SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED September 30, 1998 Commission File Number 2-76003 BAY AREA BANCSHARES California #94-2779021 900 Veterans Blvd., Redwood City, CA 94063 Telephone (650) 562-3238 Theregistrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act during the preceding 12 months, and x Yes No (2) has been subject to such filing requirements for the past 90 days. x Yes No ----- ----- 1,004,141 Shares of Common Stock Outstanding as of September 30, 1998 Part 1 Item 1 BAY AREA BANCSHARES & SUBSIDIARIES CONSOLIDATED BALANCE SHEET (UNAUDITED, IN THOUSANDS) ASSETS 09/30/98 12/31/97 Cash and due from banks $13,137 $11,464 Federal Funds Sold 22,900 7,500 fixed assets Cash and cash equivalents 36,037 18,964 Investment securities available for sale (market value approximates book value) 1,601 1,106 Investment securities held to maturity (market value of $10,847 in 1998 and $14,683 in 1997) 10,644 14,482 Loans, net of reserve for possible loan losses of $2,001 in 1998 and $1,638 in 1997 100,683 84,374 Premises and equipment,net 453 653 Real estate owned 0 0 Interest receivable and other assets 2,187 2,506 Total assets $151,605 $122,085 LIABILITIES AND SHAREHOLDERS' EQUITY Deposits Demand $36,495 $28,248 Interest-bearing transaction 51,175 41,758 Savings 7,476 6,399 Time 37,906 31,021 Total Deposits 133,052 107,426 Interest payable and other liabilities 2,247 1,671 Federal funds purchased 0 0 Federal Home Loan Bank advances 2,500 1,000 Total liabilities 137,799 110,097 Shareholders' equity: Common stock, no par value: Authorized - 20,000,000 shares; issued & outstanding 4,887 4,736 1,004,141 in 1998 and 977,035 in 1997 Unrealized (loss) gain on securities held for sale 9 (2) Additonal paid in capital 870 640 Retained earnings 8,040 6,614 Total shareholders' equity 13,806 11,988 Total liabilities and shareholders' equity $151,605 $122,085 (1) Part 1 Item 1 BAY AREA BANCSHARES & SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED, DOLLARS IN THOUSANDS) Three Months Three Months Ended Ended 09/30/98 09/30/97 Interest Income: Interest and fees on loans $2,715 $2,148 Interest on investment securities 199 252 Interest on federal funds sold 223 116 Interest on time deposits with other financial institutions 0 0 Total Interest Income 3,137 2,516 Interest Expense: Interest on interest-bearing transaction amounts 396 361 Interest on savings deposits 77 69 Interest on time deposits 492 340 Interest on short-term borrowing 29 14 Interest on notes payable and redeemable debentures 0 0 Total Interest Expense 994 784 Net interest income 2,143 1,732 Provision for possible loan losses 90 60 Net interest income after provision for possible loan losses 2,053 1,672 Noninterest income: Service charges on deposit accounts 70 55 Net loss on sales of securities 0 0 Net gain on disposal of assets 0 0 Net gain on sale of loans held for sale 0 0 Other Mortgage Banking Revenue 30 24 ATM network revenue 518 536 Other 34 34 Total noninterest income 652 649 Noninterest expense: Salaries and related benefits 834 642 Occupancy 121 116 Equipment 189 134 Professional fees 91 77 Stationery and supplies 24 30 Other 380 506 Total noninterest expense 1,639 1,505 Income before provision for income taxes 1,066 816 Provision for income taxes 445 346 Net Income 621 470 Comprehensive income: Unrealized gain (loss) on investment securities held-for- sale, net 9 0 Comprehensive Income $630 $470 Earnings per share: Average common and equivalent shares outstanding- Primary 997,000 885,000 Average common and equivalent shares outstanding- Fully Diluted 1,010,000 960,000 Earnings Per Common Share $0.62 $0.53 Earnings Per Common Share - Assuming Dilution $0.61 $0.49 (2) Part 1 Item 1 BAY AREA BANCSHARES & SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED, DOLLARS IN THOUSANDS) Nine Months Nine Months Ended Ended 9/30/98 9/30/97 Interest Income: Interest and fees on loans $7,554 $5,994 Interest on investment securities 647 732 Interest on federal funds sold 516 319 Interest on time deposits with other financial institutions 0 2 Total Interest Income 8,717 7,047 Interest Expense: Interest on interest-bearing transaction amounts 1,051 1,049 Interest on savings deposits 219 186 Interest on time deposits 1,392 891 Interest on short-term borrowing 66 14 Interest on notes payable and redeemable debentures 0 0 Total Interest Expense 2,728 2,140 Net interest income 5,989 4,907 Provision for possible loan losses 160 180 Net interest income after provision for possible loan losses 5,829 4,727 Noninterest income: Service charges on deposit accounts 192 153 Net loss on sales of securities 0 0 Net gain on disposal of assets 0 0 Net gain on sale of loans held for sale 0 12 Other Mortgage Banking Revenue 131 99 ATM network revenue 1,448 1,531 Other 90 83 Total noninterest income 1,861 1,878 Noninterest expense: Salaries and related benefits 2,141 1,798 Occupancy 366 348 Equipment 436 369 Professional fees 264 190 Stationery and supplies 70 88 Other 1,458 1,552 Total noninterest expense 4,735 4,345 Income before provision for income taxes 2,955 2,260 Provision for income taxes 1,233 946 Net Income 1,722 1,314 Comprehensive income: Unrealized gain (loss) on investment securities held-for- sale, net 11 (3) Comprehensive Income $1,733 $1,311 Earnings per share: Average common and equivalent shares outstanding- Primary 986,778 865,000 Average common and equivalent shares outstanding- Fully Diluted 1,020,000 960,000 Earnings Per Common Share $1.75 $1.52 Earnings Per Common Share - Assuming Dilution $1.69 $1.37 (3) Part 1 Item 1 BAY AREA BANCSHARES CONSOLIDATED STATEMENT OF CASH FLOWS (UNAUDITED, DOLLARS IN THOUSANDS) Nine Months Nine Months Ended Ended 9/30/98 9/30/97 Cash flows from operating activities: Net Income $1,722 $1,314 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation of premises and equipment 297 275 Provision for possible loan losses 160 180 Net gain loss on sale of assets 0 0 Funding of loans held for sale 0 (947) Proceeds from the sale of loans held for sale 0 1,682 Net gain on sale of loans held for sale 0 (12) Net loss on sale of investment securities 0 0 Net ammortization and accretion of investment premiums and discounts 82 69 Net decrease (increase) in interest receivable and other assets 319 (22) Net increase in interest payable and other liabilities 576 227 Net decrease in deferred loan fees (122) (28) Total adjustments 1,312 1,424 Net cash provided by operating activities 3,034 1,358 Cash flows from investing activities: Proceeds from sale of investment securities 0 100 Proceeds from the maturity of investment securities held for sale 0 1,000 Proceeds from the maturity of investment securities held to maturity 1,890 1,585 Mortgage backed securities principal payments 3,008 449 Purchase of investment securities held to maturity (2,349) (3,733) Purchase of investment securities held for sale 0 Net increase in gross loans (15,691) (12,653) Proceeds from the sale of Real Estate Owned 0 226 Capital expenditures (97) (138) Net cash used in investing activities (13,239) (13,164) Cash flows from financing activities: Net increase in demand deposits,transaction and savings 18,741 5,591 Net increase in time deposits 6,885 8,883 Additional Piad in Capital 230 0 Net proceeds of Federal Home Loan Bank advances 1,500 1,000 Proceeds from stock warrants and options exercised 219 263 Cash Dividends paid (297) (236) Net cash provided by financing activities 27,278 15,501 Net increase (decrease) in cash and cash equivalents 17,073 5,075 Cash and cash equivalents,beginning of period 18,964 17,861 Cash and cash equivalents,end of period $36,037 $22,936 There were $0 and $499 in loans transferred to Real Estate Owned in 1998 and 1997 respectively. (4) BAY AREA BANCSHARES & SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS All adjustments, which in the opinion of management are necessary for a fair statement of the Company's financial condition at September 30, 1998, results of operations for the three and nine month periods ended September 30, 1998 and the statement of cash flows for the nine month period ended September 30, 1998 have been included. These adjustments are of a normal and recurring nature. The results of operations and statement of cash flows are not necessarily indicative of the results for a full year's activity. The accompanying unaudited financial statements have been prepared on a basis consistent with the accounting principles and policies reflected in the Company's Annual Report for the year ended December 31, 1997. All references to the "Bank" are in reference to the Company's sole, and wholly owned, subsidiary Bay Area Bank. New Statements of Financial Accounting Standards: In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standard No. 130, "Reporting Comprehensive Income" ("SFAS 130"). Under the provisions of SFAS 130, the Company is required to report comprehensive income in its financial statements; the term comprehensive income describes the total of all components of comprehensive income including net income as well as other revenues, expenses, gains and losses that are included in comprehensive but excluded from earnings (net income). The Company started to report comprehensive income as part of the consolidated statements of operations, including other comprehensive income items added separately to net income resulting in total comprehensive income. SFAS 130 is effective with the year-end 1998 financial statements; however, the total comprehensive income is required in the financial statements for interim periods beginning in 1998. The Company adopted SFAS 130 as of January 1, 1998; the adoption of the statement did not have a material impact on the Company's financial statements. In June of 1997, the Financial Accounting Standards Board ("FASB") issued the Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS 131"). Under the provisions of SFAS 131, an entity is required to report selected information about operating segments in annual financial statements and interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The Statement uses a "management approach" to identify operating segments and defines an operating segment as a component of an enterprise (I) for which discrete financial information is available; (ii) that engages in business activities (5) that may earn revenues and incur expenses (including revenues and expenses relating to transactions with other components of the same enterprise) and (iii) whose operating results are regularly reviewed by the enterprise's chief operating decision maker. Reportable segments (aggregated if appropriate) are operating segments that meet specified quantitative thresholds based on revenues, profit or loss and assets, using a ten percent rule. SFAS 131 is effective for fiscal years beginning after December 15, 1997. Segment information that is presented for comparative purposes is to be restated to conform to the requirements of SFAS 131 unless it is impracticable to do so. The required interim disclosures are not required to be made in the initial year of application but the information for the interim periods for the initial year is required as comparative information in the second year of application. BAY AREA BANCSHARES & SUBSIDIARIES ITEM 2 Management's Discussion and Analysis of Financial Condition and Results of Operations This report may include forward-looking statements as defined in section 27A of the Securities Act of 1933, as amended, and section 21E of the Securities Exchange Act of 1934, as amended, which includes statements such as projections, plans and objectives and assumptions about the future, and such statements are subject to the safe harbor created by those sections. Forward looking statements involve certain risks and uncertainties that could cause actual results to differ materially from those in forward looking statements. Such risks and uncertainties include changes in competition, market interest rates, economic conditions and changes in the regulatory environment. Item 2A Financial Condition Liquidity Liquid assets (Cash, Federal Funds Sold and Investments) increased $13.7 million or 39.8% to $48.3 million over the nine month period from December 31, 1997 to September 30, 1998. At year-end, total liquid assets as a percentage of total assets was 28.3%, whereas on September 30, 1998 it had increased to 31.9%. Cash & due from banks increased $1.7 million over the first nine months of 1998 to $13.1 million at September 30, 1998. During the first nine months of 1998 cash and due from banks averaged $11.3 million. The portion of the total cash & due from banks representing ATM ("Automatic Teller Machine") network cash inventory has averaged approximately $2.7 million during 1998 and averaged $3.6 in the first three quarters of 1997. The reduction in ATM cash is primarily a result of more aggressive management of the cash inventory in the machines. (6) Both average and period end loans and deposits outstanding are at record levels for the Company. During the first nine months of 1998 gross loans outstanding has averaged $94.7 million as compared to $74.2 million in the first nine months of 1997, an increase of 27.6%. Gross loans were $102.7 million at September 30, 1998 a record level for the Company and a $16.7 million or 19.4% increase over the balance at December 31, 1997. Deposits have averaged $118.7 million in the first nine months of 1998 while they averaged $98.6 million during the first nine months of 1997, an increase of 20.4%. Deposits were $133.1 million at September 30, 1998, an increase of $25.7 million or 24% since year end 1997. Management believes current liquid assets and current available credit lines are adequate to cover the working capital requirements of the Company and any reasonable needs arising from deposit withdrawals. Capital Consolidated equity capital plus reserves increased $2.2 million in the first nine months of 1998 from $13.6 million or 11.16% of total gross assets at December 31, 1997 to $15.8 million or 10.43% of total gross assets at September 30, 1998. Bank capital plus reserves totaled $14.5 million on September 30, 1998 or 9.44% of total adjusted assets as compared to capital plus reserves of $12.3 million or 10.03% of total adjusted assets at December 31, 1997. At September 30, 1998 the Bank maintained a tier one capital ratio of 10.89% and a tier two capital ratio of 12.14% as compared to 11.7% and 12.9% respectively at December 31, 1997. The Bank's capital level continues to exceed State and Federal Deposit Insurance Corporation requirements and satisfies the Federal Reserve Board's current risk-based capital Guidelines. The Bank declared no dividends to the Parent company in the first nine months of 1998. The Company declared cash dividends to common shareholders of $.10 per share in September of 1998. The third quarter dividend represents twenty eight consecutive quarterly cash dividends declared by the Parent company to shareholders. Item 2B Results of Operations Results of Operations Consolidated operating profits were $621,000 ($.61 per common share assuming dilution vs. $.49 in the prior year) for the third quarter of 1998, the highest third quarter earnings in the Company's history. This represents a $151,000 or 32.1% increase over the third quarter of 1997 when net income was $470,000. (7) The increase in third quarter earnings in 1998 versus the third quarter of 1997 is a result of an increase in pretax earnings of $250,000 which is comprised of an increase in net interest income of $411,000 and an increase in other income of $3,000 offset in part by an increase in noninterest expense of $134,000 and an increase in loan loss provisions of $30,000. Consolidated operating profits were $1,722,000 ($1.69 per common share assuming dilution vs. $1.37 in the prior year) for the first nine months of 1998, the highest nine months of earnings in the Company's history. This represents a $408,000 or 31.1% increase over the first nine months of 1997 when net income was $1,314,000. The increase in nine month earnings in 1998 versus the first nine months of 1997 is a result of an increase in pretax earnings of $695,000 which is comprised of an increase in net interest income of $1,082,000 and a decrease in loan loss provisions of $20,000, offset in part by a decrease in other income of $17,000 and a increase in noninterest expense of $390,000. The growth in net interest income of 23.4% in the third quarter of 1998 is primarily a result of growth in total earning assets offset in part by a decrease in net interest margin (Net interest margin is computed by dividing annualizing net interest income by average earning assets during the respective period). Average earning assets in the third quarter of 1998 were $131.1 million, a $28.0 million or 27.1% increase over the third quarter of 1997 when earning assets averaged $103.2 million. Net interest margin in the third quarter of 1998 was approximately 6.54% as compared to 6.72% in the third quarter of 1997. The growth in net interest income of 22.1% in the first nine months of 1998 is primarily a result of growth in total earning assets offset in part by a decrease in net interest margin. Average earning assets in the first nine months of 1998 have been $121.8 million, a $24.4 million or 25.0% increase over the first nine months of 1997 when earning assets averaged $97.4 million. Net interest margin in the first nine months of 1998 was approximately 6.56% as compared to 6.72% in the first nine months of 1997. The modest decline in net interest margin that has occurred throughout the first nine months of 1998 is a result of an decrease in the yield on earning assets and an increase in the cost of deposits and advances. The yield on earning assets decreased in the first nine months of 1998 to 9.55% as compared to 9.65% in the first nine months of 1997. The cost of the Bank's deposits and advances (including demand deposits), which averaged $120.2 million in the first nine months of 1998, rose to 3.03% as compared to 2.89% in the first nine months of 1997, when the deposits and advances averaged $98.9 million. For the third quarter of 1997, the Bank's deposits and advances averaged $103.9 million in comparison to $129.7 million for the third quarter of 1998, representing a $25.8 million increase. Management believes that further compression of net interest margin may occur in the coming quarters as a result of competitive pressures on loan pricing and a decline in the prime rate, which is the index used to price the majority of the Bank's loans. If there is a further decline in net interest margin caused by reduction in interest earned on interest earning assets, management plans to (8) offset it in part by continued growth in earning assets and a decline in the cost of the Bank's sources of funds. Loan loss provisions were $90,000 in the third quarter of 1998 and $60,000 in the third quarter of 1997. Loan loss provisions for the first nine months of 1998 were $160,000 as compared $180,000 for the first nine months of 1997. The decrease in loan loss provisions thus far in 1998, as compared to 1997, is a result of a decline in nonperforming assets and a continued local economic expansion. Non performing assets at September 30, 1998 were $145,000 or .09% of total assets and 7.2% of loan loss reserves. Non performing assets at December 31, 1997 were $373,000 or .31% of total assets and 22% of loan loss reserves. There have been $72,000 in loans charged off during the nine months of 1998 and $275,000 in recoveries of loans previously charged off as compared to $113,000 in loans charged off and $7,000 in recoveries in the first nine months of 1997. Loan loss reserves of $2.0 million at September 30, 1998 represent a ratio of 1.95% of gross loans outstanding as compared to a loan loss reserve of $1.64 million or 1.90% of gross loans at December 31, 1997. The Bank's ATM revenues were down $18,000 or 3.4% in the third quarter of 1998 and fell $83,000 or 5.4% in the first nine months of 1998 in comparison to the same periods in 1997. Revenue per machine has averaged $3,448 thus far in 1998 and a decrease of 2.7% over the first nine months of 1997 in which average revenue per machine was $3,541. In addition, the average number of machines in operation has declined from approximately 49 in the first nine months of 1997 to 47 in the first nine months of 1998. The reduction in the average number of machines in service was a result of certain contracts that expired and certain unprofitable sites that were closed, primarily during 1997. The Bank continues to evaluate potential sites to redeploy some of the excess machines in the future. The ATM department contributed $235,000 to pretax profits in the first nine months of 1998 as compared to $249,000 in the first nine months of 1997. The ATM department expects to realize significant cost reductions in the future. These cost reductions include $10,000 a month savings as a result of a consultant contract that was fully amortized in June of 1998, an expected savings of approximately $6,000 per month as a result of new contractual terms with a major service provider that began in July 1998 and a reduction of depreciation expense as certain existing capital costs become fully depreciated resulting in a $7,000 a month saving of depreciation on the existing infrastructure by January of 1999. Non interest expense was up $134,000 or 8.9% in the third quarter of 1998 as compared to the third quarter of 1997 and $390,000 or 9.0% for the first nine months of 1998. The increase in both periods was comprised primarily of additional salaries and benefits which are up 19% in the first nine months of 1998. The Company is actively involved in evaluating and addressing any potential effects on the Company's operations as a result of Year 2000 ("Y2K") computer programming problems. The Bank has adopted a Policy and Strategy to guard against any disruption of service arising from the date change at January 1, 2000. The primary elements of (9) the Policy and Strategy address the Bank's ability to become Y2K compliant in the following areas: deposit data processing, wire transfer processing, loan data processing and documentation, ATM servicing and electronic data interchange systems, accounting and various internal/environmental systems, such as voicemail and electronic mail systems and HVAC and office equipment. The Bank's Year 2000 Strategy contains detailed steps for assessment of the complexity of becoming Y2K compliant, including determining (1) the effect of Y2K on the Bank's main computer system, and on each subproduct used by each department that interfaces with the main computer system; (2) hardware requirements for all applications and whether new hardware needs to be purchased; (3) whether the internal/environmental systems are Y2K compliant; and (4) whether the services provided by outside vendors with respect to the payment system functions are Y2K compliant. In addition, the assessment includes reviewing third-party contracts to determine whether vendors are required to be Y2K compliant and changing contracts or vendors as necessary to assure compliance, and reviewing the effect of Y2K on all large corporate borrowers and assessing those borrowers' ability to become Y2K compliant with respect to credit evaluations. Once the above assessment is completed, the Bank will take the steps necessary to replace equipment or software as needed, and to replace vendors of services who cannot provide certification of compliance. This is being done in connection with a planned upgrade of computer equipment and products that would go forward even if the year 2000 were not approaching. In connection with the Policy and Strategy described above, the Bank has adopted a formal testing plan, which sets forth the specific testing methodology guidelines and types of testing to be used, and sets forth the dates for which accuracy testing is to be conducted. In addition to evaluating its own systems, the Loan Committee of the Board of Directors has instructed bank management to include a Y2K exposure evaluation of all new loans submitted. The Bank's primary data processing system (which consists of software that manages loans, deposits, accounting and investments) is provided to the Bank by a third party. The programming that controls the deposit function was upgraded in 1997 in order to be year 2000 compliant. The lending, accounting and investment programs are set to be upgraded in the fourth quarter of 1998. The Bank will incur certain costs associated with the testing and determinations necessary to address Y2K compliance. These costs include the cost of the internal testing that is being done, and the costs of any outside auditors or other personnel that will be necessary to evaluate the results of the tests. In addition, the Bank will be receiving the software upgrades referred to above, and will be purchasing new computer hardware to achieve compliance. The Bank currently estimates that the cost of becoming compliant will be approximately $239,000, all of which will be capitalized and amortized over several years. The expenditures are not expected to have a material impact on the Bank's results of operations. (10) Finally, the Bank does not expect that any of its major corporate customers will have Y2K problems that result in any loan losses to the Bank from those customers, based on the due diligence that the Bank has conducted to date. However, it is relatively early in the time by which many businesses are determining their exposure to this risk, and the Bank is continuing to evaluate whether any of its customers may incur problems from the date change. In addition, despite the Company's activities regarding the Y2K issue, there can be no assurances that partial or total system interruptions and costs to update the necessary hardware and software would not have a material adverse effect on the Company PART II ITEM 6 (a) Exhibits. 3.1 Restated Articles of Incorporation of the Company (incorporated by reference to Exhibit 3.1 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1988). 3.2 Amendment to Restated Articles of Incorporation (incorporated by reference to Exhibit 3.2 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1989). 3.3 Bylaws of the Company, as amended (incorporated by reference to Exhibit 3.2 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 3.4 Amendment to Bylaws of Company (incorporated by reference to Exhibit 3.3 of the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1987). 27 Financial Data Schedule (filed herewith) (b) Form 8-K. No Reports on Form 8-K were filed during the quarter ended September 30, 1998. (11) SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. BAY AREA BANCSHARES Registrant Dated: November 11, 1998 /s/ Robert R. Haight - ---------------------------------------- Robert R. Haight President and Chief Executive Officer /s/ Anthony J. Gould - ---------------------------------------- Anthony J. Gould Chief Accounting Officer