UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the quarterly period ended March 31, 1999
or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the transitional period from to
Commission File No. 000-23877
HERITAGE COMMERCE CORP
(Exact name of registrant as specified in its charter)
California 77-0469558
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
150 Almaden Blvd., San Jose, California 95113
(Address of principal executive offices) (Zip Code)
(408) 947-6900
(Registrant's telephone number, including area code)
None
(Former name, former address and former fiscal year,if changed since last
report.)
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.
[X] Yes [ ] No
APPLICABLE ONLY TO CORPORATE ISSUERS:
The Registrant had 5,585,184 shares of Common Stock outstanding on May 3, 1999.
HERITAGE COMMERCE CORP AND SUBSIDIARY
QUARTERLY REPORT ON FORM 10-Q
Table of Contents
Part I - Financial Information Page
Item 1. Condensed Consolidated Statements of Financial Condition 1
At March 31, 1999 and December 31, 1999
Condensed Consolidated Statements of Income 2
For the three months ended March 31, 1999 and 1998
Condensed Consolidated Statements of Cash Flows 3
For the three months ended March 31, 1999 and 1998
Condensed Consolidated Notes to Financial Statements 4
Item 2. Management's Discussion and Analysis of Financial Condition 6
and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk 15
Part II - Other Information
Item 1. Legal Proceedings 16
Item 2. Submission of Matters to a Vote of Security Holders 16
Item 3. Other Information 16
Item 4. Exhibits and Reports on Form 8-K 16
Signatures 17
HERITAGE COMMERCE CORP AND SUBSIDIARY
Condensed Consolidated Statements of Financial Condition
ASSETS March 31, 1999 December 31, 1998
(Unaudited)
Cash and due from banks $ 14,837,000 $ 18,039,000
Federal funds sold 14,415,000 28,600,000
Total cash and cash equivalents 29,252,000 46,639,000
Securities available-for-sale, at fair value 52,413,000 50,249,000
Securities held-to-maturity, at amortized cost 13,867,000 26,544,000
(fair value of $14,166,000 and $27,240,000,
respectively)
Loan held for sale, at fair value 12,306,000 33,079,000
Loans 231,274,000 236,307,000
Allowance for loan losses (4,277,000) (3,825,000)
Loans, net 226,997,000 232,482,000
Premises and equipment, net 3,102,000 3,238,000
Accrued interest receivable and other assets 11,490,000 7,240,000
Other investments 8,941,000 5,460,000
TOTAL $ 358,368,000 $ 404,931,000
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits $ 322,046,000 $ 350,047,000
Deposits held for sale --- 18,911,000
Accrued interest payable and other
liabilities 5,393,000 5,276,000
Total liabilities 327,439,000 374,234,000
Commitments and contingencies
Shareholders' equity:
Preferred Stock, 10,000,000 shares
authorized; none outstanding --- ---
Common Stock, no par value; 30,000,000
shares authorized;shares issued and
outstanding: 5,561,656 at March 31,
1999 and 5,554,552 at December 31, 1998 29,455,000 29,418,000
Accumulated other comprehensive income,
net of taxes 225,000 658,000
Retained Earnings 1,249,000 621,000
Total shareholders' equity 30,929,000 30,697,000
TOTAL $ 358,368,000 $ 404,931,000
See notes to condensed consolidated financial statements
HERITAGE COMMERCE CORP AND SUBSIDIARY
Condensed Consolidated Statements of Income (Unaudited)
Three months ended March 31,
1999 1998
Interest income:
Loans, including fees $ 6,031,000 $ 3,550,000
Securities, taxable 624,000 1,233,000
Securities, non-taxable 173,000 120,000
Federal funds sold 336,000 217,000
Total interest income 7,164,000 5,120,000
Interest expense:
Deposits 2,160,000 1,342,000
Other 11,000 ---
Total interest expense 2,171,000 1,342,000
Net interest income before provision for loan
losses 4,993,000 3,778,000
Provision for loan losses 643,000 160,000
Net interest income after provision for loan
losses 4,350,000 3,618,000
Other income:
Gain on sale of loans held for sale 46,000 ---
Gain on sale of securities available for sale 771,000 18,000
Service charges and other fees 69,000 50,000
Other investment income 80,000 52,000
Other income 258,000 11,000
Total other income 1,224,000 131,000
Other expenses:
Salaries and employee benefits 2,422,000 1,580,000
Client services 661,000 325,000
Furniture and equipment 297,000 171,000
Advertising and promotion 149,000 152,000
Occupancy 232,000 150,000
Professional fees 170,000 164.000
Loan origination costs 116,000 82,000
Stationery & supplies 79,000 55,000
Telephone expense 50,000 46,000
Other 411,000 293,000
Total other expenses 4,587,000 3,018,000
Net income before income taxes 987,000 731,000
Income taxes 360,000 278,000
Net income $ 627,000 $ 453,000
Earnings per share:
Basic $ 0.11 $ 0.09
Diluted $ 0.10 $ 0.08
See notes to condensed consolidated financial statements
HERITAGE COMMERCE CORP
Condensed Consolidated Statements of Cash Flows (Unaudited)
Three Months ended March 31,
1999 1998
Cash flows from operating activities:
Net income $ 627,000 $ 453,000
Adjustments to reconcile net income to net
cash used by operating activities:
Depreciation and amortization 203,000 125,000
Provision for loan losses 643,000 160,000
Gain on sale of securities available-for-sale (771,000) (18,000)
Net amortization of premiums / accretion of
discounts (34,000) (27,000)
Proceeds from sales of loans 2,317,000 (18,000)
Originations of loans held for sale (322,000) (1,813,000)
Maturities of loans held for sale 2,158,000 18,000
Increase in accrued interest receivable and
other assets (4,248,000) (97,000)
Decrease (increase)in accrued interest payable
and other liabilities 403,000 (299,000)
Net cash provided by (used by)
operating activities 976,000 (1,516,000)
Cash flows from investing activities:
Net decrease (increase) in loans 21,462,000 (12,310,000)
Purchases of investment securities
available-for-sale (21,252,000) (11,637,000)
Maturities of investment securities
available-for-sale 2,984,000 3,046,000
Sales of investment securities
available-for-sale 27,749,000 18,000
Purchases of investment securities
held-to-maturity --- (3,083,000)
Maturities of investment securities
held-to-maturity 1,115,000 1,867,000
Purchases of corporate owned life insurance (3,480,000) (52,000)
Capital expenditures (67,000) (809,000)
Net cash provided by (used by) investing
activities 28,511,000 (22,960,000)
Cash flows from financing activities:
Net (decrease) increase in deposits (46,912,000) 61,187,000
Proceeds from exercise of stock options 38,000 ---
Net cash (used by) provided by financing
activities (46,874,000) 61,187,000
Net (decrease) increase in cash and
cash equivalents (17,387,000) 36,711,000
Cash and cash equivalents, beginning of period 46,639,000 43,185,000
Cash and cash equivalents, end of period $ 29,252,000 $ 79,896,000
Other cash flow information:
Interest paid in cash $ 2,246,000 $ 1,239,000
Income taxes paid in cash 728,000 385,000
See notes to condensed consolidated financial statements
HERITAGE COMMERCE CORP AND SUBSIDIARY
Notes to Condensed Consolidated Financial Statements
March 31, 1999
(Unaudited)
1) Basis of Presentation
The unaudited condensed consolidated financial statements of Heritage
Commerce Corp and its wholly owned subsidiaries, Heritage Bank of Commerce
and Heritage Bank East Bay, have been prepared pursuant to the rules and
regulations for reporting on Form 10-Q. Accordingly, certain information
and notes required by generally accepted accounting principles for complete
financial statements are not included herein. The interim statements
should be read in conjunction with the financial statements and notes
thereto included in the Company's Form 10-K Annual Report for the year ended
December 31, 1998.
In the Company's opinion, all adjustments necessary for a fair presentation
of these condensed consolidated financial statements have been included
and are of a normal and recurring nature. Certain reclassifications have
been made to prior year amounts to conform to current year presentation.
The results for the three months ended March 31, 1999 are not necessarily
indicative of the results expected for any subsequent period or for the
entire year ending December 31, 1999.
2) Share and Per Share Amounts
Earnings per common share (basic) are calculated based on the weighted
average number of shares outstanding during the period. Earnings per common
and common equivalent share (diluted) are calculated based on the weighted
average number of shares outstanding during the period, plus equivalent
shares representing the dilutive effect of stock options. All share
numbers have been restated for the stock split in February, 1999.
Reconciliation of weighted average shares used in computing earnings per
share are as follows:
Years ended March 31,
1999 1998
Weighted average common shares outstanding 5,556,919 4,943,844
Diluted effect of stock options outstanding 855,479 554,925
Shares used in computing diluted earnings per share 6,412,398 5,498,769
3) Adoption of FAS 133
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 133 , "Accounting for
Derivative Instruments and Hedging Activities." The Company adopted the
provisions of SFAS No. 133 effective February 1, 1999. Because of the
Company's minimal use of derivatives, the adoption of SFAS No. 133 did not
significantly impact the Company's earnings or financial position. As
allowed by SFAS No. 133 the Company transferred approximately $11.67
million of certain securities from the held-to-maturity to
available-for-sale classification. The realized and unrealized gains on
the securities transferred were not material to the Company.
4) Comprehensive Income
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income", which requires that an enterprise report and display, by major
components and as a single total, the change in its net assets during the
period from non-owner sources. This Statement is effective for fiscal
years beginning after December 15, 1997. The adoption of this Statement
in the first quarter of 1999 resulted in a change in the financial
statement presentation, but did not have an impact on the Company's
consolidated financial position, results of operations or cash flows.
Certain amounts in the prior period have been reclassified to conform to
the current presentation under SFAS No. 130. Total comprehensive income
for the three months ended March 31, 1999 and 1998 was $195,000 and
$488,000, respectively.
The following is a summary of the components of accumulated other
comprehensive income:
For the Three Months Ended
March 31,1999 March 31,1998
Net Income $ 627,000 $ 453,000
Other comprehensive income, net of tax:
Net unrealized gain on securities
available-for-sale during the period 338,000 46,000
Less:reclassification adjustment for
realized gains on available for sale
securities included in net income
during the period (770,000) (11,000)
Other comprehensive income (432,000) 35,000
Comprehensive income $ 195,00 $ 488,000
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
Net income for the quarter ended March 31, 1999 was $627,000, or $0.10 per
diluted share, as compared to net income of $453,000, or $0.08 per diluted
share, for the same period in 1998. The increase was attributable to growth
in the level of earning assets overall, and of loans in particular, funded by
new deposits at favorable weighted average rates of interest. Return on
average assets annualized for the first three months of 1999 and 1998 was
0.69%. Annualized return on average equity for the first three months of 1999
was 8.20%, compared to 8.08% for the first three months of 1998.
Average interest earning assets for the quarter ended March 31, 1999 were up
$93,595,000, or 40%, over 1998, with much of the increase primarily
attributable to growth in loans. The average rate earned on loans in the first
quarter of 1999 was 10.03%, compared to 10.93% in the first quarter of 1998.
The average rate on earning assets was 8.81% for the quarter ended March 31,
1999, compared to 8.79% for the quarter ended March 31, 1998.
Average interest bearing liabilities increased $84,193,000, or 57%, from
three months ended March 31,1998 to the same periods in 1999, with the
increase attributable to growth in interest bearing demand deposits, money
market accounts, growth in time deposits of $100,000 or more, and growth in
time deposits in support of the internet credit card program. The average
rate paid on interest bearing liabilities increased to 3.78% at March 31, 1999
from 3.65% at March 31, 1998. The Company's net interest margin was 6.14%
from the first three months ended March 31, 1999, compared with 6.49% for the
first three months ended March 31,1998.
The Company's non-performing assets increased to $2,269,000 at March 31, 1999
from zero at March 31, 1998, due to local market conditions, the increase in
size of the loan portfolio and an increase in dilinquent consumer loans.
Shareholders' equity increased $232,000 to $30,929,000, or 8.64% of assets,
at March 31, 1999, from $30,697,000 or 7.58% of assets, at December 31, 1998.
The Company's Tier 1 and total risk-based capital ratios were 10.30%
and 11.55% at March 31, 1999, compared to 9.2% and 10.4%, respectively, at
December 31, 1998, and 13.1% and 14.6%, respectively, at March 31, 1998. Due
to the overall growth in total assets, more specifically the growth in the
loan portfolio, the Company's leverage capital ratio stood at 8.32% at March
31, 1999. This compares with a leverage ratio of 9.0% at December 31, 1998
and 8.4% at March 31, 1998.
RESULTS OF OPERATIONS
Net Interest Income and Net Interest Margin
The following table presents the Company's average balance sheet, net
interest income and the resultant yields for the periods presented:
For the Three Months Ended For the Three Months Ended
March 31, 1999 March 31, 1998
Interest Average Interest Average
Average Income/ Yield/ Average Income/ Yield/
(Dollars in thousands) Balance Expense Rate Balance Expense Rate
Assets:
Loans, net $ 243,894 $ 6,031 10.03% $ 131,672 $ 3,550 10.93%
Investments securities 56,957 797 5.68% 88,375 1,353 6.21%
Federal funds sold 28,984 336 4.71% 16,193 217 5.43%
Total interest
earning assets $ 329,835 $ 7,164 8.81% $ 236,240 $ 5,120 8.79%
Cash and due
from banks 17,040 19,518
Premises and
equipment, net 3,233 2,299
Other assets 17,510 7,950
Total assets $ 367,618 $ 266,007
Liabilities and
shareholders' equity:
Deposits:
Demand,
interest bearing $ 9,464 $ 34 1.47% $ 6,205 $ 29 1.89%
Savings and
Money market 131,273 987 3.05% 95,640 739 3.13%
Time deposits,
$100,000 and over 52,678 630 4.85% 39,523 489 5.01%
Time deposits,
less than $100,000 32,591 426 5.30% 7,512 85 4.60%
Brokered Deposits 6,167 83 5.44% - - -
Other borrowings 911 11 4.87% 11 - 5.63%
Total interest
bearing liabilities $233,084 $ 2,171 3.78% $ 148,891 $ 1,342 3.65%
Demand deposits 96,908 92,020
Other liabilities 6,583 2,364
Total liabilities 336,575 243,275
Shareholders' equity 31,043 22,732
Total liabilities
and shareholders'
equity $367,618 $ 266,007
Net interest income/margin $ 4,993 6.14% $ 3,778 6.49%
Note: Yields and amounts earned on loans include loan fees of $455,000 and
$277,000 for the three month periods ended March 31, 1999 and 1998,
respectively.
The Company's net interest income for the first quarter of 1999 was
$4,993,000, an increase of $1,215,000 over the first quarter of 1998. When
compared to the first quarter of 1998, average earning assets increased by
$93,595,000. The net yield on average earning assets was 6.14% in the first
quarter of 1999, compared to 6.49% in the first quarter of 1998. The
increase in net interest income was primarily due to an increase in the
volume of interest earning assets, predominantly loans.
The following table sets forth an analysis of the changes in interest income
and interest expense. The total change is shown in the column designated
"Net Change" and is allocated in the columns to the left, to the portions
respectively attributable to volume changes and rate changes that occurred
during the period indicated. Changes due to both volume and rate have been
allocated between the volume and rate categories in proportion to the
relationship of the changes due solely to the changes in volume and rate,
respectively.
Three Months Ended March 31,
1999 vs. 1998
Increase (Decrease) Due to Change In:
(Dollars in thousands) Average Volume Average Rate Net Change
Interest earning assets
Loans, net $ 2,775 $ (294) $ 2,481
Investments securities (441) (115) (556)
Federal funds sold 148 (29) 119
Total interest earning assets $ 2,482 $ (438) $ 2,044
Interest bearing liabilities
Demand, interest bearing $ 12 $ (7) $ 5
Money Market and Savings 268 (20) 248
Time deposits, $100,000 and over 157 (16) 141
Time deposits, less than $100,000 328 133 341
Brokered Deposits 83 - 83
Other borrowings 11 - 11
Total interest bearing liabilities $ 859 $ (30) $ 829
Net interest income $ 1,623 $ (408) $ 1,215
Provision for Loan Losses
During the first quarter of 1999, the provision for loan losses was $643,000,
up $483,000 from $160,000 for the first quarter of 1998. The increase in the
provision was due to the overall growth of the loan portfolio.
Noninterest Income
The following table sets forth the various components of the Company's
noninterest income for the periods indicated:
Increase
Three months ended March 31, 1999 versus 1998
(Dollars in thousands) 1999 1998 Amount Percent
Service charges and other fees $ 69 $ 50 $ 19 38%
Gain on sale of securities
available-for-sale 771 18 753 4,183%
Gain on sale of loans 46 - 46 --
Other investment income 80 52 28 54%
Other income 258 11 247 2,245%
Total $ 1,224 $ 131 $ 1,093 834%
Noninterest income for the first three months ended March 31, 1999 was
$1,224,000, up $1,093,000, or 834%, from $131,000 for the first three months
ended March 31, 1998. This increase was primarily the result of gains
recognized on the sale of securities available-for-sale (up $753,000) and the
increase in other income (up $247,000). The sale of securities represents
favorable market conditions to sell securities. The increase in other
income is primarily due to fee income associated with the Company's internet
credit card program.
Noninterest Expense
The following table sets forth the various components of the Company's
noninterest expenses for the periods indicated:
For The Three Months Ended March 31,
Increase Percent Increase
(Dollars in thousands) 1999 1998 (Decrease) (Decrease)
Salaries and benefits $ 2,422 $ 1,580 $ 842 53%
Client services 661 360 301 84%
Furniture and equipment 297 170 127 75%
Occupancy 232 150 82 55%
Advertising and promotion 149 173 (24) (14%)
Loan origination costs 116 82 34 41%
Professional fees 170 164 6 4%
Stationery & Supplies 79 55 24 44%
Telephone expense 50 46 4 9%
All other 411 238 203 85%
Total $ 4,587 $ 3,018 $ 1,569 52%
Noninterest expenses for the first quarter of 1999 were $4,587,000, up
$1,569,000, or 52%, from $3,018,000 for the first quarter of 1998. The
increase in noninterest expenses reflects the growth in infrastructure to
support the Company's loan and deposit growth and the opening of Heritage
Bank East Bay.
Noninterest expenses consist primarily of salaries and employee benefits (53%
and 52% of total noninterest expenses for the first quarter of 1999 and 1998,
respectively) and client services (14% and 12% of total non-interest expenses
for the first quarter of 1999 and 1998, respectively). The increase in
salaries and benefits expenses was primarily attributable to an increase in
the number of employees. The Company employed 142 people at March 31, 1999,
up 37 from 105 employees at March 31, 1998. Client services expenses include
courier and armored car costs, imprinted check costs, and other client
services costs, all of which are directly related to the amount of funds on
deposit at the Company. The increase in furniture and equipment expenses and
in occupancy expenses was primarily attributable to an increase in the number
of employees and new banking locations.
FINANCIAL CONDITION
Total assets decreased 11% to $358,368,000 at March 31, 1999, compared to
$404,931,000 at December 31, 1998. The reduction was primarily due to the
sale of approximately $42,000,000 in bankruptcy deposits.
Securities Portfolio
The following table summarizes the amounts and distribution of the Company's
investment securities and the weighted average yields as of March 31, 1999:
March 31, 1999 Maturity
Within After One Year After Five
One and Within Years and After Total
Year Five Years Within Ten Years Ten Years Amortized Cost
(Dollars in thousands) Amount Yield Amount Yield Amount Yield Amount Yield Amount Yield
Securities available for sale:
U.S. Treasury $ 28,291 5.47% $ 13,203 5.98% $ --- --- $ --- --- $41,494 5.63%
U.S. government agencies 511 6.52% 3,040 6.31% --- --- --- --- 3,551 6.34%
Municipals - taxable --- --- 1,883 6.20% --- --- --- --- 1,883 6.20%
Municipals - non-taxable --- --- --- --- 3,217 4.68% 2,268 4.78% 5,485 4.72%
Total available for sale $ 28,802 5.49% $ 18,126 6.06% $ 3,217 4.68% $2,268 4.78% $52,413 5.60%
Securities held to maturity:
Municipals - taxable $ --- --- $ 5,927 6.46% $ 517 6.45% $ --- --- $ 6,444 10.2%
Municipals - non-taxable --- --- 268 4.90% 6,037 4.51% 1,118 4.59% 7,423 1.32%
Total held to maturity $ --- --- $ 6,195 6.39% $ 6,554 4.66% $1,118 4.59% $13,867 5.43%
Total securities $ 28,802 5.49% $ 24,321 6.14% $ 9,771 4.67% $3,386 4.72% $66,280 5.57%
Note: Yield on non-taxable municipals securities are not a fully tax
equivalent basis.
Loans
Total gross loans decreased 2% to $231,347,000 at March 31, 1999, as compared
to $236,402,000 at December 31, 1998. The decrease in loan balances was due
to the payoff of loans related to the consumer credit card portfolio.
The following table indicates the Company's loan portfolio for the periods
indicated:
March 31, % of December 31, % of
(Dollars in thousands) 1999 Total 1998 Total
Commercial $ 89,240 39% $ 79,567 34%
Real estate - mortgage 58,239 25% 57,216 24%
Real estate - land and construction 53,286 23% 49,270 21%
Consumer 30,582 13% 50,349 21%
Total loans 231,347 100% 236,402 100%
Deferred loan fees (73) (95)
Allowance for loan losses (4,277) (3,825)
Loans, net $ 226,997 $ 232,482
The change in the Company's loan portfolio is primarily due to the increase
in the commercial loan portfolio offset by a decline in the consumer credit
card portfolio.
The Company's loan portfolio is concentrated in commercial (primarily
manufacturing, wholesale, and service) and real estate lending, with the
balance in consumer loans. Due to increased customer dispersion outside of
the Company's primary market area attributed to the introduction of the
internet credit card, the Company has decreased the geographic risks inherent
in its loan portfolio. However, while no specific industry concentration is
considered significant, the Company's lending operations are located in the
Company's market areas that are dependent on the technology and real estate
industries and their supporting companies. Thus, the Company's borrowers
could be adversely impacted by a downturn in these sectors of the economy
which could reduce the demand for loans and adversely impact the borrowers'
abilities to repay their loans.
In February 1998, the Company entered into a contract with Internet Access
Financial Corporation to provide a credit card over the Internet. The
customers for the credit cards were not limited to Northern California, the
Company's primarily market area, as the product was available to anyone
across the country. The growth in 1998 in the consumer loan portfolio was
attributable to the introduction of this Internet credit card. As noted in
the above table, the consumer loans category declined from $50,349,000 to
$30,582,000 as of March 31, 1999. The decline is due to the credit card
owners reducing their liability.
As of March 31, 1999, the Company had $2,269,000 in non-accrual loans. At
March 31, 1999, the Company had no non-accrual loans. At March 31, 1999, the
Company had no assets classified as "Other Real Estate Owned." As of
March 31,1999, the Company had no troubled debt restructuring and no loans 90
days past due and still accruing. The increase in the total loan portfolio is
primarily responsible for the increase in non-performing assets.
Allowance for Loan Losses
Management conducts a critical evaluation of the loan portfolio monthly.
This evaluation includes an assessment of the following factors: 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.
Management has established an evaluation process designed to determine the
adequacy of the allowance for loan losses. This process attempts to assess
the risk of loss inherent in the portfolio by segregating the allowance for
loan losses into four components: "watch", "special mention", "substandard"
and "doubtful".
It is the policy of management to maintain the allowance for possible loan
losses at a level adequate for known and future risks inherent in the loan
portfolio. Based on information currently available to analyze loan loss
delinquency and a history of actual charge-offs, management believes that the
loan loss provision and allowance are adequate; however, no assurance of the
ultimate level of credit losses can be given with any certainty. Loans
are charged against the allowance when management believes that the
collectibility of the principal is unlikely.
The following table summarizes the Company's loan loss experience as well as
transactions in the allowance for loan losses and certain pertinent ratios
for the periods indicated:
Year ended
Three months ended March 31, December 31,
(Dollars in thousands) 1999 1998 1998
Balance, beginning of period/year $ 3,825 $ 2,285 $ 2,285
Charge-offs (191) --- (173)
Less recoveries --- 95 137
Net loans charged-off (191) 95 (36)
Provision for loan losses 643 160 1,576
Balance, end of period / year $ 4,277 $ 2,540 $ 3,825
Ratios:
Net charge-offs to average
loans outstanding 0.08% (0.07)% 0.02%
Allowance for loan losses to
average loans 1.84% 1.93% 2.11%
Allowance for loan losses to
total loans 1.85% 1.78% 1.62%
Allowance for loan losses to
non-performing loans 188.49% N/A 297.04%
The increase in charge-offs relates primarily to the Company's consumer
credit card portfolio.
The following table summarizes the allocation of the allowance for possible
loan losses by loan type and the allocated allowance as a percent of loans
outstanding in each loan category at the dates indicated:
March 31, 1999 December 31, 1998
Percent of Loan Percent of loan
each category to each category to
(Dollars in thousands) Amount total loans Amount total loans
Commercial $ 1,829 2.05% $ 1,567 1.98%
Real estate - mortgage 231 0.40% 224 0.39%
Real estate - land and
construction 917 1.72% 815 1.65%
Consumer 1,013 3.31% 1,146 2.28%
Unallocated 287 -- 73 --
Total $ 4,277 1.85% $ 3,825 1.62%
The increase in the loan loss reserve reflects increasing in a percentage
basis the reserve for the Company's consumer credit card portfolio. It also
reflects the increased non-performing assets in the general loan portfolio.
The Company maintains an allowance for possible loan losses to provide for
estimated losses in the loan portfolio. Additions to the allowance are made
by charges to operating expenses in the form of a provision for loan losses.
All loans that are judged to be uncollectable are charged against the
allowance and any recoveries are credited to the allowance. Management
conducts a critical evaluation of the loan portfolio monthly. This
evaluation includes an assessment of the following factors: 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.
The unallocated allowance is based upon management's evaluation of various
conditions that are not directly measured in the determination of the formula
and specific allowances. The conditions evaluated in connection with the
unallocated allowance may include existing general economic and business
conditions affecting the key lending areas of the Company, credit quality
trends, collateral values, loan volumes and concentrations, seasoning of the
loan portfolio, specific industry conditions within portfolio segments,
recent loss experience in particular segments of the portfolio, duration of
the current business cycle, and bank regulatory examination results.
Deposits
Deposits totaled $322,047,000 at March 31, 1999, a decrease of 8%, as compared
to total deposits of $350,047,000 at December 31, 1998. The decrease in
deposits was primarily due to the sale of the bankruptcy deposits. Noninterest
bearing deposits were $107,050,000 at March 31, 1999, a decrease of 11% as
compared to $120,854,000 at December 31, 1998. Interest bearing deposits
were $214,997,000 at March 31, 1999, a decrease of 6% as compared to
$229,193,000 at December 31, 1998.
The following table summarizes the distribution of average deposits and the
average rates paid for the periods indicated:
Three months ended Year ended
March 31, 1999 December 31,1998
Average Average Average Average
(Dollars in thousands) Balance Rate Paid Balace Rate Paid
Demand, non-interest bearing $ 96,908 --- $ 102,834 ---
Demand, interest bearing 9,464 1.47% 7,368 1.85%
Saving and money market 131,273 3.05% 122,157 3.46%
Time deposits, $100,000 and over 52,678 4.85% 48,861 5.04%
Time deposits,less than $100,000 32,591 5.30% 16,638 5.28%
Brokered deposits 6,167 5.44% 3,826 5.87%
Total average deposits $ 329,081 2.64% 301,684 2.63%
Deposit Concentration and Deposit Volatility
The following table indicates the maturity schedule of the Company's time
deposits of $100,000 or more as of March 31, 1999:
(Dollars in thousands) Balance % of Total
Three months or less $ 36,935 60%
Over three months through twelve months 23,236 38%
Over twelve months 900 2%
Total $ 61,071 100%
The Company focuses primarily on servicing business accounts that are
frequently over $100,000 in average size. Certain types of accounts that the
Company makes available are typically in excess of $100,000 in average balance
per account, and certain types of business clients whom the Company serves
typically carry deposits in excess of $100,000 on average. The account
activity for some account types and client types necessitates appropriate
liquidity management practices by the Company to ensure its ability to fund
deposit withdrawals.
Interest Rate Risk
The planning of asset and liability maturities and the matching of interest
rates to correspond with this maturity matching is an integral part of the
active management of an institution's net yield. To the extent maturities of
assets and liabilities do not match in a changing interest rate environment,
net yields may change over time. Even with perfectly matched repricing of
assets and liabilities, risks remain in the form of prepayment of loans or
investments or in the form of delays in the adjustment of rates of interest
applying to either earning assets with floating rates or to interest bearing
liabilities. The Company has generally been able to control its exposure to
changing interest rates by maintaining primarily floating interest rate loans
and a majority of its time certificates in relatively short maturities
The following table sets forth the interest rate sensitivity of the Company's
interest-earning assets and interest-bearing liabilities as of March 31, 1999,
using the rate sensitivity gap ratio. For purposes of the following table,
an asset or liability is considered rate-sensitive within a specified period
when it can be repriced or when it is scheduled to mature within the specified
time frame:
Within Due in Three Due After
Three to Twelve One to Five Due After Not Rate-
(Dollars in thousands) Months Months Years Five Years Sensitive Total
Interest earning assets:
Federal funds sold $ 14,415 $ --- $ --- $ --- $ --- $ 14,415
Securities 5,523 23,278 24,322 13,157 --- 66,280
Total loans 190,795 12,878 24,867 15,040 --- 243,580
Total interest
earning assets 210,733 36,156 49,189 28,197 --- 324,275
Cash and due from banks 14,837 14,837
Other assets 19,256 19,256
Total assets $ 210,733 $ 36,156 $ 49,189 $ 28,197 $ 34,093 $ 358,368
Interest bearing liabilities:
Demand, interest bearing $ 8,994 $ --- $ --- $ --- $ --- $ 8,994
Savings and money market 113,589 --- --- --- --- 113,589
Time deposits 48,376 42,682 1,356 --- --- 92,414
Total interest bearing
liabilities 170,959 42,682 1,356 --- --- 214,997
Noninterest demand deposits 107,049 107,049
Other liabilities 5,393 5,393
Shareholders' equity 30,929 30,929
Total liabilities and
shareholders' equity $ 170,959 $ 42,682 $ 1,356 $ --- $ 143,371 $ 358,368
Interest rate sensitivity GAP $ 39,774 $ (6,526) $47,833 $ 28,197 $(109,278) ---
Cumulative interest rate
sensitivity GAP $ 39,774 $ 33,248 $81,081 $109,278 --- ---
Cumulative interest rate
sensitivity GAP ratio 11.10% 9.28% 22.63% 30.49%
The foregoing table demonstrates that the Company had a positive cumulative
one year gap of $33 million, or 9.28% of total assets, at March 31, 1999. In
theory, this would indicate that $33 million more in assets than liabilities
would reprice if there was a change in interest rates over the next year. If
interest rates were to increase, the positive gap would tend to result in a
higher net interest margin. However, changes in the mix of earning assets or
supporting liabilities can either increase or decrease the net margin without
affecting interest rate sensitivity. This characteristic is referred to as a
basis risk and, generally, relates to the repricing characteristics of
short-term funding sources such as certificates of deposit.
Varying interest rate environments can create unexpected changes in prepayment
levels of assets and liabilities which are not reflected in the interest
sensitivity analysis table. These prepayments may have significant effects
on the Company's net interest margin. Because of these factors, an interest
sensitivity gap report may not provide a complete assessment of the Company's
exposure to changes in interest rates.
liquidity and Liability Management
To meet liquidity need, the Company maintains a portion of its funds in cash
deposits in other banks, in Federal funds sold, and in investment securities.
As of March 31, 1999, the Company's primary liquidity ratio was 15.2%,
comprised of $45.4 million in investment securities available-for-sale of
maturities (or probable calls) of up to five years, less $30.3 million of
securities that were pledged to secure public and certain other deposits as
required by law and contract; Federal funds sold of $14.4 million , and $14.8
million in cash and due from banks, as a percentage of total unsecured
deposits of $291.8 million.
Capital Resources
The following table summarizes risk-based capital, risk-weighted assets, and
risk-based capital ratios of the Company:
March 31, December 31,
(Dollars in thousands) 1999 1998 1998
Capital components:
Tier 1 Capital $ 30,535 $ 22,354 $ 29,850
Tier 2 Capital 3,713 2,540 3,825
Total risk-based capital $ 34,248 $ 24,894 $ 33,675
Risk-weighted assets $ 296,388 $ 170,353 $ 323,688
Average assets $ 366,918 $ 265,791 $ 332,062
Minimum
Regulatory
Requirements
Capital ratios:
Total risk-based capital 11.6% 14.6% 10.4% 8.0%
Tier 1 risk-based capital 10.3% 13.1% 9.2% 4.0%
Leverage ratio (1) 8.3% 8.4% 9.0% 4.0%
(1) Tier 1 capital divided by average assets (excluding goodwill).
On April 29, 1999, the Company filed with the SEC a registration statement
for $10 million in common stock offered by the Company. The offering will
be made on a best-efforts basis by the officers and directors of the Company
and is not underwritten. If the offering is successful, the Company intends
to use the proceeds to capitalize a new bank in Morgan Hill, California, and
for general corporate purposes. The registration statement has not become
effective. The securities may not be sold nor may offers to buy be accepted
before the registration statement becomes effective. This report does not
constitute an offer to sell or the solicitation of an offer to buy nor
shall there be any sale of the securities in any state in which an offer,
solicitation or sale would be unlawful before registration or qualification
under the securities laws of any such state.
Year 2000
The possible inability of computers, software, and other equipment utilizing
microprocessors to recognize and properly process data fields containing a
two-digit year is commonly referred to as the year 2000 problem. On January 1,
2000, such systems may be unable to accurately process certain date-based
information.
This discussion of the implications of the year 2000 problem for the Company
contains numerous forward-looking statements based on inherently uncertain
information. The cost of the project and the date on which the Company
plans to complete the internal year 2000 modifications are based on
management's best estimates of future events. The Company cannot guarantee
these estimates and actual results could differ. Although management believes
it will be able to make the necessary modifications in advance, failure to
modify the systems may have a material adverse effect on the Company.
The Company has developed a plan to assess its year 2000 preparedness,
consisting of the following phases:
- Awareness of the year 2000 problems
- Risk assessment of internal and external systems
- Renovation of problems found in the risk assessment phase
- Validation of renovated systems
- Implementation of validated systems
Resolution of the year 2000 problem is among the Company's highest
priorities, and the Company is preparing for the century change with a
comprehensive enterprise-wide year 2000 program. The Company has identified
all of the major systems and has sought external and internal resources to
renovate and test the systems. The Company is testing purchased software and
systems supported by external parties as part of the program. The Company is
evaluating customers and vendors that have significant relationships with the
Company to determine whether they are adequately preparing for the year 2000.
In addition, the Company is developing contingency plans to reduce the
impact of some potential events that may occur. The Company cannot
guarantee, however, that the systems of vendors or customers with whom it
does business will be completed on a timely basis, or that contingency plans
will shield operations from failures that may occur.
The Company has identified over 90 individual year 2000 projects. The
projects vary in size, importance and materiality, from large undertakings,
such as remediating complicated data systems, to smaller, but still important,
projects such as installing compliant computer utility systems. All of the
projects currently identified have begun, and approximately 90% have been
completed.
The Company assigns projects a priority, indicating the importance of the
function to the Company's continuing operation. This prioritization
facilitates reporting on projects based on their relative importance. The
Company has prioritized projects as "High Priority - IN House", "High
Priority - Not In House" and "Medium Priority". Both High Priority
categories have projects classified as "Mission Critical".
Mission Critical projects are defined as:
- systems vital to the continuance of a broad core business activity;
- functions, the interruption of which for longer than 3 days would
threaten the Company's viability; or
- functions that provide the environment and infrastructure necessary to
continue the broad core business activities.
Testing of all mission critical systems was complete as of March 12, 1999 and
the Company has completed a follow-up assessment of many of its clients' year
2000 preparedness. Currently, the Company's focus is on vendor follow-up and
contingency plans. The Company has communicated with all vendors with whom it
does significant business to determine their year 2000 compliance readiness
and the extent to which the Company is vulnerable to any third-party year
2000 risks. Of all the vendors that present year 2000 risks, approximately
75% have passed testing. The Company does not significantly rely on
"embedded technology" in its critical processes. All building systems in the
Company's main offices use mechanical systems rather than embedded technology
and therefore do not pose any year 2000 risks.
Risks
The principal risks associated with the year 2000 problem can be grouped into
three categories:
- the Company does not successfully ready its operations for the next
century,
- disruption of the Company's operations due to operational failures of
third parties, and
- business interruption among fund providers and obligors such that
expected funding and repayment does not take place
The only risk largely under the Company's control is preparing the Company's
internal operations for the year 2000. The Company, like other financial
institutions, is heavily dependent on its computer systems. The complexity
of these systems and their interdependence make it impractical to convert to
alternative systems without interruptions if necessary modifications are not
completed on schedule. Management believes the Company will be able to make
the necessary modifications on schedule.
Failure of third parties may jeopardize the Company's operations, but the
seriousness of this risk depends on the nature and duration of the failures.
The most serious impact on the Company's operations from vendors would
result if basic services such as telecommunications, electric power, and
services provided by other financial institutions and governmental agencies
were disrupted. Some public disclosure about readiness preparation among
basic infrastructure and other suppliers is now available. The Company is
unable, however, to estimate the likelihood of significant disruptions among
its basic infrastructure suppliers. In view of the unknown probability of
occurrence and impact on its operations, the Company considers the loss of
basic infrastructure services to be the most reasonably likely worst case
year 2000 scenario.
Operational failures among the Company's customers could affect their ability
to continue to provide funding or meet obligations when due. The information
the Company develops in the customer assessments described earlier allows the
Company to identify those customers that exhibit a risk of not making
adequate preparations for the century change. The Company is taking
appropriate actions to manage these risks.
Contingency Plans
The Company is developing year 2000 remediation contingency plans and
business resumption contingency plans specific to the year 2000. Remediation
contingency plans address the actions the Company would take if the current
approach to remediating a system is falling behind schedule or otherwise
appears to be in jeopardy of failing to deliver year 2000-ready systems when
needed. Business resumption contingency plans address the actions that the
Company would take if critical business functions cannot be carried out in
the normal manner upon entering the next century due to system or supplier
failure.
Cost
The total cost to the Company of year 2000 compliance issues, which includes
testing, system replacement and any anticipated lost revenue, has been
approximately $20,000 and is not anticipated to increase substantially through
the completion of all projects. These costs and the date on which the
Company plans to complete the Year 2000 modifications and testing process are
based on management's best estimates, which were derived utilizing numerous
assumptions of future events including the continued availability of certain
resources, third-party modification plans, and other factors. However, there
can be no guarantee that these estimates will be achieved and actual results
could differ from those plans.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
No material changes have occurred during the quarter to the Company's market
risk profile or information. For further information refer to the Company's
annual report on Form 10-K.
Part II - Other Information
Item 1. - Legal Proceedings
To the best of the Company's knowledge, there are no pending legal
proceedings to which the Company is a party which may have a materially
adverse effect on the Company's financial condition, results of operations,
or cash flows.
Item 2. - Changes in Securities and Use of Proceeds
Not Applicable
Item 3. - Defaults Upon Senior Securities
Not Applicable
Item 4. - Submission of Matters to a Vote of Security Holders
Not Applicable
Item 5. - Other Information
Not Applicable
Item 6. - Exhibits and Reports on Form 8-K
(a) Exhibits included with this filing:
Exhibit Number Name
10.1 Employment agreement January 1, 1999 with John E. Rossell
10.2 Employment agreement January 1, 1999 with Brad L. Smith
27.1 Financial Data Schedule
(b) Reports on Form 8-K
On January 6, 1999, the Company filed Form 8-K to report the appointment of
Brad L. Smith as chairman and related management information.
On January 29,1999, the Company filed Form 8-K to report year-end earnings and
a three-for-two stock split.
On April 27, 1999, the Company filed its quarterly earnings press release
with the SEC on Form 8-K.
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.
Heritage Commerce Corp
(Registrant)
May 13, 1999 /s/ John E. Rossell
Date John E. Rossell, III, President and CEO
May 13, 1999 /s/ Lawrence D. McGovern
Date Lawrence D. McGovern, Chief Financial Officer