial real estate (5,162) (2,429) (7,591) Real estate construction (280) (111) (391) Real estate residential 534 (1,586) (1,052) Consumer (185) (2,530) (2,715) --------------------------------------- Total loans (4,512) (7,700) (12,212) --------------------------------------- Total earning assets 4,438 (8,982) (4,544) --------------------------------------- Interest expense: Deposits: Savings and interest-bearing transaction 204 (1,590) (1,386) Time less than $100,000 (300) (610) (910) Time $100,000 or more (200) (736) (936) --------------------------------------- Total interest-bearing deposits (296) (2,936) (3,232) --------------------------------------- Short-term borrowed funds 915 (311) 604 Federal Home Loan Bank advance (2,245) (24) (2,269) Debt financing and notes payable 6 (144) (138) --------------------------------------- Total interest-bearing liabilities (1,620) (3,415) (5,035) --------------------------------------- Increase in Net Interest Income $6,058 ($5,567) $491 ======================================= Page 19 Provision for Loan Losses The level of the provision for loan losses during each of the periods presented reflects the Company's continued efforts to reduce credit costs by enforcing underwriting and administration procedures and aggressively pursuing collection efforts with troubled debtors. The Company provided $750 thousand and $900 thousand for loan losses in the second quarter of 2004 and 2003, respectively. For the first six months of 2004 and 2003, $1.5 million and 1.8 million were provided in each respective period. The provision reflects management's assessment of credit risk in the loan portfolio for each of the periods presented. For further information regarding net credit losses and the allowance for loan losses, see the "Classified Loans" section of this report. Noninterest Income The following table summarizes the components of noninterest income for the periods indicated (dollars in thousands). Three months ended Six months ended June 30, June 30, ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- Service charges on deposit accounts $7,360 $6,648 $14,228 $13,073 Merchant credit card fees 909 900 1,735 1,762 ATM fees and interchange 643 601 1,226 1,161 Debit card fees 638 563 1,187 1,057 Other service fees 463 380 856 749 Financial services commissions 360 210 547 418 Trust fees 258 277 508 516 Official check sales income 137 132 264 266 Mortgage banking income 131 301 263 527 Gains on sale of foreclosed property 8 7 231 10 Securities gains 395 277 2,183 293 Loss on extinguishment of debt (390) 0 (2,204) 0 Other noninterest income 749 740 1,502 1,579 ---------------------------------------------------- Total $11,661 $11,036 $22,526 $21,411 ==================================================== Noninterest income for the second quarter of 2004 was $11.7 million, up $625 thousand or 5.7% from the same period in 2003. The largest contributing factor was service charges on deposits (up $712 thousand or 10.7%), mainly the net result of enhanced overdraft programs, and declining income from account analysis deficit fees and fees collected on deposited items returned. The second largest factor was a $150 thousand or 71.4% increase in financial services commission income resulting from higher sales of variable and fixed annuities and mutual funds. Securities gains were higher by $118 thousand or 42.6%. Mortgage banking income declined $170 thousand or 56.5% largely due to losses on mortgage loan sales. In the second quarter of 2004, a $390 thousand loss on extinguishment of debt was incurred in order to prepay $20 million in FHLB advances, compared with none a year ago. Noninterest income for the first half of 2004 was $22.5 million, up $1.1 million or 5.2% from 2003. As in the quarter-to-quarter comparison, the primary contributing factor was a $1.2 million or 8.8% increase in service charges on deposits, the net result of repricing of retail checking services and enhanced overdraft programs, combined with lower income from account analysis and returned items. The next largest factor was a $221 thousand increase in gains on foreclosed properties due to a sale in the first quarter of 2004. Debit card fees rose $130 thousand or 12.3% due to increased usage. A $129 thousand or 30.9% increase in financial services income was mainly attributable to higher sales of variable and fixed annuities and mutual funds. Other service fees rose $107 thousand or 14.3% mostly due to increases in income from wire transfers and internet banking. Mortgage banking income declined $264 thousand or 50.1% due to lower loan activity and losses from mortgage loan sales. In 2004, $2.2 million in losses on extinguishment of debt was incurred as a result of prepayment of $105 million in FHLB advances, compared with none in the same period of 2003. In 2004, $2.2 million in securities gains offset above-mentioned losses on extinguishment of debt, compared with $293 thousand in securities gains in 2003. For details of securities gains and losses on extinguishment of FHLB advances, see the "Asset and Liability Management" section of this report below. Page 20 Noninterest Expense The following table summarizes the components of noninterest expense for the periods indicated (dollars in thousands). Three months ended Six months ended June 30, June 30, ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- Salaries and related benefits $13,332 $13,598 $26,858 $27,296 Occupancy 2,944 3,044 5,892 6,039 Data processing services 1,521 1,518 3,038 3,077 Equipment 1,273 1,381 2,435 2,755 Courier service 888 926 1,772 1,855 Telephone 535 423 1,107 848 Professional fees 511 457 921 870 Postage 364 401 758 821 Stationery and supplies 309 308 597 626 Loan expense 295 380 550 656 Advertising/public relations 290 311 505 532 Merchant credit card 268 316 541 658 Correspondent Service Charges 239 236 478 480 Operational losses 238 228 481 401 Amortization of deposit intangibles 136 165 272 414 Other noninterest expense 1,847 1,784 3,777 3,683 ---------------------------------------------------- Total $24,990 $25,476 $49,982 $51,011 ==================================================== Average full time equivalent staff 995 1,033 998 1,040 Noninterest expense to revenues (FTE) 37.90% 38.98% 38.04% 39.30% Noninterest expense for the second quarter of 2004 was $25.0 million, $486 thousand or 1.9% lower than in the second quarter of 2003. The largest decline was in salaries and related benefits, which were down $266 thousand or 2.0%. The reduction was primarily due to lower incentives and a decrease in salaries as a result of a decline in the number of full time equivalent ("FTE") employees, partially offset by higher workers compensation expense. Equipment expense fell by $108 thousand or 7.8% due to lower depreciation and maintenance costs. Occupancy expense fell $100 thousand or 3.3% due to the combined effect of lower utility costs, a decline in maintenance expenses and an increase in rental of bank offices. Telephone expense increased $112 thousand or 26.5% due to network upgrades. Noninterest expense was $50.0 million for the first half of 2004, which was $1.0 million or 2.0% less than in the corresponding period of 2003. The largest decrease was salaries and related benefits (down $438 thousand or 1.6%), the net result of a decline in incentives, a decrease in regular salary due to a fewer number of FTE employees and an increase in workers compensation insurance costs. Equipment expense fell by $320 thousand or 11.6% from 2003 mainly due to lower depreciation and maintenance costs. Lower amortization of deposit intangibles (down $142 thousand or 34.3%) was caused by the expiration of amortization from a purchase premium recorded in 1997. Merchant credit card expense declined $117 thousand or 17.8% attributable to overcharges for the period from January through April of 2003 and to lower rates negotiated in October of 2003. Loan expense fell $106 thousand or 16.2% compared with the same period of 2003. Telephone expense increased $259 thousand or 30.5% due to network upgrades. Provision for Income Tax During the second quarter of 2004, the Company recorded an income tax provision (FTE) of $15.5 million, $235 thousand (1.5%) higher than the second quarter of 2003; on a year-to-date basis, the income tax provision (FTE) was $31.0 million for 2004 compared to $30.3 million for 2003. The current quarter provision represents an effective tax rate of 38.7%, compared to 39.3% for the second quarter of 2003; for the first six months of 2004, the effective tax rate was 38.7%, compared to 39.4% recorded in 2003. The provision for income taxes for all periods presented is primarily attributable to the respective level of earnings and the incidence of allowable deductions and tax credits, particularly those generated from low-income housing investments. Classified Loans The Company closely monitors the markets in which it conducts its lending operations and continues its strategy to control exposure to loans with high credit risk and to increase diversification of earning assets. Loan reviews are performed using grading standards and criteria similar to those employed by bank regulatory agencies. Loans receiving lesser grades fall under the "classified" category, which includes all nonperforming and potential problem loans, and receive an elevated level of attention to ensure collection. Repossessed collateral is recorded at the lower of cost or market. Page 21 The following is a summary of classified loans and repossessed collateral on the dates indicated (dollars in thousands): At June 30, At --------------------------December 31, 2004 2003 2003 --------------------------------------- Classified loans $21,495 $27,324 $23,460 Repossessed collateral 0 1,888 90 --------------------------------------- Classified loans and repossessed collateral $21,495 $29,212 $23,550 ======================================= Allowance for loan losses / classified loans 251% 198% 230% Classified loans at June 30, 2004, decreased $5.8 million or 21.3% from June 30, 2003, reflecting the effectiveness of the Company's high underwriting standards and active workout policies. Most repossessed collateral had been sold by the end of 2003, and one remaining parcel was sold in 2004. Compared with year-end 2003, classified loans declined $2.0 million or 8.4% due to payoffs, upgrades and chargeoffs, partly offset by new downgrades. Nonperforming Loans Nonperforming loans include nonaccrual loans and loans 90 days past due as to principal or interest and still accruing. Loans are placed on nonaccrual status when they become 90 days or more delinquent, unless the loan is well secured and in the process of collection. Interest previously accrued on loans placed on nonaccrual status is charged against interest income. In addition, loans secured by real estate with temporarily impaired values and commercial loans to borrowers experiencing financial difficulties are placed on nonaccrual status even though the borrowers continue to repay the loans as scheduled. Such loans are classified as "performing nonaccrual" and are included in total nonperforming assets. When the ability to fully collect nonaccrual loan principal is in doubt, cash payments received are applied against the principal balance of the loan until such time as full collection of the remaining recorded balance is expected. Any subsequent interest received is recorded as interest income on a cash basis. The following is a summary of nonperforming loans and repossessed collateral on the dates indicated (dollars in thousands): At June 30, At --------------------------December 31, 2004 2003 2003 --------------------------------------- Performing nonaccrual loans $2,233 $1,353 $1,658 Nonperforming, nonaccrual loans 4,695 5,484 5,759 --------------------------------------- Total nonaccrual loans 6,928 6,837 7,417 Loans 90 days past due and still accruing 202 386 199 --------------------------------------- Total nonperforming loans 7,130 7,223 7,616 Repossessed collateral 0 1,888 90 --------------------------------------- Total nonperforming loans and repossessed collateral $7,130 $9,111 $7,706 ======================================= Allowance for loan losses / nonperforming loans 757% 750% 708% Performing nonaccrual loans at June 30, 2004 increased $880 thousand (65.0%) from the same date in the previous year and rose $575 thousand (34.7%) from December 31, 2003. The increase in both periods was due to new loans placed in performing nonaccrual status, partially offset by payoffs and chargeoffs. Nonperforming nonaccrual loans at June 30, 2004 decreased $789 thousand or 14.4% from the same period a year ago and $1.1 million or 18.5% from year-end, 2003. The decrease resulted from loans being returned to full-accrual status or being charged off or paid off, partially offset by loans being added to nonperforming nonaccrual status. Changes in repossessed collateral are discussed above. The amount of gross interest income that would have been recorded for nonaccrual loans for the three and six month periods ended June 30, 2004, if all such loans had performed in accordance with their original terms, was $111 thousand and $231 thousand, respectively, compared to $142 thousand and $305 thousand, respectively, for the second quarter and the first half of 2003. The amount of interest income that was recognized on nonaccrual loans from all cash payments, including those related to interest owed from prior years, made during the three and six months ended June 30, 2004, totaled $102 thousand and $167 thousand, respectively, compared to $146 thousand and $217 thousand, respectively, for the comparable periods in 2003. These cash payments represent annualized yields of 5.98% and 4.78%, respectively, for the second quarter and the first six months of 2004 compared to 7.35% and 5.22%, respectively, for the second quarter and the first half of 2003. Page 22 Total cash payments received during the second quarter of 2004 which were applied against the book balance of nonaccrual loans outstanding at June 30, 2004, totaled approximately $72 thousand. Cash payments received totaled $98 thousand for the six months ended June 30, 2004. Management believes the overall credit quality of the loan portfolio continues to be strong; however, nonperforming assets could fluctuate from period to period. The performance of any individual loan can be impacted by external factors such as the interest rate environment, economic conditions or factors particular to the borrower. No assurance can be given that additional increases in nonaccrual loans will not occur in the future. Allowance for Loan Losses The Company's allowance for loan losses is maintained at a level estimated to be adequate to provide for losses that can be estimated based upon specific and general conditions. These include credit loss experience, the amount of past due, nonperforming and classified loans, recommendations of regulatory authorities, prevailing economic conditions and other factors. The allowance is allocated to segments of the loan portfolio based in part on quantitative analyses of historical credit loss experience, in which criticized and classified loan balances are analyzed using a linear regression model to determine standard allocation percentages. The results of this analysis are applied to current criticized and classified loan balances to allocate the allowance to the respective segments of the loan portfolio. In addition, loans with similar characteristics not usually criticized using regulatory guidelines due to their small balances and numerous accounts, are analyzed based on the historical rate of net losses and delinquency trends, grouped by the number of days the payments on these loans are delinquent. A portion of the allowance is also allocated to specific impaired loans. As of the date of this report, Management considers the $53.9 million allowance for loan losses, which constituted 2.33% of total loans at June 30, 2004, to be adequate as an allowance against inherent losses. However, the risk exists of future losses which cannot be precisely quantified or attributed to particular loans or classes of loans. Management continues to evaluate the loan portfolio and assess current economic conditions that will dictate future required allowance levels. The following table summarizes the loan loss provision, net credit losses and allowance for loan losses for the periods indicated (dollars in thousands): Three months ended Six months ended June 30, June 30, ---------------------------------------------------- 2004 2003 2004 2003 ---------------------------------------------------- Balance, beginning of period $53,835 $54,154 $53,910 $54,227 Loan loss provision 750 900 1,500 1,800 Loans charged off (1,324) (1,841) (2,882) (3,869) Recoveries of previously charged off loans 688 946 1,421 2,001 ---------------------------------------------------- Net credit losses (636) (895) (1,461) (1,868) ---------------------------------------------------- Balance, end of period $53,949 $54,159 $53,949 $54,159 ==================================================== Allowance for loan losses / loans outstanding 2.33% 2.25% Asset and Liability Management The fundamental objective of the Company's management of assets and liabilities is to maximize economic value while maintaining adequate liquidity and a conservative level of interest rate risk. The Company actively solicits loans and transaction deposit accounts. Asset and liability management techniques include adjusting the duration, liquidity, volume, rates and yields, and other attributes of its loan products, investment portfolios, deposit products, and other funding sources to achieve Company objectives. The primary analytical tool used by the Company to gauge interest rate risk is a simulation model to project changes in net interest income ("NII") that result from forecast changes in interest rates. The analysis calculates the difference between a NII forecast over a 12-month period using a flat interest rate scenario, and a NII forecast using a rising rate scenario where the Fed Funds rate is made to rise evenly by 200 bp, and a falling rate scenario of 50 bp over the 12-month forecast interval triggering a response in the other forecasted rates. Company policy requires that such simulated changes in NII should be within certain specified ranges or steps must be taken to reduce interest rate risk. The results of the model indicate that the mix of interest rate sensitive assets and liabilities at June 30, 2004 would not result in a fluctuation of NII that would exceed the parameters established by Company policy. Page 23 A variety of factors affect the timing and magnitude of interest rate changes such as general economic conditions, fiscal policy, monetary policy, political developments, terrorism, and a variety of other factors. Given current conditions, the Company is anticipating rising rates, although the timing of increasing rates remains uncertain. The Company generally maintains an interest rate risk position near neutral, such that changing interest rates will not cause significant changes in net interest income. During the first half of 2004, the Company sold $195.2 million of available-for-sale securities to reduce the average duration of the securities portfolios in a rising rate environment. The Company realized securities gains of $2.2 million from these sales. Also, during the same period, the Company retired $105 million in FHLB advances with a weighted average interest rate of 3.67% in an effort to reduce its aggregate cost of funds. The majority of the retired FHLB advances had scheduled maturity dates prior to January 15, 2005, while others had scheduled maturity dates ranging from May to August 2005. Losses totaling $2.2 million were incurred to retire the FHLB advances prior to their scheduled maturity dates. Liquidity The Company's principal source of asset liquidity is marketable investment securities available for sale. At June 30, 2004, investment securities available for sale totaled $1,025 million, representing a decrease of $389 million from December 31, 2003. In addition, at June 30, 2004, the Company had customary lines for overnight borrowings from other financial institutions in excess of $500 million and a $10 million line of credit under which no amount was outstanding. Additionally, as a member of the Federal Reserve System, the Company has access to borrowing from the Federal Reserve. The Company's short-term debt rating from Fitch Ratings is F1. Management expexts the Company can access short-term debt financing if desired. The Company's long-term debt rating from Fitch Ratings is A with a stable outlook. Management is confident the Company could access additional long-term debt financing if desired. In addition, the Company generates significant liquidity from its operating activities. The Company's profitability during the first six months of 2004 and 2003 generated substantial cash flows of $54.7 million and $58.8 million, respectively, which are included in the totals provided from operations. Additional cash flows may be provided by financing activities, primarily the acceptance of deposits and borrowings from banks. In the first six months of 2004, operating activities provided cash for $36.4 million of Company stock repurchases and $17.3 million in shareholder dividends. In the same period of 2003 operating cash flows were more than sufficient to pay shareholder dividends, repay long term obligations, and repurchase common stock, collectively totaling $47.2 million. In 2004, the Company used $64.2 million from its investing activities. Purchases of securities, net of sales and maturities, were $65.4 million. The investment securities portfolio increase was generally financed by a $41.4 million increase in deposits and $121.9 million of new short-term borrowings. The remaining proceeds were used to repay FHLB advances. In 2003, purchases of investment securities, net of sales and maturities were $322.2 million, which was in part offset by net repayments of loans of $84.2 million. The investment securities portfolio increase was generally financed by a $159.6 million increase in deposits and $43.6 million of new short-term borrowings. The Company anticipates that loan demand will continue to increase moderately in 2004, consistent with economic conditions. The growth of deposit balances is expected to exceed the anticipated growth in loan demand during the period. Depending on economic conditions, interest rate levels, and a variety of other conditions, excess deposit growth will be used to purchase investment securities or to reduce short-term borrowings. Westamerica Bancorporation ("the Parent Company") is separate and apart from Westamerica Bank ("the Bank") and must provide for its own liquidity. In addition to its operating expenses, the Parent Company is responsible for the payment of dividends to its shareholders, and interest and principal payments on outstanding senior debt. Substantially all of the Parent Company's revenues are obtained from service fees and dividends received from the Bank. Payment of such dividends to the Parent Company by the Bank is limited under regulations for Federal Reserve member banks and California law. The amount that can be paid in any calendar year, without prior approval from federal and state regulatory agencies, cannot exceed the net profits (as defined) for that year plus the net profits of the preceding two calendar years less dividends paid. Management believes that such restrictions will not have an impact on the Parent Company's ability to meet its ongoing cash obligations. Page 24 Capital Resources The current and projected capital position of the Company and the impact of capital plans and long-term strategies is reviewed regularly by Management. The Company repurchases shares of its common stock in the open market with the intention of lessening the dilutive impact of issuing new shares to meet stock performance, option plans, and other ongoing requirements. In addition, other programs have been implemented to optimize the Company's use of equity capital and enhance shareholder value. Pursuant to these programs, the Company collectively repurchased 732 thousand shares and 689 thousand shares in the first six months of 2004 and 2003, respectively. The Company's capital position represents the level of capital available to support continued operations and expansion. The Company's primary capital resource is shareholders' equity, which was $329.8 million at June 30, 2004 compared to $357.3 million at June 30, 2003. This amount, which is reflective of the effect of common stock repurchases, dividends paid to shareholders and other comprehensive loss, offset by the generation of earnings and proceeds from the issuance of stock, represents a decrease of $27.5 million or 7.7% from a year ago, and a decrease of $10.6 million or 3.1% from December 31, 2003. The Company's ratio of equity to total assets fell to 7.15% at June 30, 2004, from 7.83% a year ago primarily due to lower equity which was reduced by depreciation in the available for sale investment portfolio of $23 million, net of tax, and, to a lesser extent, asset growth. The equity to assets ratio was 7.44% on December 31, 2003. The following summarizes the ratios of capital to risk-adjusted assets for the periods indicated: At June 30, At Minimum --------------------------December 31, Regulatory 2004 2003 2003 Requirement ---------------------------------------------------- Tier I Capital 10.37% 10.06% 10.13% 4.00% Total Capital 11.78% 11.32% 11.39% 8.00% Leverage ratio 6.89% 7.17% 6.85% 4.00% The risk-based capital ratios improved at June 30, 2004, compared with the prior year primarily due to a change in mix of risk-weighted assets. The leverage ratio fell mainly because of asset growth. When compared with the 2003 year-end, the risk-based capital ratios rose mainly due to the effect of lower risk-weighted assets. The leverage ratio increased slightly, the net result of an increase in the total level of tangible (excluding goodwill and purchase premiums) capital, partially offset by the effect of asset growth. Capital ratios are reviewed by Management on a regular basis to ensure that capital exceeds the prescribed regulatory minimums and is adequate to meet the Company's anticipated future needs. All ratios as shown in the table above are in excess of the regulatory definition of "well capitalized". Item 3. Quantitative and Qualitative Disclosures about Market Risk The Company does not currently engage in trading activities or use derivative instruments to control interest rate risk, even though such activities may be permitted with the approval of the Company's Board of Directors. Interest rate risk as discussed above is the most significant market risk affecting the Company. Other types of market risk, such as foreign currency exchange risk, equity price risk and commodity price risk, are not significant in the normal course of the Company's business activities. Item 4. Controls and Procedures The Company's principal executive officer and principal financial officer have evaluated the effectiveness of the Company's "disclosure controls and procedures," as such term is defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, as of June 30, 2004. Based upon their evaluation, the principal executive officer and principal financial officer concluded that the Company's disclosure controls and procedures are effective. There were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls, since the date the controls were evaluated. Page 25 PART II. OTHER INFORMATION Item 1. Legal Proceedings Due to the nature of the banking business, the Company's Subsidiary Bank is at times party to various legal actions; all such actions are of a routine nature and arise in the normal course of business of the Subsidiary Bank. Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities (a) None (b) None (c) None (d) None (e) Issuer Purchases of Equity Securities The table below sets forth the information with respect to purchases made by or on behalf of Westamerica Bancorporation or any "affiliated purchaser" (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of common stock during the quarter ended June 30, 2004 (in thousands, except per share data). (c) (d) Total Maximum Number Number of Shares of Shares (b) Purchased that May (a) Average as Part of Yet Be Total Price Publicly Purchased Number of Paid Announced Under the Shares per Plans Plans or Period Purchased Share or Programs* Programs ----------------------------------------------------------------- April 1 through April 30 128 $49.31 128 765 ----------------------------------------------------------------- May 1 through May 31 27 48.20 27 738 ----------------------------------------------------------------- June 1 through June 30 3 52.61 3 735 ----------------------------------------------------------------- Total 158 $49.19 158 735 ================================================================= * Includes 1 thousand, 6 thousand and 3 thousand shares purchased in April, May and June, respectively, by the Company in private transactions with the independent administrator of the Company's Tax Deferred Savings/Retirement Plan (ESOP). The Company includes the shares purchased in such transactions within the total number of shares authorized for purchase pursuant to the currently existing publicly announced program. The Company repurchases shares of its common stock in the open market to optimize the Company's use of equity capital and enhance shareholder value and with the intention of lessening the dilutive impact of issuing new shares to meet stock performance, option plans, and other ongoing requirements. Shares were repurchased during the second quarter of 2004 pursuant to a program approved by the Board of Directors on August 28, 2003 authorizing the purchase of up to 2 million shares of the Company's common stock from time to time prior to September 1, 2004. Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders Proxies for the Annual Meeting of shareholders held on April 22, 2004, were solicited pursuant Regulation 14A of the Securities Exchange Act of 1934. The Report of Inspector of election indicates that 27,683,886 shares of the Common Stock of the Company, out of 33,033,165 shares outstanding on February 23, 2004 the record date, were present, in person or by proxy, at the meeting. With the exception of item No.2, below, there were no "broker non-votes" on the following matters because they were considered "routine" and therefore, on those matters, brokers were able to vote shares for which no direction was provided by the beneficial owner. The following matters were submitted to a vote of the shareholders: Page 26 1. - Election of directors: For Withheld ---------- ---------- Etta Allen 27,319,094 364,792 Louis E. Bartolini 27,237,087 446,799 E.J. Bowler 27,380,828 303,058 Arthur C. Latno, Jr. 27,321,448 362,438 Patrick D. Lynch 27,230,985 452,901 Catherine C. MacMillan 27,332,564 351,322 Ronald A. Nelson 27,375,699 308,186 Carl R. Otto 27,343,148 340,738 David L. Payne 27,316,428 367,457 Edward B. Sylvester 27,379,732 304,153 Shareholders were to cast their vote for or to withhold their vote. 2. - Ratification of independent registered public accounting firm. A proposal to ratify the selection of KPMG LLP as independent registered public accountants for the Company for 2004. For : 27,212,320 Against : 296,815 Abstain : 174,751 Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibit 11: Computation of Earnings Per Share on Common and Common Equivalent Shares and on Common Shares Assuming Full Dilution Exhibit 31.1: Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-(14)(a) Exhibit 31.2: Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-(14)(a) Exhibit 32.1: Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Exhibit 32.2: Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) Reports on Form 8-K On April 16, 2004, the Company filed a Report on Form 8-K with respect to item 12, therein, reporting first quarter, 2004 financial results. Included in the report was a press release dated April 13, 2004. Page 27 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 hereunto duly authorized. WESTAMERICA BANCORPORATION (Registrant) August 6, 2004 /s/ DENNIS R. HANSEN - -------------- -------------------- Date Dennis R. Hansen Senior Vice President and Controller (Chief Accounting Officer)