UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2007 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT For the transition period from____________ to ____________ Commission file number 000-50323 SERVICE 1ST BANCORP ------------------------------------------------------ (Exact name of registrant as specified in its charter) State of California 32-0061893 -------------------------------- --------------------------------- (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 49 W. 10th Street, Tracy, California 95376 ------------------------------------------ (Address of principal executive offices) (209) 956-7800 ---------------------------------------------------- (Registrant's Telephone Number, Including Area Code) 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 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 a large accelerated filer, an accelerated filer, or non-accelerated filer. See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [X] Indicate by check whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate the number of shares outstanding of each of the issuer's classes of common equity as of the latest practicable date: No par value common stock - 2,388,739 shares outstanding at November 13, 2007. The Index to Exhibits is located at page 28. INDEX TO SERVICE 1ST BANCORP FORM 10-Q FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 Part I Page Item 1 Financial Statements 3 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3 Quantitative and Qualitative Disclosures About Market Risk 21 Item 4 Controls and Procedures 22 Item 4T Controls and Procedures 22 Part II Item 1 Legal Proceedings 22 Item 1A Risk Factors 22 Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 23 Item 3 Defaults Upon Senior Securities 23 Item 4 Submission of Matters to a Vote of Security Holders 23 Item 5 Other Information 23 Item 6 Exhibits 23 Signatures 27 Exhibit 28 Index 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 29 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 30 32.1 Certification of Service 1st Bancorp by its Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 31 2 PART I - FINANCIAL INFORMATION ITEM 1. Financial Statements SERVICE 1ST BANCORP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited) 09/30/07 12/31/06 ------------- ------------- ASSETS Cash and due from banks $ 2,815,315 $ 6,543,416 Federal funds sold 9,233,143 10,616,902 ------------- ------------- Cash and cash equivalents 12,048,458 17,160,318 Certificates of deposit with other banks 1,248,006 1,500,000 Investment securities available-for-sale 77,433,658 81,157,727 Investment securities held-to-maturity 12,699,257 4,985,995 Loans, net 121,914,162 113,508,174 Bank premises and equipment, net 1,374,788 1,388,980 Cash surrender value of life insurance 3,664,263 3,566,696 Accrued interest receivable 1,726,953 1,461,602 Other assets 2,843,904 2,490,898 ------------- ------------- Total assets $ 234,953,449 $ 227,220,390 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Noninterest-bearing demand $ 22,435,095 $ 33,848,426 Money market, NOW and savings 88,567,715 94,662,249 Time deposits under $100,000 71,771,515 48,409,724 Time deposits $100,000 and over 22,723,751 23,034,692 ------------- ------------- Total deposits 205,498,076 199,955,091 Other borrowings 9,155,000 9,155,000 Accrued interest and other liabilities 2,691,491 1,143,465 ------------- ------------- Total liabilities 217,344,567 210,253,556 Shareholders' equity: Common stock 16,023,738 16,023,738 Additional paid-in-capital 321,331 207,144 Retained earnings 1,727,803 1,147,067 Accumulated other comprehensive income, net of tax (463,990) (411,115) ------------- ------------- Total shareholders' equity 17,608,882 16,966,834 ------------- ------------- Total liabilities and shareholders' equity $ 234,953,449 $ 227,220,390 ============= ============= The accompanying notes are an integral part of these consolidated statements. 3 SERVICE 1ST BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME For the periods ending (unaudited) For the three months ended For the nine months ended -------------------------------------------------------- 09/30/07 09/30/06 09/30/07 09/30/06 -------------------------------------------------------- Interest income: Interest and fees on loans $ 2,682,351 $ 2,538,177 $ 7,813,739 $ 6,702,777 Interest on investments 1,068,120 772,295 3,122,192 2,240,323 Interest on fed funds sold 106,514 100,308 172,913 124,420 Other interest income 22,310 3,411 54,104 11,220 -------------------------------------------------------- Total interest income 3,879,295 3,414,191 11,162,948 9,078,740 Interest expense: Interest expense on deposits 1,973,618 1,436,635 5,486,939 3,488,212 Interest on borrowings 141,754 239,476 457,045 442,253 -------------------------------------------------------- Total interest expense 2,115,372 1,676,111 5,943,984 3,930,465 -------------------------------------------------------- Net interest income before provision for loan losses 1,763,923 1,738,080 5,218,964 5,148,275 Provision for loan losses 60,000 90,000 110,000 230,000 -------------------------------------------------------- Net interest income after provision for loan losses 1,703,923 1,648,080 5,108,964 4,918,275 Other Income: Service charges, fees, and other income 67,361 68,503 226,877 205,980 Gain on the sale of investment securities (6,331) -- (12,909) -- Gain on sale and servicing of loans 11,163 19,601 45,977 78,672 Referral fees on mortgage loans 35,539 60,000 247,409 60,000 Earnings on cash surrender value of life insurance 40,109 38,672 118,723 114,887 Consulting fees 50,000 -- 110,000 -- -------------------------------------------------------- Total other income 197,841 186,776 736,077 459,539 Other Expenses: Salaries and employee benefits 898,141 906,868 2,987,416 2,550,119 Occupancy expense 162,109 165,953 486,965 475,433 Equipment expense 89,003 57,187 253,078 165,352 Data processing and other professional fees 142,831 143,805 440,051 464,442 Office supplies and equipment 40,398 50,433 175,169 133,459 Loan department expense 8,204 49,214 28,858 173,739 Advertising and promotion 34,016 94,614 172,728 186,188 Directors fees and expenses 47,203 52,653 160,583 138,228 FDIC and state assessments 40,747 13,638 68,782 47,017 Other operating expenses 130,702 89,032 367,489 227,904 -------------------------------------------------------- Total other expenses 1,593,354 1,623,397 5,141,119 4,561,881 -------------------------------------------------------- Income before income taxes 308,410 211,459 703,922 815,933 Income tax expense 24,308 45,824 123,186 210,291 -------------------------------------------------------- Net income $ 284,102 $ 165,635 $ 580,736 $ 605,642 ======================================================== Net income per share - basic $ 0.12 $ 0.07 $ 0.24 $ 0.25 ======================================================== Net income per share - diluted $ 0.12 $ 0.07 $ 0.23 $ 0.24 ======================================================== The accompanying notes are an integral part of these consolidated statements. 4 SERVICE 1ST BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (unaudited) Accumulated Common Stock Additional Other Total ----------------------- Paid in Comprehensive Retained Comprehensive Shareholders' Shares Amount Capital Income Earnings Income Equity ---------------------------------------------------------------------------------------------- Balance January 1, 2006 2,386,239 $ 15,992,913 $ -- $ 299,946 $ (718,758) $ 15,574,101 Stock options exercised 2,500 30,825 30,825 Surplus from options expense 207,144 207,144 Comprehensive income: Net income $ 847,121 847,121 847,121 Unrealized losses on securities net of taxes of $217,194 308,699 -- 308,699 308,699 Reclassification adjustment for losses included in net income, net of tax of $743 (1,056) -- (1,056) (1,056) ------------- Comprehensive income $ 1,154,764 ============= ----------------------------------- ------------------------------------------ Balance December 31, 2006 2,388,739 16,023,738 207,144 1,147,067 (411,115) 16,966,834 Surplus from options expense 114,187 114,187 Comprehensive income: Net income $ 580,736 580,736 580,736 Unrealized losses on securities net of taxes of $31,870 (45,298) (45,298) (45,298) Reclassification adjustment for losses included in net income, net of tax of $5,331 (7,577) (7,577) (7,577) ------------- Comprehensive income $ 527,861 ============= ----------------------------------- ------------------------------------------ Balance September 30, 2007 2,388,739 $ 16,023,738 $ 321,331 $ 1,727,803 $ (463,990) $ 17,608,882 =================================== ========================================== The accompanying notes are an integral part of the financial statements. 5 SERVICE 1ST BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS For the nine months ended September 30, (unaudited) 2007 2006 ------------ ------------ Operating activities: Net income $ 580,736 $ 605,642 Adjustments to reconcile net income to net cash from operating activities: Provision for loan losses 110,000 230,000 Depreciation 185,647 128,728 Amortization and accretion on securities (76,750) 190,154 Earnings on cash surrender value life insurance, net (97,567) (98,605) Options Expense 73,205 149,374 Gain on sale of loans (6,737) (12,733) Loans originated for sale (63,750) (137,267) Proceeds from loan sales 70,487 150,000 Loss on sale of securities, net 12,909 -- Increase in accrued interest (265,351) (206,831) Increase in other assets (393,673) (249,193) Increase (decrease) in accrued expenses and other liabilities 1,548,026 (89,859) ------------ ------------ Net cash provided by (used in) operating activities 1,677,182 659,410 Investing activities: Purchases of securities available-for-sale (15,270,283) (12,330,690) Purchases of securities held-to-maturity (8,380,003) (680,482) Proceeds from sales of available-for-sale securities 4,247,543 -- Proceeds from sales of held-to-maturity securities 209,042 -- Proceeds from payments, maturities and calls of available-for-sale securities 14,617,211 6,951,080 Proceeds from payments, maturities and calls of held-to-maturity securities 679,912 33,042 Net increase in loans (8,515,988) (27,427,747) Certificates of deposit with other banks 251,994 (1,200,000) Purchases of premises and equipment (171,455) (812,443) ------------ ------------ Net cash used by investing activities (12,332,027) (35,467,240) Financing activities: Net (decrease) increase in demand, interest-bearing deposits and savings (17,507,865) 32,367,724 Net increase in time deposits 23,050,850 2,666,340 Increase in junior subordinated debts -- 5,155,000 Net increase in other borrowings -- 7,970,000 ------------ ------------ Net cash provided by financing activities 5,542,985 48,159,064 ------------ ------------ Net (decrease) increase in cash and cash equivalents (5,111,860) 13,351,234 Cash and cash equivalents at beginning of period 17,160,318 9,024,556 ------------ ------------ Cash and cash equivalents at end of period $ 12,048,458 $ 22,375,790 ============ ============ Supplemental disclosures of cash flow information: Cash paid during the period for: Interest $ 5,781,144 $ 3,853,017 Income taxes $ -- $ 432,000 The accompanying notes are an integral part of the financial statements. 6 SERVICE 1ST BANCORP AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - BASIS OF PRESENTATION AND MANAGEMENT REPRESENTATION The accompanying unaudited consolidated financial statements of Service 1st Bancorp (the "Company") have been prepared in accordance with the instructions to Form 10-Q and, therefore, do not include information or footnote disclosures required by generally accepted accounting principles for complete financial statements. For further information, refer to the financial statements and related footnotes included in the Company's annual report on Form 10-K for the year ended December 31, 2006. In the opinion of management, the financial statements presented herein include all adjustments (consisting of normal recurring accruals) necessary to present fairly, in all material respects, the financial position of the Company as of September 30, 2007 and the Company's income statement for the three months ended September 30, 2007 and 2006, and the statement of cash flows for the three months ended September 30, 2007 and 2006. Operating results for interim periods are not necessarily indicative of operating results for an entire fiscal year. The balance sheet as of December 31, 2006, has been derived from the audited balance sheet as of that date. Reclassifications Certain reclassifications were made to prior periods presented to conform to the current year. These reclassifications are of a normal recurring nature. Stock-Based Compensation On January 1, 2006, the Company adopted SFAS No. 123 (revised 2004) (SFAS No. 123R), "Share-Based Payment," which addresses the accounting for stock-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by issuance of such equity instruments. In January 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107, which provides supplemental implementation guidance for SFAS No. 123R. SFAS No. 123R eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and instead generally requires that such transactions be accounted for using a fair-value-based method. SFAS No. 123R requires the use of a valuation model to calculate the fair value of stock-based awards. The Company has elected to use the Black-Scholes Model for option valuation. This model incorporates various assumptions including volatility, expected life, and interest rates. The expected volatility is based on the historical volatility of the Company's common stock over the most recent period commensurate with the estimated expected life of the Company's stock options adjusted for the impact of unusual fluctuations not reasonably expected to recur and other relevant factors. The expected life of an award is based on historical experience and on the terms and conditions of the stock awards granted to employees. The assumptions used for the nine-month period ended September 30, 2007 and 2006 are as follows: WEIGHTED AVERAGE ASSUMPTIONS FOR OPTIONS GRANTED DURING THE PERIOD ENDED: September 30, 2007 September 30, 2006 ------------------ ------------------ Expected Life 60 months 72 months Stock Volatility 40.97% 55.58% Risk free interest rate 4.65% 4.77% Dividend yield 0.00% 0.00% 7 SERVICE 1ST BANCORP AND SUBSIDIARIES NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS NOTE 2 - EARNINGS PER SHARE (EPS) Basic EPS excludes dilution and is computed by dividing income available to common shareholders' by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in earnings of the entity as of September 30, 2007 and 2006. Weighted average shares outstanding used in the computation of basic earnings per share for the three months and the nine months ended September 30, 2007 were 2,388,739 and 2,388,739 respectively. Weighted average shares outstanding used in the computation of diluted earnings per share for the nine months ended September 30, 2007 and 2006 were 2,509,294 and 2,574,780 respectively. Weighted average shares outstanding used in the computation of diluted earnings per share for the three months ended September 30, 2007 and 2006 were 2,456,684 and 2,574,780 respectively. NOTE 3 - SECURITIES Securities are classified in two categories and accounted for as follows: debt and equity securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and are measured at amortized cost; and equity securities classified as available-for-sale and are measured at fair value, with unrealized gains and losses, net of applicable taxes reported in a separate component of stockholders' equity. Any gains or losses on sales of investments are computed on a specific identification basis. The tables below reflect the composition of investment securities, amortized cost, unrealized gains and losses and estimated fair values as of September 30, 2007. The amortized cost or fair values of investment securities available-for-sale at September 30, 2007 were: Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------------------------------------------------------- Available-for-Sale Securities: Obligations of U.S. Government Agencies $ 35,223,194 $ 11,100 $ (209,590) $ 35,024,704 State and political subdivisions 19,995,004 13,483 (283,539) 19,724,948 Asset backed-securities 7,488,619 6,572 (129,812) 7,365,379 Mortgage backed-securities 14,016,982 11,503 (207,564) 13,820,921 Preferred Stock 999,761 -- -- 999,761 Short-term mutual funds 500,000 -- (2,055) 497,945 --------------------------------------------------------- $ 78,223,560 $ 42,658 $ (832,560) $ 77,433,658 ========================================================= The amortized cost or fair values of investment securities held-to-maturity at September 30, 2007 were: Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value --------------------------------------------------------- Held-to-Maturity Securities: Obligations of U.S. Government Agencies $ 4,015,800 $ -- $ (170,648) $ 3,845,152 State and political subdivisions 4,616,327 119,689 (12,909) 4,723,107 Asset backed-securities 3,898,076 -- (71,273) 3,826,803 Mortgage backed-securities 169,054 2,076 (243) 170,887 --------------------------------------------------------- $ 12,699,257 $ 121,765 $ (255,073) $ 12,565,949 ========================================================= Securities carried at approximately $56,891,000 were pledged to secure deposits of public funds and borrowing arrangements. 8 SERVICE 1ST BANCORP NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS NOTE 3 - SECURITIES cont'd The tables below reflect the composition of investment securities, amortized cost, unrealized gains and losses and estimated fair values as of December 31, 2006. Gross Gross Estimated Amortized Unrealized Unrealized Fair Cost Gains Losses Value ------------ ------------ ------------ ------------ Available-for-Sale Securities: U.S. Government Agencies $ 39,415,380 $ 63,385 $ (294,940) $ 39,183,825 State and public subdivisions 19,522,737 38,074 (74,787) 19,486,024 Asset backed-securities 7,280,691 3,946 (133,943) 7,150,694 Mortgage backed-securities 15,138,808 12,460 (314,084) 14,837,184 Short-term mutual funds 500,000 -- -- 500,000 ------------ ------------ ------------ ------------ $ 81,857,616 $ 117,865 $ (817,754) $ 81,157,727 ============ ============ ============ ============ Held-to-Maturity Securities: U.S. Government Agencies $ 2,468,485 $ -- $ (17,659) $ 2,450,826 State and public subdivisions 2,313,410 119,689 (12,909) 2,420,190 Asset backed-securities 14,526 -- -- 14,526 Mortgage backed-securities 189,574 2,567 (57) 192,084 ------------ ------------ ------------ ------------ $ 4,985,995 $ 122,256 $ (30,625) $ 5,077,626 ============ ============ ============ ============ Securities carried at approximately $63,146,000 were pledged to secure deposits of public funds and borrowing arrangements. 9 NOTE 4 - LOANS Service 1st Bank's customers are primarily located in San Joaquin County. At September 30, 2007, approximately 64.9% of the Bank's loans are for real estate and construction loans and approximately 18.5% of the Bank's loans are for general commercial users including professional, retail, and small businesses. Consumer loans make up approximately 3.6% of the loan portfolio, leases make up 7.5% of the loan portfolio, with agricultural loans making up the remaining 5.5%. Generally, real estate loans are collateralized by real property while commercial and other loans are collateralized by funds on deposit, business or personal assets. Repayment is generally expected from the sale of property for real estate loans and cash flows of the borrowers for other loans. Major classifications of loans were: 9/30/2007 12/31/2006 ------------- ------------- Construction and land development loans $ 33,690,314 $ 34,248,157 Real estate loans 46,562,429 43,396,795 Commercial loans 22,902,441 23,421,351 Leases 9,210,084 8,591,815 Agricultural loans 6,787,687 4,288,022 Consumer loans 4,458,451 1,225,571 ------------- ------------- 123,611,406 115,171,711 Deferred loan fees and costs (158,194) (234,487) Allowance for loan losses (1,539,050) (1,429,050) ------------- ------------- Total net loans $ 121,914,162 $ 113,508,174 ============= ============= 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENTS REGARDING FORWARD-LOOKING STATEMENTS Certain matters discussed or incorporated by reference in this Quarterly Report on Form 10-Q including, but not limited to, matters described in "Item 2 - - Management's Discussion and Analysis of Financial Condition and Results of Operations," are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, and subject to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may contain words related to future projections including, but not limited to, words such as "believe," "expect," "anticipate," "intend," "may," "will," "should," "could," "would," and variations of those words and similar words that are subject to risks, uncertainties and other factors that could cause actual results to differ materially from those projected. Factors that could cause or contribute to such differences include, but are not limited to, the following: (1) variances in the actual versus projected growth in assets; (2) return on assets; (3) loan and lease losses; (4) expenses; (5) changes in the interest rate environment including interest rates charged on loans, earned on securities investments and paid on deposits; (6) competition effects; (7) fee and other noninterest income earned; (8) general economic conditions nationally, regionally, and in the operating market areas of the Company and its subsidiaries; (9) changes in the regulatory environment; (10) changes in business conditions and inflation; (11) changes in securities markets; (12) data processing problems; (13) a decline in real estate values in the Company's operating market areas; (14) the effects of earthquakes, floods, fires and other natural disasters, (15) terrorism, the threat of terrorism or the impact of the current military conflict in Iraq and the conduct of the war on terrorism by the United States and its allies, as well as other factors. Other cautionary statements and information set forth in this report should be carefully considered and understood as being applicable to all related forward-looking statements contained in this report, when evaluating the business prospects of the Company and its subsidiaries. Forward-looking statements are not guarantees of performance. By their nature, they involve risks, uncertainties and assumptions. The future results and shareholder values may differ significantly from those expressed in these forward-looking statements. You are cautioned not to put undue reliance on any forward-looking statement. Any such statement speaks only as of the date of this report, and in the case of any documents that may be incorporated by reference, as of the date of those documents. We do not undertake any obligation to update or release any revisions to any forward-looking statements, to report any new information, future event or other circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by law. However, your attention is directed to any further disclosures made on related subjects in our subsequent reports filed with the Securities and Exchange Commission on Forms 10-K, 10-Q and 8-K. BUSINESS ORGANIZATION Service 1st Bancorp (the "Company") is a California corporation and was incorporated on January 23, 2004 to act as a holding company for Service 1st Bank (the "Bank"). The Bank became a subsidiary of the Company effective June 26, 2004. As of September 30, 2007, the Company maintained its administrative office in Tracy, San Joaquin County and the Bank operated three full-service offices in the cities of Stockton, Tracy, and Lodi in San Joaquin County. The Bank offers a full range of commercial banking services to individuals, small and medium-sized businesses, municipalities and professionals in San Joaquin County and the surrounding communities. On August 18, 2006, the Company established a new subsidiary, Charter Services Group, Inc. ("Charter"). Charter assists new (de novo) banks in filing applications for regulatory approval to organize and to commence business as a commercial bank. Charter will also provide consulting services to new banks including formulating policies and providing other ongoing services. The following analysis is designed to provide a more complete understanding of the material changes and trends related to the Company's financial condition, results of operations, cash flows, and capital resources. This discussion should be read in conjunction with the financial statements included in Item 1 of the Annual Report on Form 10-K for the year ended December 31, 2006. 11 CRITICAL ACCOUNTING POLICIES Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires the Company's management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Note 1 to the financial statements describes the significant accounting policies used in the preparation of the financial statements. A critical accounting policy is defined as one that is both material to the presentation of the Company's financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on the Company's financial condition and results of operations. Management believes that the matters described below are critical accounting policies. Allowance for Loan Losses The allowance for loan losses is established through a provision for loan losses charged to expenses. Loans are charged against the allowance for loan losses when management believes that the collectibility of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans and commitments to extend credit, based on evaluations of collectibility and prior loss experience of loans and commitments to extend credit. The evaluations take into consideration such factors as changes in the nature and volume of the portfolio, overall portfolio quality, loan concentration, specific problem loans, commitments, and current economic conditions that may affect the borrowers' ability to pay. Summary of Financial Condition The Company's total consolidated assets increased 3.4% from December 31, 2006 to September 30, 2007. As of September 30, 2007, total consolidated assets were $234,953,449 compared to $227,220,390 as of December 31, 2006, and $218,344,941 at September 30, 2006. The increase in total assets from December 31, 2006 was primarily due to an increase in loans. Total net loans at September 30, 2007 were $121,914,162 compared to $113,508,174 at December 31, 2006 and $109,730,879 at September 30, 2006. This represents an increase in net loans of 7.4% from December 31, 2006. Cash and due from banks declined from $6,543,416 at December 31, 2006 to $2,815,315 at September 30, 2007. The reduction in cash was used to fund loan originations. Total deposits were $205,498,076 at September 30, 2007 compared to $199,955,091 at December 31, 2006 and $186,175,731 at September 30, 2006. Noninterest-bearing DDA accounts decreased from $33,848,426 at December 31, 2006 to $22,435,095 at September 30, 2007. Money market, NOW, and savings accounts decreased to $88,567,715 at September 30, 2007 from $94,662,249 at December 31, 2006. Time deposits under $100,000 increased from $48,409,724 at December 31, 2006 to $71,771,515 at September 30, 2007. The decline in noninterest-bearing DDA's was primarily related to the loss of a large title company's deposit relationship. The decline in money market, NOW, and savings accounts was primarily related to a large client moving funds from their money market account to time deposits. The increase in time deposits under $100,000 was primarily from the Bank's participation in the national Certificate of Deposit Account Registry (CDARS) program. Through this program, the Bank can offer $50,000,000 of FDIC insurance coverage for time deposits. When the Bank places these deposits into the CDARS network, it has the option of receiving reciprocal deposits from other banks in the network. Reciprocal deposits from the CDARS program increased from $42,184,035 at December 31, 2006 to $62,697,452 at September 30, 2007. Other borrowings at September 30, 2007 and December 31, 2006 were $9,155,000. The borrowings consist of $4,000,000 from the Federal Home Loan Bank of San Francisco and $5,155,000 of Trust Preferred Securities. 12 Results of Operations Net income for the three months ended September 30, 2007 was $284,102 compared to $165,635 for 2006. The increase in net income for the three months ended September 30, 2007 was from an increase in net interest income, a reduction in operating expenses, and an adjustment to the Company's effective income tax rate. Net income for the nine months ended September 30, 2007 was $580,736 compared to $605,642 for September 30, 2006. For the nine months ended September 30, 2007, the Company increased its net income and other income, but this was offset by an increase in total operating expenses. The Company's effective tax rate for 2007 was less than 2006 because the Company has more tax exempt investments. At September 30, 2007 the Company owned $25,447,816 in tax exempt investments compared to $15,244,077 at September 30, 2006. Basic earnings per share for the three months ended September 30, 2007 was $0.12 per share compared to $0.07 for the three months ended September 30, 2006. Diluted earnings per share for the three months ended September 30, 2007 and 2006 were $0.12 and $0.07, respectively. Basic earnings per share for the nine months ended September 30, 2007 were $0.24 per share compared to $0.25 for 2006. Diluted earnings per share for the nine months ended September 30, 2007 were $0.23 compared to $0.24 for 2006. 13 Net Interest Income and Net Interest Margin Net interest income, the primary component of the net earnings of a financial institution, refers to the difference between the interest earned on loans and investments and the interest paid on deposits and borrowings. Please see the tables of average balance sheet and net interest income below. The following table sets forth average balance sheet information, interest income and expense, average yields and rates, and net interest income and margin for the three months ended September 30, 2007 and 2006: September 30, 2007 September 30, 2006 ----------------------------------------- ---------------------------------------- Average Average Average Income/ Yield or Average Income/ Yield or Balance Expense Rate Paid Balance Expense Rate Paid ----------------------------------------- ---------------------------------------- Interest-earning assets: Interest-bearing deposits $ 1,719,963 $ 22,310 5.15% $ 1,041,547 $ 8,761 3.34% Investments 83,326,661 1,068,120 5.09% 67,860,945 766,945 4.48% Federal funds sold 8,398,552 106,514 5.03% 7,967,842 100,308 4.99% Loans (1) (2) 121,257,221 2,682,351 8.78% 112,096,685 2,538,177 8.98% ----------------------------- ---------------------------- Total interest-earning assets 214,702,397 3,879,295 7.17% 188,967,019 3,414,191 7.17% Allowance for possible loan losses (1,480,952) (1,300,354) Cash and due from banks 4,934,802 3,427,031 Bank premises and equipment 1,341,416 1,300,373 Accrued interest receivable 1,330,681 970,312 Other assets 7,084,293 7,891,742 -------------- -------------- Total assets $ 227,912,637 $ 201,256,123 ============== ============== Interest-bearing liabilities: Demand deposits $ 57,855,449 635,996 4.31% $ 59,569,752 592,819 3.95% Savings and money market accounts 27,732,735 204,735 2.93% 20,893,768 164,562 3.12% Time deposits 89,738,294 1,132,887 5.01% 58,924,400 679,254 4.57% Other borrowings 9,161,936 141,754 6.14% 16,640,680 239,476 5.71% ----------------------------- ---------------------------- Total interest-bearing liabilities 184,488,414 2,115,372 4.55% 156,028,600 1,676,111 4.26% Non-interest bearing demand deposits 24,445,991 28,966,666 Other liabilities 1,952,726 374,145 -------------- -------------- Total liabilities 210,887,131 185,369,411 Shareholders' equity 17,025,506 15,886,712 -------------- -------------- Total liabilities and shareholders' equity $ 227,912,637 $ 201,256,123 ============== ============== ------------ ----------- Net interest income $ 1,763,923 $ 1,738,080 ============ =========== Net interest margin on average interest earning assets (3) 3.26% 3.65% 1. Average loan balances include average deferred loan fees of $161,366 and $250,542 for the three months ended September 30, 2007 and 2006, respectively. 2. Interest on loans includes fees of $30,560 and $59,332 for the three month periods ended September 30, 2007 and 2006, respectively. 3. Net interest margin is computed by dividing net interest income by total average earning assets. All average balances have been computed using daily balances. 14 The following table sets forth average balance sheet information, interest income and expense, average yields and rates, and net interest income and margin for the nine months ended September 30, 2007 and 2006. September 30, 2007 September 30, 2006 ----------------------------------------- ---------------------------------------- Average Average Yield or Yield or Average Income/ Rate Average Income/ Rate Balance Expense Paid Balance Expense Paid ----------------------------------------- ----------------------------------------- Interest-earning assets: Interest-bearing deposits $ 1,384,464 $ 54,104 5.22% $ 897,017 $ 27,438 4.09% Investments 85,005,471 3,122,192 4.91% 68,839,982 2,224,105 4.32% Federal funds sold 4,405,621 172,913 5.25% 3,388,930 124,420 4.91% Loans (1) (2) 117,323,582 7,813,739 8.90% 101,490,247 6,702,777 8.83% ----------------------------- ----------------------------- Total interest-earning assets 208,119,138 11,162,948 7.17% 174,616,176 9,078,740 6.95% Allowance for loan losses (1,449,838) (1,215,695) Cash and due from banks 4,076,935 3,483,696 Bank premises and equipment 1,372,764 938,475 Accrued interest receivable 1,269,259 898,144 Other assets 6,862,594 6,622,173 -------------- -------------- Total assets $ 220,250,852 $ 185,342,969 ============== ============== Interest-bearing liabilities: Demand deposits $ 57,699,868 1,853,900 4.30% $ 65,330,587 1,606,003 3.29% Savings and money market accounts 27,349,141 606,929 2.97% 16,710,480 292,878 2.34% Time deposits 81,702,278 3,026,110 4.95% 48,616,873 1,589,331 4.37% Other borrowings 9,976,164 457,045 6.13% 10,682,992 442,253 5.53% ----------------------------- ----------------------------- Total interest-bearing liabilities 176,727,451 5,943,984 4.50% 141,340,932 3,930,465 3.72% Non-interest bearing demand deposits 24,463,190 27,359,286 Other liabilities 1,910,643 873,872 -------------- -------------- Total liabilities 203,101,284 169,574,090 Shareholders' equity 17,149,568 15,768,879 -------------- -------------- Total liabilities and shareholders' equity $ 220,250,852 $ 185,342,969 ============== ============== ------------ ------------ Net interest income $ 5,218,964 $ 5,148,275 ============ ============ Net interest margin on average interest earning assets (3) 3.35% 3.94% 1. Average loan balances include average deferred loan fees of $184,190 and $277,613 for the nine months ending September 30, 2007 and 2006, respectively. 2. Interest on loans includes fees of $152,869 and $169,764 for the nine months ending September 30, 2007 and 2006, respectively. 3. Net interest margin is computed by dividing net interest income by total average earning assets. All average balances have been computed using daily balances. 15 Net interest income for the three months ended September 30, 2007 was $1,763,923 compared to $1,738,080 for 2006. Net interest income for the nine months ended September 30, 2007 was $5,218,964 compared to $5,148,275 for 2006. Average interest-earning assets for the three months ended September 30, 2007 were $214,702,397 compared to $188,967,019 during the same three months of 2006. The yield earned on average interest-earning assets during the third quarter of 2007 was 7.17% compared to 7.17% during the same quarter of 2006. The average rate paid on interest bearing-liabilities increased from 4.26% for the third quarter of 2006 to 4.55% during the third quarter of 2007. Average interest-earning assets for the nine months ended September 30, 2007 were $208,119,138 compared to $174,616,176 during the same nine months of 2006. The yield earned on average interest-earning assets during the nine months ended September 30, 2007 was 7.17% compared to 6.95% during the same period of 2006. The average rate paid on interest bearing liabilities increased to 4.50% for the nine months ended September 30, 2007 compared to 3.72% during the same period for 2006. The increase in rates earned on loans, investments, and paid on deposits and borrowings was a result of the Federal Reserve Bank raising interest rates two times during the fiscal 2006 year. Also, the competition for deposits has caused higher interest expense to attract and maintain deposits. The Bank utilized time deposits at a higher rate to replace a portion of the decline of noninterest-bearing DDA and money market accounts. The Federal Reserve lowered interest rates during September 2007. The declining interest rates will impact interest earning assets more rapidly than interest bearing liabilities. Allowance and Provision for Loan Losses The Company assesses and manages credit risk on an ongoing basis through stringent credit review and approval policies, extensive internal monitoring, and established formal lending policies. Additionally, the Bank contracts with an outside source to periodically review the existing loan portfolio. Management believes its ability to identify and assess risk and return characteristics of the Company's loan portfolio is critical for profitability and growth. Management strives to continue the historically low level of credit losses by continuing its emphasis on credit quality in the loan approval process, active credit administration, and regular monitoring. Management has implemented a loan review and grading system that functions to continually assess the credit risk inherent in the loan portfolio. In extending credit and commitments to borrowers, the Bank generally requires collateral and/or guarantees as security. The repayment of such loans is expected to come from cash flows or from proceeds from the sale of selected assets of the borrowers. The Bank's requirement for collateral and/or guarantees is determined on a case-by-case basis in connection with management's evaluation of the creditworthiness of the borrower. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, income-producing properties, residences, and other real property. Construction loans and other real estate secured loans comprised 64.9% of total loans outstanding at September 30, 2007. Although management believes such loans have no more than the normal risk of collectibility, a substantial decline in the economy in general, or a decline in real estate values in the Company's primary operating market areas in particular, could have an adverse impact on the collectibility of such loans. In addition, such an occurrence could result in an increase in loan losses and an increase in the provision for loan losses, which could adversely affect the Company's future prospects, results of operations, overall profitability, and the market price of the Company's common stock. The provision for loan losses for the three months ended September 30, 2007 was $60,000 compared to $90,000 during the same quarter of 2006. The provision for loan losses for the nine months ended September 30, 2007 was $110,000 compared to $230,000 during the same period of 2006. At September 30, 2007, the allowance for loan losses was $1,539,050 compared to $1,429,050 at December 31, 2006 and $1,359,050 at September 30, 2006. The ratio of allowance for loan losses to gross loans was 1.25% at September 30, 2007 compared to 1.24% at December 31, 2006 and 1.22% at September 30, 2006. The allowance for loan losses is adjusted by charges to income and decreased by charge-offs (net of recoveries). Management's periodic evaluation of the adequacy of the allowance is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower's ability to repay, the estimated value of any underlying collateral, and current economic conditions. Additional provisions will be added as new loans are placed on the books in an amount necessary to support the risks inherent in the portfolio. 16 The following table summarizes the changes in the allowances for loan losses arising from loans charged-off, recoveries on loans previously charged-off, and additions to the allowance which have been charged to operating expenses and certain ratios relating to the allowance for loan losses. For the nine months ended September 30, 2007 2006 ------------------ ------------------ Outstanding Loans: Average for the Period $ 117,323,582 $ 101,490,247 End of the Period 123,611,406 111,303,338 Allowance For Loan Losses: Balance at Beginning of Year 1,429,050 1,123,494 Actual Charge-Offs: Commercial -- -- Consumer -- -- Real Estate -- -- ------------------ ------------------ Total Charge-Offs -- -- ------------------ ------------------ Less Recoveries: Commercial -- -- Consumer -- 5,556 Real Estate -- -- ------------------ ------------------ Total Recoveries -- 5,556 ------------------ ------------------ Net Loans Charged-Off (Recoveries) -- 5,556 Provision for Loan Losses 110,000 230,000 ------------------ ------------------ Balance at End of Period $ 1,539,050 $ 1,359,050 ================== ================== Ratios: Net Loans Charged-Off (Recoveries) to Average Loans 0.00% (.01)% Allowance for Loan Losses to Total Loans 1.25% 1.22% Net Loans Charged-Off (Recoveries) to Beginning Allowance for Loan Losses 0.00% (.49)% Net Loans Charged-Off (Recoveries) to Provision for Loan Losses 0.00% (2.42)% Allowance for Loan Losses to Nonperforming Loans 52.66% 308.15% Nonaccrual Loans, Loans Past Due 90 Days and OREO Management generally places loans on nonaccrual status when they become 90 days past due, unless the loan is well secured and in the process of collection. Loans are charged off when, in the opinion of management, collection appears unlikely. There were nonaccrual loans of $2,922,861 at September 30, 2007, $441,037 at September 30, 2006, and $435,147 at December 31, 2006. At September 30, 2007, there were loans totaling $2,922,861 that were considered impaired or troubled debt restructurings compared to $441,037 at September 30, 2006 and $435,147 at December 31, 2006. These loans were delinquent at September 30, 2007 and placed on nonaccrual, but management currently believes that there will be no material losses on these loans. The loans were placed on nonaccrual to defer future income recognition until the delinquent payments have been received. There were no loan concentrations in excess of 10% of total loans not otherwise disclosed as a category of loans as of September 30, 2007 or December 31, 2006. Management is not aware of any potential problem loans, which were accruing and current at September 30, 2007 or December 31, 2006, where serious doubt exists as to the ability of the borrower to comply with the present repayment terms. There was no other real estate owned at September 30, 2007 and December 31, 2006. 17 Other Income Other income for the three months ended September 30, 2007 was $197,841 compared to $186,776 for the same period during 2006. Other income for the nine months ended September 30, 2007 was $736,077 compared to $459,539 for the same period during 2006. The Bank offers fixed rate commercial real estate loans through a third party lender. The Bank receives fees for the packaging of the loans provided to the third party lender. The loans are funded by and become assets of the third party lender. The fees on such loans for the three months ended September 30, 2007 were $35,539 compared to $60,000 for the same quarter in 2006. The fees on such loans for the nine months ended September 30, 2007 were $247,409 compared to $60,000 for 2006. The Bank originates loans through various government guarantee programs. The guaranteed portion of these loans can be sold in the secondary market. Gains on loans sold in the secondary market and the servicing of these loans for the three months ended September 30, 2007 were $11,163 compared to $19,601 during the same period in 2006. Gains on loans sold in the secondary market and the servicing of these loans for the nine months ended September 30, 2007 were $45,977 compared to $78,672 during the same period in 2006. The gains on the guaranteed portion of loans sold for the nine months ended September 30, 2007 were $6,737 compared to a gain of $12,733 in 2006. Other Expense Salaries and employee benefits for the three months ended September 30, 2007 were $898,141 compared to $906,868 for the three months ended September 30, 2006. During the third quarter of 2007, the Company was able to reverse $44,203 of expense related to stock-based compensation. This reversal was for the portion of the risk-based compensation that had been accrued on options that were not vested prior to the employees' separation of employment with the Company. Salaries and employee benefits for the nine months ended September 30, 2007 were $2,987,416 compared to $2,550,119 for the nine months ended September 30, 2006. The overall increase in salaries and employee benefits for the nine months ended September 30, 2007 was due to an initial increase in the number of employees. In the third quarter of 2007, the number of employees declined by 8 through attrition and layoffs. Occupancy and equipment expense for the three months ended September 30, 2007 was $251,112 compared to $223,140 for the same period of 2006. Occupancy and equipment expense was $740,043 for the nine months ended September 30, 2007 compared to $640,785 for the same period during 2006. The increase in expense is related to rent for the Company's new office in Lodi, California, and annual CPI increases in the lease expense for the branch offices. Data processing and other professional fees expense was $142,831 for the three months ended September 30, 2007 compared to $143,805 for the three months ended September 30, 2006. Data processing and other professional fees for the nine months ended September 30, 2007 was $440,051 compared to $464,442 for the same period during 2006. Loan department expense for the three months ended September 30, 2007 was $8,204 compared to $49,214 for the same period of 2006. Loan department expense for the nine months ended September 30, 2007 was $28,858 compared to $173,739 for the same period of 2006. The decrease in loan department expense for the nine months ended September 30, 2007 was primarily a result of a decrease in expense for loan servicing assets. When the Company sells a government guaranteed loan it establishes a loan servicing asset, which is the anticipated servicing over the estimated remaining term of the loans sold. If these loans payoff early the remaining unamortized servicing asset is written off. During the first quarter of 2006, two large SBA loans paid off early. During the third quarter of 2007, the Bank determined that the reserve for undisbursed loans could be reduced by $27,000. The increase in other operating expenses for the three months and nine months ended September 30, 2007 was primarily from an increase in fees associated with CDARS deposits. The fee associated with CDARS deposits for the nine months ended September 30, 2007 was $112,041 compared to $35,930 for 2006. Fees related to CDARS deposits were $42,035 for the three months ended September 30, 2007 compared to $15,987 for the third quarter of 2006. The remainder of the other operating expenses increased due to the growth of the Company. Capital Resources Total shareholders' equity at September 30, 2007 was $17,608,882 compared to $16,966,834 at December 31, 2006. The primary changes in shareholders' equity were net income for the nine months ended September 30, 2007 of $580,736, an increase in additional paid in capital of $114,187 related to stock-based compensation, and a decrease in accumulated other comprehensive income, (net of tax of $52,875). The Company and the Bank are subject to regulations issued by the Board of Governors of the Federal Reserve System and the FDIC, which require maintenance of a certain level of capital. Under the regulations, capital requirements are based upon the composition of an institution's asset base and the risk factors assigned to those assets. The guidelines characterize an institution's capital as being "Tier 1" capital (defined to be principally shareholders' equity less intangible assets) and "Tier 2" capital (defined to be principally the allowance for loan losses, limited to one and one-fourth percent of gross risk weighted assets). The guidelines require the Company and the Bank to maintain a risk-based capital target ratio of 8%, one-half or more of which should be in the form of Tier 1 capital. 18 The following table shows the Company's and the Bank's actual capital amounts and ratios at September 30, 2007 and December 31, 2006, as well as the minimum capital ratios for capital adequacy under the regulatory framework (dollar amounts are in thousands). To be well- capitalized under For capital adequacy prompt corrective Actual purposes action provisions ------------------------- ------------------------- ------------------------- Amount Ratio Amount Ratio Amount Ratio ----------- ----------- ----------- ----------- ----------- ----------- As of September 30, 2007: Company: Total capital (to risk weighted assets) $ 24,763 14.2% $ 13,876 8.0% N/A N/A Tier 1 capital (to risk weighted assets) $ 18.069 10.4% $ 6,938 4.0% N/A N/A Tier 1 capital (to average assets) $ 18,069 7.9% $ 9,117 4.0% N/A N/A Bank: Total capital (to risk weighted assets) $ 22,408 12.9% $ 13,876 8.0% $ 17,345 10.0% Tier 1 capital (to risk weighted assets) $ 20,869 12.0% $ 6,938 4.0% $ 10,407 6.0% Tier 1 capital (to average assets) $ 20,869 9.3% $ 9,000 4.0% $ 11,250 5.0% As of December 31, 2006: Company: Total capital (to risk weighted assets) $ 23,956 15.3% $ 12,510 8.0% N/A N/A Tier 1capital (to risk weighted assets) $ 22,527 14.4% $ 6,255 4.0% N/A N/A Tier 1 capital (to average assets) $ 22,527 10.4% $ 8,673 4.0% N/A N/A Bank: Total capital (to risk weighted assets) $ 21,519 13.8% $ 12,510 8.0% $ 15,637 10.0% Tier 1capital (to risk weighted assets) $ 20,028 12.8% $ 6,255 4.0% $ 9,382 6.0% Tier 1 capital (to average assets) $ 20,028 9.3% $ 8,593 4.0% $ 10,741 5.0% The Bank met the "well capitalized" capital ratio measures at both September 30, 2007 and December 31, 2006. Liquidity Liquidity management refers to the Company's ability to provide funds on an ongoing basis to meet fluctuations in deposit levels as well as the credit needs and requirements of its clients. Both assets and liabilities contribute to the Company's liquidity position. Federal funds lines, short-term investments and securities, and loan repayments contribute to liquidity, along with deposit increases, while loan funding and deposit withdrawals decrease liquidity. The Company assesses the likelihood of projected funding requirements by reviewing historical funding patterns, current and forecasted economic conditions and individual client funding needs. Commitments to fund loans and outstanding letters of credit at September 30, 2007 and December 31, 2006 were approximately $35,012,000 and $40,607,000, respectively. Such loan commitments relate primarily to revolving lines of credit and other commercial loans and to real estate construction loans. Since some of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company's sources of liquidity consist of cash and due from correspondent banks, overnight funds sold to correspondent banks, unpledged marketable investments and loans held for sale and/or pledged for secured borrowings. At September 30, 2007, consolidated liquid assets totaled $35,462,656 or 15.1% of total assets compared to $47,002,000 or 20.7% of total assets on December 31, 2006. In addition to liquid assets, the Company maintains short-term lines of credit in the amount of $35,300,000 with correspondent banks. At September 30, 2007, the Company had $35,300,000 available under these credit lines. Additionally, Service 1st Bank is a member of the FHLB. At September 30, 2007, Service 1st Bank could have arranged for up to $18,768,500 in secured borrowings from the FHLB. These borrowings are secured by pledged mortgage loans. At September 30, 2007, the Company had advances, borrowings and commitments (including letters of credit) outstanding of $4,000,000, leaving $14,768,500 available under these FHLB secured borrowing arrangements. Service 1st Bank also has informal agreements with various other banks to sell participations in loans, if necessary. The Company serves primarily a business and professional customer base and, as such, its deposit base is susceptible to economic fluctuations. Accordingly, management strives to maintain a balanced position of liquid assets and borrowing capacity to volatile and cyclical deposits. 19 Liquidity is also affected by portfolio maturities and the effect of interest rate fluctuations on the marketability of both assets and liabilities. The Company can sell any of its unpledged securities held in the available-for-sale category to meet liquidity needs. These securities are also available to pledge as collateral for borrowings if the need should arise. Service 1st Bank has established a master repurchase agreement with a correspondent bank to enable such transactions. Service 1st Bank can also pledge securities to borrow from the FRB and the FHLB. The principal cash requirements of the Company are for expenses incurred in the support of administration and operations. Inflation The impact of inflation on a financial institution differs significantly from that exerted on manufacturing or other commercial concerns, primarily because its assets and liabilities are largely monetary. In general, inflation primarily affects the Company and the Bank indirectly through its effect on market rates of interest, and thus the ability of the Bank to attract loan customers. Inflation affects the growth of total assets by increasing the level of loan demand, and potentially adversely affects the Company's and the Bank's capital adequacy because loan growth in inflationary periods can increase at rates higher than the rate that capital grows through retention of earnings, which the Company may generate in the future. In addition to its effects on interest rates, inflation directly affects the Company by increasing operating expenses. The effects of inflation were not material to the Company's results of operations during the periods ending September 30, 2007 and 2006. Off-Balance Sheet Items The Company is a party to financial instruments with off-balance sheet risk in the normal course of business in order to meet the financing needs of its customers and to reduce its exposure to fluctuations in interest rates. These financial instruments consist of commitments to extend credit and letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the balance sheet. The Company's exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company applies the same credit policies to commitments and letters of credit as it does for loans included on the consolidated balance sheet. As of September 30, 2007 and December 31, 2006, commitments to extend credit and standby letters of credit were the only financial instruments with off-balance sheet risk. The Company has not entered into any contracts for financial derivative instruments such as futures, swaps, options or similar instruments. Loan commitments and standby letters of credit were $35,012,000 and $40,607,000 at September 30, 2007 and December 31, 2006, respectively. As a percentage of gross loans and leases these off-balance sheet items represent 28.3% and 35.3%, respectively. The Company has certain ongoing commitments under operating leases. The minimum commitment under these operating leases for 2007 is $508,500. Effects of Terrorism The terrorist actions on September 11, 2001 and thereafter and the conflict with Iraq have had significant adverse effects upon the United States economy. Whether the terrorist activities in the future and the actions of the United States and its allies in combating terrorism on a worldwide basis will adversely impact the Company and the extent of such impact is uncertain. Such economic deterioration could adversely affect the Company's future results of operations by, among other matters, reducing the demand for loans and other products and services offered by the Bank, increasing nonperforming loans and the amounts reserved for loan losses, and causing a decline in the Company's stock price. Website Access Information regarding the Company, the Bank, and Charter may be obtained from the Company's website at www.service1stbank.com. Copies of the Company's annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and Section 16 reports by Company insiders, including exhibits and amendments thereto, are available free of charge on the Company's website as soon as they are published by the Securities and Exchange Commission through a link to the Edgar reporting system maintained by the Securities and Exchange Commission. To access Company filings, select "Go to Service 1st Bancorp" at the bottom of the Company website page, then select "Click here to view Service 1st Bancorp SEC Filings", followed by selecting "Continue to view SEC Filings" to view or download copies of reports including Form 10-K, 10-Q or 8-K, or select "Click here to view Section 16 Reports," followed by selecting "Continue to view Section 16 Reports," to view or download reports on Forms 3, 4 or 5 of insider transactions in Company securities. 20 Item 3. Quantitative and Qualitative Disclosures About Market Risk The types of market risk exposures generally faced in the banking industry include interest rate risk, liquidity risk, equity price risk, foreign currency risk, and commodity price risk. Due to the nature of our operations, foreign currency and commodity price risk are not significant to us. See "Management's Discussion and Analysis of Financial Condition and Operations - Liquidity" for a discussion of our liquidity risk. Our interest rate risk and equity market price risk are described below. Interest Rate Risk The Company manages its interest rate risk within an overall asset and liability management framework that includes attention to credit risk, liquidity risk, and capital structure. A principal objective of asset/liability management is to manage the sensitivity of net interest income to changing interest rates. Asset and liability management activity is governed by a policy reviewed and approved annually by the Board of Directors. The Board of Directors has delegated the administration of this policy to the Funds Management Committee, a committee of the Board of Directors, which is comprised of senior executive management, and four independent directors. Two common measures used to monitor interest rate risk are economic value interest rate sensitivity and forecasted net interest income rate sensitivity. Economic Value Interest Rate Sensitivity Interest rate sensitivity is computed by estimating percentage changes in the economic value of our equity over a range of potential yield curve shocks. Economic value sensitivity is defined as the economic value of our assets less the economic value of our liabilities plus or minus the economic value of off-balance sheet items. The economic value of each asset, liability and off-balance sheet item is its discounted present value of expected cash flows. Discount rates are based on implied forward market rates of interest, adjusted for assumed shock scenario interest rate changes. The following table shows our projected percentage change in economic value sensitivity for parallel yield curve shocks as of the dates indicated relative to the value if wholesale market rates follow implied forward rates. Projected change in economic value ----------------------------- September 30, December 31, Change in interest rates 2007 2006 - --------------------------------- ------------- ------------- 100 basis point rise -18.3% -15.6% 100 basis point decline 10.2% 5.2% The economic value of portfolio equity sensitivity from December 31, 2005 to December 31, 2006 has shifted due to changes in wholesale rates, a change in the composition of customer loans, leases, investments, and deposits, and shortened wholesale borrowing maturities. Forecasted Net Interest Income Interest Rate Sensitivity The impact of interest rate changes on the next 12 months' net interest income is measured using income simulation. The various products in our balance sheet are modeled to simulate their income (and cash flow) behavior in relation to interest rate movements. Income for the next 12 months is calculated using the implied forward curve and for immediate and sustained yield curve shocks. 21 The income simulation model includes various assumptions about the repricing behavior for each product and new business volumes and pricing behaviors. Many of our assets are floating rate loans, which would subsequently reprice in response to changes in market interest rates with the repricing being the same extent as the change in the underlying contracted index. Our Liquid Gold account deposit products are assumed to reprice gradually in response to wholesale rate changes. The following table shows our projected percentage change in 12 month net interest income as a consequence of parallel yield curve shocks from the implied forward curve: Projected change in net interest income ---------------------------------- September 30, December 31, Change in interest rates 2007 2006 - --------------------------------- ---------------- --------------- 100 basis point rise 0.62% 4.32% 100 basis point decline 0.23% 1.12% Net interest income sensitivity from December 31, 2005 to December 31, 2006 evolved from a slightly asset-sensitive position to a relatively neutral position. Equity Market Price Risk We are not exposed to equity market risk through our investments in stocks. The only stocks owned are 9,346 shares of FHLB of San Francisco and 400 shares of Pacific Coast Bankers' Bank. These stocks are not actively traded on any exchange, but their market value exceeds their cost. Item 4. Controls and Procedures (a) Disclosure Controls and Procedures An evaluation of the Company's disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and other members of the Company's senior management as of the end of the Company's fiscal quarter ended September 30, 2007. The Company's Chief Executive Officer and Chief Financial Officer concluded that the Company's disclosure controls and procedures as currently in effect are effective in ensuring that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is (i) accumulated and communicated to the Company's management (including the Chief Executive Officer and Chief Financial Officer) to allow timely decisions regarding required disclosure, and (ii) recorded, processed, summarized and reported within the time periods specified in the Commission's rules and forms. (b) Internal Control Over Financial Reporting An evaluation of any changes in the Company's internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)), that occurred during the Company's fiscal quarter ended September 30, 2007, was carried out under the supervision and with the participation of the Company's Chief Executive Officer, Chief Financial Officer and other members of the Company's senior management. The Company's Chief Executive Officer and Chief Financial Officer concluded that no change identified in connection with such evaluation has materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. Item 4T. Controls and Procedures Not Applicable PART II - OTHER INFORMATION Item 1. Legal Proceedings None Item 1A. Risk Factors None 22 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None Item 3. Defaults Upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits (2.1) Plan of Reorganization and Merger Agreement (included in Annex A) incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (3.1) Articles of Incorporation, as amended, incorporated by reference from the Registrant's Form 10-QSB for the quarter ended September 30, 2005, filed with the Securities and Exchange Commission on November 10, 2005. (3.2) Bylaws, as amended, incorporated by reference from the Registrant's Form 8-K, filed with the Securities and Exchange Commission on July 23, 2007. (4.1) Specimen form of certificate for Service 1st Bancorp common stock incorporated by reference from Registrant's Form 10-QSB for the quarterly period ended September 30, 2003, filed with the Securities and Exchange Commission on November 14, 2003. (4.2) Trust Preferred Security Indenture dated August 17, 2006 between Service 1st Bancorp and Wells Fargo Bank, National Association, incorporated by reference from the Registrant's Form 10-Q for the quarterly period ended June 30, 2007, filed with the Securities and Exchange Commission on August 13, 2007. (4.3) Trust Preferred Security Amended and Restated Declaration of Trust dated August 17, 2006 between Service 1st Capital Trust I and Wells Fargo Bank, National Association, incorporated by reference from the Registrant's Form 10-Q for the quarterly period ended June 30, 2007, filed with the Securities and Exchange Commission on August 13, 2007. (4.4) Trust Preferred Security Guarantee Agreement dated August 17, 2006 between Service 1st Bancorp and Wells Fargo Bank, National Association, incorporated by reference from the Registrant's Form 10-Q for the quarterly period ended June 30, 2007, filed with the Securities and Exchange Commission on August 13, 2007. (4.5) Trust Preferred Security Junior Subordinated Debt Security dated August 17, 2006 between Service 1st Bancorp and Wells Fargo Bank, National Association, incorporated by reference from the Registrant's Form 10-Q for the quarterly period ended June 30, 2007, filed with the Securities and Exchange Commission on August 13, 2007. (4.6) Trust Preferred Security Trust Preferred Security Certificate dated August 17, 2006 between Service 1st Capital Trust I and Wells Fargo Bank, National Association, incorporated by reference from the Registrant's Form 10-Q for the quarterly period ended June 30, 2007, filed with the Securities and Exchange Commission on August 13, 2007. 23 (10.1) Lease agreement dated May 3, 2002, related to 2800 West March Lane, Suite 120, Stockton, CA 95219 incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.2) Lease agreement dated April 13, 1999 and amendment thereto dated June 17, 1999, related to 60 West 10th Street, Tracy, CA 95376, incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.3)* 1999 Service 1st Bancorp Stock Option Plan, Amendment No. 1 thereto, and related forms of Incentive and Nonstatutory Stock Option Agreements entered into with executive officers and directors, incorporated by reference from the Registrant's Form S-8, Registration No. 333-107346, filed with the Securities and Exchange Commission on July 25, 2003. (10.4) Agreement dated July 27, 1999 with BancData Solutions, Inc. for service bureau and data processing services, incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.5) Agreement with Financial Marketing Services dated February 1, 2000, incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.6)* Service 1st Bank 401(k) Profit Sharing Plan and Trust Summary Plan Description, dated January 1, 2000, incorporated by reference from the Registrant's Form S-4EF, Registration No. 333-104244, filed with the Securities and Exchange Commission on April 1, 2003. (10.7)* John O. Brooks Salary Continuation Agreement dated September 10, 2003, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (10.8)* Bryan R. Hyzdu Salary Continuation Agreement dated September 10, 2003, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (10.9)* Robert E. Bloch Salary Continuation Agreement dated September 10, 2003, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (10.10)* Patrick Carman Salary Continuation Agreement dated September 10, 2003, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (10.11)* 2004 Stock Option Plan and Forms of Incentive and Nonstatutory Stock Option Agreements, incorporated by reference from the Registrant's Form S-8, Registration No. 333-116818, filed with the Securities and Exchange Commission on June 24, 2004. (10.12)* John O. Brooks Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.13)* Bryan R. Hyzdu Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. 24 (10.14)* Robert E. Bloch Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.15)* Patrick Carman Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.16)* Shannon Reinard Employment Agreement dated July 15, 2004, incorporated by reference from the Registrant's Form 10-QSB, for the quarterly period ended September 30, 2004, filed with the Securities and Exchange Commission on November 15, 2004. (10.17) Fiserv Solutions, Inc. Agreement dated October 7, 2004, for service bureau, data processing, and item processing, incorporated by reference from the Registrant's Form 10-KSB for the year ended December 31, 2004, filed with the Securities and Exchange Commission on June 30, 2005. (10.18) Lease agreement dated May 1, 2005, related to 49 W. 10th Street, Tracy, CA 95378 incorporated by reference from the Registrant's Form 10-QSB for the quarterly period ended September 30, 2005, filed with the Securities and Exchange Commission on November 10, 2005. (10.19) Lease agreement dated October 3, 2005, related to 1901 W. Kettleman Lane, Building A, Suite 1A and 1B, Lodi, CA 95242, incorporated by reference from the Registrant's Form 10-QSB for the quarterly period ended September 30, 2005, filed with the Securities and Exchange Commission on November 10, 2005. (10.20)* Shannon Reinard Salary Continuation Agreement dated August 8, 2005, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.21)* Bryan R. Hyzdu First Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.22)* Bryan R. Hyzdu Second Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.23)* Patrick Carman First Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.24)* Patrick Carman Second Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.25)* Robert E. Bloch First Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. 25 (10.26)* Robert E. Bloch Second Amendment dated August 8, 2005 to Salary Continuation Agreement dated September 10, 2003, incorporated by reference from Registrant's Form 10-KSB for the year ended December 31, 2005, filed with the Securities and Exchange Commission on March 30, 2006. (10.27)* Director Emeritus Program approved by Board of Directors effective June 30, 2006, incorporated by reference from Registrant's Form 8-K, filed with the Securities and Exchange Commission on July 7, 2006. (10.28) Lease option exercise letter dated September 12, 2006, related to 60 West 10th Street, Tracy, CA 95376, incorporated by reference from Registrant's Form 10-K, filed with the Securities and Exchange Commission on April 2, 2007. (14.1) Code of Ethics, incorporated by reference from the Registrant's Form 10-K for the year ended December 31, 2003, filed with the Securities and Exchange Commission on March 30, 2004. (21.1) Registrant's only subsidiaries are Service 1st Bank and Charter Services Group, Inc. (31.1) Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (31.2) Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (32.1) Certification of Service 1st Bancorp by its Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Denotes management compensatory plans or arrangements. 26 SIGNATURES Pursuant to the requirements of Section 13 or 15d) 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. SERVICE 1ST BANCORP Date: November 13, 2007 By: /s/ JOHN O. BROOKS ---------------------------------- John O. Brooks Chief Executive Officer (Principal Executive Officer) Date: November 13, 2007 By: /s/ ROBERT E. BLOCH ---------------------------------- Robert E. Bloch Executive Vice President and Chief Financial Officer (Principal Financial and Accounting Officer) 27 EXHIBIT INDEX Exhibit Sequential Number Description Page Number - ----------- ------------------------------------------------------------------ ---------------- 31.1 Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 29 31.2 Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 30 32.1 Certification of Service 1st Bancorp by its Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 31 28