UNITED STATES SECURITIES & 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 September 30, 2004 Commission file number: 0-49892 PACIFIC STATE BANCORP (Exact Name of Registrant as Specified in its Charter) California 61-1407606 - ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 1899 W. March Lane, Stockton, CA 95207 --------------------------------------------------- (Address of Principal Executive Offices) (Zip Code) Registrant's Telephone Number, including Area Code (209) 943-7400 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 126-2 of the Exchange Act. Yes [ ] No [X] Indicate the number of shares outstanding of each of the registrant issuer's classes of common stock, as of the latest practicable date: Title of Class Shares outstanding as of November 12, 2004 - -------------- ------------------------------------------ Common Stock 3,447,622 No Par Value PART I ITEM 1. FINANCIAL STATEMENTS PACIFIC STATE BANCORP Condensed Consolidated Balance Sheet September 30 December 31, 2004 2003 ------------ ------------ (Unaudited) Assets - ------ Cash and due from banks $ 12,394,983 $ 5,317,323 Federal funds sold 13,375,000 7,456,000 Interest -bearing deposits in banks 1,500,000 4,000,000 Investment securities - available for sale (amortized cost of $17,602,391 in 2004 and $12,096,100 in 2003) 17,452,973 12,106,562 Loans, less allowance for loan losses of $2,011,660 in 2004 and $1,652,583 in 2003 188,188,698 155,484,998 Bank premises and equipment, net 9,512,150 8,755,992 Accrued interest receivable and other assets 8,261,084 7,803,318 ------------ ------------ Total assets $250,684,888 $200,924,193 ============ ============ Liabilities and Shareholders' Equity - ------------------------------------ Deposits: Non-interest bearing $ 51,499,688 $ 40,400,662 Interest bearing 167,512,398 135,891,546 ------------ ------------ Total deposits 219,012,086 176,292,208 Short-term borrowings 1,000,000 1,000,000 Long-term borrowings 4,000,000 4,000,000 Subordinated debentures 8,764,000 5,155,000 Accrued interest payable and other liabilities 1,973,460 1,018,450 ------------- ------------ Total liabilities 234,749,546 187,465,658 Commitments and contingencies Shareholders' equity - -------------------- Preferred stock - no par value; 2,000,000 shares authorized; none issued and outstanding -- -- Common stock - no par value; 24,000,000 shares authorized; shares issued and outstanding 3,411,622 in 2004 and 3,377,656 in 2003 7,056,596 6,936,786 Retained earnings 8,785,148 6,456,766 Accumulated other comprehensive income, net of tax 93,598 64,983 ------------ ------------ Total shareholders' equity 15,935,342 13,458,535 ------------ ------------ Total liabilities and shareholders' equity $250,684,888 $200,924,193 ============ ============ See notes to unaudited condensed consolidated financial statements 2 Pacific State Bancorp Condensed Consolidated Statement of Income (Unaudited) For the Three Months Ended For the Nine Months Ended September 30, September 30, -------------------------- ------------------------- 2004 2003 2004 2003 ----------- ----------- ----------- ----------- Interest income: Interest and fees on loans $ 3,200,369 $ 2,785,575 $ 9,093,865 $ 7,748,713 Interest on federal funds sold 26,771 4,805 41,771 73,066 Interest on investment securities 144,190 117,959 372,403 347,774 ----------- ----------- ----------- ----------- Total interest income 3,371,330 2,908,339 9,508,039 8,169,553 Interest expense: Interest on deposits 671,243 578,245 1,747,674 1,852,192 Interest on subordinated debentures 101,388 60,988 250,990 179,188 Interest on borrowings 31,112 33,741 95,625 96,769 ----------- ----------- ----------- ----------- Total interest expense 803,743 672,974 2,094,289 2,128,149 ----------- ----------- ----------- ----------- Net interest income 2,567,587 2,235,365 7,413,750 6,041,404 Provision for loan losses 138,000 138,000 366,000 398,000 ----------- ----------- ----------- ----------- Net interest income after provision for loan losses 2,429,587 2,097,365 7,047,750 5,643,404 ----------- ----------- ----------- ----------- Non-interest income Service charges 286,382 168,951 891,254 477,100 Other fee income 291,450 163,408 785,086 477,508 Gain from sale of loans 240,044 81,924 312,793 390,473 ----------- ----------- ----------- ----------- Total non-interest income 817,876 414,283 1,989,133 1,345,081 Other expenses: Salaries and employee benefits 852,527 804,887 2,580,241 2,282,964 Occupancy 200,186 171,514 535,851 500,671 Furniture and equipment 125,590 126,361 353,681 365,448 Other 661,787 545,293 1,849,078 1,605,431 ----------- ----------- ----------- ----------- Total other expenses 1,840,090 1,648,055 5,318,851 4,754,514 ----------- ----------- ----------- ----------- Income before income taxes 1,407,373 863,593 3,718,032 2,233,971 Income tax expense 513,200 333,500 1,389,650 821,900 ----------- ----------- ----------- ----------- Net income $ 894,173 $ 530,093 $ 2,328,382 $ 1,412,071 =========== =========== =========== =========== Basic earnings per share $ 0.26 $ 0.16 $ 0.68 $ 0.43 =========== =========== =========== =========== Diluted earnings per share $ 0.24 $ 0.16 $ 0.63 $ .042 =========== =========== =========== =========== Weighted average common shares outstanding 3,437,575 3,303,080 3,407,185 3,316,720 Weighted average common and common equivalent shares outstanding 3,784,982 3,394,952 3,710,882 3,408,592 See notes to unaudited condensed consolidated financial statements 3 Pacific State Bancorp and Subsidiaries Condensed Consolidated Statement of Cash Flows (Unaudited) For the Nine Months Ended September 30, ----------------------------- 2004 2003 ------------ ------------ Cash flows from operating activities: Net income $ 2,328,382 $ 1,412,071 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 366,000 398,000 Deferred loan origination fees and costs, net 67,931 35,771 Depreciation and amortization 363,542 331,447 Net gain on sale of available-for-sale investment Securities -- (2,116) Net increase in cash surrender value of life insurance Policies -- (25,780) Increase in accrued interest receivable and other assets (433,425) (217,320) Increase (decrease) in accrued interest payable and other liabilities 955,009 (56,776) ------------ ------------ Net cash provided by operating activities 3,647,439 1,875,297 ------------ ------------ Cash flows from investing activities: Net increase in interest-bearing deposits in banks 2,500,000 (3,500,000) Proceeds from sale of available-for-sale investment securities 1,633,950 150,000 Purchases of available-for-sale investment securities (7,475,900) (3,740,530) Proceeds from principal repayments from available-for-sale mortgage-backed securities 423,456 4,358,309 Proceeds from principal repayments from held-to-maturity mortgage-backed securities 33,326 102,435 Net decrease in loans (33,137,631) (26,286,189) Proceeds from sale of other real estate -- 49,704 Purchases of bank premises and equipment (1,075,958) (2,053,794) Purchase of life insurance policy -- (4,135,250) ------------ ------------ Net cash used in investing activities (37,098,757) (35,055,315) ------------ ------------ Cash flows from financing activities: Net increase in demand, interest-bearing and savings deposits 43,046,937 10,492,676 Net increase (decrease) in time deposits (327,059) 13,291,658 Proceeds from the issuance of subordinated debentures 3,609,000 -- ------------ ------------ Repurchase of common stock -- (170,546) ------------ ------------ Proceeds from stock options exercised 119,100 208,248 ------------ ------------ Net cash provided by financing activities 46,447,978 23,822,036 ------------ ------------ Increase in cash and cash equivalents 12,996,660 (9,357,982) Cash and cash equivalents at beginning of year 12,773,323 23,465,668 ------------ ------------ Cash and cash equivalents at end of period $ 25,769,983 $ 14,107,686 ============ ============ See notes to unaudited condensed consolidated financial statements 4 Pacific State Bancorp NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS September 30, 2004 1. BASIS OF PRESENTATION AND CONDENSED CONSOLIDATED FINANCIAL STATEMENTS In the opinion of management, the unaudited condensed consolidated financial statements contain all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the consolidated financial position of Pacific State Bancorp (the "Company") at September 30, 2004 and December 31, 2003, and the results of its operations for the three and nine month periods ended September 30, 2004 and 2003 and its cash flows for the nine month periods ended September 30, 2004 in conformity with the instructions to Form 10-Q and Article 10 of Regulation S-X. Certain disclosures normally presented in the notes to the consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America for annual financial statements have been omitted. These interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's 2003 Annual Report to Shareholders. The results of operations for the three month and nine month periods ended September 30, 2004 may not necessarily be indicative of the operating results for the full year. In preparing such financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and revenues and expenses for the period. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant changes in the near term relate to the determination of the allowance for loan and lease losses, the provision for taxes and the estimated fair value of investment securities. Management has determined that all of the commercial banking products and services offered by the Company are available in each branch of Pacific State Bank (the "Bank"), its wholly owned bank subsidiary, that all branches are located within the same economic environment and that management does not allocate resources based on the performance of different lending or transaction activities, Accordingly, the Company and it's subsidiary operate as one business segment. No customer accounts for more than 10% of the revenue for the Bank or the Company. 2. STOCK-BASED COMPENSATION As of September 30, 2004, the Company had one stock-based employee compensation plan, the Pacific State Bancorp 1997 Stock Option Plan (the "Plan"). The Company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under the Plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, as amended, requires the disclosure of pro forma net income and earnings per share had the Company adopted the fair value method of accounting for stock-based compensation. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models, even though such models were developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company's stock option awards. These models also require subjective assumptions, including future stock price volatility and expected time to exercise, which greatly affect the calculated values. The Company's calculations were made using the Black-Scholes option pricing model with the following assumptions: expected life, 5 years following vesting; average stock volatility of 20.34% for 2004 and 2003; risk free interest rates of 3.21% for 2004 and 2003; and no cash dividends during the expected term for 2004 and 2003. The Company's calculations are based on a multiple option valuation approach and forfeitures are recognized as they occur. Pro forma adjustments to the Company's consolidated net earnings and earnings per share are disclosed during the years in which the options become vested. The following 5 table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. For the Three Months Ended For the Nine Months Ended September 30, September 30, ---------------------------- ---------------------------- 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Net income, as reported $ 894,173 $ 530,093 $ 2,328,382 $ 1,412,071 Deduct: Total stock-based employee compensation expense determined under the fair value method for all awards, net of related tax effects 66,000 10,000 198,000 30,000 ------------ ------------ ------------ ------------ $ 828,173 $ 520,093 $ 2,130,382 $ 1,382,071 ============ ============ ============ ============ Basic earning per share - as reported $ 0.26 $ 0.16 $ 0.68 $ 0.43 Basic earning per share - pro forma $ 0.24 $ 0.16 $ 0.63 $ 0.42 Diluted earnings per share - as reported $ 0.24 $ 0.16 $ 0.63 $ 0.42 Diluted earnings per share - pro forma $ 0.22 $ 0.16 $ 0.59 $ 0.41 3. EARNINGS PER SHARE COMPUTATION Basic earnings per share are computed by dividing net income by the weighted average common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if outstanding stock options were exercised. Diluted earnings per share is computed by dividing net income by the weighted average common shares outstanding for the period plus the dilutive effect of options 4. COMPREHENSIVE INCOME Comprehensive income is reported in addition to net income for all periods presented. Comprehensive income is made up of net income plus other comprehensive income or loss. Other comprehensive income or loss, net of taxes, is comprised of the unrealized gains or losses on available-for-sale investment securities. The following table shows comprehensive income and it's components for the periods indicated: Three Months Ended Nine Months Ended 09/30/04 09/30/03 09/30/04 09/30/03 ------------ ------------ ------------ ------------ Net Income $ 894,173 $ 530,093 $ 2,328,382 $ 1,412,071 Other Comprehensive Gain (Loss) Income: Change in unrealized gain (loss) on available for sale securities 214,000 (84,000) 29,000 18,000 Reclassification adjustment 0 0 0 0 ------------ ------------ ------------ ------------ Total Other Comprehensive (Loss) Income 214,000 (84,000) 29,000 18,000 Total Comprehensive Income $ 1,108,173 $ 446,093 $ 2,357,382 $ 1,430,071 ============ ============ ============ ============ 5. COMMITMENTS AND CONTINGENCIES In the normal course of business there are outstanding various commitments to extend credit which are not reflected in the financial statements, including loan commitments of approximately $49,675,563 and stand-by letters of credit of $585,671 at September 30, 2004. However, all such commitments will not necessarily culminate in actual extensions of credit by the Company during 2004. 6 Approximately $19,946,000 of the loan commitments outstanding at September 30, 2004 are for real estate loans and are expected to fund within the next twelve months. The remaining commitments primarily relate to revolving lines of credit or other commercial loans, and many of these are expected to expire without being fully drawn upon. Therefore, the total commitments do not necessarily represent future cash requirements. Each potential borrower and the necessary collateral are evaluated on an individual basis. Collateral varies, but may include real property, bank deposits, debt or equity securities or business assets. Stand-by letters of credit are commitments written to guarantee the performance of a customer to a third party. These guarantees are issued primarily relating to purchases of inventory by commercial customers and are typically short term in nature. Credit risk is similar to that involved in extending loan commitments to customers and accordingly, evaluation and collateral requirements similar to those for loan commitments are used. Virtually all such commitments are collateralized. Deferred fees related to stand-by letters of credit are not significant. 6. STOCK SPLIT On September 16, 2004 the Company's board of directors declared a two-for-one stock split payable to shareholders of record on September 30, 2004. All references to share and per share data included in these unaudited condensed consolidated financial statements have been restated as if the stock split was affected on the first day of all periods presented. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is management's discussion and analysis of the significant changes in Pacific State Bancorp (the "Company") balance sheet accounts between September 30, 2004 and December 31, 2003 and its income and expense accounts for the three and nine month periods ended September 30, 2004 and 2003. The discussion is designed to provide a better understanding of significant trends related to the Company's financial condition, results of operations, liquidity, capital resources and interest rate sensitivity. In addition to the historical information contained herein, this report on Form 10-Q contains certain forward-looking statements. The reader of this report should understand that all such forward-looking statements are subject to various uncertainties and risks that could affect their outcome. The Company's actual results could differ materially from those suggested by such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, variances in the actual versus projected growth in assets, return on assets, loan losses, expenses, changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits, competition effects, fee and other noninterest income earned, general economic conditions, nationally, regionally and in the operating market areas of the Company and its subsidiaries, changes in the regulatory environment, changes in business conditions and inflation, changes in securities markets, data processing problems, a decline in real estate values in the Company's market area, the effects of terrorism, the threat of terrorism or the impact of potential military conflicts and the conduct of the war on terrorism by the United States and its allies, as well as other factors. This entire report should be read to put such forward-looking statements in context. To gain a more complete understanding of the uncertainties and risks involved in the Company's business, this report should be read in conjunction with the Company's annual report on Form 10-K for the year ended December 31, 2003. General Description of Business Pacific State Bancorp is a holding company with one bank subsidiary, Pacific State Bank, (the "Bank"), and two unconsolidated subsidiary guarantor trusts, Pacific State Statutory Trusts I and II. Pacific State Bancorp commenced operations on June 24, 2002 when it acquired all the then issued and outstanding shares of Pacific State Bank under a plan of reorganization approved by the Bank's shareholders on May 9, 2002. The Bank is a California state chartered bank. The Bank is a member of the Federal Reserve System. The Bank's primary source of revenue is providing loans to customers who are predominately small to middle-market businesses and middle-income individuals. Pacific State Statuatory 7 Trusts I and II are unconsolidated, wholly owned statutory business trusts formed in June 2002 and March 2004 for the exclusive purpose of issuing and selling trust preferred securities. The Bank has engaged since November 2, 1987 in a general commercial banking business, primarily in Stockton and San Joaquin County, and offers commercial banking services to residents and employers of businesses in the Bank's service area, including professional firms and small to medium sized retail and wholesale businesses and manufacturers. The Company as of September 30, 2004 had 64 employees, including 24 officers. The Bank does not engage in any non-bank lines of business. The business of the Bank is not to any significant degree seasonal in nature. The Bank has no operations outside California and has no material amount of loans or deposits concentrated among any one or few persons, groups or industries. The Bank's main office is located at 6 So. El Dorado Street, in Stockton, California; additional branches are located elsewhere in Stockton and in the communities of Angels Camp, Arnold, Groveland, Modesto and Tracy, California. Business Plan The focus of the Company's business plan is to attract "middle market" accounts, but not to the exclusion of any other business which the Company can reasonably and profitably attract. In order to provide a level of service to attract such customers, the Company has structured its specific services and charges on a basis which management believes to be profitable, taking into consideration other aspects of the account relationship. The Company offers a range of banking services to its customers intended to attract the following specific types of accounts: relatively large consumer accounts; professional group and association accounts, including the accounts of groups or firms of physicians, dentists, attorneys and accountants; and accounts of small to medium-sized businesses engaged in retail, wholesale, light industrial and service activities. Trust Subsidiaries During 2002 and 2004 the Company established business trust subsidiaries (the "Trusts") for the sole purpose of issuing capital securities ("Capital Securities") pursuant to declarations of trust. The proceeds from the sale of the Capital Securities were loaned to the Company under deeply subordinated debentures issued to the Trusts pursuant to indentures (the "Indentures"). Interest payments on the Debentures will flow through the Trusts to the Pooling Vehicles, which are the holders of the Capital Securities and similar securities issued by other financial institutions. Payments of distributions by the Trusts to the Pooling Vehicle are guaranteed by the Company. See note 8 to the consolidated financial statements in the Company's 2003 Annual Report to Shareholders. Proceeds from the issuance of the 2002 Debentures were used to provide the Bank with an additional $4.5 million in capital in order to support the continued growth of the Bank. The remaining $500,000 was placed in the Company for general corporate purposes. Proceeds from the issuance of the 2004 Debentures were used to provide the Bank with an additional $3.5 million in capital in order to support the continued growth of the Bank. Product Lines and Services The Bank currently offers the following general banking services at all of its branches: commercial, construction and real estate loans and personal credit lines, interest on checking, U.S. Savings bond services, domestic and foreign drafts, banking by appointment, automatic transfer of funds between savings and checking accounts, business courier services, checking and savings accounts for personal and business purposes, domestic letters of credit, a depository for MasterCard and Visa drafts, federal depository services, cash management assistance, wire and telephone transfers, travelers' checks, Individual Retirement Accounts, time certificates of deposit, courier service for non-cash deposits, Visa and MasterCard, revolving lines of credit to consumers secured by deeds of trust on private residences, unsecured overdraft protection credit lines attached to checking accounts, ATM cards and MasterMoney debit cards via the Star, Cirrus, Plus, MasterCard and Visa networks. The Bank is not authorized to offer trust services. The Federal Reserve Bank of San Francisco is the Company's primary correspondent relationship. The Bank currently also has correspondent relationships with City National Bank in Beverly Hills, Bank of America in San Francisco, First Tennessee Bank in Memphis, Tennessee, Compass Bank in Birmingham, Alabama, Wells Fargo Bank and Pacific Coast Bankers Bank. The Bank recognizes that, in order to be competitive, it must offer a certain consumer products. These products include, Individual Retirement Accounts, Visa and MasterCard, revolving lines of credit to consumers secured by deeds of trust on private residences, and unsecured overdraft protection credit lines attached to checking accounts. 8 These products currently offered by the Bank are designed to appeal particularly to consumers. Moreover, participation in a large-scale ATM network assists the Company in competing for consumer accounts. The Bank is an approved Small Business Administration and 504 lender, FarmerMac I and II, USDA, USDA Part-time Farmer Program, FHA and VA lender and California Capital lender. The Bank is a national leader in the underwriting of U.S. Department of Agriculture business and industry loans, as well as, a Preferred Lender for this program. Critical Accounting Policies General The Company's financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). The financial information contained within our statements is, to a significant extent, financial information that is based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use. Other estimates that we use are related to the expected useful lives of our depreciable assets. In addition, GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change. Allowance for Loan Losses The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on two basic principles of accounting: (1) Statement of Financial Accounting Standards (SFAS) No. 5 "Accounting for Contingencies", which requires that losses be accrued when they are probable of occurring and estimable and (2) SFAS No. 114, "Accounting by Creditors for Impairment of a Loan", which requires that losses be accrued for impaired loans based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The Company employs a comprehensive methodology for estimating inherent losses consistent with SFAS 5 and SFAS 114; however, actual losses could vary significantly from these estimates. For further discussion, see "Allowance for Loan Losses (ALL)". Results of Operations Three and Nine Month Periods Ended September 30, 2004 Compared to the Same Periods Ended September 30, 2003 Net income for the three month period ended September 30, 2004, was $894,000 representing an increase of $364,000, or 68.6%, over net income of $530,000 for the three month period ended September 30, 2003. Contributing factors include an increase in gain on sale of loans of 193.0%, an increase in service charge income of 69.5% and an increase in other fee income of 81.8% and net interest income increased by 14.86%. The increase in gain on sale of loan income is due to the timing of the loan sales. The increase in service charge income is the result of a new overdraft protection product offered by the bank. The increase in other income is the result of an increase in mortgage referral fees and an increase in income from an investment in bank-owned life insurance. The increase in net interest income is a result of the growth in the investments and loans offset by the growth in deposit and the effect of the change in rates. These increases were offset by increases in salaries and benefit expense, occupancy, other expenses and income tax expense. Annualized return on average assets (ROA) was 1.40% and return on average common equity (ROE) was 14.70% for the three month period ended September 30, 2004 compared with 1.07% and 19.09% respectively in 2003. Diluted earnings per share for 2004 and 2003 were $0.24 and $0.15, respectively, an increase of 60.0%. The increase in earnings per share was due to the increase in net income. 9 Net income for the nine month period ended September 30, 2004, was $2,328,000 representing an increase of $916,000, or 64.89%, over net income of $1,412,000 for the nine month period ended September 30, 2003. Contributing factors to the increase in net income was an increase in service charge income of 86.81%, an increase in other fee income of 68.96% and an increase in net interest income of 22.72% from the nine month period ended September 30, 2003. These increases were offset by decreases on the gain on sale of loans of 19.9% and by increases in salaries and benefit expense, occupancy, other expenses and income tax expense. The increase in service charge income is the result of a new overdraft protection product offered by the bank. The increase in other income is the result of an increase in mortgage referral fees and an increase in income from an investment in bank-owned life insurance. The increase in net interest income is a result of the growth in the investments and loans offset by the growth in deposit and the effect of the change in rates Annualized return on average assets (ROA) was 1.49% and return on average common equity (ROE) was 23.84% for the nine month period ended September 30, 2004 compared with 1.07% and 19.90% respectively in 2003. Diluted earnings per share for 2004 and 2003 were $0.68 and $0.42, respectively, an increase of 61.9%. The increase in earnings per share was due to the increase in net income. Net Interest Income The primary source of income for the Company is net interest income. Net interest income represents the excess of interest and fees earned on interest-earning assets (loans, securities and federal funds sold) over the interest paid on deposits and borrowed funds. Net interest income increased to $2.6 million for the three month period ended September 30, 2004 versus $2.2 million in 2003 representing a 14.86% increase. Net interest income increased to $7.4 million for the nine month period in 2004 versus $6.0 million in 2003 representing a 22.72% increase The average balance of total earning assets, during 2004, increased 22.46% to $212.3 million from $173.4 million. Average loan balances outstanding during 2004 increased $30.0 million or 19.14%. Average balances of investments and federal funds sold increased by $1.3 million or 6.07%. The average yields on loans and federal funds sold in 2004 was lower by 19 and 4 basis points respectively, while the average yield on securities decreased by 78 basis points. Total interest expense increased to $806,000 for the three month period in 2004 from $673,000 for 2003, representing a 19.4% increase. For the nine month period ended September 30, 2004 total interest expense decreased slightly to $2,100,000 from $2,128,000, representing an 1.6% decrease. While expense decreased slightly, average balances of interest-bearing liabilities increased to $150.7 million from $130.1 million for the period ended September 30, 2004, or 15.8%. Average certificates of deposit increased to $88.5 million in 2004 from $73.8 million in 2003, a 20.0% increase. The average rate paid on certificates of deposit during 2004 decreased 62 basis points to 1.87% from 2.49% for 2003, while the overall average rate paid on interest bearing deposits and borrowings decreased 12 basis points to 1.26% from 1.38% for 2003. The Company's net interest margin (net interest income divided by average earning assets) decreased 32 basis points to 4.80% for the nine months ended September 30, 2004 compared to 5.12% in 2003. The combined effect of the increase in volume of earning assets and decrease in yield on earning assets, coupled with stable funding sources resulted in an increase of $332,000 (14.9%) in net interest income for the three month period ended September 30, 2004 over 2003 and an increase of $1,372,000 (22.72%) for the nine month period ended September 30, 2004 over 2003. Non-Interest Income The Company's non-interest income consists primarily of service charges on deposit accounts, gain on sale of loans and other service fees. Non-interest income also includes ATM fees earned at various locations. For the three month period ended September 30, 2004, non-interest income represented 19.51% of the Company's revenues versus 12.48% in 2003. For the nine month period ended September 30, 2004, non-interest income represented 17.29% of the Company's revenues versus 14.14% in 2003. 10 Total non-interest income increased $403,000 to $817,000 for the three months ended September 30, 2004 from $414,000 for the same period in 2003, representing an increase of 97.3%. Total non-interest income increased $644,000 for the nine months ended September 30, 2004 to $1,989,000, representing an increase of 47.88%. The following table sets forth a summary of non-interest income for the periods indicated. Non-interest Income Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ---------------------------- Non-interest income: 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Service charges 286,382 168,951 891,254 477,100 Other fee income 291,450 163,408 785,086 477,508 Gain from sale of loans 240,044 81,924 312,793 390,473 ------------ ------------ ------------ ------------ Total non-interest income 817,876 414,283 1,989,133 1,345,081 ============ ============ ============ ============ Non-interest expense consists of salaries and related employee benefits, occupancy and equipment expenses, data processing fees, professional fees, directors' fees and other operating expenses. Non-interest expense for the three month period ended September 30, 2004 was $1.84 million compared to $1.65 million for 2003 an increase of 11.7% for 2004. Non-interest expense for the nine month period ended September 30, 2004 was $5.31 million compared to $4.75 million for 2003 an increase of 11.9% for 2004. Increases in salaries and benefits are indicative of the additions to staff to expand branch operations in line with their respective growth for the year. The following table sets forth a summary of non-interest expense for the periods indicated. Three Months Ended Nine Months Ended September 30, September 30, ---------------------------- ---------------------------- Noninterest expense: 2004 2003 2004 2003 ------------ ------------ ------------ ------------ Salaries and employee benefits 852,527 804,887 2,580,241 2,282,964 Occupancy & FFE 200,186 171,514 535,851 500,671 Furniture & Equipment 125,590 126,361 353,681 365,448 Other operating expenses 661,787 545,293 1,849,078 1,605,431 ------------ ------------ ------------ ------------ Total noninterest expense 1,840,090 1,648,055 5,318,851 4,754,514 ============ ============ ============ ============ Income Taxes The Company's provision for income taxes includes both federal income and state franchise taxes and reflects the application of federal and state statutory rates to the Company's net income before taxes. The principal difference between statutory tax rates and the Company's effective tax rate is the benefit derived from investing in tax-exempt securities and bank owned life insurance. Increases and decreases in the provision for taxes reflect changes in the Company's net income before tax. The following table reflects the Company's tax provision and the related effective tax rate for the periods indicated. Three Months Ended Nine Months Ended September 30, September 30, --------------------------- --------------------------- (Dollars in thousands) 2004 2003 2004 2003 ----------- ----------- ----------- ----------- Tax Provision $ 513 $ 334 $ 1,390 $ 822 Effective Tax Rate 36.47% 38.68% 37.38% 36.79% 11 Balance Sheet Analysis - ---------------------- Total assets increased by 24.8% from December 31, 2003 to September 30, 2004. The increase in total assets was a result of an increase in deposits from $176.3 million to $219.0 million. Net loans during this period increased from $155.5 million to $188.2 million and investments increased from $16.1 million to $19.0 million. Loans The Company focuses its lending activities primarily within Calaveras, San Joaquin, Stanislaus and Tuolumne Counties. The Company manages its credit risk through diversification of its loan portfolio and the application of underwriting policies and procedures and credit monitoring practices. Although the Company has a diversified loan portfolio, a significant portion of its borrowers' ability to repay the loans is dependent upon the professional services and residential real estate development industry sectors. Generally, the loans are secured by real estate or other assets and are expected to be repaid from cash flows of the borrower or proceeds from the sale of collateral. The following table sets forth the amounts of loans outstanding by category as of the dates indicated: September 30, December 31, ------------- ----------- 2004 2003 ------------- ----------- Dollars in thousands Commercial and Agricultural $ 50,061 $ 40,426 Real estate-Construction 34,061 28,219 Real estate-Commercial and Residential 93,781 77,386 Installment & Other 12,082 10,823 Deferred Loan Fees and Costs 216 284 Allowance for Loan and Lease Losses (2,012) (1,653) Total Net Loans $ 188,189 $ 155,485 =========== =========== Net portfolio loans have increased $32.7 million or 21.03%, to $188.2 million at September 30, 2004 from $155.5 million at December 31, 2003. Commercial and agricultural loans have increased $9.6 million or 23.83%, real estate construction projects have increased $5.8 million or 20.70%, real estate commercial loans have increased by $16.4 million or 21.19% and installment loans have increased by $1.3 million or 11.63% over December 31, 2003. The portfolio mix remains stable as compared with the mix of a year ago, with commercial and agricultural loans of approximately 26.60% of total loans, real estate construction loans of 18.10%, commercial and residential real estate loans at 49.83, and 6.42% for installment loans. The Company's policy is to place an asset on nonaccrual status when one of the following events occurs:(i) Any installment of principal or interest is 90 days or more past due (unless in management's opinion the loan is well-secured and in the process of collection), (ii) management determines the ultimate collection of principal or interest to be unlikely or iii) the terms of the loan have been renegotiated due to a serious weakening of the borrower's financial condition. Nonperforming loans are loans that are on nonaccrual, are 90 days past due and still accruing or have been restructured. There were no non-accrual loans or other real estate owned at September 30, 2004 and December 31, 2003. The Company assigns all loans a credit risk rating and monitors ratings for accuracy. The aggregate credit risk ratings are used to determine the allowance for loan losses. Management reviews the credit risk report with the Director Loan Committee on a weekly basis as well as with the Board of Directors monthly. 12 Allowance for Loan Losses (ALL) In determining the amount of the Company's Allowance for Loan Losses ("ALL"), management assesses the diversification of the portfolio. Each credit is assigned a credit risk rating factor, and this factor, multiplied by the dollars associated with the credit risk rating, is used to calculate one component of the ALL. In addition, management estimates the probable loss on individual credits that are receiving increased management attention due to actual or perceived increases in credit risk. The Company makes provisions to the ALL on a regular basis through charges to operations that are reflected in the Company's statements of income as a provision for loan losses. When a loan is deemed uncollectible, it is charged against the allowance. Any recoveries of previously charged-off loans are credited back to the allowance. There is no precise method of predicting specific losses or amounts that ultimately may be charged-off on particular categories of the loan portfolio. Similarly, the adequacy of the ALL and the level of the related provision for possible loan losses is determined on a judgment basis by management based on consideration of a number of factors including (i) economic conditions, (ii) borrowers' financial condition, (iii) loan impairment, (iv) evaluation of industry trends, (v) industry and other concentrations, (vi) loans which are contractually current as to payment terms but demonstrate a higher degree of risk as identified by management, (vii) continuing evaluation of the performing loan portfolio, (viii) monthly review and evaluation of problem loans identified as having a loss potential, (ix) monthly review by the Board of Directors, (x) off balance sheet risks and (xi) assessments by regulators and other third parties. Management and the Board of Directors evaluate the allowance and determine its desired level considering objective and subjective measures, such as knowledge of the borrowers' businesses, valuation of collateral, the determination of impaired loans and exposure to potential losses. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions and other qualitative factors. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's ALL. Such agencies may require the Company to provide additions to the allowance based on their judgment of information available to them at the time of their examination. There is uncertainty concerning future economic trends. Accordingly it is not possible to predict the effect future economic trends may have on the level of the provision for possible loan losses in future periods. The adequacy of the ALL is calculated upon three components. First is the credit risk rating of the loan portfolio, including all outstanding loans. Every extension of credit has been assigned a risk rating based upon a comprehensive definition intended to measure the inherent risk of lending money. Each rating has an assigned risk factor expressed as a reserve percentage. Central to this assigned risk factor is the historical loss record of the Company. Secondly, established specific reserves are available for individual loans currently on management's watch and high-grade loan lists. These are the estimated potential losses associated with specific borrowers based upon the collateral and event(s) causing the risk ratings. The third component is unallocated. This reserve is for qualitative factors that may effect the portfolio as a whole, such as those factors described above. Management believes the assigned risk grades and our methods for managing risk are satisfactory. The provision for loan losses decreased to $366,000 for the nine months ended September 30, 2004 versus $398,000 in 2003. The decrease in the amount of the provision is a direct result of the Company's in-depth analysis of the loan portfolio and the loan loss history of the Company. Management does not believe that there were any trends indicated by the detail of the aggregate charge-offs for any of the periods discussed. The following table summarizes the activity in the ALL for the periods indicated. 13 Nine Months Ended (Dollars in thousands) September 30, --------------------------- 2004 2003 ----------- ----------- Beginning Balance: 1,653 1,306 Provision for loan losses 366 398 Charge-offs: Commercial -7 -90 Real Estate 0 0 Other 0 -105 ----------- ----------- Total Charge-offs -7 -195 ----------- ----------- Recoveries: Commercial 0 0 Other 0 5 ----------- ----------- Total Recoveries 0 5 ----------- ----------- Ending Balance 2,012 1,514 =========== =========== ALLL to total loans 1.06% 0.97% Net Charge-offs to average loans-annualized 0.02% 0.52% There were no non-performing assets (including impaired loans, nonaccrual loans, loans 90 days past due and still accruing, and other real estate owned) at September 30, 2004, December 31, 2003 or September 30, 2003. The ratio of non-performing assets to total loans was nil at September 30, 2004, December 31, 2003 and September 30, 2003. The allowance for loan losses was $2.01 million at September 30, 2004, compared to $1.65 million at December 31, 2003 and $1.51 million at September 30, 2003. The provision for loan losses was $366,000 for the nine months ended September 30, 2004 versus $398,000 for the same period in 2003. Net charge-offs were $7,000 for the first nine months of 2004, compared to $195,000 for the first nine months of 2003. Liquidity The purpose of liquidity management is to ensure efficient and economical funding of the Company's assets consistent with the needs of the Company's depositors and, to a lesser extent, shareholders. This process is managed not by formally monitoring the cash flows from operations, investing and financing activities as described in the Company's statement of cash flows, but through an understanding principally of depositor and borrower needs. As loan demand increases, the Company can use asset liquidity from maturing investments along with deposit growth to fund the new loans. With respect to assets, liquidity is provided by cash and money market investments such as interest-bearing time deposits, federal-funds sold, available-for-sale investment securities, and principal and interest payments on loans. With respect to liabilities, liquidity is provided by core deposits, shareholders' equity and the ability of the Company to borrow funds and to generate deposits. Because estimates of the liquidity needs of the Company may vary from actual needs, the Company maintains a substantial amount of liquid assets to absorb short-term increases in loans or reductions in deposits. As loan demand decreases or loans are paid off, investment assets can absorb these excess funds or deposit rates can be decreased to run off excess liquidity. Therefore, there is some correlation between financing activities associated with deposits and investing activities associated with lending. The Company's liquid assets (cash and due from banks, federal funds sold, and available-for-sale investment securities) totaled $44.6 million or 17.8% of total assets at September 30, 2004 compared to $28.7 million or 14.28% of total assets at December 31, 2003. The Company expects that its primary source of liquidity will be earnings of the Company, acquisition of core deposits, and wholesale borrowing arrangements. 14 Capital Resources Capital adequacy is a measure of the amount of capital needed to sustain asset growth and act as a cushion for losses. Capital protects depositors and the deposit insurance fund from potential losses and is a source of funds for the investments the Company needs to remain competitive. Historically, capital has been generated principally from the retention of earnings. Overall capital adequacy is monitored on a day-to-day basis by the Company's management and reported to the Company's Board of Directors on a quarterly basis. The Bank's regulators measure capital adequacy by using a risk-based capital framework and by monitoring compliance with minimum leverage ratio guidelines. Under the risk-based capital standard, assets reported on the Company's balance sheet and certain off-balance sheet items are assigned to risk categories, each of which is assigned a risk weight. This standard characterizes an institution's capital as being "Tier 1" capital (defined as principally comprising shareholders' equity) and "Tier 2" capital (defined as principally comprising the qualifying portion of the ALLL). The minimum ratio of total risk-based capital to risk-adjusted assets, including certain off-balance sheet items, is 8%. At least one-half (4%) of the total risk-based capital is to be comprised of Tier 1 capital; the balance may consist of debt securities and a limited portion of the ALLL. The most recent notification by the Federal Reserve Bank of San Francisco (FRBSF) categorized the Company as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Company must meet the minimum ratios as set forth below. There are no conditions or events since that notification that management believes have changed the institution's category. The Company's risk-based capital ratios are presented below. To Be Well Capitalized Under For Capital Prompt Corrective Actual Adequacy Purposes Action Provisions --------------------- ---------------------- ----------------------- (in Thousands) Minimum Minimum Minimum Minimum Amount Ratio Amount Ratio Amount Ratio ------------ ----- ------------ ------- ------------ ------- Company As of September 30, 2004: Total capital (to risk weighted assets) $ 25,338 12.13% $ 14,827 8.00% N/A 10.00% Tier I capital (to risk weighted assets) $ 20,084 9.62% $ 7,413 4.00% N/A 6.00% Tier I capital (to average assets) $ 20,084 8.42% $ 9,537 4.00%* N/A 5.00% As of December 31, 2003: Total capital (to risk weighted assets) $ 19,125 11.6% $ 13,239 8.00% N/A 10.00% Tier I capital (to risk weighted assets) $ 16,782 10.1% $ 6,619 4.00% N/A 6.00% Tier I capital (to average assets) $ 16,782 8.3% $ 8,129 4.00%* N/A 5.00% - ---------- * The leverage ratio consists of Tier I capital divided by quarterly average assets. The minimum leverage ratio is 3 percent for banking organizations that do not anticipate significant growth and that have well-diversified risk, excellent asset quality and in general, are considered top-rated banks. For all other institutions the minimum rate is 4%. ITEM 4. Controls and Procedures. The Company's Chief Executive Officer and Chief Financial Officer, based on their evaluation of the Company's disclosure controls and procedures (as defined in Exchange Act Rule 13a--14(c15(e) or 15d-15(e))) as of the end of the period covered by this report, have concluded that the Company's disclosure controls and procedures are designed to ensure that information required to be disclosed 15 by the Company in its periodic SEC filings is recorded, processed and reported within the time periods specified in the SEC's rules and forms. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's periodic SEC filings. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including cost limitations, judgments used in decision making, assumptions regarding the likelihood of future events, soundness of internal controls, fraud, the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can provide only reasonable, and not absolute, assurance of achieving their control objectives. There were no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls over financial reporting subsequent to the date of their evaluation. Part II - Other Information Item 6. Exhibits 31.1 Certification of Chief Executive Officer (section 302 of Sarbannes-Oxley Act 31.2 Certification of Chief Executive Officer (section 302 of Sarbannes-Oxley Act 32 Certification pursuant to section 906 of the Sarbannes-Oxley Act 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. Pacific State Bancorp Date: November 15, 2004 BY: /s/ STEVEN A. ROSSO ------------------------------------- Steven A. Rosso President and Chief Executive Officer Date: November 15, 2004 BY: /s/ JOANNE ROBERTS ------------------------------------- JoAnne Roberts Vice President and Chief Financial Officer 16 EXHIBITS 31.1 Certification of Chief Executive Officer (section 302 of the Sarbanes-Oxley Act). 31.2 Certification of Chief Financial Officer (section 302 of the Sarbanes-Oxley Act). 32 Certification pursuant to section 906 of the Sarbanes-Oxley Act. 17